As can be seen from Chart 1, throughout that year markets expected the Real to depreciate as evidenced by the fact that the implied forward exchange rate was lower than the spot rate by more than the crawl would imply.11 In order to defend the crawling peg, the central bank raised interest rates in September 1998 from 20% to 40% a year. The implied forward exchange rate promptly fell. Raising interest rates actually increased the expectation that the peg would be abandoned, since markets knew that high interest rates were likely to prove politically unsustainable. Any government prepared to keep interest rates that high was not likely to win re-election. In January 1999 a second speculative attack on the peg occurred. And this time the peg was abandoned. Although short-term interest rates were raised  8  Svensson (2003) takes a view that is related to the argument here. In his opinion, commitment to ‘targeting rules’ objectives that the central bank must pursue - are workable, while commitment to ‘instrument rules’ - reaction functions - are not, since it is “impossible” that “every conceivable contingency be anticipated” [p439]. 9  This is cited in David Dewey (1918), page 68. 10  The costs and benefits of discretion in a world where we cannot describe future possible states of the world are set out in Philippe Aghion and Patrick Bolton (2002). 11  The forward rate was below the spot rate even allowing for the devaluation implied by the crawling peg.
First, they expand the possibility frontier of the technology of collective decisions and can be designed to raise the cost of those decisions deviating from pre-announced contingent paths. Second, they are set up explicitly to exercise a degree of discretion - “constrained discretion” - subject to the broad objective of price stability. Discretion is inevitable because of the need to learn about the economic environment. Institutions thereby become repositories of experience and knowledge which they communicate to society as a whole. III. Case Study I: Exchange rate regimes in Brazil and the UK  I want to illustrate the importance of institutions and the credibility of their stability by three case studies. My first example concerns the collapse of exchange rate regimes in Europe and Latin America. It demonstrates that economic institutions require a broad base of political support if financial markets are to believe that those institutions are likely to survive. For a while fixed exchange rate regimes enjoyed a degree of support in both Europe, with the Exchange Rate Mechanism (ERM), and Latin America. But experience shows that, in terms of credibility in financial markets, the design of those policy regimes was less important than the fact of their having broad political support. Brazil in 1998-99 is a case in point. In 1998 Brazil operated a crawling peg exchange rate regime.