Working Paper: NBER ID: w3727
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. Thanks to the predominance of a few agricultural products and natural resources in their exports, CFA member countries have suffered frequent shocks in their terms of trade. A flexible exchange rate could have possibly alleviated the costs of these external shocks. On the other hand, CFA member countries have managed to maintain lower inflation levels than their neighbors. 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. Nonetheless, 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 tradeoffs, the output costs of maintaining a fixed exchange rate have outweighed the benefits of lower inflation.
Keywords: exchange rates; CFA franc zone; inflation; economic performance
JEL Codes: F31; F33
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 rates in CFA countries (E31) |
| time-consistency problem in discretionary macroeconomic policy (E61) | inflation differential (E31) |
| fixed exchange rates (F31) | economic variability (E39) |
| fixed exchange rates (F31) | output costs (D24) |
| output costs (D24) | outweigh benefits of lower inflation (E31) |