Why Do Countries Float the Way They Float?

Abstract

Countries that are classified as having floating exchange rate systems (or very wide bands) show strikingly different patterns of behavior. They hold very different levels of international reserves and allow very different volatilities to the movements of the exchange rate relative to the volatility that they tolerate either on the level of reserves or on interest rates. We document these differences and present a model that explains them as the optimal response of a Central Bank that attempts to minimize a standard loss function, in an environment in which firms are credit-constrained and incomplete markets limit their ability to avoid currency mismatches. This model suggests that the difference in the way countries float cold be related to their differing levels of exchange rate pass-through and the differing ability to avoid currency mismatches. We test these implications and find a very strong and robust relationship between the pattern of floating and the ability of a country to borrow internationally in its own currency. We find weaker and less robust evidence on the importance of pass-through to account for differences across countries with respect to their exchange rate/monetary management.