Abstract
Should exchange rate regime classifications be based purely on some measure of exchange rate flexibility, or should such flexibility be judged in proportion to the degree of exchange market pressure (EMP), as reflected in the behaviour of international reserves? Some authors have claimed that the best approach to classifying exchange rate regimes is to estimate to what extent EMP is absorbed in reserve variability rather than exchange rate variability. Empirical evidence is presented on the variability of reserves and exchange rates for 193 countries from 1980 to 2019. Pegged regimes do not display any more reserve volatility than floats. In most regimes there is a small but statistically significant positive correlation between reserve accumulation and exchange rate appreciation in monthly data, but this effect is no stronger in less flexible regimes, where intervention is expected to be greater. A flexibility index is constructed, based on the ratio of exchange rate flexibility to reserve volatility, and is compared to one based solely on exchange rate flexibility by investigating its conformity with the IMF de facto classification. The flexibility index that takes reserves into account does not improve the identification of pegs, but it helps to a limited extent to distinguish free floats from managed floats.
Highlights
Exchange rate classification schemes are usually based exclusively on the behaviour of the exchange rate, at least in distinguishing some form of peg or band from a float (e.g. Bleaney and Tian 2017; Ilzetzki et al 2017; Shambaugh 2004; see Tavlas et al 2008, for a survey)
Frankel and Wei (2008, p. 7) condemn “...the folly of judging a country’s exchange rate regime by looking at variation in the exchange rate” and they go on to say: “One must focus on exchange rate variability relative to reserve variability to gauge where a country sits on the spectrum of fixed to floating.”
The argument that exchange rate classifications should be based on exchange rate flexibility relative to reserve variability has a natural appeal, because it captures to what degree the exchange rate is being managed by intervention
Summary
Exchange rate classification schemes are usually based exclusively on the behaviour of the exchange rate, at least in distinguishing some form of peg or band from a (possibly managed) float (e.g. Bleaney and Tian 2017; Ilzetzki et al 2017; Shambaugh 2004; see Tavlas et al 2008, for a survey). Exchange market pressure in its most basic form is measured as the sum of the percentage exchange rate appreciation (usually relative to the US dollar) and the percentage increase in international reserves. If reserve volatility were not higher under pegs, the observation that pegs tend to have a lower ratio of exchange rate flexibility to reserve volatility would derive entirely from the exchange rate element, and observers would be justified in ignoring reserve volatility in identifying pegs This issue has not usually been explicitly addressed; instead, proponents of particular classification schemes have tended to answer it only implicitly, by either taking some account of reserve volatility or ignoring it completely in defining a peg (see Tavlas et al 2008, for a survey).
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