For sometime now I have been following the debate on the appropriate exchange rate strategy for Jamaica. If I am not mistaken, this debate has been led primarily by the former Prime Minister of Jamaica and now distinguished fellow at UWI, Edward Seaga. Mr Seaga's main thesis is that of all the nominal anchors available to the finance minister, fixing the exchange rate remains the alternative which is most consistent with overall economic stability and development. While others, for example, Don Robotham, have dismissed this policy prescription as "madness".

The purpose of this article is to examine Mr Seaga's proposal and suggest what I think is the policy prescription the finance minister should adopt. Wherever possible, I will define terms and phrases economists generally take for granted. As a result, the reader well versed in exchange rate economics will find the article a bit boring at times.

The choice of exchange rate strategy has long been a very contentious issue among economists. To be sure, there are several exchange rate policy options available to any government. The corner or extreme solutions are fixed and floating exchange rate regimes. An exchange rate is said to be floating when a government allows market forces or demand and supply factors to determine the price of its currency in relation to another currency. Fixed or pegged exchange rate refers to any system where the government (central bank) announces buying and selling rates for its currency in relation to another currency and importantly, promises to trade in unlimited amounts at that rate.

In practice, corner solutions (fixed or float) are the exception rather than the rule, and what we end up with in the real world are interior solutions or intermediate regimes between fixed and floating. There is the additional complexity of de jure and de facto exchange rate regimes. In other words, what a country announces as the official exchange rate system may be quite different from what it obtain in practice. Perhaps, in a later article we will look at these different systems, however, the purpose of this peace is to address the appropriateness of fixed versus floating exchange rate systems for Jamaica.

Why fix?
The main problem with fixed exchange rate regimes stems primarily from the open economy trilemma in macroeconomics. Without being overly technical, the open economy trilemma refers to the impossibility of having independent monetary policy, capital mobility and fixed exchange all at the same time. In other words, if a country wants to fix its exchange rate, this means it has to sacrifice monetary independence or impose capital controls. Financial markets have become highly integrated and very few governments would contemplate capital controls in this age of financial globalisation. Therefore, to satisfy the trilemma, governments invariably will choose to give up monetary independence.

Given this background, anyone with a cursory understanding of how an open economy operates will readily identify the problem with fixing the exchange rate. Consider a country that has suffered an adverse terms of trade shock. This is a serious problem even if the country were operating a floating exchange rate system. However, the potential problems are magnified with a fixed exchange rate. If we take for granted that nominal prices (and wages) are sticky downwards in the short run, employment and output must fall locally to correct the external imbalance.

The student preparing for her CAPE exam will then ask the question; why can't the government lower interest rates and stimulate demand to curb the possibly recessionary effects outlined above? The answer to this question is embedded in the trilemma pointed out before. If capital is mobile, then the government has to give up monetary independence in order to maintain the fixed exchange rate. To explain further, let's assume that the Jamaican currency is pegged to the U.S$.
Assume further that the government wants to lower interest rates below those offered in the U.S. by increasing the supply of Jamaican dollars. Since there is no currency risk involve, an investor will simply use the additional money supplied by the government to buy U.S$ from the Bank of Jamaica and invest the proceeds abroad at the higher interest rate. The government's decision to increase the local money supply with a view to reduce the domestic interest rates failed because it would have lost an equivalent amount of foreign reserves with no subsequent effects on domestic interest rates.

In sum, fixing the exchange rate is tantamount to having your domestic monetary policy determined by the country to which the domestic currency is pegged. The problem can become quite serious if the business cycles in the two countries are not significantly correlated. Hong Kong, China, Argentina and Lithuania experienced first hand the problem of being pegged to the U.S. dollar during a period of dollar appreciation in the late 1990's.

So, is Mr. Seaga crazy? Why would a country choose to fix in light of these potential problems? I listened to Mr Seaga on a radio talk show sometime ago and in his patented indomitable style, he asked the moderator the following question.

The Caribbean
Why are countries, for example, members of the eastern Caribbean with fixed exchange rates, have had better economic performances than Jamaica over a comparable time period? To be sure, anyone who is willing to shrug off what the former prime minister of Jamaica is suggesting will have to address this question head on.

For example, in the Caribbean, Antigua and Barbuda, Bahamas, Barbados, Dominica, Grenada, St Kitts & Nevis, St Lucia and St Vincent and Grenadines all have pegged exchange rates.

Therefore, the question is not whether fix exchange rates can be effective in small developing economies like Jamaica. Rather, the issue is whether fix exchange rates are optimal for small developing countries. In other words, are the potential risks associated with fixed exchange rates worth taking?

Why not fix?
Perhaps, the main advantages of fixed exchange rate are the imposition of financial discipline and price stability. These advantages increase exponentially for countries that have had a poor record in maintaining price stability. While Jamaica's inflation performance has been improving, there is no doubt that the period of the 1990's still carry some sway in investors' inflationary expectation.

In addition, the fact that the government has a fairly large stock of domestic debt outstanding increases the benefit to the government from inflating the economy. In other words, ceteris paribus, it is in the government's interest to inflate the economy to reduce the real cost of servicing the debt outstanding. Investors know this; therefore, the government may want to signal to the market that it is tying its own hands by committing to a nominal anchor, fixing the exchange rate.
This is one way of making a binding commitment to the market that the debt will not be inflated away. There are other benefits from fixing the exchange rate, however, in the interest of brevity, I will not explore these.

While there are significant advantages from fixing the exchange rate, I do not think this is the optimal solution for Jamaica. I do not like the idea of using an asset price as the nominal anchor. It is well known in financial circles that market expectations play a significant role in the pricing of financial asset. Attempting to fix the exchange rate in a period of changing investor sentiment can be detrimental to the economy. Given that fiscal policy usually affects the economy with a lag, a small open economy needs monetary independence to deal with business cycles and external shocks.

It is true that a fix exchange rate promotes international trade through exchange rate predictability; however, a fix exchange rate does not insulate an economy from the vagaries of the international capital market. Any country will suffer a currency crisis once the international market views the peg as unsustainable.

What about the credibility of government policy which fix exchange rates are said to promote? It is true that a government needs to signal to the market its inflation fighting credentials. However, there are other ways to achieve this credibility with the capital market that do not involve fixing the exchange rate. There are several other nominal anchors the government could use to achieve the credibility objectivity.
For example, the government could explicitly target the inflation rate. This would involve the government signaling to the market its long run target for inflation. The current Federal Reserve chairman has done a lot of work in this area.

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