Working Paper: CEPR ID: DP561
Authors: Shantayanan Devarajan; Dani Rodrik
Abstract: We develop a simple formal framework to clarify the trade-offs involved in the choice between a fixed and flexible exchange-rate system. We then apply the framework to the CFA Zone countries in Africa, which have maintained a fixed parity with the French franc since independence. The predominance of a few agricultural products and natural resources in their exports has meant that CFA member countries have suffered frequent shocks in their terms of trade. A flexible exchange rate might have alleviated the cost of these external shocks. On the other hand, CFA member countries have managed to maintain lower inflation levels than their neighbours. Our framework provides a way of weighing these costs and benefits. The inflation differential between CFA and non-CFA African countries has been around 14 percentage points. We attribute this differential to the standard time-consistency problem inherent in discretionary macroeconomic policy. None the less, our highly stylized calculations suggest that fixed exchange rates have been, on the whole, a bad bargain for the CFA member countries. Under `reasonable' output-inflation trade offs, these countries would have been better off having the flexibility to adjust to external shocks.
Keywords: exchange rates; CFA zone
JEL Codes: F31; 011; 055
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| fixed exchange rate regime (F33) | lower inflation levels (E31) |
| fixed exchange rate regime (F33) | reduced output during external shocks (F41) |
| fixed exchange rate regime (F33) | costs outweigh benefits (D61) |
| lower inflation levels (E31) | better economic performance (P17) |
| reduced output during external shocks (F41) | worse economic performance (P17) |