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Exchange Rate Interventions and Insurance: Is “Fear of Floating” a Cause For Concern?

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  • Francisco Gallego
  • Geraint Jones

Abstract

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.

Suggested Citation

  • Francisco Gallego & Geraint Jones, 2005. "Exchange Rate Interventions and Insurance: Is “Fear of Floating” a Cause For Concern?," Working Papers Central Bank of Chile 326, Central Bank of Chile.
  • Handle: RePEc:chb:bcchwp:326
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    References listed on IDEAS

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    Cited by:

    1. Gallego, Francisco A. & Tessada, José A., 2012. "Sudden stops, financial frictions, and labor market flows: Evidence from Latin America," Journal of Development Economics, Elsevier, vol. 97(2), pages 257-268.
    2. Hans Keiding & Mette J. Knudsen, 2005. "Rational Fear of Floating: A Simple Model of Exchange Rates and Income Distribution," Discussion Papers 05-03, University of Copenhagen. Department of Economics.
    3. Levan Efremidze & Samuel M. Schreyer & Ozan Sula, 2011. "Sudden stops and currency crises," Journal of Financial Economic Policy, Emerald Group Publishing, vol. 3(4), pages 304-321, November.

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