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Limits of Floating Exchange Rates

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  • Pascal Towbin
  • Sebastian Weber

Abstract

A traditional argument in favor of flexible exchange rates is that they insulate output better from real shocks, because the exchange rate can adjust and stabilize demand for domestic goods through expenditure switching. This argument is weakened in models with high foreign currency debt and low exchange rate pass-through to import prices. The present study evaluates the empirical relevance of these two factors. We analyze the transmission of real external shocks to the domestic economy under fixed and flexible exchange rate regimes for a broad sample of countries in a Panel VAR and let the responses vary with foreign currency indebtedness and import structure. We find that flexible exchange rates do not insulate output better from external shocks if the country imports mainly low pass-through goods and can even amplify the output response if foreign indebtedness is high.

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Bibliographic Info

Paper provided by International Monetary Fund in its series IMF Working Papers with number 11/42.

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Length: 51
Date of creation: 01 Feb 2011
Date of revision:
Handle: RePEc:imf:imfwpa:11/42

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Keywords: Currency pegs; Economic models; External debt; External shocks; Flexible exchange rates; Floating exchange rates; exchange rate; currency debt; foreign currency debt; exchange rate regime; exchange rate regimes; exchange rates; exchange rate pass; foreign debt; domestic currency; balance sheet effects; external shock; flexible exchange rate; balance sheet effect; floating exchange rate; fixed exchange rates; exchange rate policy; flexible exchange rate regimes; fixed exchange rate; nominal exchange rate; real exchange rate; low debt; exchange rate depreciation; flexible exchange rate regime; exchange rate changes; total external debt; external finance; floating exchange rate regimes; exchange rate fluctuations; reserve bank; private debt; exchange rate rule; exchange arrangements; exchange rate regime classification; domestic debt; central bank; exchange rate classification; real exchange rates; short term debt; exchange rate dummy; exchange policy; currency mismatches; long term debt; history of exchange rate; floating exchange rate regime; exchange rate depreciations; exchange rate peg; exchange rate overshooting; fixed exchange rate regimes; constant exchange rate; external indebtedness; currency board; debt ratio; exchange rate movements; debt burden; debt problems; exchange rate arrangements; international lending; exchange restrictions; freely floating exchange rate; exchange rate data; currency depreciation; currency areas;

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References

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  1. Hoffmann, Mathias, 2003. "Fixed versus Flexible Exchange Rates: Evidence from Developing Countries," Royal Economic Society Annual Conference 2003 109, Royal Economic Society.
  2. Timothy J. Kehoe & Kim Ruhl, 2008. "Data Appendix to "Are Shocks to the Terms of Trade Shocks to Productivity?"," Technical Appendices 07-40, Review of Economic Dynamics.
  3. Carmen M. Reinhart & Kenneth S. Rogoff, 2004. "The Modern History of Exchange Rate Arrangements: A Reinterpretation," The Quarterly Journal of Economics, MIT Press, vol. 119(1), pages 1-48, February.
  4. Timothy J. Kehoe & Kim J. Ruhl, 2007. "Are shocks to the terms of trade shocks to productivity?," Staff Report 391, Federal Reserve Bank of Minneapolis.
  5. Hausmann, Ricardo & Panizza, Ugo & Stein, Ernesto, 2001. "Why do countries float the way they float?," Journal of Development Economics, Elsevier, vol. 66(2), pages 387-414, December.
  6. Aasim M. Husain & Ashoka Mody & Nienke Oomes & Robin Brooks & Kenneth Rogoff, 2003. "Evolution and Performance of Exchange Rate Regimes," IMF Working Papers 03/243, International Monetary Fund.
  7. Raddatz, Claudio, 2007. "Are external shocks responsible for the instability of output in low-income countries?," Journal of Development Economics, Elsevier, vol. 84(1), pages 155-187, September.
  8. Charalambos G. Tsangarides, 2010. "Crisis and Recovery," IMF Working Papers 10/242, International Monetary Fund.
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Citations

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Cited by:
  1. Sergio Sola, 2013. "Temporary and Persistent Fiscal Policy Shocks," IHEID Working Papers 06-2013, Economics Section, The Graduate Institute of International Studies.
  2. Tomasz Wieladek & Sergi Lanau, 2012. "Financial Regulation and the Current Account," IMF Working Papers 12/98, International Monetary Fund.
  3. Glocker, C. & Towbin, P., 2012. "Reserve Requirements for Price and Financial Stability - When Are They Effective?," Working papers 363, Banque de France.
  4. Nickel, Christiane & Tudyka, Andreas, 2013. "Fiscal stimulus in times of high debt: reconsidering multipliers and twin deficits," Working Paper Series 1513, European Central Bank.
  5. Georgiadis, Georgios, 2012. "Towards an explanation of cross-country asymmetries in monetary transmission," Discussion Papers 07/2012, Deutsche Bundesbank, Research Centre.
  6. Christian Saborowski & Sebastian Weber, 2013. "Assessing the Determinants of Interest Rate Transmission Through Conditional Impulse Response Functions," IMF Working Papers 13/23, International Monetary Fund.
  7. Georgiadis, Georgios, 2012. "The panel conditionally homogenous vectorautoregressive model," MPRA Paper 37755, University Library of Munich, Germany.

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