CREDIBILITY AND EXCHANGE-RATE MANAGEMENT IN DEVELOPING-COUNTRIES

The paper discusses the role of credibility factors in the conduct of exchange rate policy in developing countries. The analysis is based on a simple framework in which policymakers are concerned about inflation and external competitiveness. Price setters in the nontradable sector of the economy engage in a strategic game against the authorities. The model generates a 'devaluation bias' which undermines the credibility of a fixed exchange rate. The role of reputational factors, signaling considerations, and joining a currency union as possible solutions to this bias is examined.