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Corner Solutions, Crises, and Capital Controls: A Theory and an Empirical Analyas on the Optimal Exchane Rate Regime in Emerging Economies

  • Yasuyuki Swada

    (University of Tokyo)

  • Pan A. Yotopoulos

    (Stanford University)

In a regime of free foreign exchange markets and free capital movements the reserve (hard) currencies are likely to substitute for the local soft currency in agents’ portfolia that include currency as an asset. This argument implies a process of cumulative circular causation with currency substitution leading to devaluation of soft currencies which in turn induces further currency substitution. At the theoretical level, the “fundamentals model” of currency crisis is formally extended by incorporating currency substitution in an inter-temporally optimizing framework. Next the model is implemented empirically by constructing a currency-softness index as a causal proxy of currency substitution and it is tested in an international cross section sample of countries. Two empirical findings emerge. First, there is a negative relationship between the currency-softness index and the degree of nominal-exchange-rate devaluation. Second, there is a systematic negative relationship between the softness of a currency and the level of economic development. Hence, a unipolar corner solution of floating exchange rate would not be sustainable for low-income countries with soft currencies. Rather a unipolar regime with a hard fixed exchange rate or even a middle-ground solution of fixed but adjustable exchange rate becomes optimal as long as the mobility of financial capital is restricted. Moreover, the optimal choice of exchange rate regime should be systematically linked with the level of development.

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Paper provided by Stanford Institute for Economic Policy Research in its series Discussion Papers with number 04-037.

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Date of creation: Aug 2005
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Handle: RePEc:sip:dpaper:04-037
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  1. Sawada, Yasuyuki, 2001. "Secondary market efficiency for LDC bank loans and international private lending, 1985-1993," Journal of International Money and Finance, Elsevier, vol. 20(4), pages 549-562, August.
  2. Pan A. Yotopoulos & Yasuyuki Sawada, 2005. "Exchange Rate Misalignment: A New Test of Long-Run PPP Based on Cross-Country Data," CIRJE F-Series CIRJE-F-318, CIRJE, Faculty of Economics, University of Tokyo.
  3. Guillermo A. Calvo & Leonardo Leiderman & Carmen M. Reinhart, 1993. "Capital Inflows and Real Exchange Rate Appreciation in Latin America: The Role of External Factors," IMF Staff Papers, Palgrave Macmillan, vol. 40(1), pages 108-151, March.
  4. Feenstra, Robert C., 1986. "Functional equivalence between liquidity costs and the utility of money," Journal of Monetary Economics, Elsevier, vol. 17(2), pages 271-291, March.
  5. Robert E. Lucas, Jr. & Nancy L. Stokey, 1985. "Money and Interest in a Cash-in-Advance Economy," NBER Working Papers 1618, National Bureau of Economic Research, Inc.
  6. Martin Uribe, 1995. "Hysteresis in a simple model of currency substitution," International Finance Discussion Papers 509, Board of Governors of the Federal Reserve System (U.S.).
  7. Stiglitz, Joseph E & Weiss, Andrew, 1981. "Credit Rationing in Markets with Imperfect Information," American Economic Review, American Economic Association, vol. 71(3), pages 393-410, June.
  8. Summers, Robert & Heston, Alan, 1991. "The Penn World Table (Mark 5): An Expanded Set of International Comparisons, 1950-1988," The Quarterly Journal of Economics, MIT Press, vol. 106(2), pages 327-68, May.
  9. Stanley Fischer, 2001. "Exchange Rate Regimes: Is the Bipolar View Correct?," Journal of Economic Perspectives, American Economic Association, vol. 15(2), pages 3-24, Spring.
  10. Robert P. Flood & Nancy P. Marion, 1998. "Self-Fulfilling Risk Predictions: An Application to Speculative Attacks," IMF Working Papers 98/124, International Monetary Fund.
  11. Cavallari, Lilia & Corsetti, Giancarlo, 2000. "Shadow rates and multiple equilibria in the theory of currency crises," Journal of International Economics, Elsevier, vol. 51(2), pages 275-286, August.
  12. Sawada, Yasuyuki, 1994. "Are the heavily indebted countries solvent?: Tests of intertemporal borrowing constraints," Journal of Development Economics, Elsevier, vol. 45(2), pages 325-337, December.
  13. repec:cup:cbooks:9780521482165 is not listed on IDEAS
  14. Flood, Robert P. & Garber, Peter M., 1984. "Collapsing exchange-rate regimes : Some linear examples," Journal of International Economics, Elsevier, vol. 17(1-2), pages 1-13, August.
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