Destabilizing Effects of Exchange-Rate Escape Clauses
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This paper studies policy rules with escape clauses, analyzing as an example fixed exchange
rate systems that allow member countries the freedom to realign in periods of stress. While
well-designed escape-clause rules can raise society's welfare in principle, limited credibility
makes it difficult to implement such rules in practice. An EMS-type institution that imposes
political costs on policymakers who realign may raise welfare, but can also produce
equilibria far inferior to an irrevocably fixed exchange rate. Switches between multiple
equilibria may have the character of sudden speculative attacks.