In an open and deregulated economic environment, exchange rates can play an important role in macroeconomic management for stability and growth. The increasing role of exchange rates since the early 1970s has indeed been a break from the Bretton Woods tradition of the 1950s and 1960s that assigned a limited role for exchange rates in economic affairs. However, the banking and currency crises of the 1990s that afflicted many developing countries in different regions have provided a somber lesson that in a global economic setting, exchange rate policy, and monetary and financial policy more broadly, cannot be treated in a business as usual fashion. This is more so for countries, which have underdeveloped financial systems, poor governance but open capital accounts. The stake is indeed high because the way an emerging market economy conducts its exchange rate policy does have a profound impact on its current and future macroeconomic performance. As the experiences of various countries in Asia, Africa and Latin America suggest, economic, social and political costs of mis-aligned real exchange rates, policy-induced or structural, could be formidable (Edwards, 1989; Ghosh, Lane, Schulze-Ghattas, Bulir, Hamann and Mourmouras, 2002). Therefore, it becomes a vital policy issue to choose an exchange rate system that is compatible with a developing economy's characteristics and needs. I. Exchange Rate Policy and Exchange Rate Management
In the simplest sense, exchange rate policy addresses the management of rates at which the domestic currency is converted to another currency(ies) by a public agency such as a central bank. These rates can be converted at a fixed rate or a floating(changing) rate. Exchange rate policy is managed in one of two ways: through a fixed rate or through
a floating rate.
Management, under a floating exchange rate system, can be defined in a broad sense to include both direct intervention by the public agency in foreign exchange markets and changes in interest rates (monetary policy instrument). Thus, exchange rate policy remains closely related to monetary policy and could be synonymous with it depending on the country's exchange rate arrangements. For example, when the authorities of a country adopt a fixed or pegged exchange rate system, they lose control over monetary policy, provided that there is perfect capital mobility. In practical sense, this means that the domestic currency interest rate (id) equals the foreign currency interest rate (if) plus any country risk premium (r ) on holding domestic currency assets. This relationship follows the uncovered interest rate parity condition: id = if + r + d , where d is expected rate of depreciation of the domestic currency.1 Under a fixed exchange rate system that is credible, d is zero and, if there is no country risk premium, id equals if . It is only when the exchange rate floats independently, the central bank gains control over monetary policy, in the sense that it can set the domestic currency interest rate irrespective of the foreign currency interest rate. However, the above formula (the uncovered interest rate parity condition) suggests that, at equilibrium, the domestic currency interest rate would deviate from the foreign currency interest rate to the extent measured by r + d , where d can be approximated by the inflation differential between the home and foreign countries. Therefore, given foreign inflation and domestic risk premium, the concept of independent monetary policy, meaning the ability to set the domestic interest or inflation rate, makes sense when the exchange rate is floating. By definition, under a fixed or pegged exchange rate system, the nominal exchange rate remains fixed. However, one measure of the real exchange rate (defined below) would show that the real exchange rate can change under this system...