Flexible Exchange Rate Regime Research Articles

Monetary Unions and National Welfare

This paper studies monetary regime choice between monetary union and flexible exchange rate regime in a large open economy framework. The classical approach emphasizes that monetary unions are inherently costly because a single interest rate cannot respond effectively to different shocks of members of the union. Therefore, it is argued that countries with similar shocks should establish a monetary union so that the cost of one-size-fits-all monetary policy is minimized. This study reveals that when there are inefficient shocks (namely those which distort the economy asymmetrically and break the 'divine coincidence') and countries are large, the classical approach fails. In that case, monetary regime choice should depend on relative variation (mean preserving spread) of inefficient shocks rather than proximity of shocks. A union implicitly imposes cooperation in monetary policy between its members. This cooperation improves response to foreign inefficient shocks while it worsens responses to domestic inefficient shocks slightly less in terms of domestic welfare. Therefore, a country chooses monetary union over flexible exchange rate regime if variation of foreign shocks is close to or larger than variation of domestic shocks. That is on the condition that losing exchange rate flexibility is not costly or has a small cost. In this way, the domestic country 'ties the hand of the foreign country' and prevents foreign monetary policy actions which hurt domestic welfare. Both countries benefit from cooperation provided by the union, if variances (spreads) of domestic and foreign shocks are close enough. Then, a monetary union becomes Pareto Improvement. How close variances should be so that monetary union is welfare increasing or Pareto Improvement, and welfare loss or gain of losing exchange rate flexibility are contingent upon price rigidity and trade elasticity.

The long-run interrelationship between exchange rate and interest rate: the case of Mexico

Purpose The purpose of this paper is to analyse the long-term nature of the interrelationship between interest rate and exchange rate. Design/methodology/approach By employing Mexican data, the authors estimate a non-linear autoregressive distributed lags (NARDL) model to investigate the nature of the changes and the interaction between interest rate and exchange rate in response to monetary authorities’ actions. Findings The results show that, contrary to simplistic predictions, the real exchange rate causes the real interest rate in an asymmetric way. The bounds testing approach of the NARDL models suggests the presence of co-integration among the variables and the exchange rate variations appear to have significant long-run effects on the interest rate. Most importantly, these effects are asymmetric and positive variations in the exchange rate have a lower impact on the interest rate. It is also interesting to report that the reverse is not true: the interest rate in the long-run exerts no statistical significant impact on the exchange rate. Practical implications The asymmetric long-term relationship between real exchange rate and real interest rate is evidence of why monetary authorities are reluctant to free float exchange rate. In Mexico, as in most developing countries, monetary policy strongly responds to exchange rate movements because these have relevant effects on commercial trade. Moreover, in dollarized economies these effects are stronger because of pass-through impacts to inflation, income distribution and balance-sheet equilibrium (the well-known “original sin”). Originality/value Under inflation targeting and flexible exchange rate regime, despite central banks pursue the control of short-term interest rate, in the long-run one could observe that it is the exchange rate that influences the interest rate, and that this reverse causality is stronger in emerging economies. This paper contributes by analysing the asymmetric relationship between the variables.

Macroeconomic adjustment with managed exchange rates and capital controls: Some lessons from China

This paper examines the performance of capital controls and exchange-rate management when the economy finds itself in dark corners. These are times when the real sector experiences a sequence of prolonged negative shocks from world demand, while the central bank faces low world interest rates on its foreign-exchange reserve holdings. We examine two regimes, one of a fixed exchange rate with strong capital controls and another with a more open capital account with a managed exchange rate. We show how this model replicates recent experiences of China as it moved from a relatively fixed exchange rate regime with strong capital controls to a more flexible exchange rate regime with a more open capital account. Our results show that capital-account liberalization should be accompanied by domestic price liberalization to avoid large losses in foreign exchange reserve and jumps in unemployment during dark corners in the more open regime.

In Search of Lost Time

This paper investigates what factors affect the duration of sudden stops in capital flows using quarterly data for a large panel of countries. We find that countries with floating exchange rate regimes tend to experience shorter sudden stop episodes and that fixed exchange rate regimes are associated with longer periods of low output growth following sudden stops. These effects are quantitatively large: having a flexible exchange rate regime increases the probability of exiting the sudden stop state by between 50 to 80 percent. Flexible exchange rate regimes significantly shorten the duration of output decelerations following sudden stops by over 30 percent. Positive variations in terms of trade also abbreviate the duration of sudden stops. In terms of policies, identification is trickier, but the evidence suggests that monetary policy tightening shortens the duration of sudden stops. Changes in capital account restrictions do not seem to matter.

Remittances, Output, and Exchange Rate Regimes: Theory with an Application to Latin America

Immigrant remittances have a broad effect on the receiving economies. We show this impact on the main macroeconomic aggregates is dependent on the policy arrangements in place that manage capital flows. We look at remittance inflows in a small open economy to examine their influence on output under alternative exchange rate regimes. Using a simple stochastic limited participation model, we are able to reproduce dynamics consistent with the empirical literature. We find that the dynamics of labor, inflation, and output are dependent on the parameterization of the utility function and on the monetary rule governing the evolution of the interest rate and in particular with respect to the response of interest rates to exchange rate movements. We find that the initial drop of output resulting from a remittances shock is similar under alternative exchange rate regimes, but the subsequent recovery of output is faster and stronger under more flexible exchange rate regimes. We provide suggestive empirical evidence from a panel Vector Autoregression specification for 17 Latin American countries that corroborates our results.

Drivers of Inflation and Inflation Volatility and Their Effects on Macroeconomic Fluctuations in Indonesia and Thailand

Indonesia and Thailand, two major open economies in Southeast Asia operating under managed-float exchange rate systems, have remained susceptible to both external and domestic shocks since the East-Asian financial crisis of the late 1990s. This paper investigates the transmission of external shocks to these economies via their impact on inflation and inflation volatility. The empirical results suggest that in both Indonesia and Thailand, inflation and inflation volatility are more sensitive to external shocks relative to domestic shocks, consistent with the globalization hypothesis. Inflation and inflation volatility are also found to have a feedback relation between them, consistent with the Friedman‐Ball and Cukierman‐Meltzer propositions, and they drive the real exchange rate up while adversely affecting output and asset prices. A positive inflation shock has immediate and persistent adverse effects on domestic output, consistent with the inflation literature for developing countries. The empirical results highlight the implications for economic theory and policy measures. In Indonesia and Thailand, policymakers can improve the conduct of rule-based monetary policy by fostering a more flexible exchange rate regime, to keep inflation stable and to raise the people’s social welfare.

Exchange Rate Regimes and Economic Growth in Nigeria

In view of the fact that economic theory does not clearly identify which kind of exchange rate regime would be more likely to promote economic growth, this paper seeks to determine the differential impact of exchange rate policy on economic growth in Nigeria under a fixed and a flexible exchange rate regimes from 1973 to 2017 using the dummy variable regression model. The annual time series data of the variables that are used in the estimation of the model are obtained from The World Bank: The World Tables, 1974 and World Bank World Development Indicators. The differential intercept is positive but statistically insignificant and differential slope coefficient is positive and statistically significant, strongly suggesting that the exchange rate-economic growth regressions for the fixed and flexible exchange rate regimes are different. The slope coefficient for a flexible exchange rate regime is greater than the slope coefficient for a fixed exchange rate regime by 7.8472 units. The calculated F-statistic is greater than the tabulated F-statistic at 5 percent level of significance and at 6 and 38 degrees of freedom. This implies that there is an evidence of structural instability. The regression coefficient of exchange rate is positive and statistically significant. The result shows that the switch from a fixed exchange rate regime to a flexible exchange rate regime leads to an increase in exchange rate and the depreciation of exchange rate has significant positive impact on economic growth in Nigeria. A flexible exchange rate regime would promote economic growth more than a fixed exchange rate regime. We recommend the sustainability of a flexible exchange rate regime that has been in operation since 1986 in order to increase economic growth in Nigeria. Keywords: Exchange rate regimes, Economic growth, Dummy variable regression model, Secondary data, Nigeria DOI : 10.7176/JESD/10-18-19 Publication date :September 30 th 2019

How Can We Explain Regime Type Differences If Citizens Don't Vote Based on Foreign Economic Policy?

Abstract Political economy research shows that more democratic governments generally have more open trade policies with more flexible exchange rate regimes, yet political behavior theory argues that citizens do not think of foreign economic policy as salient and do not cast their votes considering such issues. This note investigates the puzzle about how democracies could have different foreign economic policies than autocracies if citizens do not vote based on these international issues. Using a political model with two possible ways for societal actors to influence state policy (electoral and/or special interest pressure), it first considers how voting based on salient domestic outcomes like inflation and unemployment may lead democratic governments towards more open trade and flexible exchange rates. Second, if more societal groups are able to lobby as special interests in more democratic regimes, then governments may also be pushed toward these same foreign economic policies. Thus, there is no fundamental contradiction between the political economy empirical results and the political behavior theory, although scholars need to adjust their theories to explain foreign economic policy differences across political regime type.

Destabilizing Balance Sheet Effects in the New Consensus Model

This paper proposes a simple modification of an otherwise standard New Consensus open economy model. We include an endogenous risk premium to show that a Taylor Rule that satisfies the Taylor Principle may lead to instability if exchange rate depreciations worsen the balance sheet of firms, exerting a negative effect on output and employment. Thus, the adoption of Inflation Targeting and a flexible exchange rate regime introduces destabilizing forces in economies that are exposed to liability dollarization, and this helps to rationalize central bank interventions in the foreign exchange market to avoid large exchange rate fluctuations.

ASEAN income gap and the optimal exchange Rate Regime

ABSTRACTThis article investigates the optimal exchange rate regime in a group of ASEAN countries, which minimizes the adverse effects of foreign demand shocks on real output, the real exchange rate, price level and between-country income gap. Using a panel structural vector autoregressive model for small open economies, we show that the extent by which foreign demand shocks influences the between-country income gap depends on the exchange rate regime and the transmission channels through output, the price level and the real exchange rate. Our results show that a fixed exchange rate is better in insulating output and real exchange rates against adverse foreign demand shocks. Nevertheless, a flexible exchange rate regime achieves lower inflation and narrows the income gap across countries. Further, foreign demand shocks explain a larger portion of the forecast error variance of macroeconomic variables under a fixed than under a flexible exchange rate regime.

What Drives Stops in Cross-Border Bond Flows?

This paper empirically explores the determinants of stop episodes driven by bond flows using quarterly data from 38 economies over the period 1995–2011. Drastic bond-led stop episodes may greatly destabilize domestic financial markets and lead to financial crisis, threatening the sustainability of the financial system. Using the complementary log–log regression method, we found that bond-led stop episodes were associated with contagion and domestic factors rather than global factors. The results of our estimation showed that the probability of bond-led stop episodes was higher in countries with larger financial markets or with more overvalued real exchange rates. The main policy implications of our results, particularly for emerging economies, are that bond-led stop episodes were less likely to occur in countries with higher levels of institutional quality, lower capital account restrictions, or more flexible exchange-rate regimes. Finally, we found that capital control played a relatively greater role in predicting bond-led stops in emerging economies than did exchange-rate regimes.

External competitiveness and the role of fiscal policy: does fiscal austerity matter?

During and after the sovereign debt crisis that hit most of the EU member states after the Great Recession, the question of the effectiveness of fiscal policy vis-a-vis ensuring sustainable growth rates and changing the economic structure of member states was highly debated. Accordingly, this paper investigates the effects of shocks in government purchases and net taxes on the export competitiveness of the eleven new EU member states: Bulgaria, the Czech Republic, Estonia, Croatia, Latvia, Lithuania, Hungary, Poland, Romania, Slovenia and Slovakia. The countries are treated as a homogenous sample, but the empirical analysis extends beyond this. Namely, the paper examines two subsamples based on the exchange rate regimes of the eleven new EU member states: the fixed vs the flexible exchange rate regime. By applying the panel VAR analysis, over the 1999-2015 period, we have reached the following conclusions. First, fiscal austerity influences the level of exports in our sample. Second, the effects of shocks in fiscal policy on the level of exports are short-lived. Third, shocks in government purchases are the most important determinant for all the new EU member states. And fourth, shocks in net taxes influence the level of export only in the countries that have the flexible exchange rate regimes. Our results contribute to the literature that examines the effects of fiscal policy on the competitiveness of national economies by highlighting both the duration effect of fiscal policy on the level of export and also by pointing to the optimal economic instrument used with respect to the currency arrangement of the country.

Angola

A 36-month Extended Arrangement under the Extended Fund Facility (hereafter the “arrangement”) was approved last December, with access of SDR 2,673 million (361 percent of quota). Lower international oil prices would reduce oil revenues, widen the current account deficit, and stymie growth recovery. The authorities are implementing a proper policy response to the weakened outlook, through a conservative supplementary budget for 2019, alternative sources of cheaper financing, and progress toward a more flexible exchange rate regime.

Impairment of monetary autonomy: Case of “trilemma” vs. “duo”

In a unified framework comprising 33 diverse economies, this study investigates the role of flexible exchange rate regime vis-à-vis capital controls in providing insulation against monetary autonomy impairment. We find both of them to be equally effective. We also investigate the debate between the Mundellian “trilemma” and the “duo”. Our findings show that in the presence of capital openness, the flexible exchange rates restrict autonomy impairment only at the shorter horizon of 3 months, not at the longer horizon of 12 months.

International Risk-Sharing and Optimal Monetary Policy in a Small Commodity-Exporting Economy

This paper evaluates the welfare implications of alternative monetary policy regimes for a small commodity-exporting economy. In line with the existing literature, welfare analysis shows that a flexible exchange rate regime tends to outperform a fixed nominal exchange rate. However, this paper shows that the welfare costs of a nominal peg vary considerably with the extent of international risk-sharing. In a model with complete and frictionless asset markets, real exchange rate volatility is small, and welfare losses from the nominal peg are negligible. By contrast, under financial autarky, a fixed nominal exchange rate generates significant volatility in inflation and results in large welfare costs. I also consider the welfare properties of flexible regimes, showing that core consumer inflation targeting and non-commodity domestic inflation targeting are not generally optimal, although their welfare costs are small compared to those of a fixed regime. Furthermore, the welfare ranking of these two regimes might depend on the currency in which the tradable goods are priced (producer-currency pricing vs. local-currency pricing).

Targeting Inflation and Exchange Rate Management in Tunisia Before and After the Revolution

This paper investigates the dynamic links between the exchange rate and inflation in Tunisia, using annual data during the 1984/2016 period. First, we implement a unit root analysis to test stationarity. This study makes use of both primary and secondary data and VAR Granger Causality/Block Erogeneity Wald Tests were adopted as estimation techniques. Granger causality results revealed that there is a unidirectional causal link between inflation and the exchange rates running from inflation to the exchange rates and that these exchange rates have no impact on inflation. This study provides some implications regarding potential constraints on the monetary policy. A policy of inflation targeting, as an alternative monetary policy, combined with a compatible regime of flexible exchange rates could provide a solution to this dilemma.

Monetary Independence of Central and Eastern European Economies with Flexible Exchange Rate Regimes

According to the macroeconomic trilemma, the floating exchange rate regime provides room for monetary independence. The paper examines whether this is the case in CEE economies. The ARDL bounds tests are used. A level relationship between domestic and euro interest rates is found in all CEE countries, although evidence for Hungary is weak. It is demonstrated that the crude monetary independence indices do not capture the relevant relationship adequately. It is concluded that the Czech Republic and Poland will be able to retain monetary independence when the ECB embarks on the tightening its monetary policy, but not Hungary or Romania.

How to Promote the Exchange Rate Marketization and Capital Account Liberalization in the Stage of High Quality Development of Economy? Empirical Evidence from 134 Economies

The promotion order between exchange rate marketization and capital account openness is one of the hotspots and debates in the field of international finance. Some scholars support the reform order of internal first, external next”, while others believe that they should be promoted in a coordinated manner. In view of the above two points, some scholars try to use econometric methods such as the Granger causality test and VAR model to determine the promotion order, but these methods are often limited to the selection of samples and depend on the data to a large degree, and different samples may draw different conclusions. Due to the lack of a reference system, the promotion order between exchange rate marketization and capital account openness is not determined. What is the basis or determination? The economic development level, total factor productivity or financial stability? If there is no basis, it is difficult to make a clear judgment on the promotion strategy. If the reference system is abandoned, the investigation only based on the data does not have practical significance. In view of this, this paper refers to the study of Rodriguez（2017）, constructs the influence equation of the exchange rate regime on total factor productivity（with capital account openness as the conversion variable）and the influence equation of capital account openness on total factor productivity（with the exchange rate system as the conversion variable）, respectively. Moreover, total factor productivity is selected as the reference system, and a non-linear modeling technology PSTR model is adopted to investigate the promotion strategy. It is revealed that the exchange rate regime has a significant non-linear effect on total factor productivity, the influence coefficient changes from negative to positive with the increase of capital account openness, which indicates that capital account openness can weaken the negative impact of exchange rate fluctuations on total factor productivity. The influence coefficient of capital account openness on total factor productivity is negative, and it shows obvious stage characteristics with the change of the exchange rate regime. When the exchange rate regime is flexible enough, its negative impact decreases significantly, which indicates that a more flexible exchange rate regime is conducive to absorbing the negative impact of capital account openness. Therefore, with total factor productivity as a reference system, there is a mutual adjustment mechanism between exchange rate marketization and capital account openness. Capital account openness is the premise of exchange rate marketization, and exchange rate marketization is also the prerequisite of capital account openness. They should be promoted in a coordinated way. Compared with the existing results, the possible contributions of this paper are as follows: First, the exchange rate regime and capital account openness are taken as the key explanatory variable and adjustment variable respectively, which enriches the literature with respect to the promotion order of exchange rate marketization and capital account openness, and overcomes the shortcomings of the existing literature that only employ one of them as the key explanatory variable and adjustment variable, making the research more comprehensive and detailed. Second, compared with most existing literature that directly adopt the interactive terms（only the first-order non-linear relations can be identified）, this paper utilizes a non-linear method—the PSTR model, which can identify higher-order non-linear relations and solve the problem of missing implicit non-linear relations. Third, compared with most existing literature focusing on economic growth or financial crisis, this paper conducts the analysis from the perspective of total factor productivity to re-judge the promotion order. The study can provide theoretical support and a decision-making basis for how to promote exchange rate marketization and capital account openness in the constitutive reform and transition from quantitative growth to qualitative development of China’s economic development.

Inflation targeting and output-inflation tradeoffs

This article assesses whether the adoption of inflation targeting (IT) helps reduce the output-inflation tradeoff. We address the self-selection problem of IT policy adoption by the endogenous switching regressions, and show that the output-inflation tradeoffs are significantly lower in IT countries not only over the whole sample but also across the developed and developing country subsamples. In addition, we also find strong evidence supporting the positive selection hypothesis, i.e., countries have higher probability of adopting IT are exactly those who benefit more (larger reduction of output-inflation tradeoff) from the implementation of IT. Additional results reveal that economies with higher trade openness, lower financial openness, and less flexible exchange rate regime are associated with larger tradeoff between output and inflation, but the effects are only statistically significant in the IT regime.

The Global Economic Recovery 10 Years After the 2008 Financial Crisis

This paper takes stock of the global economic recovery a decade after the 2008 financial crisis. Output losses after the crisis appear to be persistent, irrespective of whether a country suffered a banking crisis in 2007–08. Sluggish investment was a key channel through which these losses registered, accompanied by long-lasting capital and total factor productivity shortfalls relative to precrisis trends. Policy choices preceding the crisis and in its immediate aftermath influenced postcrisis variation in output. Underscoring the importance of macroprudential policies and effective supervision, countries with greater financial vulnerabilities in the precrisis years suffered larger output losses after the crisis. Countries with stronger precrisis fiscal positions and those with more flexible exchange rate regimes experienced smaller losses. Unprecedented and exceptional policy actions taken after the crisis helped mitigate countries’ postcrisis output losses.