Exchange rate policy in the Pacific: an evaluation of currency basket regimes.

Abstract

The Pacific island countries have opted for exchange rate regimes with varying degrees of flexibility. Whereas several microstates have adopted an external currency as their legal tender, others have decided to use a basket currency, and yet others have chosen a managed float. The choice of exchange rate regime can have far reaching economic consequences. In the paper, we study the basket currency arrangements by Fiji, Samoa, the Solomon Islands, and Tonga.We first build a new four-country exchange rate model that illustrates how monetary authorities should best determine the weights of the basket currencies given certainmacroeconomic objective functions. In this model, we explicitly include tourism flows. In the second part of the paper, we estimate the de facto weights of foreign currencies in the currency basket of the four countries. We show how the composition has changed amid the global financial crisis. Finally, we demonstrate that the current weights are not optimal compared with the predictions of our model.