How much to commit to an exchange rate rule : balancing credibility and flexibility

The purpose of this paper is to identify the factors which determine the strength of commitment that policymakers choose to back up a fixed exchange rate system. In practice the commitment level is achieved by choosing a particular set of monetary and exchange rate arrangements. The authors develop a Barro-Gordon type model in which the policymaker has to decide how much to commit under uncertainty. An important assumption is that the stronger the commitment to the fixed exchange rate the greater the political cost of reneging on it. Thus, prior to deciding on the choice of exchange rate arrangements the policymaker has to weigh the benefits, to the disinflation program, from making a strong commitment against the potential costs of being forced to renege on it. Some of the more technical details are presented in appendices. The paper illustrates the results of the model with examples from Latin American countries and concludes with a comparison of the results of the authors approach with related work.