The choice of exchange rate regime is a perennial issue for policy makers. But, in the wake of the recent volatility in global capital markets, this issue has taken on special relevance for emerging markets. Recent exchange rate crises have led some to conclude that, in an environment of capital market volatility, more exchange rate flexibility is desirable.
Unfortunately, accepting more exchange rate flexibility can also represent a choice among undesirable alternatives: facing an adverse shock, central banks must “pick their poison.” Letting the currency depreciate, they have to accept unwanted effects on both possible acceleration of inflation through the pass-through and further domestic financial fragilities caused by increased foreign currency liabilities. Raising the interest rate to defend the exchange rate, on the other hand, may adversely impact economic activity, financial sector balance sheets, or both.
An exchange rate regime should ultimately reflect a central bank’s preference as to how such a shock should be transmitted to the domestic economy. However, providing evidence on this issue can be problematic. As is well known, a country’s stated exchange rate policy can differ substantially from its actual one, as observed by Levy-Yeyati and Sturzenegger (2002), Bubula and Otker-Robe (2002), and Reinhart and Rogoff (2002) among others. Moreover, exactly how to measure the exchange rate regime—that is, the degree of flexibility—remains an open question, which will be discussed in greater detail below.
This paper examines choice of exchange rate regimes and their effect on the economies in emerging markets. First, we empirically characterize a country’s exchange rate regime as a dynamic response to capital account shocks—how countries “pick their poison.” Second, we analyze the impact of capital market shocks on the domestic economy—the outcome of the “poison.” Specifically, we assess the effect of such shocks on three key domestic variables: real economic growth, inflation, and the primary fiscal balance, conditional on an exchange rate regime chosen by the central bank. In this way, we can evaluate how—if at all—the choice of exchange rate regime affects the outcome of external shocks to the domestic economy.
More specifically, our model casts this policy decision in two dimensions. In one dimension, the central bank decides whether to adjust monetary aggregates (reserves, with corresponding domestic credit flows) or prices (exchange rates, interest rates), or some combination thereof. In the other dimension, the central bank decides which of the prices to adjust: interest rates, exchange rates, or some combination thereof.
Contents
I. Introduction
II. A Structural Vector Autoregression (SVAR) Approach
- A. The Basic Model
B. Identification
C. How Does the Central Bank Distribute an External Capital Market Shock (eN)?
III. Empirical Results: Brazil, Mexico, and Turkey
- A. Central Bank Reactions and Tradeoffs
B. The Transmission of Capital Account Shocks eN to the Domestic Economy
IV. What If the Exchange Rate Had Been More (or Less) Flexible? A Counterfactual Analysis
V. Summary and Conclusion
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Pick Your Poison: The Exchange Rate Regime and Capital Account Volatility in Emerging Markets
