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Living with the Fear of Floating: An Optimal Policy Perspective

  • Amartya Lahiri
  • Carlos A. Vegh

As documented in recent studies, developing countries (classified by the IMF as floaters or managed floaters) are extremely reluctant to allow for large nominal exchange rate fluctuations. This 'fear of floating' is reflected in the fact that, in spite of being subject to larger shocks, developing countries exhibit lower exchange rate variability and higher reserve variability than developed countries. Moreover, there is a positive correlation between changes in the exchange rate and interest rates and a negative correlation between both changes in reserves and the exchange rate and changes in interest rates and reserves. We build a simple model that rationalizes these key features as the outcome of an optimal policy response to monetary shocks. The model incorporates three key frictions: an output cost of nominal exchange rate fluctuations, an output cost of higher interest rates to defend the currency, and a fixed cost of intervention.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 8391.

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Date of creation: Jul 2001
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Publication status: published as Living with the Fear of Floating: An Optimal Policy Perspective , Amartya Lahiri, Carlos A. Végh. in Preventing Currency Crises in Emerging Markets , Edwards and Frankel. 2002
Handle: RePEc:nbr:nberwo:8391
Note: IFM
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  1. Correia, I. & Rabelo, S. & Naves, J.C., 1994. "Business Cycles in a Small Open Economy," RCER Working Papers 382, University of Rochester - Center for Economic Research (RCER).
  2. Guillermo A. Calvo & Carmen M. Reinhart, 2002. "Fear Of Floating," The Quarterly Journal of Economics, MIT Press, vol. 117(2), pages 379-408, May.
  3. Guillermo A. Calvo & Carmen M. Reinhart, 2000. "Fixing for Your Life," NBER Working Papers 8006, National Bureau of Economic Research, Inc.
  4. Eduardo Moron & Juan F. Castro, 2002. "Uncovering Central Bank Monetary Policy Objectives: Going Beyond Fear of Floating," Macroeconomics 0205002, EconWPA.
  5. Carlos A. Rodríguez, 1993. "Macroeconomic Developments in Romania," CEMA Working Papers: Serie Documentos de Trabajo. 90, Universidad del CEMA.
  6. Sebastian Edwards & Carlos A. Vegh, 1997. "Banks and Macroeconomics Disturbances under Predetermined Exchange Rates," NBER Working Papers 5977, National Bureau of Economic Research, Inc.
  7. Craig Burnside & Martin Eichenbaum & Sergio Rebelo, 1999. "Hedging and financial fragility in fixed exchange rate regimes," Working Paper Series WP-99-11, Federal Reserve Bank of Chicago.
  8. Agenor, Pierre-Richard & Aizenman, Joshua, 1999. "Financial sector inefficiencies and coordination failures : implications for crisis management," Policy Research Working Paper Series 2185, The World Bank.
  9. Pablo Druck & Pietro Garibaldi, 2000. "Inflation Risk and Portfolio Allocation in the Banking System," CEMA Working Papers: Serie Documentos de Trabajo. 181, Universidad del CEMA.
  10. Cadenillas, Abel & Zapatero, Fernando, 1999. "Optimal Central Bank Intervention in the Foreign Exchange Market," Journal of Economic Theory, Elsevier, vol. 87(1), pages 218-242, July.
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