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Appendix A. Model
Appendix B. Derivation of the IS-LM-BP Equations
Appendix C. Solving the system
Appendix D. Data Sources
This paper has benefited from suggestions by Marcel Fratzscher, Domenico Giannone, Stefan Gerlach, Cedric Tille, Charles Wyplosz, and participants at SSES Congress 2009, RES 2010, CEPII-Brugel Workshop 2010, Banque de France, and Bank of Canada. We also like to thank Harald Anderson, Ken Chikada, Irineu de Carvalho Filho, Atish Ghosh, David Gregorian, Albert Jäger, Mustafa Saiyid, and Jerome Vandenbussche for helpful comments. Part of this research was conducted while both authors were at the Graduate Institute Geneva and funding from the Swiss National Science Foundation is gratefully acknowledged. The views expressed are those of the authors and do not necessarily reflect the views of the institutions they are associated with.
In a recent study, Tsangarides (2010) finds that the output response to the shock during the financial crises 2008/09 of countries with a peg was comparable to countries that maintained floating exchange rate regimes.
Consistent with these findings, Engel (1993) finds empirically that the law of one price holds better for homogeneous goods.
Another strand of the literature considers the extent of pass-through to be endogenous to monetary policy and therefore to the exchange rate regime (Taylor, 2000). Under this theory, firms adjust their optimal pricing strategy to the monetary policy regimes in place and more stable inflation increases the incentive to prices in domestic currency. Our analysis focuses on the effect of import structure and we detail this choice in Section III.
Loayza and Raddatz (2007) are closest to our empirical approach, but only let the coefficients on exogenous variables vary and impose homogeneity on the dynamics of endogenous variables.
Hausmann, Panizza, and Stein (2001) find that “fear of floating” occurs more often in countries with high foreign currency debt. Authorities limit exchange fluctuations, although they declare themselves officially as floaters. This can be interpreted as indirect evidence of the favorability of fixed exchange rate regimes under such circumstances.
While limited pass through diminishes expenditure switching in the IS curve, it also makes the effect of a depreciation on investment in the BP curve more positive, because it limits the increase in prices. The limited increase in prices reduces the contractionary investment cost effect and increases the expansionary real risk free rate effect. If foreign currency debt is large, the effect of limited pass-through on the price of investment in the BP curve is less important and the effect of diminished expenditure switching in the IS curve dominates.
In the appendix we consider an alternative specification that aims for a stable money supply in the short run and a stable price level in the medium run and show that this policy can be replicated by the exchange rate rule with an appropriately chosen κ = κ(ξ,ω).
Increasing κ lets the shape of the exchange rate response become increasingly concave.
In the empirical part we will be using these measures alternatively.
There is a direct link in the model between the share of foreign debt to GDP and the parameter ξ which is derived in the appendix.
We do not distinguish public and private debt. While accurate data of comparable coverage is not easily available, using overall debt as opposed to private debt, is likely to work against finding balance sheet effects.
In our analysis we focus on import prices because exchange policy can affect exports both if export prices are set in domestic or in foreign currency. If they are set in domestic currency a nominal depreciation makes them cheaper in foreign currency. The depreciation then leads to an increase in export demand and a rise in export volume. If prices are set in foreign currency a depreciation leads to an increase in the domestic currency value of exports, while the export volume is constant.
Apart from few exceptions, if various measures exist, they tend to be identical or highly correlated.
The original dataset is somewhat shorter than our sample. For missing countries we used the updated information provided by Reinhart and Rogoff (2004) on the partner country
Under the strict exogeneity assumption the model can equivalently be written in VARX form
Loayza and Raddatz (2007) apply a similar technique, but let only the coefficients on the external variable coefficients vary with country characteristics. The procedures leaves more degrees of freedom, but assumes that there is only heterogeneity in the initial response, but not in the transmission. The authors find that less flexible labor markets and higher trade openness increase the response of a country’s GDP to terms of trade shocks.
Alternatively, we can generate a dummy based on the division of country observations with high and low external debt level and high and low raw materials share. While the continuous indicator imposes that the response changes in a (log) linear manner with the indicator value, the dummy implies a threshold effect relationship. Results with dummies (not presented) underpin our findings.
In the presence of fixed effects and lagged dependent variables, IV (or GMM) estimators are preferable from an asymptotic point of view if N is large and T is small. Fixed estimates are consistent for a large T.
The programs to perform the estimation method as well as the programs to generate impulse responses and bootstrapped confidence intervals are available from the authors upon request.
Different to the original procedure which was not described for the Panel VAR context, we draw initial observations panel specific and perform the simulation for each country.
We simulated the response for each country over the entire sample length and eliminated at the end of the simulation those observations that where missing in the original sample to maintain the same weight for each country as in the initial data. Since the procedure requires the multiplication of the newly generated data with the interaction terms in the respective period, missing observations need to be filled by interpolation. These observations will however not be part of the newly generated data as explained above.
The conclusion is similar if we use other horizons.
The discussed theory predicts that the response of output under a peg stays constant, whereas it actually falls in the data. As discussed above, a higher share of raw materials might also lead to other effects than higher exchange rate pass-trough, such as lower import substitutability. In that case a given terms of trade shock will have larger effects on output under both exchange rate regime, since the higher costs can be absorbed less easily. A negative correlation between exchange rate pass-trough and import substitutability would work against our finding that a higher raw material share improves the buffer properties of a floating exchange rate regime. The fact that we still find that output reacts less to the negative terms of trade shock therefore strengthens our case.
Results are in line with the former findings and confidence intervals remain reasonably tight. To save space results are not reported but available from the authors.
For simplicity we assume that their marginal costs in foreign currency
The share of differentiated goods plays no role, because no shocks occur in the second period and foreign producers of differentiated goods take shocks in the initial period into account.
The LM curve is independent of the exchange rate due to the log in real money holdings. Allowing a more general framework does not affect the results.
Where Γ = (Φ-1+μ),
With no capital market imperfections (µ = 0) the solution simplifies to
We assume κ not too strong, such that ∂y/∂x > 0.