Exchange Rate Management Regimes

Policy Dilemma in a Small Open Economy

Economic Adjustment to an External Shock

A country that has historically struggled with high inflation decides to implement a fixed exchange rate regime to stabilize its prices. Soon after, it faces a severe negative shock to external demand for its exports. In this situation, what is the primary macroeconomic cost the country will likely face by maintaining the fixed rate, compared to allowing its currency to float?

For a country with a history of high and volatile inflation, adopting a floating exchange rate regime is generally the most effective first step to anchor inflation expectations and stabilize the domestic price level.