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Choosing an Exchange Rate Regime

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  • César Calderón
  • Klaus Schmidt Hebbel

Abstract

Choosing an exchange rate regime is one of the most important decisions in macroeconomic policymaking. Some countries may peg their currency to gain credibility and control domestic inflation, while others may be more prone to float due to the larger incidence of real shocks. In spite of the abundant literature on the determinants of the exchange rate regime choice, the empirical literature has been unable to produce robust results on how countries select their exchange rate arrangements. Some argue that the problems of the empirical literature may rely on: (a) the failure of traditional measures of exchange rate regimes in capturing information of the regime in force (deeds) rather than the announced regime that is self-reported by countries (words). (b) The modeling of the dependent variable: whether the issue is to model the adoption of pegs (vis-à-vis floating) or choose within a wider array of regimes. (c) The use of a comprehensive set of determinants of exchange rate regime choice that takes into account factors associated to theories of choice determination (optimum currency area theory, financial approach, among others). This paper attempts to address the issues mentioned above using a sample of 110 countries with annual information over the period 1975-2005 using de facto exchange rate regime classifications and a comprehensive set of explanatory variables. We find the following stylized facts. First, factors associated with the optimum currency area approach are good predictors of adopting pegs: countries that are smaller in size and with stronger trade linkages are more likely to peg their currencies. Second, factors related to the financial approach are consistent with the impossible trinity: countries with higher openness and higher financial development are more likely to adopt floating regimes. Finally, we find that countries with high inflation and larger external and fiscal imbalances are more prone to adopt pegs.

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Bibliographic Info

Paper provided by Central Bank of Chile in its series Working Papers Central Bank of Chile with number 494.

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Date of creation: Oct 2008
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Handle: RePEc:chb:bcchwp:494

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  1. Philip Lane & Gian Maria Milesi-Ferretti, 2001. "THE EXTERNAL WEALTH OF NATIONS: Measures of Foreign Assets and Liabilities For Industrial and Developing Countries," CEG Working Papers 20012, Trinity College Dublin, Department of Economics.
  2. Jeffrey Sachs & Aaron Tornell & Andres Velasco, 1996. "Financial Crises in Emerging Markets: The Lessons from 1995," Harvard Institute of Economic Research Working Papers 1759, Harvard - Institute of Economic Research.
  3. Arellano, Manuel & Honore, Bo, 2001. "Panel data models: some recent developments," Handbook of Econometrics, in: J.J. Heckman & E.E. Leamer (ed.), Handbook of Econometrics, edition 1, volume 5, chapter 53, pages 3229-3296 Elsevier.
  4. Arellano, Manuel & Carrasco, Raquel, 2003. "Binary choice panel data models with predetermined variables," Journal of Econometrics, Elsevier, vol. 115(1), pages 125-157, July.
  5. Husain, Aasim M. & Mody, Ashoka & Rogoff, Kenneth S., 2005. "Exchange rate regime durability and performance in developing versus advanced economies," Journal of Monetary Economics, Elsevier, vol. 52(1), pages 35-64, January.
  6. Mark Gertler & Simon Gilchrist & Fabio M. Natalucci, 2003. "External constraints on monetary policy and the financial accelerator," BIS Working Papers 139, Bank for International Settlements.
  7. David Cook & Woon Gyu Choi, 2002. "Liability Dollarization and the Bank Balance Sheet Channel," IMF Working Papers 02/141, International Monetary Fund.
  8. Ekaterini Kyriazidou, 1997. "Estimation of a Panel Data Sample Selection Model," Econometrica, Econometric Society, vol. 65(6), pages 1335-1364, November.
  9. Guillermo A. Calvo & Carlos A. Vegh, 1999. "Inflation Stabilization and BOP Crises in Developing Countries," NBER Working Papers 6925, National Bureau of Economic Research, Inc.
  10. Ramcharan, Rodney, 2007. "Does the exchange rate regime matter for real shocks? Evidence from windstorms and earthquakes," Journal of International Economics, Elsevier, vol. 73(1), pages 31-47, September.
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Cited by:
  1. Nora Lustig & Jaime Ros, 2011. "Latin America's Economic Challenges: Lessons for Emerging Economies," Working Papers 1112, Tulane University, Department of Economics.

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