We saw in the last chapter that the avoidance of persistent real exchange rate misalignment should be an important macroeconomic objective for emerging economies. The most important policy decision that a country can make in pursuit of this objective concerns the management of the nominal exchange rate. And in managing the nominal exchange rate, the most fundamental decision that has to be made is the choice of exchange rate regime.

The considerations that govern the choice of exchange rate regime are subject to influence by the surrounding economic environment. In the context of emerging economies, an important factor influencing this choice is financial reform. As we saw in Chapter 15, capital account liberalization, in particular, is likely to interact with technological and institutional developments in industrial countries to create a much greater degree of financial integration with world capital markets among emerging economies that open up their capital accounts and have solvent public sectors under current circumstances than has been true in the past. This development has important implications for macroeconomic management in such countries, not least because the well-known “impossible trinity” of open-economy macroeconomics implies that perfect international capital mobility, monetary autonomy, and an officially determined exchange rate cannot coexist. The implication is that capital account liberalization may place restrictions on the types of exchange rate arrangements that are feasible for emerging economies.

This chapter will explore these issues, and review arguments for alternative exchange rate arrangements in emerging economies under conditions of high capital mobility.