Testing the Unstable Middle and Two Corners Hypotheses About Exchange Rate Regimes

Abstract

The recent rash of international currency crises has generated considerable interest in role that exchange rate regimes have played in contributing to these crises. Many economists have argued that efforts to operate adjustably pegged exchange rate regimes have been a major contributor to the unstable hypothesis and some have argued that this unstable middle is so broad that only two corners of hard fixes or floating rates will be stable in a world of high capital mobility - two corners or bipolar hypothesis. Two recent empirical studies by researchers at International Monetary Fund reach opposing conclusions on these issues. We examine issue further and show that conclusions can be quite sensitive to how exchange rate regimes are grouped into categories and measures of currency crises that are used. In general we find that dead center of adjustable peg is by far most crisis prone broad type of exchange rate regimes, but that countries need not go all way to freely floating rates or hard fixes to substantially reduce risks of currency crises.