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Optimal fear of floating: the role of currency mismatches and fiscal constraints

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  • Eduardo J. J. Ganapolsky

Abstract

Evidence suggests that developing countries are much more concerned with stabilizing the nominal exchange rate than developed countries. This paper presents a model to explain this observation, based on the hypotheses that both interventions and depreciations are costly. Interventions are costly because they generate a financial need in a fiscally constrained government that relies solely on distortionary taxes. Depreciations are costly because the country, in particular its financial sector, is exposed to a currency mismatch between its assets and its liabilities that is not effectively hedged. The results suggest that the amount of intervention will depend on the degree of currency mismatch between assets and liabilities, the elasticity of money demand, and the relative size of the financial system. It would be expected that countries with a high degree of currency mismatch and large financial sectors would intervene heavily in foreign exchange markets, as long as the money demand is not too sensitive to the nominal interest rate.

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  • Eduardo J. J. Ganapolsky, 2003. "Optimal fear of floating: the role of currency mismatches and fiscal constraints," FRB Atlanta Working Paper 2003-31, Federal Reserve Bank of Atlanta.
    • Handle: RePEc:fip:fedawp:2003-31
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    Cited by:

    1. Eduardo J. J. Ganapolsky, 2003. "Reserve requirements, bank runs, and optimal policies in small open economies," FRB Atlanta Working Paper 2003-39, Federal Reserve Bank of Atlanta.
    2. Demosthenes N. Tambakis, 2007. "Fear of Floating and Social Welfare," International Journal of Central Banking, International Journal of Central Banking, vol. 3(3), pages 183-204, September.
    3. Honig, Adam, 2005. "Fear of floating and domestic liability dollarization," Emerging Markets Review, Elsevier, vol. 6(3), pages 289-307, September.
    4. Carlos E. León Rincón & Alejandro Revéiz Herault, 2008. "La dolarización financiera: experiencia internacional y perspectivas para Colombia," Revista de Economía Institucional, Universidad Externado de Colombia - Facultad de Economía, vol. 10(18), pages 313-341, January-J.

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