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Living with the Fear of Floating: An Optimal Policy Perspective

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Author Info
Amartya Lahiri
Carlos A. Vegh

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Abstract

As documented in recent studies, developing countries (classified by the IMF as floaters or managed floaters) are extremely reluctant to allow for large nominal exchange rate fluctuations. This 'fear of floating' is reflected in the fact that, in spite of being subject to larger shocks, developing countries exhibit lower exchange rate variability and higher reserve variability than developed countries. Moreover, there is a positive correlation between changes in the exchange rate and interest rates and a negative correlation between both changes in reserves and the exchange rate and changes in interest rates and reserves. We build a simple model that rationalizes these key features as the outcome of an optimal policy response to monetary shocks. The model incorporates three key frictions: an output cost of nominal exchange rate fluctuations, an output cost of higher interest rates to defend the currency, and a fixed cost of intervention.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 8391.

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Date of creation: Jul 2001
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Handle: RePEc:nbr:nberwo:8391

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Find related papers by JEL classification:
F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics
E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy

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Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
  1. Sebastian Edwards & Carlos A. Vegh, 1997. "Banks and Macroeconomics Disturbances under Predetermined Exchange Rates," NBER Working Papers 5977, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  2. Agenor, Pierre-Richard & Aizenman, Joshua, 1999. "Financial sector inefficiencies and coordination failures : implications for crisis management," Policy Research Working Paper Series 2185, The World Bank. [Downloadable!]
  3. Craig Burnside & Martin Eichenbaum & Sergio Rebelo, 1999. "Hedging and financial fragility in fixed exchange rate regimes," Working Paper Series WP-99-11, Federal Reserve Bank of Chicago. [Downloadable!]
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  4. Eduardo Moron & Juan F. Castro, 2002. "Uncovering Central Bank Monetary Policy Objectives: Going Beyond Fear of Floating," Macroeconomics 0205002, EconWPA. [Downloadable!]
  5. Cadenillas, Abel & Zapatero, Fernando, 1999. "Optimal Central Bank Intervention in the Foreign Exchange Market," Journal of Economic Theory, Elsevier, vol. 87(1), pages 218-242, July. [Downloadable!] (restricted)
  6. Guillermo A. Calvo & Carmen M. Reinhart, 2000. "Fear of Floating," NBER Working Papers 7993, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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