Optimal and Sustainable Exchange Rate Regimes: A Two-Country Game-Theoretic Approach

This paper attempts to identify optimal and sustainable exchange rate regimes in a world economy comprising two countries. By developing a Barro-Gordon two-country macroeconomic model, noncooperative equilibria are obtained under different assumptions of monetary policy commitments and different exchange rate regimes. Then, using a three-stage game approach to the strategic choice of monetary policy instruments, optimal and sustainable exchange rate regimes are identified. Determining such regimes depends fundamentally on the authorities' ability to make monetary policy commitments. The results indicate that international coordination of regime choice may be necessary to ensure optimal outcomes.