In this paper we demonstrate that exchange rate regime switching is compatible
with optimal government policies. Nominal exchange-rate regimes are
formalized as equilibrium commitments on future seigniorage policies, and the
collapse of an exchange-rate peg as an excusable default which allows the
government to lump-sum tax private sector money holdings. We demonstrate that
a regime in which the exchange-rate peg is allowed to collapse when government
spending is unusually high is a trigger-strategy equilibrium. Such a regime
can be superior to both fixed and flexible exchange rate because it combines
some of the flexibility of the floating exchange rates with some of the
benefits of precommitment afforded by fixed rates.
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