The Optimal Choice of Exchange Rate Regime for Jordanian Dinar

(ProQuest: ... denotes formulae omitted.)1.IntroductionShortly after Bretton-Woods System of adjustable fixed exchange rate fall down, on 15 August 1971, many exchange regimes spread in the developing countries. Some tended to peg the domestic currency to the SDR, or to a basket of currencies of major trading partners. Other countries adopted a form of partial or administrated floating exchange rate system. The decision of selecting a certain exchange rate system is affected by openness level, diversification, and availability of international reserves. The concern of a country was to stabilize its currency exchange rate against currencies of its major trading partners for the purpose of creating stability in domestic prices.Choosing the appropriate exchange rate system has become a vital issue for Jordanian economy, considering the increasing number of countries integrated into the international money market at the present time. Initially, choosing the exchange rate regime was based on the criteria of the Optimum Currency Area (OCA). And whether to adopt a fixed or a flexible exchange rate depends on factor mobility (Mundell, 1961), economic openness (McKinnon, 1963), economic diversification (Kenen, 1969), and cost/benefit (Woods, 1973).More recently, Stockman (1999), Yagci (2001), and Hammond and Rummel (2005) indicate that choosing an exchange rate system depends on various considerations, including: size of the economy, openness, production diversification, deviation of inflation from the level of inflation of main trading partners, labor and capital mobility, shocks, and flexibility of the financial policy.This study attempts to find out the best exchange rate pegging regime for the JD in order to create stability against currencies of its major trading partners, ensure stability in the domestic prices level, protect against the rise of the cost of imports, and minimize the Jordanian foreign debt.This paper is organized as follows: in Section 2, gives a brief overview of different considerations in selecting the exchange rate system. In Section 3, we present the different pegging regimes and their advantages and disadvantages. In Section 4, we discuss the optimal exchange rate system for the JD. Section 5 describes the data and the used methodology. Section 6 concludes the paper.2.Considerations in selecting the exchange rate systemTypically, choosing the exchange rate system is influenced by macroeconomic conditions of each country and nature of the shocks to which it is exposed. Domestic shocks require an exchange rate system different from the external one.Countries are advised to adopt a fixed exchange rate system to ensure greater stability in the domestic price levels if its economy is characterized by being small, open with less diversified production and exports structure and more dependent on foreign trade. The fixed exchange rate is considered a more attractive option for countries with a small variation in the inflation rate and development scale, compared to their trading partners. According to Mundell (1961) this alternative is appropriate when there is a high degree of labor mobility. On the other hand, a large economy that is less open, and more diversified in production and exports structure with capital mobility is advised to adopt flexible exchange rates (IMF, World Economic Outlook, 1997). The IMFu0027s annual report on (2000) indicates that pegging to a single currency system is not the best choice for all the countries under all conditions, and flexible exchange rates may be more suitable under globalization. Taking this in mind, many emerging market countries adopted flexible exchange rate systems for better adjustment to economic conditions, inflation, and objects of the monetary policy (IMF, Annual Report, 2000). Few economies with a large volume of trade adopt fixed exchange rate (Rose, 2011). In addition, pegging exchange rates offered slight advantages to emerging markets in terms of either inflation or growth performance, since such systems are associated with a larger probability of currency and financial disorders (Ghosh and Ostry, 2009). …