Degree Of Exchange Rate Flexibility Research Articles

Exchange rate in emerging markets: Shock absorber or source of shock?

This paper examines the stabilization role of flexible exchange rates for emerging economies within the Latin America and Asia regions. Based on a structural VAR model, we utilize zero, sign and exchange rate pass-through restrictions to identify structural macroeconomic shocks. Overall, we find that exogenous exchange rate shocks drive around half of total exchange rate fluctuations in emerging economies. Despite this predominant role, we find evidence that exchange rates do not act as a source of shocks to the real economy, but they instead absorb and reduce output growth and inflation volatilities. Based on counterfactual analyses, we further find that this shock-insulation property is highly shock-dependent, where the benefits of flexible exchange rates are sizable for demand and global monetary policy shocks, but are overall small in the face of supply shocks. Results also differ across time horizons, where the shock stabilization benefits are mainly limited to the short run for output, but also extend to the medium term for inflation. We also find that the net benefits of flexible exchange rates as a shock absorber are in general larger for emerging economies in Latin America than in Asia, particularly during crises periods. Finally, while we find that the stabilization role of exchange rates hinges upon the nature of underlying structural shocks, there is also a positive association with structural determinants such as a country's degree of exchange rate flexibility and trade openness.

Testing the \u2018Fear of Floating\u2019 Hypothesis: A Statistical Analysis for Eight African Countries

This paper revisits the fear of floating hypotheses for eight African countries from the collapse of the Bretton Woods fixed exchange rate system in the early 1970s up until December 2017. This long period of calendar time allows us to extend previous studies by examining the fear of floating hypotheses in two distinct ways. First, we look at a set of descriptive statistics to compare the degree of exchange rate flexibility under alternative de jure exchange rate regimes. We find no statistical difference between exchange volatility between declared floaters and fixers, but greater reserve volatility between the floaters, which is suggestive of fear of floating. Second, we use a non-linear, threshold VAR model, estimated for each country, to test for a relationship between exchange rate changes and reserve changes. The results suggest some evidence of a fear of floating for countries which have declared a de jure floating regime, with the regime-dependent impulse responses indicating that exchange rate appreciation due to positive reserve shocks is more prevalent in the high reserve regimes, indicative that level of foreign reserves available are important for their exchange rate policies. In general, although the countries with de jure floating regimes have a lower threshold than those with pegged regimes, reserves adjust by more than the exchange rates showing a fear of floating.

Revision of the Effectiveness of China’s Sterilization Policies Considering the Role of the Reserve Requirement Ratio Adjustment

ABSTRACT This paper integrates changes in the reserve requirement ratio with other related monetary policies and estimates the offset and sterilization coefficients to examine the effectiveness of China’s sterilization operations. The results show that China’s sterilization operations have been fairly effective and China has been able to control domestic money supply relatively well despite a limited degree of exchange rate flexibility. The results also indicate that the failure to take changes in reserve requirements ratio into account leads to a substantial underestimate of the effectiveness of China’s sterilization operations, illustrating that this policy is nonnegligible in studying China’s sterilization operations.

International Capital Flows and the Independence of China's Monetary Policy

This article estimates the quantitative relationship between international capital flows and China's monetary policy. A major innovation over most previous studies is taking into consideration the effects of changes in the reserve requirement ratio. Employing the method of the Federal Reserve Bank of St. Louis, this article translates the change in the reserve requirement ratio into the change in the monetary base, while the money multiplier remains unchanged. The change in the reserve requirement ratio is combined with the other monetary policies that directly affect the monetary base to construct an integrated measure of monetary policy. We then construct a modified offset and sterilization coefficients model. We find that the failure to take reserve requirement ratio changes into account leads to an underestimation of both the degree of sterilization and of capital mobility as measured by the offset coefficients. The results show that China's capital flows are quite limited, while China's monetary policy is able to almost completely sterilize monetary base fluctuations caused by international capital flows. Thus, we find that China has been able to maintain a great deal of domestic monetary policy independence despite a limited degree of exchange rate flexibility.

Monetary Policy Spillovers, Capital Controls and Exchange Rate Flexibility, and the Financial Channel of Exchange Rates

We assess the empirical validity of the trilemma (or impossible trinity) in the 2000s for a large sample of advanced and emerging market economies. To do so, we estimate Taylor-rule type monetary policy reaction functions, relating the local policy rate to real-time forecasts of domestic fundamentals, global variables, as well as the base-country policy rate. In the regressions, we explore variations in the sensitivity of local to base-country policy rates across different degrees of exchange rate flexibility and capital controls. We find that the data are in general consistent with the predictions from the trilemma: Both exchange rate flexibility and capital controls reduce the sensitivity of local to base-country pol- icy rates. However, we also find evidence that is consistent with the notion that the financial channel of exchange rates highlighted in recent work reduces the extent to which local policymakers decide to exploit the monetary autonomy in principle granted by flexible exchange rates in specific circumstances: The sensi- tivity of local to base-country policy rates for an economy with a flexible exchange rate is stronger when it exhibits negative foreign-currency exposures which stem from portfolio debt and bank liabilities on its external balance sheet and when base-country monetary policy is tightened. The intuition underlying this finding is that it may be optimal for local monetary policy to mimic the tightening of base-country monetary policy and thereby mute exchange rate variation because a depreciation of the local currency would raise the cost of servicing and rolling over foreign-currency debt and bank loans, possibly up to a point at which finan- cial stability is put at risk.

Monetary Policy Spillovers, Capital Controls and Exchange Rate Flexibility, and the Financial Channel of Exchange Rates

We assess the empirical validity of the trilemma (or impossible trinity) in the 2000s for a large sample of advanced and emerging market economies. To do so, we estimate Taylor-rule type monetary policy reaction functions, relating the local policy rate to real-time forecasts of domestic fundamentals, global variables, as well as the base-country policy rate. In the regressions, we explore variations in the sensitivity of local to base-country policy rates across different degrees of exchange rate flexibility and capital controls. We find that the data are in general consistent with the predictions from the trilemma: Both exchange rate flexibility and capital controls reduce the sensitivity of local to base-country policy rates. However, we also find evidence that is consistent with the notion that the financial channel of exchange rates highlighted in recent work reduces the extent to which local policymakers decide to exploit the monetary autonomy in principle granted by flexible exchange rates in specific circumstances: The sensitivity of local to base-country policy rates for an economy with a flexible exchange rate is stronger when it exhibits negative foreign-currency exposures which stem from portfolio debt and bank liabilities on its external balance sheet and when base-country monetary policy is tightened. The intuition underlying this finding is that it may be optimal for local monetary policy to mimic the tightening of base-country monetary policy and thereby mute exchange rate variation because a depreciation of the local currency would raise the cost of servicing and rolling over foreign-currency debt and bank loans, possibly up to a point at which financial stability is put at risk.

No Pain, All Gain? Exchange Rate Flexibility and the Expenditure-Switching Effect

Theoretical models on the relationship between prices and exchange rates predict that the magnitude of expenditure switching affects the optimal choice of exchange rate regime. Focusing on the transmission of terms-of-trade shocks to domestic real variables we document that the magnitude of the expenditure switching effect is positively associated to the degree of exchange rate flexibility. Moreover, results show that flexible exchange rates allow for significant adjustment in relative prices, which in turn lowers the burden of adjustment on demand for domestic goods and, in some cases, facilitates a faster and more durable external adjustment process. These results, which are robust to accounting for possible non-linearities due to balance sheet effects or currency mismatches, shed new light on the shock absorbing properties of flexible exchange rates.

No Pain, All Gain? Exchange Rate Flexibility and the Expenditure-Switching Effect

Theoretical models on the relationship between prices and exchange rates predict that the magnitude of expenditure switching affects the optimal choice of exchange rate regime. Focusing on the transmission of terms-of-trade shocks to domestic real variables we document that the magnitude of the expenditure switching effect is positively associated to the degree of exchange rate flexibility. Moreover, results show that flexible exchange rates allow for significant adjustment in relative prices, which in turn lowers the burden of adjustment on demand for domestic goods and, in some cases, facilitates a faster and more durable external adjustment process. These results, which are robust to accounting for possible non-linearities due to balance sheet effects or currency mismatches, shed new light on the shock absorbing properties of flexible exchange rates.

Os determinantes do impacto da crise financeira internacional sobre a taxa de crescimento do PIB

Resumo O objetivo principal deste trabalho é avaliar os determinantes do impacto da crise financeira internacional sobre a mudança na taxa de crescimento do PIB (2009-2008) para 118 países, utilizando estimações por MQO. Os resultados econométricos para os modelos estimados tendo como variável dependente a diferença entre a taxa de crescimento do PIB real em 2009, e o projetado em 2008 para 2009, indicam que apreciações cambiais e uma piora na percepção dos investidores estão associadas a uma maior diferença entre a taxa de crescimento do PIB real de 2009 em relação à taxa de crescimento projetada em 2008 para 2009. Além disso, um aumento no nível de reservas internacionais e uma melhora na situação orçamentária do governo estão associados a uma diminuição na diferença entre a taxa de crescimento do PIB real de 2009 em relação à taxa de crescimento projetada em 2008 para 2009. Os resultados das estimações para os modelos com a variável dependente dada pela diferença entre a taxa de crescimento de 2009 e 2008 revelam que o nível de reservas internacionais, a medida do grau de flexibilidade do regime cambial (classificação de regime cambial) e o PIB per capita são estatisticamente significativos, e países com maior montante de reservas internacionais, PIB per capita e grau de flexibilidade cambial estão associados a uma menor variação na taxa de crescimento entre 2009 e 2008.

Exchange rate flexibility and credit during capital inflow reversals: Purgatory … not paradise

We identify periods of capital inflows reversals—looking at both gross and net capital flows—and document the behavior of macro and credit variables in economies with different degrees of exchange rate flexibility. We find that more exchange rate flexibility moderates credit swings during capital flow cycles, mainly because it is associated with milder credit growth during the boom. Flexibility, however, cannot completely shield the economy from a credit reversal. We observe what we dub as a recovery puzzle: credit growth in economies with more flexible exchange rate regimes remains tepid well after the capital flow reversal takes place. This results stress potential complementarity of macro-prudential policies with the exchange rate regime. More flexible regimes could help smoothing the credit cycle through capital surcharges and dynamic provisioning that build buffers to counteract the credit recovery puzzle. In contrast, more rigid exchange rate regimes would benefit the most from measures to contain excessive credit growth during booms, such as reserve requirements, loan-to-income ratios, and debt-to-income and debt-service-to-income limits.

Friedman Redux: External Adjustment and Exchange Rate Flexibility

Milton Friedman argued that flexible exchange rates would facilitate external adjustment. Recent studies find surprisingly little robust evidence that they do. We argue that this is because they use composite (or aggregate) exchange rate regime classifications, which often mask very heterogeneous bilateral relationships between countries. Constructing a novel dataset of bilateral exchange rate regimes that differentiates by the degree of exchange rate flexibility, as well as by direct and indirect exchange rate relationships, for 181 countries over 1980–2011, we find a significant and empirically robust relationship between exchange rate flexibility and the speed of external adjustment. Our results are supported by several “natural experiments” of exogenous changes in bilateral exchange rate regimes.

Exchange Rate Flexibility and Credit during Capital Inflow Reversals: Purgatory…not Paradise

We document the behavior of macro and credit variables during episodes of capital inflows reversals in economies with different degrees of exchange rate flexibility. We find that exchange rate flexibility is associated with milder credit growth during the boom but, even though smaller than in more rigid regimes, it cannot shield the economy from a credit reversal. Furthermore, we observe what we dub as a recovery puzzle: credit growth in economies with more flexible exchange rate regimes remains tepid well after the capital flow reversal takes place. This results stress the complementarity of macro-prudential policies with the exchange rate regime. More flexible regimes could help smoothing the credit cycle through capital surchages and dynamic provisioning that build buffers to counteract the credit recovery puzzle. In contrast, more rigid exchange rate regimes would benefit the most from measures to contain excessive credit growth during booms, such as reserve requirements, loan-to-income ratios, and debt-to-income and debt-service-to-income limits.

Exchange Rate Flexibility and Credit During Capital Inflow Reversals: Purgatory…Not Paradise

We document the behavior of macro and credit variables during episodes of capital inflows reversals in economies with different degrees of exchange rate flexibility. We find that exchange rate flexibility is associated with milder credit growth during the boom but, even though smaller than in more rigid regimes, it cannot shield the economy from a credit reversal. Furthermore, we observe what we dub as a recovery puzzle: credit growth in economies with more flexible exchange rate regimes remains tepid well after the capital flow reversal takes place. This results stress the complementarity of macro-prudential policies with the exchange rate regime. More flexible regimes could help smoothing the credit cycle through capital surchages and dynamic provisioning that build buffers to counteract the credit recovery puzzle. In contrast, more rigid exchange rate regimes would benefit the most from measures to contain excessive credit growth during booms, such as reserve requirements, loan-to-income ratios, and debt-to-income and debt-service-to-income limits.

Friedman Redux: External Adjustment and Exchange Rate Flexibility

Milton Friedman argued that flexible exchange rates would facilitate external adjustment. Recent studies find surprisingly little robust evidence that they do. We argue that this is because they use composite (or aggregate) exchange rate regime classifications, which often mask very heterogeneous bilateral relationships between countries. Constructing a novel dataset of bilateral exchange rate regimes that differentiates by the degree of exchange rate flexibility, as well as by direct and indirect exchange rate relationships, for 181 countries over 1980–2011, we find a significant and empirically robust relationship between exchange rate flexibility and the speed of external adjustment. Our results are supported by several “natural experiments” of exogenous changes in bilateral exchange rate regimes.

Monetary Policy in Hybrid Regimes: The Case of Kazakhstan

This paper analyzes the monetary policy framework in Kazakhstan. The authorities have been successful in containing inflation in the context of a managed exchange rate regime. Over the past two years, the central bank has taken steps to enhance its ability to regulate liquidity in the financial system. However, the current policy interest rate does not properly signal the stance of policy, reflected in a weak transmission from the policy rate to money market interest rates. With the use of a stylized model, the paper studies the macro determinants of money market interest rates under the current framework, and illustrates both the benefits and challenges of active interest rate policy. The model shows that limited use of instruments to steer short-term interest rates weakens the framework’s ability to counteract shocks. Finally, the paper explores the implications of varying degrees of exchange rate flexibility for interest rate policy and open market operations.

Household and Firm Leverage, Capital Flows and Monetary Policy in a Small Open Economy

This paper outlines a framework for analyzing the interaction between financial frictions at the household and firm level, liability dollarization and optimal monetary policy in a small, open economy subject to productivity and capital inflow shocks. It is found that, first, for the shocks under review, the extent of co-movement of financial variables pertaining to entrepreneurs and homeowners crucially depends on the degree of exchange rate flexibility. Second, for a central bank not concerned with financial stability, reacting to inflation and output is considered optimal. Third, including financial stability in the central bank's objectives results in an optimal monetary policy rule reacting to exchange rate depreciation, but not to credit growth, even in the case of large capital inflow shocks. In fact, reacting to credit growth reinforces the initial shock, increasing financial imbalances.

Short‐ and Long‐term Growth Effects of Exchange Rate Adjustment

AbstractThe European sovereign debt crisis revived the discussion concerning pros and cons of exchange rate adjustment in the face of asymmetric shocks. In the spirit of Keynes, exit from the euro area is to regain rapidly international competitiveness. In the spirit of Schumpeter, exchange rate stability with structural reforms would be beneficial towards the long‐run growth performance. Previous literature has estimated the average growth of countries with different degrees of exchange rate flexibility. This literature is augmented by analyzing short‐ and long‐term growth effects of exchange rate flexibility in a panel‐cointegration framework for a sample of 60 countries clustered in five country groups. The estimations show that countries with a high degree of exchange rate stability exhibit a higher long‐term growth performance. It is shown that the degree of business cycle synchronization with the anchor country matters for the impact of exchange rate flexibility on growth.

MEASURING EXCHANGE RATE FLEXIBLITY: A TWO-PARAMETER EXCHANGE MARKET PRESSURE APPROACH

Recognition that official classifications of exchange rate regimes are often misleading has led to considerable interest in behavioral measures. Many of these measures are related to the concept of exchange market pressure that shows how policy interventions affect how much a given change in excess demand in the foreign exchange market shows up changes in reserves versus changes in the exchange rate. We argue that this is the correct conceptual approach to measuring the degree of exchange rate flexibility of a regime, but that several of the most popular applications of this approach use functional forms that destroy useful information. One important problem that has been overlooked is that the approach is clearly defined only for leaning against the wind intervention and we find that fairly often changes in reserves and exchanges do not fit with this type of intervention. A second important issue is that where there are trends the interpretation of these types of measures becomes more difficult. We suggest that to deal with this issue a two parameter approach is needed rather than the one parameter measure that have been used in most of the previous literature. We illustrate the approach with an application to Japan.

Do Exchange Rate Regimes Matter for Inflation and Exchange Rate Dynamics? The Case of Central America

AbstractThis paper makes an empirical contribution to discussion of the optimal exchange rate regime. Using a new dataset for Central American countries, we compare the dynamics of the real exchange rate (RER) between dollarised and non-dollarised countries. Our results show that the two dollarised countries in the region, El Salvador and Panama, are quite different in terms of RER dynamics. In El Salvador the RER spends more time away from its equilibrium level than in the non-dollarised countries in the region, while the contrary is true for Panama. We also find that inflation persistence is similar in El Salvador to the other countries, but smaller in Panama. This leads us to the conclusion that some degree of exchange rate flexibility helps countries to have a more aligned RER. Nevertheless, a long-lived, highly credible dollarised economy, like Panama, can reduce inflation persistence to such an extent that RER misalignments are in fact less frequent than in countries with more flexible exchange rate regimes.

L'impact des crises financières globales sur les marchés des changes des pays émergents

Résumé L’objet de cet article est d’étudier si les régimes de change des pays émergents ont tendance à être infléchis dans le sens d’une plus grande flexibilité lors des crises financières globales. Afin de tester cette hypothèse, nous évaluons le degré de flexibilité des taux de change par leur volatilité. Nous en étudions ensuite le lien avec divers indicateurs de tension sur les marchés financiers mondiaux. Nous testons en particulier l’existence de non-linéarités en estimant des modèles à changement de régime sur un échantillon de vingt et un pays émergents sur la période allant de janvier 1994 à septembre 2009. Les résultats montrent que la flexibilité des taux de change augmente plus que proportionnellement avec le degré de tension sur les marchés financiers pour la plupart des pays de l’échantillon. Nous mettons également en évidence des effets non linéaires de contagion régionale entre les marchés des changes des pays appartenant à une même zone géographique.