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Why Do Countries Float the Way They Float?

  • Ricardo Hausmann
  • Ugo Panizza
  • Ernesto H. Stein

Countries that are classified as having floating exchange rate systems (or very wide bands) show strikingly different patterns of behavior. They hold very different levels of international reserves and allow very different volatilities in the movements of the exchange rate relative to the volatility that they tolerate either on the level of reserves or in interest rates. We document these differences and present a model that explains them as the optimal response of a Central Bank that attempts to minimize a standard loss function, in an environment in which firms are credit-constrained and incomplete markets limit their ability to avoid currency mismatches. This model suggests that the difference in the way countries float could be related to their differing levels of exchange rate pass-through and differences in their ability to avoid currency mismatches. We test these implications and find a very strong and robust relationship between the pattern of floating and the ability of a country to borrow internationally in its own currency. We find weaker and less robust evidence on the importance of pass-through to account for differences across countries with respect to their exchange rate/monetary management.

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Paper provided by Inter-American Development Bank, Research Department in its series Research Department Publications with number 4205.

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Date of creation: May 2000
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Handle: RePEc:idb:wpaper:4205
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  1. Reinhart, Carmen & Calvo, Guillermo, 2002. "Fear of floating," MPRA Paper 14000, University Library of Munich, Germany.
  2. Eichengreen, Barry & Rose, Andrew K & Wyplosz, Charles, 1996. "Contagious Currency Crises," CEPR Discussion Papers 1453, C.E.P.R. Discussion Papers.
  3. Barro, Robert J. & Gordon, David B., 1983. "Rules, discretion and reputation in a model of monetary policy," Journal of Monetary Economics, Elsevier, vol. 12(1), pages 101-121.
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  10. Diaz-Alejandro, Carlos, 1985. "Good-bye financial repression, hello financial crash," Journal of Development Economics, Elsevier, vol. 19(1-2), pages 1-24.
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  12. Eichengreen, Barry & Rose, Andrew & Wyplosz, Charles, 1996. " Contagious Currency Crises: First Tests," Scandinavian Journal of Economics, Wiley Blackwell, vol. 98(4), pages 463-84, December.
  13. Svensson, L-E-O, 1996. "Inflation Forecast Targeting : Implementaing and Monitoring Inflation Targets," Papers 615, Stockholm - International Economic Studies.
  14. Luis Felipe Céspedes & Roberto Chang & Andrés Velasco, 2004. "Balance Sheets and Exchange Rate Policy," American Economic Review, American Economic Association, vol. 94(4), pages 1183-1193, September.
  15. Reinhart, Carmen & Calvo, Guillermo, 2001. "Fixing for your life," MPRA Paper 13873, University Library of Munich, Germany.
  16. Ernesto H. Stein & Jeffry Frieden, 2000. "The Political Economy of Exchange Rate Policy in Latin America: An Analytical Overview," Research Department Publications 3118, Inter-American Development Bank, Research Department.
  17. P. Krugman & L. Taylor, 1976. "Contractionary Effects of Devaluations," Working papers 191, Massachusetts Institute of Technology (MIT), Department of Economics.
  18. Aizenman, Joshua & Frenkel, Jacob A, 1985. "Optimal Wage Indexation, Foreign Exchange Intervention, and Monetary Policy," American Economic Review, American Economic Association, vol. 75(3), pages 402-23, June.
  19. Philippe Bacchetta, 2000. "Monetary Policy with Foreign Currency Debt," Working Papers 00.03, Swiss National Bank, Study Center Gerzensee.
  20. Sebastian Edwards & Miguel A. Savastano, 1999. "Exchange Rates in Emerging Economies: What Do We Know? What Do We Need to Know?," NBER Working Papers 7228, National Bureau of Economic Research, Inc.
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