Exchange rate realignments and realignment expectations

One view of exchange rate realignments is that they undermine the credibility of a fixed exchange rate by creating expectations of further realignments. This paper presents an alternative model where the private sector attaches a higher probability to a realignment when there is spare capacity in the economy. The model shows that a realignment can enhance the credibility of the fixed rate by reducing the level of spare capacity. However, it is also shown that if realignment expectations are formed in this way, a fixed rate system may seriously destabilise the economy.