| The departing point for this dissertation is an empirical regularity: the tremendous volatility among the world's three major currencies (dollar, euro, yen) in the past three decades. I address two major issues, a positive and a normative one. First, how does this volatility affect small open economies around the globe? Second, what is, then, the optimal way for these economies to manage their currencies, given the imperfections and incompleteness which typically afflict their financial markets?; Chapter 1 offers an empirical investigation of the effects of G-3 currency volatility on small open economies in East Asia and Eastern Europe, two regions lying on the fault lines among the three major currencies. I use statistical tests, a linear regression model, and a VAR model to make two points. First, the choice of a major currency as an exchange rate anchor matters for the volatility of domestic prices and output. Second, G-3 currency volatility affects significantly domestic business cycles in both East Asia and Eastern Europe.; Chapter 2 investigates theoretically the optimal way for small economies to manage their currencies given international monetary instability and given imperfect and incomplete domestic financial markets. I build a dynamic sticky-price macro model which updates an older literature on the optimal basket peg and merges it with a current literature on credit market imperfections and balance sheet effects. The model's policy recommendation is that small East Asian economies should continue keying on the dollar, not only because the bulk of their trade is invoiced in dollars, but also because most of their foreign debt is dollar-denominated and unhedged.; Chapter 3 builds a micro-economic hedging model to illustrate the interaction between the exchange rate regime and the risk management problem of foreign currency debtors in an East Asian emerging economy exposed to yen-dollar volatility. Because both merchants and capital account debtors face an incomplete menu of hedging facilities, a dollar peg makes it easier for them to manage exchange rate risk. Dollar debtors, who are in the majority, will choose not to hedge. Yen debtors can resort to the well-developed yen-dollar forward market. |
