Real-world currency calibration: modelling fixed exchange rates
Document ID: 2010-1649
Published on: 20th January 2010
The optimal choice of exchange rate regime is among the perennially debated issues in international economics. Exchange rate flexibility leads to efficient outcomes in the presence of sticky prices . Friedman (1953) and Mundell (1961) contain a more thorough discussion of advantages of a floating exchange rate. However, we believe that there is no single exchange rate regime that is suitable to all economies at all times. Whatever regime is adopted, it must fit consistently into the overall framework of macroeconomic policy.
In our ESG models, we currently do not distinguish between floating and fixed exchange rates. Exchange rates are modelled assuming that Purchasing Power Parity (PPP) or Uncovered Interest Rate Parity (UIRP) holds. These models assume a freely floating exchange rate. This note has two purposes.
First, we outline a new model for fixed or managed exchange rates. In the latter case, the currency board has an established target zone. We illustrate how the exchange rate model works using the HKD/USD exchange rate as an example. The fixed exchange rate model is proposed by Hui and Fong (2007).
This model is currently not implemented in the ESG, contact Barrie & Hibbert if you are interested in this model. The second part of this paper discusses a number of alternative ways that can be used in the current set up of our ESG models to model a fixed exchange rate.
We illustrate how the fixed exchange rate model works with the HKD/USD as an example.
