Exchange Rate Regimes and the Sources of Real Exchange Rate Fluctuations: Evidence from East Asia

This paper investigates how the sources of real exchange rate (RER) fluctuations differ under different exchange rate regimes using data of two East Asian countries, namely, Korea and Thailand, which have adopted different exchange rate regimes over the last few decades. The sources of RER fluctuations are decomposed into supply, demand, monetary, and exchange rate-specific shocks, among which the last captures changes in the RER that are not related to fundamentals. These shocks are identified by means of a structural VAR identified by sign restrictions which are drawn from a standard dynamic stochastic open economy macro model. Our main findings are as follows. Exchange rate-specific shocks are much more important to the fluctuations of the RER in the floating regime than in the peg one. They are also an important source of fluctuations of the interest rate, output, and the price level. Demand shocks are the most important source of RER fluctuations in both exchange rate regimes. The findings imply a tradeoff in designing the exchange rate regime, i.e. the tradeoff between the need to allow the (nominal and real) exchange rate to adjust to fundamental shocks and the need to limit the undesirable fluctuations of the exchange rate that do not come from fundamentals.