Chapter

3 Countries’ Choice of Exchange Rate Regime

Author(s):
Atish Ghosh, Jonathan Ostry, and Charalambos Tsangarides
Published Date:
March 2011
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Although exchange rate policy is just one facet of a country’s overall set of macroeconomic policies, an appropriate choice of exchange rate regime can help the country meet particular macroeconomic goals. This chapter first describes broad trends in exchange rate regimes based on a three-way, de jure and de facto categorization into pegged, intermediate, and floating regimes. It then summarizes the findings of a comprehensive empirical analysis of how the exchange rate regime affects macroeconomic performance. The chapter concludes by drawing some implications for countries’ choice of exchange rate regime. The appendix discusses issues of regime classification.

Trends in Regimes

The past decade has seen important developments in the choice of exchange rate regime across countries. In advanced economies, the most significant development was the adoption of a common currency by euro area countries in 1999 (Box 3.1). Among emerging market economies (Figure 3.1a), three trends are discernible. First, consistent with Mussa and others (2000) and the bipolar prescription, there is significant hollowing out of the intermediate regime category.1 Second, since the first review, the proportion of both de jure and de facto floating exchange rate regimes has roughly doubled. Contrary to the prescription in Rogoff and others (2004), however, the proportion of de facto floating regimes has fallen somewhat since 2003. Third, there is significant divergence between the de jure and de facto classifications. In a number of cases, the central bank intervenes in the foreign exchange market without taking on the formal commitment to the peg. This is reflected in a larger number of de facto pegs than de jure pegs, and a larger number of de jure floats than de facto floats.2 Though the latter phenomenon has decreased since 1998, in some 40 percent of de jure floats, the country does not have a de facto floating exchange rate regime (Figure 3.2).

Figure 3.1.Frequency Distribution of Exchange Rate Regimes for Emerging Market and Developing Countries

(In percent)

Source: IMF staff estimates.

Figure 3.2.Emerging Market Countries: De Jure and De Facto Floats

(In percent)

Source: IMF staff estimates.

In developing countries, there has been no hollowing out of the (de jure or de facto) intermediate regime category (Figure 3.1b). The proportion of de jure pegs and de jure floats has also remained roughly constant over the past decade (with a slight increase in pegs and decrease in floats). And, as with EMEs, there is significant divergence between de jure and de facto regimes.

The divergence between de jure commitments and de facto behavior, evident in both emerging market and developing countries, nearly always reflects cases where the central bank intervenes but does not commit to the parity (Table 3.1). The opposite case—taking on a de jure commitment but de facto not defending the parity—is much rarer. Indeed, across the full sample, in more than 90 percent of cases where the exchange rate is de jure pegged it is also de facto pegged, but in only 50 percent of cases where the exchange rate de jure floats does it also de facto float.

Table 3.1Distribution of Exchange Rate Regimes
De Jure Classification
ClassificationPeggedIntermediateFloating
Pegged1,58847781
Intermediate921,677392
Floating1953476
Total1,6992,207949
Percentage consensus93.576.050.2
Source: Based on Anderson (2008).
Source: Based on Anderson (2008).

Together, these trends suggest that developing and emerging market countries have only partially followed the advice of previous studies. Thus, consistent with Mussa and others (2000), there has been some hollowing out of the middle. And, following Rogoff and others (2004), more emerging market countries are de jure floating their exchange rates. Contrary to the prescriptions of these two reviews, however, a large proportion of developing and emerging market countries de facto peg their exchange rates—intervening in the foreign exchange markets without taking on the formal commitment to the peg. But, as elaborated on below, this may be the worst of both worlds: providing neither the policy discipline and credibility of a formal peg, nor the flexibility that a floating exchange rate affords. Whereas the inflation benefits of pegging accrue mainly to de jure pegs (particularly in emerging market countries), the costs in terms of susceptibility to crisis and more abrupt external adjustment apply equally to de facto and de jure pegs.

Macroeconomic Performance under Alternative Exchange Rate Regimes

Although the theoretical literature on the choice of exchange rate regime is vast, at some risk of oversimplification it can be categorized into three main strands.3 The first examines the adjustment, policy effectiveness, and insulating properties of the regime—whether the exchange rate regime facilitates adjustment to trade imbalances, against what types of shocks (domestic or foreign, nominal or real) the regime best insulates output, and whether the regime constrains other macroeconomic stabilization policies. Some papers take the analysis a step further to ask whether the lower volatility of output translates into higher average growth. The second strand, originating in postwar Europe, weighs the benefits of adopting pegged exchange rates (or a common currency) to foster deeper goods and capital market integration against the cost of giving up the exchange rate as an adjustment tool. The third strand, rooted in the high-inflation experiences of the 1970s and 1980s, considers how an exchange rate peg can provide a precommitment device to a central bank battling entrenched inflationary expectations, helping it to disinflate by disciplining credit expansion and by engendering confidence in the currency. Although such exchange-rate-based stabilizations enjoyed several successes, their overall record was more mixed (with initial disinflation often followed by a consumption boom, overvaluation, and a fresh balance of payments crisis), while the capital account crises of the 1990s seemed to further underscore the fragility of fixed exchange rate regimes and their susceptibility to crisis.

Box 3.1.Ten Years of the Euro: Achievements and Challenges

The launch of the euro in January 1999 marked the final phase of the three-stage plan—proposed in 1988 and formalized within the Maastricht Treaty in 1992—to create the European Economic and Monetary Union (EMU). Initially comprising 11 EU members, the euro area has since expanded to include 16 countries that account for about 18 percent of global GDP, while the euro has become the world’s second dominant reserve currency.

Macroeconomic Performance

The skepticism surrounding the introduction of the euro and the adoption of a single monetary policy by the EMU member states in the presence of decentralized economic and fiscal policies has been countered by a decade of macroeconomic stability in these countries. During the past 10 years, nominal variables such as inflation and interest rates have stabilized and converged to lower levels in the euro area (Figures 1 and 2), while real variables such as output have also exhibited less volatility. The employment rate has improved, but that did not translate into faster economic growth, and real GDP growth—on average, about 2 percent from 1999–2008—has stayed at broadly the same level as 1990–98. The euro is also estimated to have boosted bilateral trade among member countries, albeit modestly. Recent studies find the euro effect on intraregional trade to be in the range of 10 to 15 percent (Frankel, 2008). Additionally, there is no evidence of trade diversion; instead, Baldwin (2006) finds that the euro created external and internal trade through reduced transaction costs.

Figure 1.Inflation Level and Volatility

Sources: IMF, World Economic Outlook; and Organization for Economic Cooperation and Development statistics.

Figure 2.Ten-Year Government Bond Yields

(Spread over German bunds; in percentage points)

Source: IMF, World Economic Outlook.

Productivity and Competitiveness

Few gains appear to have been achieved in the euro area in terms of productivity growth, which has—on average—slowed post-euro compared to the decade before. Meanwhile, unit labor costs have increased and, in some countries, outweighed any productivity improvements between 1999 and 2007. Alesina, Ardagna, and Galasso (2008) find that adoption of the euro has been associated with an accelerated pace of structural reforms in the product market but not in the primary labor market. Further, in the run-up to the euro adoption, some countries experienced substantial wage moderation that was consistent with the fiscal and inflationary discipline undertaken to join the currency union, but the single currency does not appear to have had an effect on wage moderation in the past decade.

Implications of the Financial Crisis

The current global financial crisis presents significant challenges to the euro area. Economic activity has slowed, and average real growth was negative for four consecutive quarters from 2008:Q3–2009:Q2. So far, owing in part to the credibility of the euro, member countries with a large banking sector and foreign currency debt have been spared the crises that have beset smaller European countries. However, uncertainty is high as budget deficits and public debt have grown, and spreads on the 10-year government bond yields of Greece, Ireland, Portugal, and Italy over that of Germany have surged (Figure 3). Without the exchange rate as an adjustment tool, recovery may prove challenging, yet the financial crisis also offers the opportunity to advance with structural reforms, particularly in the labor market, to improve productivity and competitiveness.

Figure 3.Monthly 10-Year Government Bond Yields

(Spread over German bunds; in percentage points)

Source: IMF, World Economic Outlook.

Note: This box was prepared by Mahvash Qureshi. The euro area referred to here includes Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Portugal, Spain, and Greece.

The theoretical literature thus gives rise to a number of empirical questions: Does the regime constrain monetary and fiscal policies? Are pegged exchange rates associated with lower inflation? Are there systematic differences in growth performance across regimes? Are floating exchange rates less susceptible to crisis? Do floating exchange rates facilitate external adjustment? Do pegged exchange rates promote cross-border goods and capital market integration? To help answer these questions, this section reports the key findings of a comprehensive empirical analysis based on some 150 advanced, emerging market, and developing countries over 1980–2007, using the three-way (pegged, intermediate, floating) de jure and de facto regime classifications.4

Macroeconomic Policies

Since exchange arrangements are just part of the overall macroeconomic policy package, a first question is how the choice of regime affects the scope for monetary and fiscal policies. Regarding monetary policy, the “impossible trinity” implies that a country cannot have a pegged exchange rate, open capital account, and independent monetary policy. But how important is this constraint in practice?

Empirically, pegged exchange rate regimes seem to constrain the ability of monetary policy to react to domestic macroeconomic conditions considerably more than either intermediate or floating regimes do:

  • Estimated interest rate reaction functions (“Taylor rules”) show that monetary policy reacts to inflation and the output gap under floating and intermediate regimes, but not under pegged exchange rate regimes (Table 3.2a).5
  • Similar results are obtained across country income groups (Table 3.2b–d), though the loss of autonomy under pegged exchange rate regimes is more pronounced for emerging market and developing countries than for advanced economies.6
  • Robustness tests (not reported here) suggest that the lower responsiveness of monetary policy under pegged exchange rates also holds for countries with low capital mobility; distinguishing pegged exchange rate regimes according to the degree of sterilization (because heavy sterilizers may have greater autonomy); and adding the exchange rate to the interest rate reaction function (on the grounds that, even under a flexible exchange rate regime, the central bank may react to the exchange rate).
Table 3.2.Monetary Policy under Alternative Exchange Rate Regimes
De Jure ClassificationDe Facto Classification
Dependent Variable: Interest RateCoefficientt-StatisticCoefficientt-Statistic
a. All countries
Inflation0.241.71*0.141.00
Pegged regimes * inflation–0.21a–1.50–0.19a–1.19
Intermediate regimes * inflation–0.17–1.130.030.21
Output gap0.142.33**0.402.67***
Pegged regimes * output gap–0.13a–2.17**–0.41a–2.73***
Intermediate regimes * output gap0.040.57–0.24–1.50
Anchor interest rate0.380.970.451.55
Anchor interest rate * Pegged regimes0.120.320.120.44
Anchor interest rate * Intermediate regimes–0.31a–0.69–0.42a–1.27
Number of observations, R21,9020.121,8420.15
b. Advanced economies1
Inflation0.051.67*0.061.50
Inflation * Pegged regimes–0.09–2.25**–0.09a–1.80*
Output gap0.031.500.031.00
Output gap * Pegged regimes0.010.33–0.02a–0.67
Anchor interest rate0.402.50**0.382.53**
Anchor interest rate * Pegged regimes0.361.290.423.00***
Number of observations, R25420.245390.25
c. Emerging market countries1
Inflation0.252.50**0.322.91***
Inflation * Pegged regimes–0.41a–2.16**–0.68–5.67***
Output gap0.292.90***0.303.00***
Output gap * Pegged regimes–0.33a–2.36**–0.19a–1.19
Anchor interest rate0.190.210.020.02
Anchor interest rate * Pegged regimes0.10a0.150.98a1.24
Number of observations, R25010.194760.24
d. Developing countries1
Inflation0.093.00***0.092.25**
Inflation * Pegged regimes–0.02–0.50–0.02–0.40
Output gap0.133.25***0.174.25***
Output gap * Pegged regimes–0.13a–3.25***–0.17a–4.25***
Anchor interest rate0.070.30–0.07–0.28
Anchor interest rate * Pegged regimes0.451.96*0.642.46**
Number of observations, R29460.119240.12
Source: IMF staff estimates.Note: Regression of change in interest rate on inflation, output gap, and anchor country interest rate with dummies and interactive dummies for pegged and intermediate exchange rate regimes. Regression shows the response of the domestic interest rate (proxy for monetary policy) to inflation, the output gap (positive indicates output above potential), and the identified anchor country’s interest rate. The omitted category is floating exchange rate regimes (in the three-way classification) and floating and intermediate exchange rate regimes (in the two-way classification). Significant regime interactive coefficients indicate that the policy response under that regime differs from the response under the omitted category. Insignificant sum of interacted and noninteracted variable indicates that policy does not react to that variable under that exchange rate regime. Asterisks indicate statistical significance at the 10(*), 5(**), and 1(***) percent levels.

Combination of the coefficient on the interacted variable (inflation, output gap, anchor interest rate) with the coefficient on the noninteracted variable is not statistically significantly different from zero. Example: Combined coefficient of 0.03 (= 0.24 – 0.21) under pegged regimes implies that interest rates are 0.03 percentage point higher for each percentage point of inflation. Insignificant sum of coefficients implies that 0.03 is not statistically significantly different from zero.

Two-way classification of regimes: pegged regimes compared to intermediate and floating regimes.

Source: IMF staff estimates.Note: Regression of change in interest rate on inflation, output gap, and anchor country interest rate with dummies and interactive dummies for pegged and intermediate exchange rate regimes. Regression shows the response of the domestic interest rate (proxy for monetary policy) to inflation, the output gap (positive indicates output above potential), and the identified anchor country’s interest rate. The omitted category is floating exchange rate regimes (in the three-way classification) and floating and intermediate exchange rate regimes (in the two-way classification). Significant regime interactive coefficients indicate that the policy response under that regime differs from the response under the omitted category. Insignificant sum of interacted and noninteracted variable indicates that policy does not react to that variable under that exchange rate regime. Asterisks indicate statistical significance at the 10(*), 5(**), and 1(***) percent levels.

Combination of the coefficient on the interacted variable (inflation, output gap, anchor interest rate) with the coefficient on the noninteracted variable is not statistically significantly different from zero. Example: Combined coefficient of 0.03 (= 0.24 – 0.21) under pegged regimes implies that interest rates are 0.03 percentage point higher for each percentage point of inflation. Insignificant sum of coefficients implies that 0.03 is not statistically significantly different from zero.

Two-way classification of regimes: pegged regimes compared to intermediate and floating regimes.

Turning to fiscal policy, the unsustainability of a peg when the government is money-financing the fiscal deficit is well known; more generally, the fiscal theory of the price level stresses that a pegged exchange rate will not be sustainable unless fiscal policy—including money and bond financing—is sufficiently flexible to respect the government’s present value budget constraint at a price level consistent with the peg.7

  • In terms of simple averages, overall general government deficits are smaller under pegged and intermediate regimes than in floating regimes, especially in developing countries (Table 3.3). Fiscal policy is also much less countercyclical under pegged exchange rate regimes (and, to a lesser extent, under intermediate exchange rate regimes) than under floating regimes (Table 3.4a).
  • This pattern generally holds across country income groups (Table 3.4b–d)—except that, in EMEs, fiscal policy is not significantly countercyclical under any exchange rate regime (and is strongly procyclical under pegged regimes), and it is much less countercyclical in developing countries than in advanced economies.
Table 3.3.Overall Government Balance, 1990–2007(In percent of GDP)
De JureDe Facto
PeggedIntermediateFloatingPeggedIntermediateFloating
All countries–1.9–1.9–3.4–2.1–2.6–2.2
Advanced–0.8–1.4–1.5–1.1–2.1–0.6
Emerging–3.2–3.0–4.0–3.5–3.1–3.8
Developing–2.2–1.6–5.7–2.4–2.9–4.6
Sources: IMF, World Economic Outlook; and, IMF staff estimates.
Sources: IMF, World Economic Outlook; and, IMF staff estimates.
Table 3.4.Fiscal Policy under Alternative Exchange Rate Regimes
De Jure ClassificationDe Facto Classification
Dependent Variable: Fiscal StanceCoefficientt-StatisticCoefficientt-Statistic
a. All countries
Output gap–8.35–3.39***–9.37–3.54***
Pegged regimes * output gap9.732.36**10.552.38**
Intermediate regimes * output gap1.70.480.220.06
Number of observations, R27400.457400.45
b. Advanced economies
Output gap–18.92–2.86***–23.42–3.43***
Pegged regimes * output gap30.692.63***32.333.02***
Intermediate regimes * output gap–10.21–1.38–3.34–0.44
Number of observations, R23000.633000.62
c. Emerging market countries
Output gap–7.86–1.102.10.43
Pegged regimes * output gap30.89a2.76***10.94a1.40
Intermediate regimes * output gap11.621.35–3.27–0.57
Number of observations, R21740.501740.52
d. Developing countries
Output gap–7.52–2.27**–11.66–2.67***
Pegged regimes * output gap11.012.16**16.562.44**
Intermediate regimes * output gap6.031.186.741.05
Number of observations, R22660.432660.44
Source: IMF staff estimates.Note: Regression of fiscal stance (cyclically-neutral general government balance–actual balance; increase represents a fiscal expansion) on output gap (+ indicates output above potential) with regime dummies and regime interaction terms and other control variables (coefficients not reported): inflation, domestic interest rate, and public debt and government expenditure (both in percent of GDP). Regression shows response of fiscal policy to output gap under alternative exchange rate regimes. Negative coefficient on output gap indicates countercyclical fiscal policy under floating exchange rate regimes (the omitted regime category); positive interactive regime dummy of equal or greater magnitude implies procyclical fiscal policy under that regime. Asterisks indicate statistical significance at the 10(*), 5(**), and 1(***) percent levels.

Combined coefficient on the output gap and the regime interaction is positive and significant at the 10 percent level, implying procyclical fiscal policy. Example: Combined coefficient of 23.0 (=–7.86 + 30.80) under pegged regimes implies that the fiscal stance is tightened by 0.23 percent of GDP for each percentage point of the output gap.

Source: IMF staff estimates.Note: Regression of fiscal stance (cyclically-neutral general government balance–actual balance; increase represents a fiscal expansion) on output gap (+ indicates output above potential) with regime dummies and regime interaction terms and other control variables (coefficients not reported): inflation, domestic interest rate, and public debt and government expenditure (both in percent of GDP). Regression shows response of fiscal policy to output gap under alternative exchange rate regimes. Negative coefficient on output gap indicates countercyclical fiscal policy under floating exchange rate regimes (the omitted regime category); positive interactive regime dummy of equal or greater magnitude implies procyclical fiscal policy under that regime. Asterisks indicate statistical significance at the 10(*), 5(**), and 1(***) percent levels.

Combined coefficient on the output gap and the regime interaction is positive and significant at the 10 percent level, implying procyclical fiscal policy. Example: Combined coefficient of 23.0 (=–7.86 + 30.80) under pegged regimes implies that the fiscal stance is tightened by 0.23 percent of GDP for each percentage point of the output gap.

One possibility is that the cycle in emerging market countries is driven by capital flows; when there are capital outflows, an expansionary fiscal policy would widen the risk premium and prompt further capital outflows, threatening the peg. Therefore, fiscal policy is constrained to be countercyclical. This is only a partial explanation, however, because it does not account for procyclicality during the boom period of capital inflows.

Pegged exchange rate regimes thus impose significant constraints on the conduct of other macro-economic policies. Under a peg, monetary policy largely follows the anchor currency’s interest rate, and, while the fiscal deficit is smaller, so is the use of countercyclical fiscal policy. Pegging the exchange rate may therefore be a double-edged sword: potentially useful for countries lacking credible institutions and macroeconomic discipline, but, by the same token, constraining the use of macroeconomic policies to offset shocks in countries that do have sufficient policy discipline.

Inflation

The strongest implications in the theoretical literature on the effects of the nominal exchange rate regime concern the behavior of nominal variables such as price inflation. Policy credibility models suggest that pegged exchange rates should be associated with lower inflation because they both instill policy discipline (limit the rate of central bank credit expansion) and engender confidence in the currency (increase the private sector’s willingness to hold the currency, leading to lower inflation for a given rate of monetary expansion).8 For countries trying to disinflate against a history of high inflation, pegging the exchange rate to a strong anchor currency may therefore be a way of “importing” credibility and low inflation. But it is also possible that, if the exchange rate is undervalued and there are limits to sterilization, maintaining the parity in the face of balance of payments surpluses would lead to faster money growth and higher inflation; particularly if the anchor currency is itself subject to depreciation and inflation, the country could end up importing higher inflation. In terms of simple averages, however, the former effect dominates: across the full sample of countries, inflation is lowest under de jure pegs (Table 3.5).

Table 3.5Inflation, 1980–2007(In percent per year)
De JureDe Facto
PeggedIntermediateFloatingPeggedIntermediateFloating
All countries8.010.813.611.015.59.5
Advanced2.76.73.62.77.52.8
Emerging market11.612.917.111.015.510.4
Developing8.111.117.48.213.215.9
Sources: IMF, World Economic Outlook; and, IMF staff estimates.
Sources: IMF, World Economic Outlook; and, IMF staff estimates.

The finding of lower inflation under pegged exchange rates generally holds, controlling for other likely determinants of inflation:

  • For the full sample, de jure pegs are associated with about 5 percent lower inflation than intermediate or floating regimes (Table 3.6a). This reflects a direct association between inflation and the exchange rate regime (i.e., controlling for all of these determinants, the residual “confidence” effect in the policy credibility models), and an indirect association through the behavior of money growth under the regime (the “discipline” effect).
  • Pegged exchange rates are not associated with lower inflation in advanced economies (Table 3.6b). These countries generally have strong institutions that provide policy credibility regardless of the exchange rate regime, and their inflation performance is similar to that of potential anchor currencies, so there would be little benefit to “importing” the credibility of an anchor currency.9
  • For developing and emerging market countries, the association between low inflation and regime is stronger for de jure pegs than for de facto pegs (Table 3.6c–d). This may reflect the formal commitment by the central bank to maintain the parity under a de jure peg, which, in policy credibility models, is costly to break and leads to the better inflation performance. Dropping those de facto pegged exchange rate observations that are not also classified as pegs under de jure classification yields statistically significant effects of the regime (Table 3.6, “peg consensus”). Therefore, de facto pegs in which the central bank is also making a formal commitment are indeed associated with lower inflation than floating regimes.10
  • Across the full sample (i.e., including advanced economies), countries with floating regimes and explicit inflation-targeting frameworks have lower inflation than countries with pegged regimes (Table 3.6f). But for EMEs, pegged exchange rates outperform inflation targeting—a result that holds both for the full sample period (1980–2007) and for a more recent period (2000–07), when inflation-targeting frameworks in emerging market countries have become more prevalent and better developed.
  • The relative inflation performance of pegged exchange rate regimes when the country has a balance of payments surplus depends on the source—current account or capital account—of that surplus. In the face of large current accountsurpluses (above 2 percent of GDP—the top 30th percentile of the sample), money growth under pegged exchange rates is higher because the accumulation of reserves cannot be sterilized. This faster money growth results in higher inflation under pegged regimes compared with floating exchange rates (Table 3.6g). In the face of large capital inflows (above 2.5 percent of GDP—the top 30th percentile of the sample), money growth under pegged exchange rates is again higher (compared with times when there are no such inflows). But money growth in the face of capital inflows is even higher under floating regimes—presumably reflecting looser credit policy in “good times” of capital inflows.11 As a result, inflation is lower under pegged exchange rate regimes even in the face of capital inflows (Table 3.6h).
Table 3.6Inflation under Alternative Exchange Rate Regimes
De Jure ClassificationDe Facto ClassificationPeg Consensus1
Dependent Variable: InflationCoefficientt-StatisticCoefficientt-StatisticCoefficientt-Statistic
a. All countries
Constant0.0313.11***0.0151.86*0.0030.01
Pegged regimes–0.046–9.57***–0.002–0.33–0.0122.62***
Intermediate regimes0.0030.710.05512.47***0.05310.51***
Number of observations, R22,1740.472,0650.481,7160.43
b. Advanced economies
Constant–0.029–3.21***–0.015–1.28–0.021–0.01**
Pegged regimes0.0275.630***–0.013–2.47***0.036.13***
Intermediate regimes0.0225.130***0.0255.48***0.046.57***
Number of observations, R24420.714370.743730.73
c. Emerging market countries
Constant0.0644.92***0.0442.91***0.020.02
Pegged regimes–0.106–7.86***0.0120.75–0.044–2.93***
Intermediate regimes–0.031–3.19***0.0745.61***0.053.57***
Number of observations, R25820.605220.644150.58
d. Developing countries
Constant0.0563.71***0.0482.20**0.030.03
Pegged regimes–0.059–8.93***–0.051–5.81***–0.065–6.70***
Intermediate regimes–0.002–0.280.0030.330.010.54
Number of observations, R21,1500.381,1060.329280.34
e. Observations with below 5 percent per year inflation
All countries
Constant0.0243.93***0.0213.45***
Pegged regimes–0.011–5.94***–0.007–4.16***
Intermediate regimes0.000–0.190.0041.60
Number of observations, R29810.149550.17
f. Relative to inflation-targeting floating regimes
All countries
Constant0.0121.540.0233.29***
Pegged regimes0.0225.06***0.0102.25**
Intermediate regimes0.07014.58***0.06113.33***
Number of observations, R218090.4217600.43
Emerging market countries
Constant0.0322.45**0.0302.32**
Pegged regimes–0.047–4.02***–0.037–4.01***
Intermediate regimes0.0333.61***0.0535.14***
Number of observations, R24780.614430.62
Table 3.6(concluded)
De Jure ClassificationDe Facto Classification
Dependent Variable: InflationCoefficientt-StatisticCoefficientt-Statistic
g. Current account balance above 2 percent of GDP2
All countries
Constant0.0211.50–0.007–0.62
Pegged regimes0.0292.72***0.0636.21***
Intermediate regimes0.0344.77***0.08910.03***
Number of observations, R24100.574070.60
Emerging market countries
Constant0.0511.65–0.034–0.88
Pegged regimes–0.033–0.800.0401.08
Intermediate regimes0.0070.230.1283.33***
Number of observations, R21050.701040.80
h. Capital inflows exceeding 2.5 percent of GDP2
All countries
Constant0.0010.140.0242.96***
Pegged regimes–0.042–7.32***–0.019–2.72***
Intermediate regimes0.0274.77***0.0365.35***
Number of observations, R21,0400.499880.49
Emerging market countries
Constant0.0251.250.0371.78*
Pegged regimes–0.092–5.71***–0.102–7.11***
Intermediate regimes–0.004–0.360.0191.33
Number of observations, R22690.572410.60
Source: IMF staff estimates.Note: Regression of inflation (decimal fraction, per year) on regime dummies and other control variables; instrumental variable estimation; t-statistics based on clustered, robust standard errors. Regression shows the association between inflation (as a decimal fraction, per year) and the exchange rate regime, taking into account both the direct channel (i.e., controlling for all other determinants) and the indirect channel through the behavior of broad money growth under the regime. Negative coefficient on pegged or intermediate exchange rate regime dummies indicates lower inflation under that regime relative to inflation under floating exchange rate regimes (the omitted category). Example: Coefficient of–0.046 for pegged regimes implies 4.6 percent per year lower inflation under pegged exchange rate regimes compared to floating regimes, taking into account differential money growth and controlling for other variables. Other control variables (coefficients not reported): annual dummies, broad money growth, real GDP growth, trade openness, central bank governor turnover rate (proxy for low central bank independence), terms of trade growth, and fiscal balance (in percent of GDP). Asterisks indicate statistical significance at the 10(*), 5(**), and 1(***) percent levels.
1Includes only de facto pegged exchange rate regime observations that are also classified as de jure pegs.
2Sample’s 30th percentile of positive current account balances and positive net capital flows, respectively.
Source: IMF staff estimates.Note: Regression of inflation (decimal fraction, per year) on regime dummies and other control variables; instrumental variable estimation; t-statistics based on clustered, robust standard errors. Regression shows the association between inflation (as a decimal fraction, per year) and the exchange rate regime, taking into account both the direct channel (i.e., controlling for all other determinants) and the indirect channel through the behavior of broad money growth under the regime. Negative coefficient on pegged or intermediate exchange rate regime dummies indicates lower inflation under that regime relative to inflation under floating exchange rate regimes (the omitted category). Example: Coefficient of–0.046 for pegged regimes implies 4.6 percent per year lower inflation under pegged exchange rate regimes compared to floating regimes, taking into account differential money growth and controlling for other variables. Other control variables (coefficients not reported): annual dummies, broad money growth, real GDP growth, trade openness, central bank governor turnover rate (proxy for low central bank independence), terms of trade growth, and fiscal balance (in percent of GDP). Asterisks indicate statistical significance at the 10(*), 5(**), and 1(***) percent levels.
1Includes only de facto pegged exchange rate regime observations that are also classified as de jure pegs.
2Sample’s 30th percentile of positive current account balances and positive net capital flows, respectively.

Thus, except in the face of large current account surpluses, pegging the exchange rate is associated with significantly lower inflation—especially in cases where the central bank is willing to take on the formal commitment to the peg. Moreover, this association survives a battery of robustness tests, including the possibility of “regime endogeneity” (in which low-inflation countries are more likely to adopt or maintain a peg, rather than the other way around).12

Output Growth and Volatility

A key purpose of the international monetary system, as stressed in the IMF’s Articles, is to provide a framework that sustains sound economic growth. In terms of unconditional averages, output growth (per capita, constant prices in national currency) in advanced economies is higher under pegged and intermediate exchange rate regimes than under floating exchange rate regimes (Table 3.7). In emerging market and developing countries, growth rates do not differ markedly between pegged and floating exchange rate regimes, while intermediate regimes exhibit the highest output growth rates.

Table 3.7Output Growth, 1980–2007(Per capita, in percent per year)
De JureDe Facto
PeggedIntermediateFloatingPeggedIntermediateFloating
All countries1.41.91.41.61.71.5
Advanced2.52.31.92.52.21.9
Emerging market1.22.41.51.72.21.6
Developing1.31.51.11.41.41.1
Source: IMF, World Economic Outlook; and, IMF staff estimates.
Source: IMF, World Economic Outlook; and, IMF staff estimates.

While the theoretical literature linking the nominal exchange rate regime to real variables is less developed, there are several channels through which the regime might matter for output growth. For instance, the regime may affect trade and inflation, with most empirical studies finding that greater trade openness and lower inflation are associated with faster output growth. The regime also may affect volatility: if nominal or real exchange rate volatility is detrimental to growth, then floating regimes may be associated with lower growth. Some studies also stress the importance of a competitive level of the real exchange rate; inasmuch as pegged exchange rates are more susceptible to overvaluation because of higher inflation than the anchor currency (or, conversely, to undervaluation if the central bank is able to resist real appreciation pressures through intervention), this might affect growth performance.13

For the exchange rate regime to be linked to growth performance through the channels mentioned above, these variables must differ systematically across regimes—which they do (Table 3.8). Pegged exchange rate regimes are associated with (statistically significantly) greater overvaluation—but lower volatility—of the real exchange rate, lower inflation, and greater trade openness than floating regimes. The overvaluation of the real exchange rate is particularly pronounced for de jure pegs, where there may be residual inflation dynamics (or Balassa-Samuelson effects) such that inflation continues at a higher rate than in the anchor country. At least in some de facto pegs, the central bank may be intervening to limit the appreciation of the nominal (and real) exchange rate in the face of balance of payments surpluses; nevertheless, although the difference is not statistically significant, de facto pegs are more prone to overvaluation than de facto floats. Intermediate regimes are associated with (statistically significantly) lower real exchange rate overvaluation, lower price volatility, and higher trade, but also higher inflation (again compared with floating exchange rate regimes).

Table 3.8Channels of Indirect Association between Regime and Output Growth
De JureDe Facto
PeggedIntermediatePeggedIntermediate
Competitive real exchange rate–0.162***0.034–0.0390.127***
Real exchange rate volatility–0.854***0.303–1.303***–0.123
Price volatility0.033–0.464***0.224–0.308**
Inflation–0.039***–0.011–0.0030.054***
Trade openness0.359***0.127***0.374***0.121***
Source: IMF, World Economic Outlook; and, IMF staff estimates.Note: Relative to floating regimes; includes other controls from growth regression. Higher value indicates more competitive (less overvalued) real exchange rate. Volatility measured as standard deviation of monthly growth rates. Asterisks indicate statistical significance at the 5(**) and 1(***) percent levels.
Source: IMF, World Economic Outlook; and, IMF staff estimates.Note: Relative to floating regimes; includes other controls from growth regression. Higher value indicates more competitive (less overvalued) real exchange rate. Volatility measured as standard deviation of monthly growth rates. Asterisks indicate statistical significance at the 5(**) and 1(***) percent levels.

Taking these various indirect channels into account, and controlling for other growth determinants:

  • Across the full sample of countries, intermediate exchange rate regimes are associated with about 0.5 percentage point a year higher growth than pegged or floating exchange rate regimes (Table 3.9a).
  • The faster growth performance under intermediate regimes stems mainly from the emerging market country sample—and is stronger for the de jure classification than for the de facto classification (Table 3.9c). The statistical decomposition into the various indirect channels suggests that intermediate regimes are associated with faster growth because they combine more competitive real exchange rates than pegged exchange rate regimes with lower real exchange rate volatility, greater trade openness, and—to some degree—lower inflation than floating exchange rate regimes.14 The main systematic difference between pegged and intermediate exchange rate regimes is that the former are more susceptible to overvaluation of the exchange rate, suggesting that growth performance under pegged exchange rates can be improved if overvaluation can be avoided.
  • The finding of higher growth in EMEs under intermediate regimes is robust to alternative econometric specifications, including the possibility that the choice of regime is endogenous to the country’s growth performance. Moreover, similar results are obtained using five-year average, rather than annual, real GDP growth rates (the differential in favor of intermediate regimes rising to 1 percentage point)—the main difference being that pegged exchange rate regimes also perform well in the five-year growth regressions, with about 1 percentage point higher growth a year than floating exchange rate regimes (though the difference is not statistically significant; see Table 3.9, “five-year average growth” columns).
  • For developing countries, no very clear results are obtained—growth seems to be determined by factors other than the exchange rate regime. There is some evidence of slower growth under de jure pegs—which are more likely to be subject to overvaluation of the exchange rate (Table 3.9d). But annual output growth rates in developing countries are likely to be very noisy. Regressions using five-year growth rates suggest somewhat higher growth under pegged and especially intermediate exchange rate regimes than floating regimes, though the differences are not statistically significant.
Table 3.9.Output Growth under Alternative Exchange Rate Regimes
Annual Growth RatesFive-Year Average Growth Rates
De jure classificationDe facto classificationDe jure classificationDe facto classification
Dependent Variable: Real GDP GrowthCoefficientt-StatisticCoefficientt-StatisticCoefficientt-StatisticCoefficientt-Statistic
a. All countries
Constant–0.005–0.29–0.007–0.40–0.026–0.86–0.032–1.06
Pegged regimes–0.004–1.90*–0.001–0.220.0071.600.0081.31
Intermediate regimes0.0062.91***0.0052.05**0.0102.62***0.0091.67*
Number of observations, R21,7420.181,6670.183980.203980.2
b. Advanced economies
Constant0.1723.44***0.1713.29***0.1351.93*0.1432.04**
Pegged regimes–0.002–0.62–0.002–0.700.0010.270.0020.59
Intermediate regimes–0.003–1.26–0.003–1.30–0.002–0.740.0000.00
Number of observations, R24730.274700.261000.441000.42
c. Emerging market countries
Constant0.0310.610.1062.04**0.1091.550.0921.14
Pegged regimes0.0030.52–0.004–0.740.0121.260.0000.00
Intermediate regimes0.0113.28***0.0000.000.0142.44**–0.002–0.30
Number of observations, R25020.384530.371100.31100.29
d. Developing countries
Constant–0.017–0.67–0.000–0.01–0.015–0.29–0.023–0.44
Pegged regimes–0.007–1.68*–0.008–1.210.0060.770.0020.11
Intermediate regimes–0.001–0.24–0.002–0.280.0091.170.0050.35
Number of observations, R27670.199130.181880.231880.23
Source: IMF staff estimates.Note: Regression of per capita output growth in constant local currency prices (decimal fraction, per year) on regime dummies and other control variables; instrumental variable estimation; t-statistics based on clustered, robust standard errors. Regression shows association between output growth (as a decimal fraction, per year) and the exchange rate regime, taking into account both the direct (i.e., controlling for all other determinants) and indirect channels through the behavior of competitiveness (relative price of traded/nontraded goods, controlling for per capita income), real exchange rate volatility, inflation, price volatility, and trade openness. Positive coefficients on pegged or intermediate exchange rate regime dummies indicate higher per capita output growth under that regime relative to growth under floating regimes (the omitted category). Other control variables (coefficients not reported): annual dummies, initial per capita income, population growth, average years of schooling, terms of trade growth, investment, fiscal balance, and government spending (all in percent of GDP). Example: Coefficient of 0.006 implies per capita output growth is 0.6 percentage point higher under intermediate regimes compared to floating regimes. Asterisks indicate statistical significance at the 10(*), 5(**), and 1(***) percent levels.
Source: IMF staff estimates.Note: Regression of per capita output growth in constant local currency prices (decimal fraction, per year) on regime dummies and other control variables; instrumental variable estimation; t-statistics based on clustered, robust standard errors. Regression shows association between output growth (as a decimal fraction, per year) and the exchange rate regime, taking into account both the direct (i.e., controlling for all other determinants) and indirect channels through the behavior of competitiveness (relative price of traded/nontraded goods, controlling for per capita income), real exchange rate volatility, inflation, price volatility, and trade openness. Positive coefficients on pegged or intermediate exchange rate regime dummies indicate higher per capita output growth under that regime relative to growth under floating regimes (the omitted category). Other control variables (coefficients not reported): annual dummies, initial per capita income, population growth, average years of schooling, terms of trade growth, investment, fiscal balance, and government spending (all in percent of GDP). Example: Coefficient of 0.006 implies per capita output growth is 0.6 percentage point higher under intermediate regimes compared to floating regimes. Asterisks indicate statistical significance at the 10(*), 5(**), and 1(***) percent levels.

Beyond average growth performance, the volatility of output growth may also be of interest. Theory suggests that more flexible exchange rate regimes should reduce, although not eliminate, the impact of aggregate supply shocks, because they allow real wages to adjust in the face of nominal rigidities, whereas the impact of aggregate demand shocks depends on their source and the economy’s financial openness. Empirically, there is some evidence of greater output volatility under pegged exchange rates than either intermediate or floating exchange rate regimes. This result (not reported) stems from advanced economies (where shocks are mainly to the fiscal balance), and from developing countries (where the main shocks are to the terms of trade, money velocity, and the fiscal balance). Controlling for the magnitude of these shocks, the standard deviation of output growth remains about 1 percentage point a year higher under pegged exchange rate regimes—perhaps reflecting the lower scope for countercyclical macroeconomic policies under pegs. For emerging market countries, by contrast, pegged and intermediate regimes are associated with lower volatility than floating exchange rates (regardless of whether crisis episodes are included in the sample).

Crisis Susceptibility

Financial crises are a more extreme form of volatility, and avoiding them is a key goal of the international monetary system—important to the individual country because of the economic and social costs of the crisis, and important to the rest of the system because of the risk of contagion. How does the choice of exchange rate regime affect the risk of a crisis? The string of capital account crises at the turn of the century—starting with the European Exchange Rate Mechanism crises of 1992–93 and culminating with the collapse of Argentina’s currency board in early 2002—seemed to underscore the fragility of fixed exchange rate regimes. Likewise, the foreign-currency-denominated “debt overhangs” in a number of European emerging market countries with pegged exchange rates in the current global crisis suggest that such regimes may be more susceptible to unsustainable asset booms. But is this a misperception based on a handful of spectacular but ultimately unrepresentative cases? Or does it hold systematically in the data?

Empirical analysis of the frequency of crises by regime suggests the following:

  • Across the full sample of countries, and consistent with the reasoning behind the bipolar prescription, currency crises are somewhat more common under intermediate regimes than pegged or floating exchange rate regimes (Table 3.10a).15
  • In financially open developing or emerging market countries, there is significantly higher likelihood of a financial (debt, sudden stop, banking) crisis under a pegged or an intermediate regime than under a floating exchange rate regime (Table 3.10b).16 This greater susceptibility holds for both the de jure and the de facto classifications, suggesting that the additional “wiggle room” afforded by a de facto practice rather than a de jure commitment does not reduce the vulnerability to crisis (but also that the greater credibility for a de jure commitment does not reduce the likelihood of crisis). Among financially closed economies, there are no significant differences in crisis probabilities across regimes.
  • Despite casual empiricism about credit booms and pegged exchange rate regimes, such booms (including those that end in crisis) are not, on average, more likely under pegged exchange rate regimes than under other regimes (not reported).
  • Finally, more general “growth crises” (i.e., sharp declines in GDP growth regardless of the shock) are no more likely under pegged or intermediate exchange rate regimes than under floating exchange rate regimes (not reported).
Table 3.10Likelihood of Currency or Financial Crisis by Exchange Rate Regime(In percent of regime observations)
Dependent Variable: Occurrence of

Currency or Financial Crisis
De Jure ClassificationDe Facto Classification
PeggedIntermediateFloatingPeggedIntermediateFloating
a. Currency crises1
All countries4.24.9c4.63.95.6b,c3.4
Advanced economies0.01.50.50.01.80.0
Emerging market countries5.56.5c4.94.57.6b,d0.9
Developing countries4.45.3c6.44.25.8a7.5a
b. Financial crisis (open capital account)2,3
All countries19.719.2c14.919.4a,d18.414.4
Advanced economies8.316.018.45.419.4a,c16.1 a,c
Emerging market countries29.620.115.830.8b,c16.615.0
Developing countries18.522.5c11.118.418.9a12.1
Source: IMF staff estimates.Note: Logistic regression of crisis probability on regime dummies and other crisis determinants (lagged values of exchange rate overvaluation, and external debt, foreign reserves, and general government balance, all in percent of GDP). Logistic regression showing likelihood of currency crisis, financial (sudden stop, debt, or banking) crises, in percent of regime observations, controlling for other crisis determinants. Statistical significance at the 10 percent of higher level indicated by:

Probability of crisis under the regime differs from one of the other regimes, not controlling for other crisis determinants.

Probability of crisis under the regime differs from both of the other regimes, not controlling for other crisis determinants.

Probability of crisis under the regime differs from one of the other regimes, controlling for other crisis determinants.

Probability of crisis under the regime differs from both of the other regimes, controlling for other crisis determinants.

Example: coefficient of 4.2 under pegged regimes implies that in 4.2 percent of pegged regime observations there is a currency crisis.

Currency crisis is defined as a devaluation or depreciation of at least 25 percent over a 12-month period, provided the devaluation/depreciation is at least 10 percentage points greater than in the preceding 12 months (Frankel and Rose, 1996).

Financial crisis is a union of banking crisis, debt crisis, and sudden stops.

Open capital account refers to above-sample median of the IMF AREAER-based Chinn and Ito (2006) index of capital controls.

Source: IMF staff estimates.Note: Logistic regression of crisis probability on regime dummies and other crisis determinants (lagged values of exchange rate overvaluation, and external debt, foreign reserves, and general government balance, all in percent of GDP). Logistic regression showing likelihood of currency crisis, financial (sudden stop, debt, or banking) crises, in percent of regime observations, controlling for other crisis determinants. Statistical significance at the 10 percent of higher level indicated by:

Probability of crisis under the regime differs from one of the other regimes, not controlling for other crisis determinants.

Probability of crisis under the regime differs from both of the other regimes, not controlling for other crisis determinants.

Probability of crisis under the regime differs from one of the other regimes, controlling for other crisis determinants.

Probability of crisis under the regime differs from both of the other regimes, controlling for other crisis determinants.

Example: coefficient of 4.2 under pegged regimes implies that in 4.2 percent of pegged regime observations there is a currency crisis.

Currency crisis is defined as a devaluation or depreciation of at least 25 percent over a 12-month period, provided the devaluation/depreciation is at least 10 percentage points greater than in the preceding 12 months (Frankel and Rose, 1996).

Financial crisis is a union of banking crisis, debt crisis, and sudden stops.

Open capital account refers to above-sample median of the IMF AREAER-based Chinn and Ito (2006) index of capital controls.

These results are generally in line with the findings of earlier studies that emerging market countries with more open capital accounts may be more vulnerable to currency and financial crises under less flexible exchange rate regimes, though the regime does not appear to influence the risk of other crises (including credit busts and growth crises). Because crisis probabilities depend on other factors as well as the regime, the results suggest that emerging market countries opting for less flexible exchange rate regimes should ensure other strong fundamentals to help offset the greater likelihood of Crisis.17

External Adjustment

An important characteristic of floating exchange rates, emphasized in the early literature (Friedman, 1953), is that they should facilitate external adjustment. Some more recent studies, however, conclude that adjustment to current account imbalances is no slower under pegged (or intermediate) exchange rate regimes than under floating regimes.18 Although there is little pattern to average current account balances across regimes, the magnitude of current account surpluses and deficits tends to be larger under less flexible exchange rate regimes (Table 3.11).19

Table 3.11Current Account Balances(In percent of GDP)
De JureDe Facto
PeggedIntermediateFloatingPeggedIntermediateFloating
Advanced economies
  • Surpluses
5.45.04.25.34.55.0
  • Deficits
–4.4–3.3–3.8–3.7–3.4–3.9
Emerging market economies
  • Surpluses
7.94.12.65.94.22.4
  • Deficits
–5.7–4.5–3.4–5.5–4.4–2.7
Developing economies
  • Surpluses
6.28.46.17.07.74.6
  • Deficits
–10.7–8.3–8.4–10.2–8.6–7.1
Sources: IMF, World Economic Outlook; and, IMF staff estimates.
Sources: IMF, World Economic Outlook; and, IMF staff estimates.

Larger deficits and surpluses are not necessarily a problem: there is no theory that optimal current account balances should be zero or even close to zero. Nonetheless, large imbalances, especially deficits, may portend an abrupt—and disruptive—adjustment. One simple, albeit crude, way to identify potentially problematic imbalances, therefore, is according to whether they ended in an “abrupt reversal”—as that term is commonly used in the current account reversals literature (Freund, 2005). Are such abrupt reversals, and hence the buildup of “unsustainable” imbalances, more prevalent under certain regimes? The empirical analysis suggests two results (Table 3.12). First, the magnitude of surpluses or deficits prior to an abrupt reversal is generally smaller under floating regimes than under pegged or intermediate regimes. Second, the likelihood of a deficit that ends abruptly tends to be highest under less flexible regimes—intermediate regimes in emerging market countries, and pegged regimes in developing countries. Moreover, reversals of deficits that developed under pegged (or, to a lesser extent, intermediate) exchange rate regimes are more costly than those that developed under floating exchange rate regimes (both because the imbalances tend to be larger and because the real exchange rate absorbs less of the current account adjustment). For example, the reversal of a deficit that developed under a pegged or an intermediate exchange rate regime is associated with a decline in output growth of about 1 to 1.5 percentage points a year, compared with almost no decline for those that developed under floating regimes.20

Table 3.12.Current Account Reversals(In percent)
De Jure ClassificationDe Facto Classification
Prior

balance1
Upper

quartile
Lower

quartile
Reversal

probability2
Prior

balance1
Upper

quartile
Lower

quartile
Reversal

probability2
a. Advanced economies
Surplus
  • Pegged regimes
7.69.24.82.37.97.69.23.4
  • Intermediate regimes
5.56.53.42.64.44.24.81.9
  • Floating regimes
3.74.33.20.93.73.74.31.1
Deficit
  • Pegged regimes
–6.3–6.3–6.30.8–6.3–6.3–6.30.6
  • Intermediate regimes
–6.2–3.9–8.54.2*–6.0–5.5–3.85.4**
  • Floating regimes
–5.3–3.9–5.92.3–4.7–4.7–3.41.1
b. Emerging market countries
Surplus
  • Pegged regimes
10.914.88.40.910.49.414.80.8
  • Intermediate regimes
9.112.25.30.98.87.711.71.0
  • Floating regimes
5.06.04.10.30.0
Deficit
  • Pegged regimes
–10.6–6.5–12.50.7–11.4–9.7–8.50.8
  • Intermediate regimes
–9.2–6.5–11.02.0**–8.6–8.0–6.41.9**
  • Floating regimes
–10.3–7.2–13.50.70.0
c. Developing countries
Surplus
  • Pegged regimes
12.314.27.21.411.59.914.20.9
  • Intermediate regimes
10.510.25.10.911.76.614.51.0
  • Floating regimes
6.68.55.10.56.66.38.51.1
Deficit
  • Pegged regimes
–22.2–11.2–23.24.9–20.6–14.3–9.64.6
  • Intermediate regimes
–19.7–8.5–17.42.8–20.8–13.1–9.92.9*
  • Floating regimes
–13.7–8.8–18.23.1*–10.4–9.9–9.12.9
Source: IMF staff estimates.Note: Reversals defined by (i) a current account deficit or surplus that exceeds 2 percent of GDP (4 percent of GDP for developing and emerging market countries), (ii) the average deficit (surplus) improves (deteriorates) by 2 percent of GDP (4 percent of GDP for emerging market economies and developing countries), (iii) the maximum (minimum) deficit (surplus) in the five years after the reversal is not larger (smaller) than the minimum (maximum) in the years before the reversal, and (iv) the deficit (surplus) improves (deteriorates) by at least one-third. Table indicates the likelihood (in percent of regime observations) and magnitude of current account imbalances that are subject to sharp reversals, as defined in Freund (2005). Asterisks denote differences from pegged regime proportions that are significant at the 10 (*), 5 (**), and 1 (***) percent levels.

Maximum surplus or deficit prior to the reversal, in percent of GDP.

Frequency of reversal as a proportion of exchange rate regime observations.

Source: IMF staff estimates.Note: Reversals defined by (i) a current account deficit or surplus that exceeds 2 percent of GDP (4 percent of GDP for developing and emerging market countries), (ii) the average deficit (surplus) improves (deteriorates) by 2 percent of GDP (4 percent of GDP for emerging market economies and developing countries), (iii) the maximum (minimum) deficit (surplus) in the five years after the reversal is not larger (smaller) than the minimum (maximum) in the years before the reversal, and (iv) the deficit (surplus) improves (deteriorates) by at least one-third. Table indicates the likelihood (in percent of regime observations) and magnitude of current account imbalances that are subject to sharp reversals, as defined in Freund (2005). Asterisks denote differences from pegged regime proportions that are significant at the 10 (*), 5 (**), and 1 (***) percent levels.

Maximum surplus or deficit prior to the reversal, in percent of GDP.

Frequency of reversal as a proportion of exchange rate regime observations.

Further evidence of slower external adjustment under less flexible exchange rate regimes comes from an analysis of the persistence of the current account dynamics. Table 3.13 reports the persistence of the current account balance, allowing for threshold effects for “large” current account surpluses (top 75th percentile of the distribution of current account balances) and large deficits (bottom 25th percentile).21

Table 3.13.Nonlinear Current Account Persistence Regression by Regime
De Jure ClassificationDe Facto Classification
Dependent Variable:DeficitSurplusDeficitSurplus
Current Account BalanceCoefficientt-StatisticCoefficientt-StatisticCoefficientt-StatisticCoefficientt-Statistic
a. Floating exchange rate regimes
CAt-110.514.56***0.487.45***0.517.71***0.403.21***
CAt-11 × 1(CAt-1 < q.25)–0.03–0.29–0.17–1.24
CAt-11 × 1(CAt-1 > q.75)0.020.090.040.27
Number of observations717717373373
b. Intermediate exchange rate regimes
CAt-110.6617.78***0.161.270.5812.30***0.141.12
CAt-11 × 1(CAt-1 < q.25)–0.44–3.10***–0.40–2.88***
CAt-11 × 1(CAt-1 > q.75)0.734.98***0.674.16***
Number of observations1,7281,7281,6831,683
c. Pegged exchange rate regimes
CAt-110.5312.42***0.509.30***0.6511.17***0.519.90***
CAt-11 × 1(CAt-1 < q.25)–0.01–0.19–0.11–1.69*
CAt-11 × 1(CAt-1 > q.75)0.161.590.302.94***
Number of observations1,0541,0541,2981,298
Sources: Ghosh, Terrones, and Zettelmeyer (2008); and IMF staff estimates.Note: Regression shows how the persistence of the current account balance depends on whether the current account is in large deficit (bottom quartile of the sample distribution) or in large surplus. Under floating exchange rate regimes, there are no significant threshold effects, and the persistence coefficient is around 0.5. Threshold effects are negative for deficit countries under intermediate regimes (and slightly negative under pegged exchange rate regimes), implying that a large deficit is subject to more abrupt correction (i.e., is less persistent) under these regimes. Threshold effects are positive for surplus countries under pegged and intermediate exchange rate regimes, implying that a large surplus is more likely to persist under these regimes. Asterisks indicate statistical significance at the 10(*), 5(**), and 1(***) percent levels, based on robust/clustered standard errors; country fixed effects included but not reported. Example: An autoregressive coefficient of 0.21 (= 0.66–0.44) for large deficits under intermediate regimes implies that the half-life of the current account deficit falls from 1.7 (= ln(0.5)/ln(0.66) years to 0.5 (= ln(0.5)/ln(0.21)) years.

Autoregression of current account balance (in percent of GDP) on lagged current account balance, with threshold interactive terms for deficits in the lower quartile of the sample and for surpluses in the upper quartile of the sample of current account balances.

Sources: Ghosh, Terrones, and Zettelmeyer (2008); and IMF staff estimates.Note: Regression shows how the persistence of the current account balance depends on whether the current account is in large deficit (bottom quartile of the sample distribution) or in large surplus. Under floating exchange rate regimes, there are no significant threshold effects, and the persistence coefficient is around 0.5. Threshold effects are negative for deficit countries under intermediate regimes (and slightly negative under pegged exchange rate regimes), implying that a large deficit is subject to more abrupt correction (i.e., is less persistent) under these regimes. Threshold effects are positive for surplus countries under pegged and intermediate exchange rate regimes, implying that a large surplus is more likely to persist under these regimes. Asterisks indicate statistical significance at the 10(*), 5(**), and 1(***) percent levels, based on robust/clustered standard errors; country fixed effects included but not reported. Example: An autoregressive coefficient of 0.21 (= 0.66–0.44) for large deficits under intermediate regimes implies that the half-life of the current account deficit falls from 1.7 (= ln(0.5)/ln(0.66) years to 0.5 (= ln(0.5)/ln(0.21)) years.

Autoregression of current account balance (in percent of GDP) on lagged current account balance, with threshold interactive terms for deficits in the lower quartile of the sample and for surpluses in the upper quartile of the sample of current account balances.

Under floating regimes, there are no threshold effects: regardless of whether the current account is in surplus or deficit, and regardless of the magnitude of the imbalance, the autoregressive coefficient is about 0.5 (i.e., a half-life of one year).

  • Under pegged and intermediate exchange rate regimes, threshold effects are significant and go in opposite directions according to whether the country has a surplus or deficit (Table 3.13bc). When the current account is in deficit, the threshold effect is negative—implying that large deficits unwind more abruptly under intermediate and pegged exchange rate regimes.22 When the current account is in surplus, the threshold effect is positive—implying that once surpluses become large, they also become highly persistent under these less flexible regimes.

In sum, large imbalances (deficits or surpluses) are more likely under less flexible regimes. Conditional on a large deficit developing under a pegged or an intermediate exchange rate regime, it is more likely to reverse abruptly than under a floating regime. Conditional on a large surplus developing under a pegged or intermediate exchange rate regime, it is more likely to persist than under a flexible exchange rate regime. As such, the results confirm the intuition of the early literature that less flexible exchange rate regimes tend to impede adjustment of external imbalances and that, in particular, surpluses are likely to be more persistent under less flexible regimes.

International Trade

One of the key attributes of a stable system of exchange rates, according to the IMF’s Articles, is that it should facilitate the exchange of goods, services, and capital. By reducing exchange rate uncertainty, pegged exchange rate regimes should lower the costs of cross-border transactions—particularly those that involve long horizons, such as foreign direct investment, where the uncertainty cannot be easily hedged (Council of the European Communities, 1970). A first question, therefore, is whether less flexible exchange rate regimes indeed reduce real exchange rate volatility—and over what horizon. As shown in Figure 3.3, pegged and intermediate exchange rate regimes exhibit lower real exchange rate volatility than floating regimes, with the volatility decreasing with the length of the horizon. Even at a one-year horizon, however, the volatility under floating regimes is close to twice that under pegged or intermediate regimes (Mussa, 1986). But at very long horizons (four to five years), average volatility of the real exchange rate under floating regimes is actually slightly lower than under intermediate regimes—essentially because the floating exchange rate helps offset inflation differentials.

Figure 3.3.Real Exchange Rate Volatility at Alternative Horizons

Sources: IMF Information Notice System database; and IMF staff estimates.

The lower real exchange rate volatility under less flexible regimes translates into greater bilateral trade among countries that share an exchange rate peg (Table 3.14):

Table 3.14Impact of Pegged Exchange Rates on Goods and Services Trade
De Jure ClassificationDe Facto Classification
Dependent Variable:All countriesAdvanced

Advanced
Advanced

EME/DC
EME/DC

EME/DC
All countriesAdvanced

Advanced
Advanced

EME/DC
EME/DC

EME/DC
Bilateral Exports
Currency union0.240***0.237***0.1170.3500.193**0.271***0.1080.324
(0.09)(0.03)(0.21)(0.29)(0.09)(0.03)(0.21)(0.29)
Direct peg (excluding currency union)0.191**0.1070.125**–0.6060.143*0.159**0.102*–0.069
(0.08)(0.07)(0.06)(1.06)(0.07)(0.07)(0.05)(1.06)
Indirect peg–0.095***–0.002–0.025–0.077**–0.178***0.043**0.092***–0.185***
(0.02)(0.02)(0.03)(0.03)(0.02)(0.02)(0.03)(0.02)
Short-run real exchange rate volatility–0.009–0.0070.003–0.113***–0.010–0.0070.003–0.118***
(0.01)(0.01)(0.01)(0.03)(0.01)(0.01)(0.01)(0.03)
Long-run real exchange rate volatility–0.196***–0.027–0.129***–0.202***–0.194***–0.027–0.132***–0.198***
(0.02)(0.02)(0.02)(0.04)(0.02)(0.02)(0.02)(0.04)
Distance–1.629***–0.425***–0.660***–2.353***–1.623***–0.427***–0.670***–2.396***
(0.08)(0.10)(0.14)(0.12)(0.08)(0.10)(0.14)(0.13)
Volatility of G-3 currencies–0.020***–0.040***–0.018**0.003–0.019***–0.040***–0.017**0.004
(0.01)(0.01)(0.01)(0.01)(0.01)(0.01)(0.01)(0.01)
Product of country-pair GDPs1.283***0.437***0.481***1.153***1.283***0.448***0.481***1.151***
(0.03)(0.05)(0.04)(0.04)(0.03)(0.05)(0.04)(0.04)
Log (real GDP per capita)–0.080***0.770***0.816***–0.116**–0.077**0.754***0.819***–0.109**
(0.03)(0.06)(0.04)(0.05)(0.03)(0.06)(0.04)(0.05)
Observations157,6217,76764,94684,908157,6217,76764,94684,908
Number of country pairs10,9283503,5187,06010,9283503,5187,060
Sources: Qureshi and Tsangarides (2010); and IMF staff estimates.Note: Regression shows the impact on bilateral trade of a currency union, other direct peg, or indirect peg. Countries B and C have an indirect peg if they both peg to country A, but do not explicitly peg to each other. Example: coefficient of 0.24 for currency unions implies that trade between two countries in a currency union is 1.27 (= exp(0.24)) times greater (i.e., an increase of 27 percent) than between two countries that do not share a currency union. Robust standard errors in parentheses; asterisks indicate statistical significance at the 10(*), 5(**), and 1(***) percent levels. Regression of bilateral trade (exports of goods and nonfactor services) on currency union, direct and indirect peg dummies, gravity determinants (distance and GDP), per capita GDP, short-run (standard deviation of within-year monthly growth rates) and long-run (three-year moving standard deviation of annual growth rates) real exchange rate volatility, and dummies (not reported) for common language, common border, free-trade agreements, landlocked countries, common colonial relationship, current or former colony. EME = emerging market economies; DC = developing countries.
Sources: Qureshi and Tsangarides (2010); and IMF staff estimates.Note: Regression shows the impact on bilateral trade of a currency union, other direct peg, or indirect peg. Countries B and C have an indirect peg if they both peg to country A, but do not explicitly peg to each other. Example: coefficient of 0.24 for currency unions implies that trade between two countries in a currency union is 1.27 (= exp(0.24)) times greater (i.e., an increase of 27 percent) than between two countries that do not share a currency union. Robust standard errors in parentheses; asterisks indicate statistical significance at the 10(*), 5(**), and 1(***) percent levels. Regression of bilateral trade (exports of goods and nonfactor services) on currency union, direct and indirect peg dummies, gravity determinants (distance and GDP), per capita GDP, short-run (standard deviation of within-year monthly growth rates) and long-run (three-year moving standard deviation of annual growth rates) real exchange rate volatility, and dummies (not reported) for common language, common border, free-trade agreements, landlocked countries, common colonial relationship, current or former colony. EME = emerging market economies; DC = developing countries.
  • Participation in a currency union is associated with increased bilateral trade by a factor of 1.3. This association holds for the full sample of countries, for advanced economy to nonadvanced economy (i.e., EME and developing countries) trade, and for trade between the EME/developing countries; it is weakest for the advanced economy to EME/developing country sample.
  • Turning to other forms of direct peg (i.e., other than currency unions), the effect on raising bilateral trade is very similar, whereas indirect pegs have few or even negative effects.23 The beneficial effect of a currency union or direct peg decreases with the distance between the trading partners. As such, pegs (or a currency union) may be particularly useful for countries seeking greater regional integration.24
  • Part of the impact of the regime stems from lower real exchange rate volatility. The effect goes beyond the impact of lower volatility, however, because the pegged exchange rate dummy (a fortiori, the currency union dummy) is significant even controlling for short-run and longer-term volatility.25 This likely reflects reduced exchange rate uncertainty (as opposed to ex post volatility), and, in the case of a currency union, lower transaction costs of a common currency. In addition, the volatility of the key currency exchange rates (dollar-euro, dollar-yen) itself has a depressive effect on global trade.26

Capital Flows

In addition to the exchange of goods and services, a stable system of exchange rates should facilitate the exchange of capital among countries—but in a manner that promotes economic and financial stability. Capital flows should therefore help mitigate the effects of shocks, not exacerbate them. While a full examination of the nature and characteristics of capital flows is beyond the scope of this paper, a simple metric of the consumption-smoothing effects of capital flows is given by the ratio of the volatility of consumption growth to the volatility of “national cash flow”—output net of investment and government consumption (Ghosh and Ostry, 1997).27 In practice, there are two reasons capital flows may not smooth consumption: first, if capital flows are limited, including because the capital account is not open; and second, if capital flows are destabilizing—either because they are procyclical (positively correlated with national cash flow) or because they represent an independent source of volatility.

Table 3.15 reports the average volatility (three-year centered standard deviation) of the growth of private consumption (in constant, local currency prices) and of national cash flow (GDP minus investment and government consumption, deflated by the GDP deflator), both expressed in per capita terms. Episodes of currency or financial crises are not excluded, because a susceptibility to crisis might be one of the ways in which the regime adds instability to capital flows. Across regimes, not surprisingly, the volatility of national cash flow is lower for advanced economies, followed by emerging market countries, with developing countries exhibiting the highest volatility. More interestingly, the ratio of consumption growth volatility to national cash flow volatility is lowest for advanced economies, with developing and EMEs exhibiting broadly similar ratios (though somewhat higher for the latter). It is also noteworthy that, across the sample, the volatility of consumption growth is generally greater than the volatility of national cash flow, suggesting that risk-sharing is far from perfect and that capital flows typically do not help smooth consumption.28

Table 3.15Consumption-Smoothing Capital Flows under Alternative Exchange Rate Regimes
De Jure ClassificationDe Facto Classification
Full SampleOpen Capital Account4Full SampleOpen Capital Account4
σ(Δc)1σ(Δz)2σ(Δc)/

σ(Δz)3
σ(Δc)1σ(Δz)2σ(Δc)/

σ(Δz)3
σ(Δc)1σ(Δz)2σ(Δc)/

σ(Δz)3
σ(Δc)1σ(Δz)2σ(Δc)/

σ(Δz)3
a. All countries
All regimes0.050.061.350.040.051.330.050.061.310.040.051.29
Pegged regimes0.060.081.250.050.071.32**0.060.081.230.050.081.26
Intermediate regimes0.040.061.29**0.040.061.22**0.040.061.300.030.051.25*
Floating regimes0.040.041.600.030.031.520.030.031.610.020.021.44
b. Advanced economies
All regimes0.020.021.230.010.021.250.020.021.260.010.021.28
Pegged regimes0.010.020.86*0.010.020.950.010.020.920.010.021.00
Intermediate regimes0.020.031.300.020.021.280.020.021.390.020.021.36
Floating regimes0.010.011.300.010.011.360.010.011.380.010.011.41
c. Emerging market countries
All regimes0.040.041.400.040.041.470.040.041.340.040.041.48
Pegged regimes0.050.051.620.050.051.750.040.051.400.050.051.48
Intermediate regimes0.040.051.250.040.051.320.040.051.200.030.051.32
Floating regimes0.030.031.630.020.021.550.030.022.060.030.022.07
d. Developing countries
All regimes0.060.081.370.060.091.310.060.091.320.060.091.18
Pegged regimes0.070.101.25*0.070.091.35**0.070.101.270.070.111.32**
Intermediate regimes0.060.081.30*0.050.091.08*0.050.071.320.050.071.08
Floating regimes0.070.071.810.060.061.720.070.061.670.060.060.95
Source: IMF staff estimates.Note: Ratio of volatility of consumption growth to volatility of national cash flow growth indicates the extent to which capital flows are consistent with consumption-smoothing. Regression of this ratio on pegged and intermediate exchange rate regime dummies indicates whether consumption-smoothing under these regimes differs significantly from the consumption-smoothing under floating exchange rate regimes (the omitted category).
1Δc is the growth in real consumption per capita; σ(Δc) is a three-year moving standard deviation, excluding cases where the exchange rate regime changed during the three-year period.
2National cash flow, z, is defined as z = (GDP–investment–government consumption)/GDP deflator expressed in per capita terms; Δz is the corresponding growth rate in z; σ(Δz) is a three-year moving standard deviation, excluding cases where the exchange rate regime changed during the three-year period.
3Asterisks represent significance level for the rejection of the null hypothesis that the coefficient of pegged or intermediate regimes is equal to the floating regime (omitted category) in the following regression: σ(Δc)/σ(Δz) = b0 + b1Peg + b2Int + e, with country and time fixed effects. Asterisks indicate statistical significance at the 10(*) and 5(**) percent levels.
4Observations with above-median score on the IMF AREAER-based Chinn and Ito (2006) capital account openness index.
Source: IMF staff estimates.Note: Ratio of volatility of consumption growth to volatility of national cash flow growth indicates the extent to which capital flows are consistent with consumption-smoothing. Regression of this ratio on pegged and intermediate exchange rate regime dummies indicates whether consumption-smoothing under these regimes differs significantly from the consumption-smoothing under floating exchange rate regimes (the omitted category).
1Δc is the growth in real consumption per capita; σ(Δc) is a three-year moving standard deviation, excluding cases where the exchange rate regime changed during the three-year period.
2National cash flow, z, is defined as z = (GDP–investment–government consumption)/GDP deflator expressed in per capita terms; Δz is the corresponding growth rate in z; σ(Δz) is a three-year moving standard deviation, excluding cases where the exchange rate regime changed during the three-year period.
3Asterisks represent significance level for the rejection of the null hypothesis that the coefficient of pegged or intermediate regimes is equal to the floating regime (omitted category) in the following regression: σ(Δc)/σ(Δz) = b0 + b1Peg + b2Int + e, with country and time fixed effects. Asterisks indicate statistical significance at the 10(*) and 5(**) percent levels.
4Observations with above-median score on the IMF AREAER-based Chinn and Ito (2006) capital account openness index.

Turning to the effect of the exchange rate regime, across the full sample of countries, the relative volatility of consumption growth is (statistically significantly) higher under floating regimes than under pegged or intermediate regimes. This suggests that capital flows under floating regimes may be more volatile and less driven by fundamentals than under other exchange rate regimes. This pattern holds across country income groups—except for the more financially open developing countries under the de facto classification. Of course, an important exception to this finding is crisis episodes, with the discussion above suggesting that EMEs with open capital accounts and less flexible regimes are more susceptible to crisis; however, such crises are infrequent enough that they do not overturn the result that, on average (i.e., including both crisis and noncrisis periods), capital flows allow a greater degree of consumption smoothing under pegged and intermediate regimes than under floating regimes.

Why should floating regimes be associated with less consumption-smoothing capital flows? As discussed above, real exchange rate volatility is generally greater under more flexible regimes, which may be both a manifestation and a cause of more volatile capital flows. The greater volatility of capital flows under floating regimes is likely to be reflected in greater real exchange rate volatility, while the real exchange rate uncertainty deters capital flows that require longer-term real exchange rate stability (such as foreign direct investment). It turns out that net portfolio investment inflows (as a share of total net capital inflows) are indeed higher under floating regimes, except for developing countries under the de facto classification (Table 3.16). Although portfolio flows are not necessarily more unstable than direct foreign investment or other types of investment flows (or more likely to be “hot money” that is not driven by fundamentals), the correspondence between higher consumption volatility and this pattern of inflows is suggestive. Overall, though the evidence is not conclusive, capital flows under pegged and intermediate regimes appear to be more conducive to consumption-smoothing than flows under floating regimes.

Table 3.16.Structure of Net Capital Inflows(In percent of net portfolio, direct, and other inflows)
De JureDe Facto
PeggedIntermediateFloating PeggedIntermediateFloating
Portfolio Flows
Advanced economies45.528.237.143.527.038.4
Emerging market economies7.913.545.58.218.137.4
Developing economies5.33.75.15.63.9–1.1
Direct Investment
Advanced economies18.720.620.818.820.321.3
Emerging market economies67.154.560.861.552.872.4
Developing41.557.869.946.955.668.7
Sources: IMF, World Economic Outlook; and, IMF staff estimates.
Sources: IMF, World Economic Outlook; and, IMF staff estimates.

Implications for the Choice of Regime

The empirical findings underscore that the optimal regime depends very much on the macroeconomic challenges facing the country and its circumstances. Indeed, a key difference between this paper and earlier IMF reviews is not only its more comprehensive look at the evidence, but also its more nuanced message. With this in mind, are there broad generalizations about how a country might choose its exchange rate regime?

For developing and emerging market countries that face persistent inflationary dynamics, lack policy credibility (or institutions and mechanisms to impart such credibility), or are trying to disinflate against a history of high inflation, pegging the nominal exchange rate may bring significant benefits. Two points are noteworthy in this regard: first, the inflation benefits of pegging hold even with relatively low inflation (less than 5 percent a year, per Table 3.6e); second, as inflation differentials narrow around the globe, the benefit from pegging to a low-inflation anchor currency diminishes. A potential nuance to this story is that inflation differentials have picked up recently, but the likely persistence of this trend going forward in unclear, and would depend on, among other things, the effectiveness of the full gamut of economic policies in dealing with the financial crisis, the credibility of exit strategies, and the aftermath of the earlier food and fuel price shock (Figure 3.4).

Figure 3.4.Inflation

(In percent)

Source: IMF staff estimates.

In choosing to peg, of course, countries limit their scope to adopt countercyclical policy measures, though such constraints may be appropriate when policies otherwise lack credibility or the central bank is battling entrenched expectations. Reaping the credibility benefits, however, requires a formal commitment to the peg—simply intervening in the foreign exchange market to keep the exchange rate constant does not suffice. In addition, a clear exception to the inflation dividend from pegging is countries facing persistently large current account surpluses that cannot be durably sterilized.

If a country chooses a pegged exchange rate regime, it faces two questions: against which currency to peg, and how hard a peg to adopt. The choice of anchor currency depends on its expected performance (which, given the current financial turmoil and the need to unwind the massive easing that has taken place across the major currency regions, is now more uncertain) and the country’s trading patterns.29 In light of this uncertainty, and because most countries trade with all of the major trading blocs and would not want to lose competitiveness through cross-currency movements, there may be a case for basket pegs. In general, however, basket pegs provide a smaller inflation dividend than single-currency pegs, partly because they are less transparent (especially if the basket is not publicly known). Therefore, if a basket peg is adopted, its weights should be publicly announced or an established basket (e.g., Special Drawing Rights) should be used. As regards the “hardness” of the peg, although inflation performance is strongest under currency board arrangements, inasmuch as few regimes are truly permanent, an important consideration is the difficulty of engineering a graceful exit from hard pegs—unless the country has a “natural” exit such as monetary union.

Turning to output growth, there appears to be no trade-off between inflation and sustained growth: low inflation and price volatility are associated with faster output growth. Although the evidence is not as definitive, growth performance appears to be stronger under less flexible exchange rate regimes (intermediate regimes and, if overvaluation can be avoided, pegged exchange rate regimes). Pegged exchange rates (a fortiori, currency unions) also help foster greater cross-border trade, and could thus be particularly helpful for countries seeking closer regional integration. There is also some evidence that less flexible regimes are associated with a greater share of “consumption smoothing” capital flows.

The major trade-off in choosing a relatively inflexible versus a flexible exchange rate regime is therefore not between inflation and growth, but rather between those two measures of economic performance on the one hand, and the ease of external adjustment and risk of financial crisis on the other:

While not a detriment to sustained growth over the medium run, relatively inflexible regimes seem more prone to currency and financial crises. This highlights the importance of other country fundamentals—including the fiscal balance, level of external debt, and reserves coverage of short-term debt—as potential offsets to mitigate the risk of crisis in a country that adopts a relatively inflexible exchange rate regime.

Large imbalances (deficits and surpluses) are more likely under inflexible regimes, and the unwinding of large deficits is more costly—in terms of forgone growth—under such regimes. This highlights the need for other adjustment mechanisms (e.g., labor market flexibility) to address external imbalances under such regimes.

The experience of European emerging market countries over the past few years may be illustrative in this regard. Although many of the countries with less flexible regimes enjoyed strong growth in the years leading up to the present crisis, they also built up large external imbalances, increasing their vulnerability to abrupt and disruptive adjustment as well as to financial crisis. Less flexible regimes have also tended to limit the scope for countercyclical macroeconomic policies in the face of the current global crisis.

Finally, large surpluses are less likely to be unwound in a timely manner under inflexible regimes and, if they arise in countries that are systemically important, they are likely to amplify systemic risks. Together with the finding that domestic performance (especially inflation) is not ameliorated by a rigid exchange rate regime in the presence of large external surpluses, the findings underscore the benefits of greater exchange rate flexibility both to reap domestic economic benefits and to reduce systemic risks.

1More formal statistical tests, however, reject the strict bipolarity hypothesis as a positive prediction. These tests are based on the notion that, if the bipolar hypothesis is correct, then countries should never switch from either pole toward more intermediate exchange rate regimes; specifically, using a Markov transition matrix, neither hard pegs (monetary union/currencyboard) nor free floats are an absorbing state (i.e., once adopted, never abandoned), and the union of the set of hard pegs and free floats does not constitute a closed set (i.e., some countries transition from these regimes to intermediate exchange rate regimes).
2These groups overlap but are not identical because some de facto pegs are de jure intermediate regimes, and some de jure floats are de facto intermediate regimes.
3See Ghosh, Gulde, and Wolf (2003, Chapter 3) for a survey of the literature.
4To prevent “contamination” across regimes (e.g., inflationary pressures that build up under a pegged exchange rate regime being attributed to the subsequent float after the peg collapses), the empirical analysis excludes the year of, and the year following, a change in exchange rate regime. The main findings aregenerally robust to longer exclusion windows.
5Regressions are estimated by ordinary least squares, include annual fixed effects, with t-statistics based on robust, country-clustered standard errors. This section was prepared, in part, by Jay Shambaugh. Similar findings are obtained using explicit policy interest rates (available for a smaller sample of countries) and forward-looking measures of inflation and the output gap. See also Borenzstein, Zettelmeyer, and Philippon (2001); Shambaugh (2004); and di Giovanni and Shambaugh (2008).
6Although emerging market and developing countries tend tobe less financially open than advanced economies, they are also “smaller” in the world capital markets, and thus have less policy autonomy.
7See Krugman (1979); Canzoneri, Cumby, and Diba (1998); and Wolf and others (2008) on the fiscal theory of the price level as applied to exchange rate regimes.
8These models are often based on a Barro and Gordon (1983) setup in which the central bank has an incentive to create surprise inflation (either to boost employment or to reduce the real value of public debt) that imparts an inflationary bias to the economy. Pegging the exchange rate provides a precommitment device, allowing the central bank to import the credibility of the anchor currency (Cukierman, 1992). The empirical work follows Ghosh and others (1997a, b); Ghosh, Gulde, and Wolf (2003); and Wolf and others (2008). The discussion here is in terms of the consumer price index; asset price inflation (specifically, credit booms) under alternative regimes is discussed below.
9For instance, inflation averaged some 2 to 2.5 percent a year for Germany/euro area and 4 percent for the United States over 1980–2006—not much below the average inflation rate for the whole advanced economy sample (about 5 percent a year).
10This explains why Rogoff and others (2004), who used a de facto classification but did not distinguish between de facto pegs and cases where the central bank both de facto pegs the exchange rate and makes a de jure commitment to the parity, concluded that pegging the exchange rate brings no inflation advantage to emerging market countries. Likewise, restricting the sample of de facto intermediate regimes to those where the central bank is also making a de jure commitment to a pegged or intermediate exchange rate regime yields a significant negative coefficient for the effect of intermediate regimes on inflation in the EME sample.
11This applies to both the de jure and the de facto classifications of floating regimes, and therefore does not reflect de jure floats acting as de facto pegged or intermediate regimes. Such higher credit growth would be an implication of “balance sheet models” in which domestic credit depends on the collateral that firms can post, and the value of that collateral increases with the appreciation of the exchange rate (see Aghion, Bachchetta, and Banerjee, 2000).
12These results are based on a “two-stage” model—a “firststage” probit on the choice of regime (with the identifying restriction that geographic concentration of exports and country size help determine the choice of exchange rate regime but not inflation performance directly), and a “second-stage” regression in which the fitted regime choice is used in lieu of the regime dummy. Two further robustness test are (a) to estimate the regression using five-year average panels to help control for country-specific effects (e.g., national aversion to inflation) and for noncontemporaneous effects of the regime on inflation, and (b) to include country fixed effects. Both yield the finding of lower inflation under pegged exchange rates. Finally, evidence from regime transitions suggests that adoption of pegged regimesis associated with lower inflation, and exchange-rate-based disinflation programs are equally or more likely to succeed than disinflation attempts undertaken under more flexible regimes.
14This would also explain why the results are somewhat stronger for the de jure than the de facto classification of intermediate regimes. Recall from above that de facto intermediate regimes exhibit higher money growth and inflation than de jure intermediate regimes (because the central bank is not making a formal commitment); this has real consequences here as the higher inflation feeds through to lower growth.
15In developing countries, however, currency crises are actually more likely under floating exchange rate regimes (Table 3.10a), probably reflecting instances of economic collapse in which the currency also collapses (“freely falling” currencies, in the terminology of Reinhart and Rogoff, 2004).
16However, the output costs of crises—measured as the change in the real GDP growth rate over the three years following the crisis to the three years prior to the crisis—do not seem to depend on the exchange rate regime prevailing at the time of the crisis.
17While countries with less flexible exchange rate regimes are more susceptible to crisis, they could try to compensate for the higher crisis risk by improving their fundamentals (e.g., exchange rate overvaluation, debt, foreign reserves, fiscal balance). For example, the analysis in Postelnyak (2008) suggests that for countries with pegged regimes to achieve a comparable (though still somewhat higher) probability of crisis to countries with floating regimes, they would need to have 18 percent of GDP lower external debt or 5 percent of GDP higher foreign exchange reserves, or a stronger fiscal balance of 1¼ percent of GDP, or some combination of these.
18Chinn and Wei (2008) claim that mean reversion of the current account balance does not depend on the exchange rate regime; for contrary evidence, see Ghosh, Terrones, and Zettelmeyer (2008).
19Moreover, imbalances measured as deviations of actual current accounts from Consultative Group on Exchange Rate Issues (Lee and others, 2008) are larger and more likely (statistically significantly so) under pegged or intermediate regimes (about 2 to 2.5 percent of GDP) than under floating regimes (1.5 percent of GDP).
20The comparison is between average growth in the three years following the reversal and growth in the year of the reversal. An alternative metric tries to capture the cost of the entire episode—taking into account growth performance during the buildup of the imbalance and the costs associated with the subsequent reversal—relative to the long-run growth performance of the country. By this metric, reversals of deficits that developed under pegged exchange rate regimes are associated with a decline in growth of about 0.5 percentage point, compared with an increase in growth of about 0.5 percentage point for those that developed under floats.
21Chinn and Wei (2008) do not consider thres hold effects, which is why they conclude that persistence of current account imbalances does not depend on the exchange rate regime.
22The lower persistence of large current account deficits holdsespecially for intermediate exchange rate regimes, where addingthe coefficients on the autoregressive term and the threshold interaction terms yields a persistence parameter of about 0.2, compared with about 0.5 under pegged or floating exchange rate regimes. Recall that intermediate exchange rate regimes are the most likely to experience large deficits (that reverse abruptly) and the most likely to experience currency crises.
23Country B and country C are said to have an indirect peg if they are both pegged to country A but do not explicitly peg to each other. The estimates suggest a negative impact of an indirect peg on the bilateral trade between countries B and C, which may reflect trade diversion to country A.
24This conclusion is based on interactive distance-regime dummies, which are not reported in Table 3.14. Greater distance may imply less price convergence (despite a common currency) if countries are far apart because of the transportation costs of goods arbitrage, implying greater real exchange rate volatility.
25Note that long-run volatility is significant controlling for the regime but short-run volatility is not. From Figure 3.3, this probably reflects the much larger differences in volatility across regimes at short horizons than at longer horizons (so that including the exchange rate regime in the regression eliminates the independent effect of short-run real exchange rate volatility).
26The sharp increase in uncertainty about key exchange rates as the current crisis deepened may have been one factor behind the observed decline in international trade (though other factors, such as the lack of trade finance, were likely more important). For example, the forward-looking expectation of the standard deviation of changes in the exchange rate implied by at-the-money-options for the dollar-euro and the dollar-yen more than tripled from 0.1 to 0.3 between August and October of 2008; over the same period, the growth of world merchandise trade fell from 8 percent to–30 percent a year (Rancière, 2009).
27This is related to, but distinct from, efficient risk-sharing inperfectly integrated global financial markets; see Dell’Ariccia and others (2008).
28If crisis episodes are excluded, the relative volatility of consumptionis lower in more financially open economies, except foremerging market countries under floating regimes.
29Particular issues arise in the case of major oil producers, given the structure of the economy and the dollar pricing of oil in world markets; see Frankel (2003), Ghosh and Kim (2007), Habib and Stráský (2008), IMF (2008), and Setser (2007) for a discussion of the issues.

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