A New Approach to Exchange Rate Management in Small Open Financially Integrated Economies

This paper was prepared for the Handbook of Small States - Economic, Social and Environmental Issues (Routledge 2018), edited by Lino Briguglio of the University of Malta. You can also access this publication on The Social Sciences Research Network.

We propose an integrated fiscal and monetary approach to economic stabilisation policy in small open financially integrated economies (SOFIEs), using fiscal policy to achieve external balance at a targeted exchange rate. This approach overcomes the conundrum of the conventional Mundell-Fleming view in today’s world of international financial integration, where capital controls do not insulate the small domestic economy, and where local authorities cannot be indifferent to the volatility of the exchange rate of local currency, and the potential harm to savings, investment, capital flight and domestic financial stability. In today’s world, the standard prescription of flexible exchange rates and independent monetary control targeting inflation presents challenges with which SOFIEs have struggled, with little success. We describe the framework for an alternative which suits the circumstances of SOFIEs.

Small open economies like those of the Caribbean struggle to avoid large devaluations of their currencies, which erode domestic living standards and are a disincentive to potential investors. The key to effectively managing the exchange rate is maintaining an adequate store of foreign reserves at the central bank at all times, with which the bank can defend the rate. In a chapter of the newly-published Handbook of small states, Professor Winston Moore of UWI, Jamila Beckles of the Central Bank of Barbados and I, show how central bank’s foreign reserves can be maintained at adequate levels in all circumstances, with the use of tax measures and adjustments of government expenditure.

Our chapter, entitled “A new approach to exchange rate management in small open financially integrated economies”, explains why small states get no benefit from a devaluation. Devaluation does not increase earnings of foreign exchange, because the prices of the goods and services small countries export are denominated in US dollars, not in local currency. Nor does devaluation have any significant effect on production for local use, because there are few local products that can be produced locally, even at higher local currency prices. What is certain is that with devaluation all imported goods become less affordable.

We provide evidence to show that countries prefer to link their currencies to the US dollar, or, for small European countries, the euro. Our analysis also indicates that countries that have been more successful in managing the exchange rate have achieved higher living standards than those that have not.

The Handbook of small states – economic, environmental and social aspects, is edited by Professor Lino Briguglio of the University of Malta, and published by Routledge. The economics sections include chapters dealing with trade, finance and regulatory frameworks, while the social theme covers health, migration, population ageing, as well as overall social wellbeing. The environmental theme examines matters such as measuring environmental performance, natural disasters, the ocean economy, and the validity of the Sustainable Development Goals. All the book’s chapters draw practical policy implications from the analysis.

A description of the Handbook may be found on the Routledge website, where an electronic copy may be purchased for US$48.56.

DeLisle Worrell

May 21, 2018