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This study examines the relationship between the foreign exchange regime and macroeconomic performance in Eastern Africa. The study focuses on seven countries, five of which decisively liberalized their foreign exchange regimes. The study assesses the relationship between (i) growth and various determinants, including the exchange regime, the real exchange rate, and current account liberalization; and (ii) inflation and various determinants, including lagged inflation, the nominal exchange rate, the exchange regime, and liberalization. We find that in our sample, for the determinants of growth, investment and the real exchange rate are significant determinants but not the exchange regime or liberalization; and for inflation, the lagged inflation rate, nominal exchange rate, and the de facto regime are significant. Exchange rate pass-through is limited.

The effect of the exchange rate regime on inflation and growth is examined. The 30-year data set includes over 100 countries and nine regime types. Pegged regimes are associated with lower inflation than intermediate or flexible regimes. This anti-inflationary benefit reflects lower money supply growth (a discipline effect) and higher money demand growth (a credibility effect). Output growth does not vary significantly across regimes: Countries with pegged regimes invest more and are more open to international trade than those with flexible rates, but they experience lower residual productivity growth. Output and employment are more variable under pegged rates than under flexible rates.

This paper argues that, in improving the efficient allocation of resources, financial sector development could dampen the appreciation effect of capital inflows. Using dynamic panel data techniques, the paper finds that the exchange rate appreciation effect of FDI inflows is indeed attenuated when financial and capital markets are larger and more active. The main implication of these results is that one of the main dangers associated with large capital inflows in emerging markets-the destabilization of macroeconomic management due to a sizeable appreciation of the real exchange rate-can be mitigated partly by developing a deep financial sector.

What determines the currency to which countries peg or \"anchor\" their exchange rate? Data for over 100 countries between 1980 and 1998 reveal that trade network externalities are a key determinant. This implies that anchor currency choice may well be suboptimal in that certain currencies, e.g., the U.S. dollar, could be oversubscribed. It also implies that changes in anchor choices by a small number of countries can have large and rapid effects on the international monetary system. Other factors found to be related to anchor choice include the symmetry of output shocks and the currency denomination of liabilities.