Managing Small Open Economies: Exchange Rate Systems and Real Sector Shocks

Published: 2002

Author: Arthur Grimes

One of the most important macro-economic policy choices facing governments is the choice of a country's exchange rate regime and associated monetary policy objective(s). At one end of the spectrum, a country can choose to have a freely floating exchange rate, with monetary policy designed to achieve some explicitly stated goal. For instance, New Zealand pioneered an approach in which the independent central bank, operating with a floating exchange rate, was charged with maintaining annual inflation within a specified target range at all times.

At the other end of the spectrum, a country can choose not to have an independent monetary and exchange rate policy at all. It can adopt another country's currency as legal tender (as did Panama with the United States dollar) or else negotiate a common currency area, possibly with a federal currency arrangement. A majority of European Union members have agreed to set aside their national currencies (and centuries of monetary histories) to adopt the Euro as a single shared currency from 1 January 2002.

Leaders from Japan, China, Korea and 10 South-East Asian nations, meeting in Manila in November 1999, have adopted a vision for a (distant) future monetary union amongst themselves.

Commentators such as Beddoes (1999) predict that by 2030 the world will have two major currency zones, one European, the other American.

Another recently published study (Grimes, Holmes and Bowden, 2000) argues that New Zealand should seriously consider adopting a currency based either on the Australian dollar or the United States dollar. These trends and commentaries reflect a new-found theoretical and practical enthusiasm for regional currency blocs.

In this paper we examine the potential for three small open developed economies in the Asia-Pacific region - New Zealand, Australia and Singapore - to explore alternative currency and monetary policy arrangements. Each of these three countries currently pursues an independent monetary policy with a flexible exchange rate system. This has benefits, as we itemise in section 2. However it may also have costs; we itemise these in the context of analytical debate over whether flexible exchange rates predominantly provide a "buffer" (or "cushion") against shocks versus a view that they may cause, or at least unnecessarily exacerbate, shocks.

In section 3, we examine a number of data relationships for these countries over the 1980-1998 period. Our emphasis is on the role of the exchange rate in cushioning against terms of trade shocks, but we also examine other cyclical economic shocks as well.

We extend this analysis in section 4 by taking an explicitly dynamic look at the relationship between terms of trade and real exchange rate movements within each of these three countries. Differing monetary policy approaches, both across countries and across time periods, result in different relationships between the two variables under different regimes. In particular, we examine how the pursuit of an inflation targeting regime may alter the dynamic relationship between the exchange rate and the terms of trade.

Brief conclusions are supplied in section 5. These cover the potential of the three countries to embark on currency union with one another and with other countries. They also provide some insights into the effect of inflation targeting on exchange rate behaviour.

This is a chapter in a physical book with no electronic version available.


Grimes, Arthur. 2002. "Managing Small Open Economies: Exchange Rate Systems and Real Sector Shocks" in Globalization and the Asia Pacific Economy, Kyung Tae Lee, Ed. London: Routledge, pp. 226-244.