H.-L. Han International Review of Economics and Finance 9 2000 323–350 325
first set of results includes a vector autoregression VAR, variance decomposition, and impulse-response function analysis. The second set of results includes the test for
cointegration and the estimation of cointegrating vector for the group of currencies. Section 6 is the concluding remarks.
2. Literature review
Most of the literature relating to the choice of exchange rate arrangements is cast in terms of a dichotomy between fixed and flexible exchange rates. In practice, however,
systems of rigidly fixed or perfectly flexible rates are hardly ever observed. Different types of exchange rates arrangements may be appropriate for different countries, de-
pending on their structural characteristics, external environments, and macroeconomic and political circumstances. Moreover, as structural characteristics, external environ-
ments, or macroeconomic and political circumstances change over time, market pres- sures on exchange rates may sometimes become so overwhelming that they essentially
force changes in the exchange rate arrangements like what happened in Thailand.
Discussions of optimal currency arrangements have changed considerably over the past half-century. The debate over fixed versus flexible exchange rates around 1960
centered on the issue of whether international capital flows would be stabilized under flexible rates Friedman, 1953. A new school of thought emerged in 1960s, analyzing
the types of structural characteristics that made it optimal for a country to choose one type of arrangement over the other Mundell, 1969; McKinnon, 1963; Kenen,
1969. These studies focused on a number of relevant structural characteristics of economies, including size and openness, diversity of production activities and occupa-
tional skills, geographic factor mobility, fiscal redistribution mechanisms, policy prefer- ences, wage and price flexibility, exposure to shocks, and level of financial develop-
ment. Mundell also led the analysis of optimal currency areas. He defined an optimal currency area as “a domain within which exchange rates are fixed,” rather than an
area with a single currency.
The conventional wisdom in the 1970s was that the currencies of developed countries should float but the currencies of less-developed countries LDCs should not. With the
advent of generalized floating, both Malaysia and Singapore allowed their currencies to float until both countries decided in 1975 to peg their currencies to baskets of currencies
of their trading partners. Korea and Thailand initially pegged their currencies to the U.S. dollar, but later switched to pegging their currencies to basket composites after
a major devaluation of the nominal exchange rates. Korea switched from the dollar peg to the composite peg in 1980 following a 20-percent devaluation, while Thailand
adopted the basket pegging arrangement after a devaluation in 1985. The Philippines officially adopted the U.S. dollar peg system, while making several adjustments to
the nominal parity through a series of devaluations Gan, 1994.
Analysis of optimal exchange rate arrangements in the 1980s and 1990s was extended largely in association with deliberations over the move toward monetary integration
in Europe. It has emphasized issues such as the adverse effects of exchange rate uncertainty, the credibility of monetary policy, the option value of an inflation tax,
326 H.-L. Han International Review of Economics and Finance 9 2000 323–350
the scope for international policy cooperation, and the endogeneity of factor mobility or other structural characteristics Edison Melvin, 1990. By the mid-1980s, the
policy-making community actively discussed proposals for replacing the system of flexible exchange rates among major currencies with a system of target zones Krug-
man, 1991. A “target zone” is an arrangement with wide margins around an adjustable set of exchange rates. In early 1990s, the theory of optimal currency areas was to
consider various practical issues associated with the move toward monetary integration in Europe Bayoumi, 1994.
More recently, the study on exchange rate regimes is linked with financial fragility and macroeconomic policies. Chang and Velasco 1997 found that a currency board
cannot implement a socially optimal allocation. In addition, bank runs are possible under a currency board. They also found that a fixed exchange rate system may
implement a social optimum but is more prone to bank runs and exchange rate crises than a currency board. However, they found that a flexible exchange rate system
implements the social optimum and eliminates runs, provided the exchange rate and central bank lending policies are appropriately designed.
The focus of this paper is to search for explanations for the 1997 Asian foreign exchange market crises. Therefore, only the currency basket arrangement that has been
adopted by most of the Southeast Asian countries is studied here. One explanation is that the choices of weights to determine basket composites of these countries may
not be adequate to deter speculators from attacking these Southeast Asian currencies. For example, the top priority of the central bank of Thailand for the period of 1985
to 1997 has been to hold the baht stable against a basket of currencies dominated by the U.S. dollar. The policy helped to cut inflationary expectations in Thailand and
made it one of the world’s fastest-growing economies, but also created a huge current account deficit. The inter-relationship between currency basket weights, overall trade
balances, and price level will be analyzed in our model.
3. The basic model
