On the relevance of floating exchange rate policies by Alexandre B. Cunha

I study the relevance of the composition of the public debt between domestic and foreign liabilities in a standard stochastic small open-economy framework. The government issues nominal bonds of several maturities with noncontingent face value at redemption. Intervening in the exchange market to implement an adequate state-contingent path for the nominal exchange rate is an effective way for the government to prevent the economy from reaching any competitive equilibrium it wishes to rule out. Most sterilized interventions are not neutral; however, few of them are. As a consequence, the composition in question is undetermined. Hence, a floating regime may decentralize every competitive outcome, even one induced by a pegging policy. Conversely, outcomes brought forth by a floating regime can also be induced by a policy that prescribes active government intervention in the foreign currency market. Moreover, an open-market operation can be replaced by an equivalent combination of an exchange intervention plus a restructuring of the domestic debt maturity. Introducing in the model strategic behavior by the government combined with asymmetric information or lack of commitment can remove that indeterminacy. Hence, these factors seem to be the major determinants of a possible relation between floating exchange rate policies and economic outcomes