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Exogenous Shocks and Exchange Rate Management in Developing Countries

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  • Sajid Anwar

    (LUMS)

  • S. Zahid Ali
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    Abstract

    Even though globalization benefits less developed countries (LDCs), it also makes them more vulnerable to the exogenous shocks to the economies. Many LDCs rely on imported technologies and intermediate inputs to compete in the international export markets with better quality and cost efficient products. In this regard, exchange rate policies in respective countries have a direct bearing on the cost of production. This paper examines alternative exchange rate regimes to suggest an appropriate exchange rate policy in the context of developing countries. The paper utilizes a small open economy model involving direct supply-side effects of exchange rate and expectations of key economic variables and considers four possible exchange rate policies, e.g., fixed exchange rate, perfectly flexible exchange rate, leaning against the wind, and leaning with the wind. Contrary to the conventional wisdom, the paper finds that in the event of a shock, leaning against the wind is likely to be the most appropriate exchange rate policy. Moreover, in the event of rigid wages, a fixed exchange rate policy is advisable.

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    Bibliographic Info

    Paper provided by East Asian Bureau of Economic Research in its series Finance Working Papers with number 22245.

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    Date of creation: Jan 2007
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    Handle: RePEc:eab:financ:22245

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    Related research

    Keywords: globalization; exchange rate regimes; exchange rate policy;

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    1. Carlin, Wendy & Soskice, David, 2004. "The 3-Equation New Keynesian Model: A Graphical Exposition," CEPR Discussion Papers 4588, C.E.P.R. Discussion Papers.
    2. Bailliu, Jeannine & Lafrance, Robert & Perrault, Jean-Francois, 2003. "Does Exchange Rate Policy Matter for Growth?," International Finance, Wiley Blackwell, vol. 6(3), pages 381-414, Winter.
    3. Stanley Fischer, 1986. "Contracts, Credibility, and Disinflation," NBER Working Papers 1339, National Bureau of Economic Research, Inc.
    4. Ivan Roberts & Rod Tyers, 2003. "China's Exchange Rate Policy: The Case for Greater Flexibility," Asian Economic Journal, East Asian Economic Association, vol. 17(2), pages 155-184, 06.
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