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Regime-Switching in Exchange Rate Policy and Balance Sheet Effects

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  • Norbert Fiess
  • Rashmi Shankar

Abstract

It is well accepted that exchange rate policy in many emerging markets has been characterized by shifts between a stronger and weaker commitment to peg. This raises the following questions, which we address in our paper: Does intervention policy exhibit clearly defined and periodic shifts? What drives this policy variability? We identify clearly defined switches between high and low intervention in all the countries in our sample. We also find strong evidence that balance sheet effects, proxied by the stock ratio of external liabilities to assets, and economic performance, as measured by GDP and stock market indices, determine the likelihood of the regime shift. Specifically, an increase in reserve currency debt raises potential capital losses from devaluation and reduces the probability of switching to a low intervention regime. We use a panel of quarterly data starting 1985 through 2004 for a sample of 15 countries, mostly from East Asia and Latin America. We adopt a novel two-step empirical strategy in this paper. First, we measure the policy response of the central bank in two ways, both derived from the monetarist model: a standard exchange market pressure index and a model-based volatility ratio that is endogenized relative to Japan, our “benchmark” floater. We apply regime-switching methods to these “policy response indices.” This generates a time-series of unconditional probabilities of switching between high and low intervention. In the second step, we establish a set of variables that explains changes in these probabilities

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Bibliographic Info

Paper provided by Business School - Economics, University of Glasgow in its series Working Papers with number 2005_16.

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Date of creation: Jul 2005
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Handle: RePEc:gla:glaewp:2005_16

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  1. Luis Felipe Céspedes & Roberto Chang & Andrés Velasco, 2004. "Balance Sheets and Exchange Rate Policy," American Economic Review, American Economic Association, vol. 94(4), pages 1183-1193, September.
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  19. repec:rus:hseeco:124089 is not listed on IDEAS
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Cited by:
  1. Walter, Stefanie, 2008. "A New Approach for Determining Exchange-Rate Level Preferences," International Organization, Cambridge University Press, vol. 62(03), pages 405-438, July.

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