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Corner Solutions, Crises, and Capital Controls: A Theory and an Empirical Analyas on the Optimal Exchane Rate Regime in Emerging Economies

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Author Info

  • Yasuyuki Swada

    (University of Tokyo)

  • Pan A. Yotopoulos

    (Stanford University)

Abstract

In a regime of free foreign exchange markets and free capital movements the reserve (hard) currencies are likely to substitute for the local soft currency in agents’ portfolia that include currency as an asset. This argument implies a process of cumulative circular causation with currency substitution leading to devaluation of soft currencies which in turn induces further currency substitution. At the theoretical level, the “fundamentals model” of currency crisis is formally extended by incorporating currency substitution in an inter-temporally optimizing framework. Next the model is implemented empirically by constructing a currency-softness index as a causal proxy of currency substitution and it is tested in an international cross section sample of countries. Two empirical findings emerge. First, there is a negative relationship between the currency-softness index and the degree of nominal-exchange-rate devaluation. Second, there is a systematic negative relationship between the softness of a currency and the level of economic development. Hence, a unipolar corner solution of floating exchange rate would not be sustainable for low-income countries with soft currencies. Rather a unipolar regime with a hard fixed exchange rate or even a middle-ground solution of fixed but adjustable exchange rate becomes optimal as long as the mobility of financial capital is restricted. Moreover, the optimal choice of exchange rate regime should be systematically linked with the level of development.

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Bibliographic Info

Paper provided by Stanford Institute for Economic Policy Research in its series Discussion Papers with number 04-037.

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Date of creation: Aug 2005
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Handle: RePEc:sip:dpaper:04-037

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Related research

Keywords: exchange-rate regime; financial crises; currency substitution; exchange rate and capital liberalization in developing countries;

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References

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  1. Summers, Robert & Heston, Alan, 1991. "The Penn World Table (Mark 5): An Expanded Set of International Comparisons, 1950-1988," The Quarterly Journal of Economics, MIT Press, vol. 106(2), pages 327-68, May.
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  3. Sawada, Yasuyuki, 2001. "Secondary market efficiency for LDC bank loans and international private lending, 1985-1993," Journal of International Money and Finance, Elsevier, vol. 20(4), pages 549-562, August.
  4. Sawada, Yasuyuki, 1994. "Are the heavily indebted countries solvent?: Tests of intertemporal borrowing constraints," Journal of Development Economics, Elsevier, vol. 45(2), pages 325-337, December.
  5. Stanley Fischer, 2001. "Exchange Rate Regimes: Is the Bipolar View Correct?," Journal of Economic Perspectives, American Economic Association, vol. 15(2), pages 3-24, Spring.
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  8. Cavallari, Lilia & Corsetti, Giancarlo, 2000. "Shadow rates and multiple equilibria in the theory of currency crises," Journal of International Economics, Elsevier, vol. 51(2), pages 275-286, August.
  9. Uribe, Martin, 1997. "Hysteresis in a simple model of currency substitution," Journal of Monetary Economics, Elsevier, vol. 40(1), pages 185-202, September.
  10. Flood, Robert P. & Garber, Peter M., 1984. "Collapsing exchange-rate regimes : Some linear examples," Journal of International Economics, Elsevier, vol. 17(1-2), pages 1-13, August.
  11. Pan A. Yotopoulos & Yasuyuki Sawada, 2005. "Exchange Rate Misalignment: A New Test of Long-Run PPP Based on Cross-Country Data," CIRJE F-Series CIRJE-F-318, CIRJE, Faculty of Economics, University of Tokyo.
  12. Yotopoulos,Pan A., 1996. "Exchange Rate Parity for Trade and Development," Cambridge Books, Cambridge University Press, number 9780521482165, April.
  13. Flood, Robert P. & Marion, Nancy P., 2000. "Self-fulfilling risk predictions:: an application to speculative attacks," Journal of International Economics, Elsevier, vol. 50(1), pages 245-268, February.
  14. Guillermo A. Calvo & Leonardo Leiderman & Carmen M. Reinhart, 1993. "Capital Inflows and Real Exchange Rate Appreciation in Latin America: The Role of External Factors," IMF Staff Papers, Palgrave Macmillan, vol. 40(1), pages 108-151, March.
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Cited by:
  1. Yasuyuki Sawada & Pan A. Yotopoulos, 2006. "Growth and Poverty Reduction Under Globalization: The Systematic Impact of Exchange Rate Misalignment," Discussion Papers 06-014, Stanford Institute for Economic Policy Research.

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