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Living with the Fear of Floating: An Optimal Policy Perspective

In: Preventing Currency Crises in Emerging Markets

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  • Amartya Lahiri
  • Carlos A. Végh

Abstract

As documented in recent studies, developing countries (classified by the IMF as floaters or managed floaters) are extremely reluctant to allow for large nominal exchange rate fluctuations. This 'fear of floating' is reflected in the fact that, in spite of being subject to larger shocks, developing countries exhibit lower exchange rate variability and higher reserve variability than developed countries. Moreover, there is a positive correlation between changes in the exchange rate and interest rates and a negative correlation between both changes in reserves and the exchange rate and changes in interest rates and reserves. We build a simple model that rationalizes these key features as the outcome of an optimal policy response to monetary shocks. The model incorporates three key frictions: an output cost of nominal exchange rate fluctuations, an output cost of higher interest rates to defend the currency, and a fixed cost of intervention.

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This chapter was published in:

  • Sebastian Edwards & Jeffrey A. Frankel, 2002. "Preventing Currency Crises in Emerging Markets," NBER Books, National Bureau of Economic Research, Inc, number edwa02-2, octubre-d.
    This item is provided by National Bureau of Economic Research, Inc in its series NBER Chapters with number 10646.

    Handle: RePEc:nbr:nberch:10646

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    1. Guillermo A. Calvo & Carmen M. Reinhart, 2000. "Fear of Floating," NBER Working Papers 7993, National Bureau of Economic Research, Inc.
    2. Correia, Isabel & Neves, Joao C. & Rebelo, Sergio, 1995. "Business cycles in a small open economy," European Economic Review, Elsevier, vol. 39(6), pages 1089-1113, June.
    3. Sebastian Edwards & Carlos A. Vegh, 1997. "Banks and Macroeconomics Disturbances under Predetermined Exchange Rates," NBER Working Papers 5977, National Bureau of Economic Research, Inc.
    4. Burnside, A Craig & Eichenbaum, Martin & Rebelo, Sérgio, 1999. "Hedging and Financial Fragility in Fixed Exchange Rate Regimes," CEPR Discussion Papers 2171, C.E.P.R. Discussion Papers.
    5. Reinhart, Carmen & Calvo, Guillermo, 2001. "Fixing for your life," MPRA Paper 13873, University Library of Munich, Germany.
    6. Eduardo Moron & Juan F. Castro, 2002. "Uncovering Central Bank Monetary Policy Objectives: Going Beyond Fear of Floating," Macroeconomics 0205002, EconWPA.
    7. Pablo Druck & Pietro Garibaldi, 2000. "Inflation Risk and Portfolio Allocation in the Banking System," CEMA Working Papers: Serie Documentos de Trabajo. 181, Universidad del CEMA.
    8. Cadenillas, Abel & Zapatero, Fernando, 1999. "Optimal Central Bank Intervention in the Foreign Exchange Market," Journal of Economic Theory, Elsevier, vol. 87(1), pages 218-242, July.
    9. Agenor, Pierre-Richard & Aizenman, Joshua, 1999. "Financial sector inefficiencies and coordination failures : implications for crisis management," Policy Research Working Paper Series 2185, The World Bank.
    10. Carlos A. Rodríguez, 1993. "Macroeconomic Developments in Romania," CEMA Working Papers: Serie Documentos de Trabajo. 90, Universidad del CEMA.
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