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Do Exchange Rate Regimes Matter For Inflation And Exchange Rate Dynamics? The Case Of Central America

  • Rodrigo Caputo G.
  • Igal Magendzo

This paper makes an empirical contribution to the discussion on the optimal exchange rate regime. Using as astudy case the experience of the Central American countries, we compare the dynamics of the Real Exchange Rate (RER) and inflation persistence between dollarized economies and countries with some degree of exchange rate flexibility. Our results show that the two dollarized countries in the region, El Salvador and Panama, are quite different in terms of RER and inflation dynamics. While in El Salvador the RER spends more time away from the equilibrium level than the non-dollarized countries in the region, the opposite is true for Panama. We also find that inflation persistence in El Salvador is similar to that of the other countries, but smaller in Panama. This leads us to the conclusion that some degree of exchange rate flexibility helps countries to have a RER more aligned with its fundamentals. Nevertheless, a long-lived, highly credible dollarized economy, like Panama, can reduce inflation persistence to such an extent that RER misalignments are actually less frequent than in countries with more flexible exchange rate regimes.

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Paper provided by Central Bank of Chile in its series Working Papers Central Bank of Chile with number 517.

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Date of creation: Jun 2009
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Handle: RePEc:chb:bcchwp:517
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  1. Hamid Faruqee, 1995. "Long-Run Determinants of the Real Exchange Rate: A Stock-Flow Perspective," IMF Staff Papers, Palgrave Macmillan, vol. 42(1), pages 80-107, March.
  2. Lawrence J. Christiano & Martin Eichenbaum & Charles Evans, 2001. "Nominal rigidities and the dynamic effects of a shock to monetary policy," Proceedings, Federal Reserve Bank of San Francisco, issue Jun.
  3. Corbo, Vittorio, 2001. "Is it time for a common currency for the Americas?," Journal of Policy Modeling, Elsevier, vol. 23(3), pages 241-248, April.
  4. Thomas Lubik & Frank Schorfheide, 2003. "Do Central Banks Respond to Exchange Rate Movements? A Structural Investigation," Economics Working Paper Archive 505, The Johns Hopkins University,Department of Economics.
  5. Rodrigo Caputo & Felipe Liendo, 2005. "Monetary Policy, Exchange Rate and Inflation Inertia in Chile: a Structural Approach," Working Papers Central Bank of Chile 352, Central Bank of Chile.
  6. Rudi Dornbusch, 2001. "Fewer Monies, Better Monies," American Economic Review, American Economic Association, vol. 91(2), pages 238-242, May.
  7. Amartya Lahiri & Carlos A. Vegh, 2001. "Living with the Fear of Floating: An Optimal Policy Perspective," NBER Working Papers 8391, National Bureau of Economic Research, Inc.
  8. Lars E. O. Svensson, 1992. "An Interpretation of Recent Research on Exchange Rate Target Zones," Journal of Economic Perspectives, American Economic Association, vol. 6(4), pages 119-144, Fall.
  9. Paul R. Krugman, 1988. "Target Zones and Exchange Rate Dynamics," NBER Working Papers 2481, National Bureau of Economic Research, Inc.
  10. Jordi Gali & Mark Gertler, 2000. "Inflation Dynamics: A Structural Econometric Analysis," NBER Working Papers 7551, National Bureau of Economic Research, Inc.
  11. Claudio Paiva, 2001. "Competitiveness and the Equilibrium Exchange Rate in Costa Rica," IMF Working Papers 01/23, International Monetary Fund.
  12. Andrew K. Rose & Eric van Wincoop, 2001. "National Money as a Barrier to International Trade: The Real Case for Currency Union," American Economic Review, American Economic Association, vol. 91(2), pages 386-390, May.
  13. Claudio Paiva, 2006. "External Adjustment and Equilibrium Exchange Rate in Brazil," IMF Working Papers 06/221, International Monetary Fund.
  14. Rodrigo Caputo G. & Bernardo Dominichetti H., 2005. "Revisión Metodológica en el Cálculo del IPE e Implicancias sobre los Modelos de Serie de Tiempo Para el TCR," Notas de Investigación Journal Economía Chilena (The Chilean Economy), Central Bank of Chile, vol. 8(1), pages 77-82, April.
  15. Lawrence H. Summers, 2000. "International Financial Crises: Causes, Prevention, and Cures," American Economic Review, American Economic Association, vol. 90(2), pages 1-16, May.
  16. Edwards, Sebastian, 2001. "Dollarization: Myths and realities," Journal of Policy Modeling, Elsevier, vol. 23(3), pages 249-265, April.
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