Exchange Rate Adjustment in Financial Crises∗

In the 1990’s many economists criticized emerging market countries for their unwillingness to allow exchange rates to adjust. The ‘fear of floating’ was seen as severe distortion in the international monetary system, and a hindrance to good macroeconomic policy for these countries. In the worst case, a persistent defence of an exchange rate peg could lead to over -borrowing and precipitate currency and financial crises, as witnessed in Asia in 1997/98. According to Obstfeld and Rogoff, 1995, exchange rate flexibility should be a key part of the macroeconomic adjustment process for open economies with liberalized capital accounts. In recent years, many emerging economies have in fact moved much more towards flexible exchange rate regimes. But the experience with volatile exchange rates has been decidedly mixed. As has long been acknowledged, even in advanced economies, exchange rates tend to overshoot, and wide movements in real exchange rates may in fact exacerbate rather than alleviate the impact of external macroeconomic shocks. For emerging economies, the lesson is the same, only more-so. In many instances, highly volatile