Establishing a new currency and exchange rate determination: the case of Lithuania

The purpose of this paper is to consider the problems which arise when establishing a new institution such as a currency in a newly independent state, in our case Lithuania. After it gained independence and followed it’s own path of economic and political development exchange rate management issues became crucial to the macroeconomic stability of the economy. To this end, Lithuanian experience between 1992- 1995 and a brief overview of the history and current state of the banking and financial system are presented. The paper also addresses the main problems of exchange rate determination in Lithuania. Empirical tests of different models of exchange rate determination are presented: the test of the highly inflationary period prior to currency reform supported the flexible price monetary model, while empirical tests of the currency substitution model provided the best results in explaining currency appreciation after the reform. The analysis provides some insights into the behaviour of the real exchange rate and questions concerning the sustainability of the fixed exchange rate in Lithuania. While the choice of a floating exchange rate regime may be justified in terms of the potential economic benefits, the fixing of the exchange rate through the currency board arrangement may be explained purely by political motivation. As the sustainability of the fixed exchange rate is questionable in the long run, several options for quitting the currency board at the lowest costs are elaborated in the paper.