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Exchange Rate Interventions and Insurance: Is Fear of Floating a Cause for Concern?

In: External Vulnerability and Preventive Policies

  • Francisco Gallego

    (Pontificia Universidad Católica de Chile)

  • Geraint Jones

    (Massachusetts Institute of Technology)

Fear of floating” is one of the central empirical characteristics of exchange rate regimes in emerging markets. However, while some view “fear of floating” in terms of the optimal ex post monetary response to external shocks, protecting balance sheets and avoiding inflation, others have argued that from an ex ante perspective such a policy leads to private sector underinsurance against sudden stops. A commitment to floating during potential crises would increase the incentives of the private sector to conserve international liquidity. This paper develops a model of the optimal exchange rate regime when both ex ante and ex post concerns are present. Since it is only “fear of floating” during potential sudden stops which undermines insurance, we reexamine the data on exchange rate regimes for evidence that exchange rate flexibility is state-contingent. We find most emerging markets exhibit non-contingent policies with a uniformly low level of flexibility, which together with an absence of substituteinsurance policies supports the claim that greater exchange rate flexibility during sudden stops would be desirable for such countries. However, more recent floats with intermediate levels of credibility exhibit little state contingency because of a uniformly high degree of flexibility. More established floats with high credibility exhibit statecontingent regimes, retaining a capacity for discretionary intervention, but floating during potential crises. Exchange rate flexibility is associated with increased private sector hoarding of dollar assets and reduced incidence of sudden stops. Together the evidence suggests that the insurance benefits to floating for emerging markets can be substantial and that the credibility of the monetary policy framework is central to successful implementation of this policy.

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This chapter was published in: Ricardo Caballero & César Calderón & Luis Felipe Céspedes & Norman Loayza (Series Editor) & Klaus Schmidt-Hebbel (Series Editor) (ed.) External Vulnerability and Preventive Policies, , chapter 11, pages 353-398, 2006.
This item is provided by Central Bank of Chile in its series Central Banking, Analysis, and Economic Policies Book Series with number v10c11pp353-398.
Handle: RePEc:chb:bcchsb:v10c11pp353-398
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  1. Alina Carare & Mark R. Stone, 2003. "Inflation Targeting Regimes," IMF Working Papers 03/9, International Monetary Fund.
  2. Guillermo A. Calvo & Carmen M. Reinhart, 2002. "Fear Of Floating," The Quarterly Journal of Economics, MIT Press, vol. 117(2), pages 379-408, May.
  3. Ricardo Hausmann & Ugo Panizza & Ernesto H. Stein, 2000. "Why Do Countries Float the Way They Float?," IDB Publications (Working Papers) 6467, Inter-American Development Bank.
  4. Sebastian Edwards, 2002. "The Great Exchange Rate Debate After Argentina," NBER Working Papers 9257, National Bureau of Economic Research, Inc.
  5. Kaminsky, Graciela Laura & Schmukler, Sergio L., 2002. "Short-run pain, long-run gain : the effects of financial liberalization," Policy Research Working Paper Series 2912, The World Bank.
  6. Barry Eichengreen & Ricardo Hausmann, 1999. "Exchange rates and financial fragility," Proceedings - Economic Policy Symposium - Jackson Hole, Federal Reserve Bank of Kansas City, pages 329-368.
  7. Barry Eichengreen & Michael D. Bordo, 2002. "Crises Now and Then: What Lessons from the Last Era of Financial Globalization," NBER Working Papers 8716, National Bureau of Economic Research, Inc.
  8. Levy Yeyati, Eduardo & Sturzenegger, Federico & Reggio, Iliana, 2010. "On the endogeneity of exchange rate regimes," European Economic Review, Elsevier, vol. 54(5), pages 659-677, July.
  9. Barro, Robert J., 1986. "Reputation in a model of monetary policy with incomplete information," Journal of Monetary Economics, Elsevier, vol. 17(1), pages 3-20, January.
  10. Bofinger, Peter & Wollmershaeuser, Timo, 2001. "Managed Floating: Understanding the New International Monetary Order," CEPR Discussion Papers 3064, C.E.P.R. Discussion Papers.
  11. 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.
  12. Jay C. Shambaugh, 2004. "The Effect of Fixed Exchange Rates on Monetary Policy," The Quarterly Journal of Economics, MIT Press, vol. 119(1), pages 300-351, February.
  13. Sebastian Edwards, 2001. "Exchange Rate Regimes, Capital Flows and Crisis Prevention," NBER Working Papers 8529, National Bureau of Economic Research, Inc.
  14. Corrinne Ho & Robert N. McCauley, 2003. "Living with flexible exchange rates: issues and recent experience in inflation targeting emerging market economies," BIS Working Papers 130, Bank for International Settlements.
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