Economic Models - Convex Optimization

176 Fabrizio Iacone and Renzo Orsi
replaced the monetary anchor by introducing a direct inflation target (Czech
Republic starting in 1998, Poland in 1999). The progressive weakening of
the exchange rate commitment took place in Hungary and Slovakia too, but
in these last two countries, the switch of targets was not complete: Hungary
retained a fixed exchange rate commitment, albeit with a very wide band,
while Slovakia did not implement an explicit inflation targeting because of
the high role that administrated prices still had in the consumer prices. Anyway
this is not an unanimous attitude: the three Baltic States kept a fixed
exchange rate with an extremely tight band, apparently trying to exploit the
credibility acquired with it during the first phase of the transition, and Estonia
even withstood a moderate speculative attack rather than devaluating.
Once again, Slovenia went in the opposite direction: according to Capriolo
and Lavraac, a more aggressive exchange rate strategy has been pursued
since 2001, with an active, albeit informal, crawling peg.
2.2. Exchange Rate and Direct Inflation Targeting
The fixed exchange rate played a key role in the stabilization phase; nowadays,
it is still the reference of monetary policy in the Baltic States, and it is
also present in Hungary. Since, the exchange rate commitment is also part of
the Maastricht criteria, where two years of participation to the exchange rate
mechanism (ERM) 2 is required, the decision of Poland, Czech Republic,
and Slovakia, to completely abandon it may indeed seem to be a paradox.
Surely, a small country cannot ignore the effect of the exchange rate
fluctuations on the stability of financial institutions and the economy as
a whole, but a commitment to a fixed parity is a much stronger policy.
Whether, macroeconomic stability and inflation control are helped or
hindered by this depends on the credibility of the commitment itself.
There can be little doubt that an exchange rate commitment is a risky
policy: the integration of the financial markets allows the mobilization of
large amounts of funds, and no central bank can muster enough foreign
exchange reserves to resist a sustained attack, nor indeed may desire to do
it, because the mere defence of the currency could require a substantial rise
in the domestic interest rates, for which the economy may be even more
detrimental than the devaluation that it was trying to prevent. Against an
exchange rate commitment, stands the evidence of speculative attacks in
the past: consider, for example, the break up of the ERM 1, when even
the French currency suffered some pressure, although the fiscal, financial,
and macroeconomic situation of the country was not worse than it was
in Germany. The same lesson can indeed be derived by looking at the