In this paper the collapse of a bilateral fixed exchange-rate regime is described as the optimizing decision of the two countries' monetary authorities on when to break down the cooperative exchange-rate agreement. In particular, the two countries experience a trade-off between (a) fixing the nominal exchange rate, and therefore losing monetary independence, but having exogenous benefits from the agreement, and (b) letting the nominal exchange rate freely fluctuate so as to isolate the countries from asymmetric shocks on nominal variables. The paper derives the optimal exit decision in a stochastic framework when there are exogenous and irreversible benefits from the fixed exchange-rate regime. As a result, the agreement tends to last longer than it would in a deterministic framework even though big asymmetric shocks hit the two countries. This could well describe why the exchange-rate arrangement among the European countries (i.e. the Exchange Rate Mechanism of the European Monetary System) lasted so long with no realignments after 1987. In particular, the crisis occurred a few years after both German Monetary Unification and the burst of the last European recession.Center for Research on Economic and Social Theory, Department of Economics, University of Michiganhttp://deepblue.lib.umich.edu/bitstream/2027.42/100672/1/ECON145.pd
