New Political Economy Of Exchange Rate Regime Choice

When there is an interest inhomogeneity between a policy-maker and the public, and if the society can not restrict the choice of the policy-maker effectively, the policy-maker is inclined to maximize its own interests by inflationary monetary policy. If the public realizes this trait of policy-maker's behavior, they will expect the inflation in the future will be very high, thus the economy will eventually equilibrate at high inflation and high inflation expectation. This is similar to the result of non-cooperative game. Under this condition, not only the policy-maker's welfare is reduced, but also the public's. This paper argues that the policy-maker can restrict its own policy choice by choosing fixed exchange rate regime, this restriction can be regarded as a punishment mechanism when policy-maker resorts to the high inflation policy to maximize its own interests. If the public realize the validity of this punishment mechanism, they will lower its inflation expectation, and the policy-maker will choose low inflation. This equilibrium under fixed exchange rate regime is similar to the result of cooperative game. It can not only improve the welfare of policy-maker, but also improve the welfare of the public. As the inflation expectation is variable, the public's expectation is an additional restriction to the policy-maker's choice. With these two restrictions, the policy-maker will choose inflation lower than that under fixed exchange rate regime. This result is named as reputation equilibrium in the paper. Although the fixed exchange rate regime can reduce inflation effectively and at the same time improve the policy-maker and the public's welfare, it has its own disadvantage. When there is time lag of monetary policy, the policy-maker will make high and unexpected inflation in the later part of his term, and the policy-maker will reduce inflation to establish its low-inflation reputation at the beginning of his term of office. This phenomenon is considered as Political Business Cycle.