The Choice of Exchange Rate Regime and Speculative Attacks

We develop a framework for studying the choice of exchange rate regime in an open economy where the local currency is vulnerable to speculative attacks. The optimal regime is determined by a policymaker who trades off the loss from nominal exchange rate uncertainty, against the cost of maintaining a given regime. This cost is affected in turn by the likelihood of a speculative attack. Searching for the optimal regime within the class of exchange rate bands, we show that the optimal regime is either a peg (a zero-width band), a free float (an infinite-width band), or a non degenerate finite width band. In the latter case, the exchange rate is allowed to move freely only within a band set around some center rate. We examine the determinants of the optimal band width and show, among other things, that, ceteris paribus, lower costs of moving across currencies induce policymakers to set more flexible exchange rate systems. This lowers, in turn, the likelihood of financial crises. More generally the framework of the paper can be used to shed new light on the recent world wide trend towards a bipolar system of exchange rate arrangements