The mobility of international capital flows is causing emerging market nations to choose between a free-floating currency exchange regime and a currency board (or taken to the limit, dollarization)
Describe how each of the regimes would work and identify at least two likely economic results for each regime.
What will be an ideal response?
Answer: With free float the exchange rate is market determined and beyond the control of the country's central bank or government. The economic results are likely to be an independent monetary policy, free movement of capital, but less stability in the exchange rate. Such instability may be more than an emerging market country's small financial market can bear. A currency board on the other hand is an implied legislative commitment to fix the foreign exchange rate with a specific currency, generally the country's major trading partner. Dollarization is taking this policy to the extreme whereby the emerging market nation forgoes its currency for that of its major trading partner. An example of Dollarization is Panama using U.S. dollars as the official Panamanian currency. With such a regime, independent monetary policy is lost and political influence on monetary policy is eliminated. However, the benefits accruing to countries as a result of the ability to print its own money, seignorage, is lost.
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