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Authors:

• Leonard K. CHENG
  Hong Kong University of Science and Technology

• Zihui MA
  Remin University, China

In this paper we develop a small open economy model of currency boards that features a banking sector as well as households and firms to study the effects of different exchange rate policies in response to a loss of international competitiveness and speculative pressure for devaluation. If we follow Obstfeld and Rogoff’s approach that all prices are fixed in the short run but fully flexible in the long run, then it is shown that if the exchange rate fails to devalue to fully restore the domestic economy’s international competitiveness, then output, employment, wages, consumption, and the monetary authority’s net foreign reserve position all decline. In contrast, if devaluation fully restores the domestic economy’s international competitiveness without triggering a higher interest rate, then employment, output and all the financial variables remain at the original equilibrium level even in the short run. However, if the interest rate is higher in anticipation of the devaluation, then short run and long run consumption, the wage rate, the monetary authority’s net reserve position will be lower as a result. That is, stabilizing the interest rate is welfare improving. If alternatively we adopt Calvo’s approach that in every period only a fraction of firms are allowed to adjust prices, then we can simulate the model for Hong Kong’s economy during the Asian financial crisis in 1997-98 to determine the effects of different policies in response to the loss in international competitiveness. The simulation results reveal that abandoning the currency board and devaluing the Hong Kong dollar to offset the exogenous loss in in-ternational competitiveness would lead to smaller short run fluctuations of the macro-economy than maintaining the currency board. However, if abandoning the currency board regime is ruled out as a policy option, then stabilizing the interest rate via confidence-boosting measures such as “Hong Kong dollar put options” would be superior to the alternative strategy of defending the exchange rate system with interest rate hikes.