An important decision in the design of macroeconomic policies in any country is the choice of currency and monetary regime. Not surprisingly, there is an enormous literature on currency and monetary regimes. This chapter sets out a policy menu for East Timor based on this literature, constructed in a way that suits the country's characteristics and needs.

There are two basic decisions to be made in choosing a currency and monetary regime. The first is whether to have a fixed or a flexible exchange rate. The decision to fix or float depends on weighing the advantages of one against the other, and assessing which works in practice. The second decision concerns the detail of the arrangements.

The chapter is structured in the following way. The following section looks at the first decision: whether to fix or to float the exchange rate, and what this means for monetary policy. The third section assesses different types of fixed exchange rate regimes, namely the standard peg, currency board and ‘dollar-ization’. The fourth section looks at which countries would be suitable pegging partners for East Timor. The chapter concludes by offering an assessment.

FIX OR FLOAT?

The first decision in selecting a currency and monetary regime is whether to fix or to float the currency. For a small economy like East Timor, there are two main issues to consider in making this choice.

Which Regime Is More Stabilizing?

The first is to assess the relative merits of having a fixed or flexible exchange rate. This decision ultimately turns on whether an independent exchange rate provides a country with a means to stabilize its economy as the external economic circumstances it faces change. If being able to change the exchange rate helps stabilize the economy, then having a more flexible regime is, in principle, helpful and preferable.