The exchange rate in Papua New Guinea - getting it right

Abstract

This paper provides new theoretical discussion and empirical evidence on the controversial issue of the choice of exchange rate regime in Papua New Guinea. It is motivated by the theory of optimal currency areas which argues that the appropriate domain for a single currency for two or more regions depends on the extent to which the regions share common external shocks. An error-components model is used to examine empirically to what extent Papua New Guinea shares common external shocks with its major trading partner, Australia. The econometric results suggest that industry-specific disturbances common to both countries play a dominant role in explaining the variations of sectoral output growth rates in Australia and Papua New Guinea. It is argued that there may be a case for a currency board arrangement in Papua New Guinea with a fix to the Australian dollar, both as a short-term and medium-term strategy. Show more