Twin Fallacies About Exchange Rate Policy in Emerging Markets

2007

The purpose of this paper is to challenge couple of dangerous theoretical misconceptions in open-economy macro, namely, in respect to desirability or sustainability of available exchange rate regimes and inflation targeting framework and their mutual compatibility in small open economies with incomplete (emerging) markets. First of all, we dismiss the ruling »two corner solution« as dogma in scientific disguise. Furthermore, all the benefits of more flexible intermediate regimes (sliding currency bands) as well as empirical support of their wellbeing have been put forward. As to the monetary policies, majority of transition countries recognised superiority of inflation targeting over alternative monetary concepts. However, until very recently some emerging market economies failed to realize the benefits of full-fledged -let alone flexible-inflation targeting. In what follows, the article counters another theoretical dogma: that inflation targeting in emerging market economies must go hand in hand with fully flexible exchange rate regime. Having said that, and again contrary to the mainstream literature in the field, paper exposes some serious weaknesses of the so-called dirty (or managed) floating as an intermediate regime: in particular, its potential sub optimality in practice and its hidden incompatibility with widespread inflation targeting strategies. Paper concludes by reiterating the inevitability of close relationship between inflation targeting and exchange rate targeting and hence suggests several possible reaction functions for the monetary authorities in emerging markets among those already laid out in the related literature. 1 This paper partly draws on research carried at and the hospitality of The Centre for the study of Global Governance of the LSE, where the author was a visiting fellow under the auspices of the FCO/OSI/LSE Faculty Development in South East Europe Programme.

Journal of Development Economics, 1997

Most anti-inflation plans have used a nominal exchange rate anchor even though many other variables can serve this role. The conventional wisdom is that an exchange rate anchor imposes more macroeconomic discipline than other anchors, though theory does not yet provide any clear reason why this is so. We explain the link between an exchange rate anchor and discipline with a model that assumes that the public can monitor the nominal exchange rate more easily than it can the other variables. In our model, a Barro-Gordon game of incomplete information with imperfect monitoring, we show that serious stabilizers prefer more visible anchors, such as the nominal exchange rate. We also show that in some circumstances serious stabilizers will choose to fix the exchange rate even when fixed exchange rates have some costs, such as diminished capabilities to respond to external shocks.

International Organization, 2010

If governments choose economic policies that often run counter to their public commitments, are those commitments meaningless? We argue that government proclamations can be critical in signaling economic policy intentions+ We focus on the realm of exchange rate policy, in which countries frequently implement an exchange rate regime that differs from the officially declared regime+ We argue that the official exchange rate regime is one of the most important signals of a government's economic policy preferences+ When a government makes a de jure public commitment to a fixed exchange rate, it sends a signal to domestic and international markets of its strict monetary-policy priorities+ In contrast, a government that proclaims a floating exchange rate signals a desire to retain discretion over monetary policy, even if it has implemented a de facto fixed rate+ We use data on 110 developed and developing countries from 1974 to 2004 to test two hypotheses: first, that governments that adopt de facto fixed exchange rates will experience less inflation when they back up their actions with official declarations; and second, that governments that abide by their commitments-as demonstrated by a history of following through on their public declarations of a fixed exchange rate regime-will establish greater inflationfighting credibility+ Within developing countries, democratic institutions enhance this credibility+ Results from fixed-effects econometric models provide strong support for our hypotheses+ It comes as no surprise that governments often pursue economic policies that differ from their official proclamations+ Policymakers face short-term incentives to deviate from policy commitments that are otherwise optimal in the long term, including protecting property rights, maintaining free trade, and keeping prices stable+ If deviations from official policy become the norm, then government proclamations may seem of little value+ However, the disparate actors in any economy depend on

2003

This paper analyzes the linkages between the credibility of a target zone regime, the volatility of the exchange rate, and the width of the band where the exchange rate is allowed to fluctuate. These three concepts should be related since the band width induces a trade-off between credibility and volatility. Narrower bands should give less scope for the exchange rate to fluctuate but may make agents perceive a larger probability of realignment which by itself should increase the volatility of the exchange rate. We build a model where this trade-off is made explicit. The model is used to understand the reduction in volatility experienced by most EMS countries after their target zones were widened on August 1993. As a natural extension, the model also rationalizes the existence of non-official, implicit target zones (or fear of floating), suggested by some authors.

Journal of Economic Perspectives, 2003

Journal of International Money and Finance, 2008

JEL classification: F310 D720

This note summarizes some of the highlights of my longer paper with Guillermo Calvo"Fear of Floating." Many emerging market countries have suffered financial crises. One view blames soft pegs for these crises. Adherents to that view suggest that countries move to corner solutions-hard pegs or floating exchange rates. We analyze the behavior of exchange rates, reserves, and interest rates to assess whether there is evidence that country practice is moving toward corner solutions. We focus on whether countries that claim they are floating are indeed doing so. We find that countries that say they allow their exchange rate to float mostly do not-there seems to be an epidemic case of "fear of floating.

2002

Lately, many emerging market countries (EMC) have engaged in‡ation targeting (IT). But a recent strand of literature ...nds evidence of ‘fear of ‡oating’ amongst EMC. Limiting the ‡exibility of the exchange rate has the risk of turning it into an anchor in the eyes of the public. In this paper we test whether the interest rate defenses of the exchange rate have been excessive or not in these countries. We ...nd that in some this is not the case, as they were aimed to prevent deviations of the exchange rate from its long run equilibrium value, while other countries seem to have intervened to any ‡uctuation of the exchange rate. We link these ...ndings with measures of liability dollarization, credibility, and pass-through. JEL Classi...cation: E58, F31

2010

Despite increasing capital mobility and the subsequent difficulty in controlling exchange rates, intermediate exchange-rate regimes have remained widespread, especially in emerging and developing economies. This piece of evidence hardly fits the "impossible Trinity" theory arguing that it becomes difficult to control the exchange rate without a "hard" device when capital flows are freed. Calvo and Reinhart (2000) have suggested several explanations for such "fear of floating": exchange rate pass-through, liability dollarization, dollar invoicing of domestic and external transactions, and an underdeveloped market for currency hedging make it more desirable to stabilize the nominal exchange rate. However, the New-Keynesian model, which has become the main workhorse for studying exchange-rate regime choice since the 1990s, typically opposes fixed nominal pegs to free-floating regime, without considering intermediate regimes. We intend to fill this gap here...

2002

Most of the empirical literature on exchange rate regimes uses the IMF de jure classification based on the regime announced by the governments, despite the recognized inconsistencies between reported and actual policies in many cases. To address this problem, we construct a de facto classification based on data on exchange rates and international reserves from all IMF-reporting countries over the period 1974-2000, which we believe provides a meaningful alternative for future empirical work on the topic. The classification sheds new light on several stylized facts previously reported in the literature. In particular, we find that the de facto pegs have remained stable throughout the last decade, although an increasing number of them shy away from an explicit commitment to a fixed regime, a phenomenon we call "fear of pegging." We confirm the hollowing out hypothesis and show that, as expected, it does not apply to countries with limited access to capital markets. We also fi...