Economic trilemma and exchange rate management in Egypt

Abstract

The recent banking and exchange rate crises in Latin America, East Asia, Eastern Europe and Turkey have proved that a fixed exchange rate is unsustainable in the context of growing financial globalization. The other corner solution advocated by the IMF—the free float—makes economies subject to high fluctuations. Therefore, the main question for most emerging market economies, and particularly for Egypt since January 2003, is what kind of managed float to have. This paper presents a single-equation econometric model approach to define the variables that determined the real exchange rate behavior in Egypt during the 1971–99 period as an indicator of the government's de facto exchange rate policy. The empirical findings confirm that the Egyptian economic policy mix has almost always led to some real exchange rate volatility, which is inconsistent with the fixed exchange rate policy. Therefore, it is believed that the most viable solution for Egypt is the ‘managed bands’ regime around a crawling effective equilibrium central parity, with no pre-announced management bands parameters. This choice will allow Egyptian policy-makers to steer the economy out of the numerous regional and international political and economic shocks.

Keywords:

• Economic trilemma
• exchange rate policies
• ‘managed bands’
• JEL CLASSIFICATIONS: F31
• F36
• F41

Notes

 For further discussion on inflation targeting policy, see Panizza (2002).

 Since the mid-1950s, the IMF has considered the independent float as the optimum exchange rate regime, as noted by Mundell (1997a).

 Bourbonnais (2002).

 Elbadawi (1997) uses this error correction term to calculate the speed of adjustment of the exchange rate towards its long-term equilibrium path.

 A ‘crawling peg’ is an exchange rate adjustment method, which gradually changes the par value of an exchange rate by small amounts. That system allows for large and sometimes chaotic international capital flows and, therefore, requires an adequate accompanying interest rate policy. This necessity, unfortunately, leaves no room for the use of interest rates as instruments of the domestic macroeconomic policy for solving problems such as unemployment induced by balance of payments deficits.