Choosing an Optimal Exchange Rate Regime for Emerging Market Economies*

Mei Dongzhou  and Gong Liutang
Guanghua School of Management, Peking University, Beijing, China

 
Abstract: China and other emerging market economies hold large amounts of US dollar (USD)-denominated assets while their enterprises mainly raise funds from domestic banks. These economies’ currencies are under a constant pressure to appreciate. The authors of this paper apply the model used in Bernanke et al. (1999) to small open economies in order to find out the optimal exchange rate regime for the emerging market economies. Findings indicate that a country’s choice of exchange rate regime is directly associated with its percentage of USD-denominated assets and the strength of the financial accelerator effect. A managed floating rate regime is more desirable than a free floating regime because of its ability to better avoid liquidity traps given appreciation pressure. A managed floating rate regime also outperforms a fixed exchange rate regime because the former tends to cause less welfare loss. These factors make a managed floating rate regime the optimal choice for emerging market economies. Lastly, the authors propose policy steps and suggestions based specifically on China’s current situation.
Key words: US dollar-denominated assets, financial accelerator, exchange rate regime

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