Optimal currency baskets and the third currency phenomenon: exchange rate policy in Southeast Asia

Abstract

Abstract Recent financial crises seem to have led to the broad consensus that developing countries should steer clear of exchange rate regimes that lie anywhere between the two extremes or [corner solutions] of credibly fixed or flexible arrangements. But is this a reasonable position to adopt? Would developing countries be well advised to follow this policy recommendation? Should developing countries opt only for the corner solutions? Did the crisis‐hit South‐east Asian countries (Indonesia, Malaysia, Thialand and Philippines), make a mistake in effectively pegging to the US dollar rather than in pegging per se ? Did pegging to the US dollar constitute a sub‐optimal peg? If it did, what would have been the optimum peg? This paper attempts to provide answers to the preceding questions. The paper also conjectures more broadly about monetary policy in developing countries. Copyright © 2002 John Wiley & Sons, Ltd.