The first step in finding a solution is to agree on the problem. If there is indeed a problem with the upward pressure that capital inflows are causing on the pegged exchange rate, then we need to address it. If none exists, then why fix what ain't broke
Defining the problem is not as simple as it looks, more so since the case details are mum on crucial information like inflation rates, interest rates, balance of trade, our buying power and demographic profile, employment and so on. In the absence of such data, we have to resort to assumptions and predict the worst that can happen. Having foreseen the assumed problems, we proceed to craft elegant solutions that will entrench us in the pantheon of modern-day mandarins adept at slaying the economic dragons threatening our world.
Offhand our exercise looks easy, but it is not, and this judgment has less to do with the dearth of facts than with the basic givens. "A rich East Asian nation with a pegged currency fixed to the US dollar for ten years, supported by monetary policy of tight capital outward flows and unrestricted inflows, is experiencing an upward pressure on the exchange rate." The question remains: what to do now
Deciding on a strategy depends on a clear understanding of the world's monetary system, the role that exchange rates play, how they are determined, and what will happen if we do nothing. As Robert Solomon said (1977, cited in Samuelson, 1992):
The world's monetary system is like the traffic lights in a city, taken for granted until it begins to malfunction and to disrupt people's livesA well-functioning monetary system will facilitate international trade and investment and smooth adaptation to change. A monetary system that functions poorly may not only discourage the development of trade and investment among nations but subject their economies to disruptive shocks when necessary adjustments are prevented or delayed (pp. 1, 7).
What is the worst that can happen and what should we do to prevent it
The World's Monetary System
The world's monetary system refers "to the set of policies, institutions, practices, regulations, and mechanisms that determine the rate at which one currency is exchanged for another" (Shapiro, 1996). It is the coordinated way each nation manages its supply of money so that we can buy and sell each other's goods, doing business by exchanging pieces of paper, the value of which we agree on, called money.
In the recent past (which in East Asia means less than three hundred years ago), each nation was free to decide how much of its currency to circulate to buy goods. This turned out to be unwise because wantonly printing money and giving it artificial value caused absurd price increases, a phenomenon we know now by a word that sends shivers down central bankers' spines: inflation.
Clear and Present Dangers
Inflation is just one danger of being at the wrong end of currency speculators bent on attacking exchange rates that, in our case, may cause a revaluation or strengthening of our currency, the Eck (symbol: X). How did we conclude that speculators are after revaluation and not devaluation (or