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Exchange rate overshooting and the costs of floating

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  • Nouriel Roubini
  • Michele Cavallo
  • Kate Kisselev

Abstract

Currency crises are usually associated with large real depreciations. In some countries real depreciations are perceived to be very costly(''fear of floating''). In this paper we try to understand the reasons behind this fear. We first look at episodes of currency crises in the '90s and establish that countries entering a crisis with high levels of foreign debt tend to experience large real exchange rate overshooting (devaluation in addition of the long run equilibrium level) and large output contractions. We develop a model of currency crises that helps explain this evidence. The key element of the model is the presence of a margin constraint on the domestic country. Real devaluations, by reducing the value of domestic assets relative to international liabilities, make countries with high foreign debt more likely to hit the constraint. When countries hit the constraint they are forced to sell domestic assets and this causes a further devaluation of the currency (overshooting) and a reduction of their stock prices (overreaction). This fire sale can have a significant negative wealth effect. The model highlights a key tradeoff when considering fixed v/s flexible regime; a fixed exchange regime can, by avoiding exchange rate overshooting, mitigate the negative wealth effect but at the cost of additional distortions and output drops in the short run. There are plausible parameter values under which fixed exchange rates dominate flexible

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Bibliographic Info

Paper provided by Society for Computational Economics in its series Computing in Economics and Finance 2004 with number 62.

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Date of creation: 11 Aug 2004
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Handle: RePEc:sce:scecf4:62

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Keywords: Balance sheet effects; Currency Crises; Exchange rate policy;

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Cited by:
  1. Tracy Yue Wang & David Hirshleifer & Bing Han, 2010. "Investor Overconfidence and the Forward Discount Puzzle," 2010 Meeting Papers 1201, Society for Economic Dynamics.
  2. Towbin, Pascal & Weber, Sebastian, 2013. "Limits of floating exchange rates: The role of foreign currency debt and import structure," Journal of Development Economics, Elsevier, vol. 101(C), pages 179-194.
  3. Martin D. D. Evans & Richard K. Lyons, 2003. "Are Different-Currency Assets Imperfect Substitutes?," CESifo Working Paper Series 978, CESifo Group Munich.
  4. Felipe Meza & Erwan Quintin, 2005. "Financial crises and total factor productivity," Center for Latin America Working Papers 0105, Federal Reserve Bank of Dallas.
  5. Benjamin, David M. & Meza, Felipe, 2007. "Total factor productivity and labor reallocation: the case of the 1997 Korea crisis," Discussion Paper Series In Economics And Econometrics 0701, Economics Division, School of Social Sciences, University of Southampton.
  6. Frankel, Jeffrey & Cavallo, Eduardo, 2004. "Does Openness to Trade Make Countries More Vulnerable to Sudden Stops, or Less? Using Gravity to Establish Causality," Working Paper Series rwp04-038, Harvard University, John F. Kennedy School of Government.
  7. Saki Bigio & Marco Vega, 2006. "Monetary Policy under Balance Sheet Uncertainty," Computing in Economics and Finance 2006 157, Society for Computational Economics.
  8. Oya Pınar Ardıc & Faruk Selcuk, 2006. "The dynamics of a newly floating exchange rate: the Turkish case," Applied Economics, Taylor & Francis Journals, vol. 38(8), pages 931-941.
  9. Frankel, Jeffrey, 2005. "Contractionary Currency Crashes In Developing Countries," Working Paper Series rwp05-017, Harvard University, John F. Kennedy School of Government.
  10. Philip R. Lane, 2003. "Business Cycles and Macroeconomic Policy in Emerging Market Economies," Trinity Economics Papers 20032, Trinity College Dublin, Department of Economics.
  11. Enrique G. Mendoza, 2002. "Why Should Emerging Economies Give up National Currencies: A Case for 'Institutions Substitution'," NBER Working Papers 8950, National Bureau of Economic Research, Inc.
  12. Brad Setser & Nouriel Roubini & Christian Keller & Mark Allen & Christoph B. Rosenberg, 2002. "A Balance Sheet Approach to Financial Crisis," IMF Working Papers 02/210, International Monetary Fund.
  13. Michele Cavallo, 2005. "To float or not to float? exchange rate regimes and shocks," FRBSF Economic Letter, Federal Reserve Bank of San Francisco, issue jan7.
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