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Limits of Floating Exchange Rates; the Role of Foreign Currency Debt and Import Structure

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  • Pascal Towbin
  • Sebastian Weber

Abstract

A traditional argument in favor of flexible exchange rates is that they insulate output better from real shocks, because the exchange rate can adjust and stabilize demand for domestic goods through expenditure switching. This argument is weakened in models with high foreign currency debt and low exchange rate pass-through to import prices. The present study evaluates the empirical relevance of these two factors. We analyze the transmission of real external shocks to the domestic economy under fixed and flexible exchange rate regimes for a broad sample of countries in a Panel VAR and let the responses vary with foreign currency indebtedness and import structure. We find that flexible exchange rates do not insulate output better from external shocks if the country imports mainly low pass-through goods and can even amplify the output response if foreign indebtedness is high.

Suggested Citation

  • Pascal Towbin & Sebastian Weber, 2011. "Limits of Floating Exchange Rates; the Role of Foreign Currency Debt and Import Structure," IMF Working Papers 11/42, International Monetary Fund.
  • Handle: RePEc:imf:imfwpa:11/42
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    Keywords

    External debt; External shocks; Economic models; Currency pegs; Imports; Flexible exchange rates; Floating exchange rates; Exchange rate regime; balance sheet effect; pass-through; interacted panel VAR; external shock; exchange rate; currency debt; foreign currency debt; exchange rate regimes; Prices; Business Fluctuations; and Cycles: General (includes Measurement and Data); International Monetary Arrangements and Institutions; International Lending and Debt Problems; Open Economy Macroeconomics;

    JEL classification:

    • F33 - International Economics - - International Finance - - - International Monetary Arrangements and Institutions
    • F34 - International Economics - - International Finance - - - International Lending and Debt Problems
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

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