Exchange rate and reserve regimes: Theory and the Latin American experience

The theory of nominal exchange rate and reserve regimes is explored and applied to the Latin American case. It is well known that, under certain conditions, the nominal exchange rate policy and the concomitant reserve holding policy which the central bank follows has no effect on consumer welfare, prices, or the equilibrium allocation of goods. Among the conditions necessary for this result are (1) symmetric information sets for all parties and (2) the incorporation by the private sector of future tax liabilities brought about by current increases in government debt. Departing from these assumptions, several ideas are discussed. First it is shown that when a small debtor country and a creditor rest-of-world have asymmetric information sets, the stock of reserves held by the country may serve as a signal to lenders, gain the country better terms in international credit markets, and hence affect the welfare of residents of the economy. This consideration is used to explain observed differences in reserve holding behavior among Latin American countries between the pre- and post- debt crisis periods. Second, the effect which nominal exchange rate policy has on the real exchange rate and the current account is explored. Among Latin countries, it is shown that (1) despite many different nominal exchange rate policies, co-movements of real exchange rates and current accounts are quite similar across country, but (2) during certain episodes nominal exchange rate policies have affected real exchange rates and current account balances. A possible source of exchange rate policy effectiveness, the non-incorporation of future tax liabilities into the current spending plans of the private sector, is examined.