This paper studies the impact of exchange rate regimes on inflation, nominal money growth, real interest rates, and GDP growth. We find that, for nonindustrial economies, “long” pegs (lasting five or more years) are associated with lower inflation than floats, but at the cost of slower growth. A similar trade-off between inflation and growth is still present in the case of “hard” pegs (currency boards and economies without separate legal tender), whose growth performance does not differ significantly from that of conventional pegs. In contrast, “short” pegs clearly underperform floats, as they grow slower without providing any gains in terms of inflation.

Abstract

This paper studies the impact of exchange rate regimes on inflation, nominal money growth, real interest rates, and GDP growth. We find that, for nonindustrial economies, “long” pegs (lasting five or more years) are associated with lower inflation than floats, but at the cost of slower growth. A similar trade-off between inflation and growth is still present in the case of “hard” pegs (currency boards and economies without separate legal tender), whose growth performance does not differ significantly from that of conventional pegs. In contrast, “short” pegs clearly underperform floats, as they grow slower without providing any gains in terms of inflation.

The proper assessment of the costs and benefits of alternative exchange rate regimes has been a hotly debated issue and remains perhaps one of the most important questions in international finance. The theoretical literature has concentrated on the trade-off between monetary independence and credibility implied by different exchange rate regimes, as well as in the insulation properties of each arrangement in the face of monetary and real shocks.1 Recent episodes of financial distress have refocused the discussion by introducing the question of which exchange rate regime is better suited to deal with increasingly global and unstable world capital markets.2 In particular, given the increasing importance of international capital flows and the predominance of external over domestic monetary shocks, the traditional trade-off has narrowed down to a price stability-growth dilemma, according to which fixes are expected to enhance the credibility of noninflationary monetary policies, reducing inflation and the volatility of nominal variables, while floats are seen as allowing the necessary price adjustments in the face of external (real and financial) shocks, reducing output fluctuations and improving growth performance.

The terms of the debate about exchange rate regimes and the views prevalent in policy circles have evolved over time, as they have rarely been independent from the characteristics of international financial markets. In the 1980s, in a context of relatively closed capital markets, external shocks were less relevant and, with many countries struggling with disinflation policies, monetary aspects appeared to be much more important than today. The issues stressed in the academic literature have changed accordingly: while economists in the 1980s concentrated on studying the implications of exchange rate regimes as stabilization instruments (or as credibility enhancers), today the debate focuses on how different regimes may act as absorbers of external shocks or provide a shield against speculative attacks.3

The lack of consensus on the subject has been paralleled by recent developments in the real world. Recent years have witnessed an unprecedented number of changes of exchange rate regimes, in a way that seems to provide partial support to almost any view about the long-run trends in the choice of regimes. Thus, while the inherent vulnerability of intermediate exchange rate arrangements to sudden aggregate shocks revealed by the notorious collapses of pegs or managed floats in Southeast Asia and Latin America have suggested to some observers the convenience of more flexible regimes, a number of countries have taken the opposite path, moving toward monetary unions or unilateral dollarization, as was the case in Europe in the aftermath of the European Monetary System (EMS) crisis of 1992, or in Ecuador with the recent adoption of the U.S. dollar as legal tender.

The debate is further complicated by another important consideration: Characterizing the exchange rate regimes actually in place in different countries is not a trivial task. Calvo and Reinhart (2000), for example, have pointed out that many countries that claim to be floaters intervene heavily in exchange rate markets to reduce exchange rate volatility, suggesting a mismatch between de jure and de facto regimes. Similarly, Levy-Yeyati and Sturzenegger (2000a) highlight the recent increase in what could be labeled “fear of pegging”: countries that run a de facto peg but avoid an official commitment to a fixed parity.4

With all this in mind, in this paper we revisit the inflation-growth trade-off, using an extensive database that includes 154 countries and covers the post-Bretton Woods era. We deliberately ignore the Bretton Woods period in which fixes were dominant, largely for political reasons, to concentrate in the recent period of increasing financial integration, in which, we believe, the linkage between exchange rate regimes and the real economy better reflected the choice of individual countries’ monetary authorities.

Several new aspects are introduced in our analysis. First, we use a de facto classification, described in detail in Levy-Yeyati and Sturzenegger (2000a) (henceforth denoted LYS), that groups exchange rate regimes according to the actual behavior of the main relevant variables, as opposed to the traditional classification compiled by the IMF based on the de jure (i.e., legal) regime that the countries’ authorities declare to be running.5 By doing this, we refine the analysis substantially. On the one hand, we avoid the misclassification of pegs that pursue independent monetary policies (and eventually collapse) and floats that subordinate their monetary policy to smooth out exchange rate fluctuations, which may bias the statistics of the tests toward lack of significance or incorrect interpretations. On the other hand, the new classification makes a distinction between high and low volatility economies, providing a natural way to discriminate the impact of the regime in tranquil and turbulent times.

Second, we distinguish between “long” and “short” pegs; long pegs are defined as those in place for five or more consecutive years and short pegs as those in place for less than five years. We find the distinction useful at least in two respects. On the one hand, it allows us to determine whether the impact on macroeconomic variables is a product of the regime in place or rather the result of the short-run effect of a regime switch. On the other hand, our focus on long pegs addresses the concern that the poor showing of many conventional pegs may be mainly attributable to countries with weaker macroeconomic and political fundamentals that are forced to implement ultimately unsustainable fixed exchange rate regimes.

Third, in addition to looking at the inflation-growth trade-off, the paper examines the impact of exchange rate regimes on the cost of capital, as measured by the real interest rate, something that has not been done yet in the literature, to our knowledge. The issue has important policy implications inasmuch as lower interest rates are typically invoked as a key argument in favor of fixed exchange rates and, more recently, of the full adoption of a foreign currency as legal tender.

Fourth, we conduct a “deeds vs. words” comparison that makes use of both the LYS and the IMF-based classification, which sheds light on a number of issues. For example, it allows us to test the extent to which economic performance is determined by the actual (as opposed to the reported) exchange rate policy, as well as the “announcement” value of a de jure peg, above and beyond the actual behavior of the regime.

Finally, we test whether fixed exchange rate arrangements that imply a harder commitment, such as currency boards or currency unions (a group usually referred to as “hard” pegs), are different from (and better than) conventional fixes and other regimes in general. This increasingly popular hypothesis stresses that the stronger commitment embedded in a hard peg reduces the vulnerability of the regime to speculative attacks (thus enhancing growth) while reaping all the benefits in terms of lower inflation.6

The main findings discussed in the paper are the following:

The plan of the paper is as follows. Section I succinctly describes the LYS and IMF classification used in the econometric tests. Section II presents the data. Section III shows the main empirical findings for inflation and money growth. Section IV discusses the impact of regimes on real interest rates. Section V looks at the relation between regimes and growth. Section VI explores whether hard pegs behave differently from conventional pegs. Section VII outlines some areas for future research and concludes.

I. Exchange Rate Regime Classification

LYS Classification

The LYS de facto classification7 that we used in this paper is based on three variables closely related to exchange rate behavior: (1) exchange rate volatilitye), measured as the average of the absolute monthly percentage changes in the nominal exchange rate during the year; (2) volatility of exchange rate changesΔe), measured as the standard deviation of the monthly percentage changes in the exchange rate; and (3) volatility of reservesr), measured as the average of the absolute monthly change in international reserves relative to the monetary base in the previous month.8

Underlying the LYS classification is the idea that, according to the behavior of these three variables, we should be able to identify the exchange rate regime that a country is actually following. For example, a textbook flexible exchange rate regime is characterized by little intervention in the exchange rate market together with high volatility of exchange rates. Conversely, a fixed exchange rate regime should display little volatility in the nominal exchange rate while reserves fluctuate substantially. Finally, an intermediate regime corresponds to the case in which volatility is relatively high across all variables.9 Table 1 summarizes the patterns that, a priori, should be expected for the different regimes in terms of the three classification variables.

Table 1.

LYS Classification Criteria

article image

Note that countries that do not display significant variability in either variable are denoted “inconclusive.” Two reasons underlie this label. The first relates to the fact that it is virtually impossible, in the absence of shocks, to assess how exchange rate regimes will actually behave when put to a test. The second derives from the hypothesis that countries that do not face sizable shocks should be less informative about the real impact of the regime, and that their inclusion in our econometric tests may bias the regime coefficients downward.

Once the three classification measures are computed for our universe of countries, the points corresponding to each country-year observation are assigned to the different groups of Table 1 using K-Means Cluster Analysis.10 Finally, countries grouped in the “inconclusive” category are reclassified in a second round using exactly the same procedure.11 This two-stage procedure allows us to differentiate first- and second-round regimes, in turn associated with high and low volatilities in the underlying classification variables.12

IMF Classification

As we mentioned above, we also conduct our tests using an IMF-based classification for the purpose of comparison with previous work, as well as to address issues related to the announcement value of an exchange rate regime, particularly in the case of pegs.13 The IMF has changed the way it classifies exchange rate regimes over the years. Before 1998, the IMF grouped countries into three basic categories: pegs, limited flexibility, and more flexibility, in turn divided into several subgroups. After 1998, the IMF moved to an eight-way classification: no separate legal tender, currency boards, conventional fixed, horizontal bands, crawling pegs, crawling bands, dirty float, and free floats. In general, however, the categories can be readily mapped on a simpler grouping that includes different forms of pegs (to a single currency, or to a disclosed or undisclosed basket), intermediate regimes (crawling pegs, bands, managed floats, cooperative arrangements), and pure floats.

Levy-Yeyati and Sturzenegger (2000a) discuss at length the nature of the mismatches between both classifications. In particular, they show that their number for any given year hovers around 50 percent of all cases. The IMF has recently started to acknowledge the difference between deeds and words by reporting, in some cases, countries with a formal regime and a different de facto one. These regimes are identified by the superscript 6 in IMF (1999). In what follows, we deliberately ignore this distinction when considering the IMF classification and assign countries according to their “legal” arrangement.

II. The Data

Our sample covers annual observations for 154 countries over the period 1974–99. A list of countries, as well as the definitions and sources of the variables used in the paper, is presented in Appendix I. With the exception of the political instability and secondary school enrollment variables used in the growth regressions, all of our data come from the IMF and the World Bank. Data availability varies across countries and periods, so the tests in each subsection were run on a consistent subsample of observations (which is reported in each case along with the results).

The LYS de facto classification covers a sample of 2,825 observations, of which 637 are labeled inconclusive in the second round. Table 2 shows the distribution of the remaining 2,188 observations, along with the alternative IMF-based classification for the same group of observations.

Table 2.

Distribution of Exchange Rate Regimes

article image

III. Inflation and Money Growth

A First Pass at the Data

The typical association of fixed exchange rates with lower inflation rates is based primarily on the belief that a peg may play the role of a commitment mechanism for monetary authorities, inasmuch as an expansionary monetary policy is inconsistent in the long term with a fixed exchange rate, and that the failure to comply with the commitment entails some political cost to the authorities (Romer, 1993, and Quirk, 1994). To this effect, which should work entirely through the behavior of the monetary aggregates, the literature adds the potential impact of a credible peg on inflation expectations, which might stabilize money velocity and reduce the sensitivity of prices to temporary monetary expansions. In this way, a fixed exchange rate regime is expected to affect the link between money and prices. Similarly, particularly in those cases in which dollar indexation is widespread, a credible peg may help reduce inertial inflation by placing a limit to devaluation expectations.

Table 3 provides a first pass at the data. The table shows the means and medians of inflation for each of our control groups, namely, the floating, intermediate, and fixed exchange rate regimes according to the IMF and the LYS classification (the latter being further disaggregated into first and second rounds). For consistency, the sample of 1,925 observations comprises all countries and years classified by LYS (see Table 2) for which data on inflation and monetary growth are available. Because the sample includes many countries that exhibit extraordinarily high inflation, it seems reasonable to concentrate the analysis in the medians, which are less affected by such extreme values.

Table 3.

Inflation and Money Growth

article image
Source: IMF’s International Financial Statistics.Note: Exchange rate classifications: IMF de jure from IFS, LYS de facto from Levy-Yeyati and Sturzenegger (2000a).

For both classifications, the intermediate regimes are the ones that fare the worst in terms of inflation. However, important differences emerge when comparing fixes and floats. Whereas the IMF index seems to indicate, quite surprisingly, that fixes are associated with slightly higher inflation levels, the result reverses when we group observations according to the LYS classification. This is a logical consequence of the fact that the IMF classification does not distinguish between successful and collapsing pegs, and thus includes within the fix group countries that displayed high inflation levels as a result of inconsistent monetary policies that eventually led to a currency crisis.14

The table also shows that, as expected, second-round observations correspond to lower inflation rates, indicating that this group captures country observations with relatively less volatility. Within this group, inflation decreases monotonically as we move to regimes with less flexibility.

As mentioned above, one way a regime (and particularly, a peg) may influence inflation is by imposing discipline on the dynamics of money creation. As expected, the numbers for money growth presented in the table mirror those for inflation. While the IMF index, if anything, seems to indicate that the rate of money growth (ΔM2) tends to increase more rapidly under fixed than under floating exchange rates, the LYS classification finds the opposite result. Again, in both cases intermediate regimes stand out as the most expansionary, which is consistent with the numbers for inflation.

Inflation

These results have to be confirmed by a more careful analysis where we control for relevant additional variables that may also be affecting both inflation and money growth. We start from a standard money demand equation to obtain

π=ΔmαΔGDP+βi+Δv.(1)

Here, π represents the inflation rate, Δm is the rate of growth of broad money, ΔGDP is real output growth, i is the nominal interest rate, ν is money velocity, and α and β are positive constants. As mentioned, the exchange rate regime may affect inflation indirectly through its disciplinary effect on Δm, as well as directly through lower inflation expectations. While it is not completely clear how this last channel may be modeled, a first assessment of this “credibility” effect may be obtained by including regime dummies in the money demand equation (1). More precisely, we use a dummy IMFINT (IMFFIX) that takes the value of one when an observation is classified as an intermediate (fixed) regime by the IMF. The dummies LYSINT and LYSFIX are constructed in a similar way from the LYS classification.

As additional explanatory variables, we include a measure of the openness of the economy (OPEN) to control for the potential disciplinary effect elicited by international arbitrage, three regional dummies corresponding to Latin American (LATAM), sub-Saharan African (SAFRICA), and transition economies (TRANS), and year dummies.15 Finally, we add the lagged dependent variable (INF1) as a regressor to capture for the effect of past policies on current expectations, as well as to control for the possibility of backward-looking indexation. To reduce the influence of outliers in the econometric test, the sample excludes high-inflation countries, defined as those with annual inflation rates above 50 percent.

The results, presented in Table 4, are largely consistent with those sketched in the previous discussion.16 The coefficients for real GDP, money, openness, and interest rate growth (respectively, ΔGDPM2, OPEN, and ΔINTRATE), as well as lagged inflation, are all highly significant and of the expected sign.

Table 4.

Inflation

article image
Notes: ***, **, and * represent 99, 95, and 90 percent significance, respectively. Heteroscedasticity-consistent standard errors are in italics.

Sample includes only low- to moderate-inflation countries (annual inflation below 50 percent).

Regarding the regime effect, both classifications yield the same result when applied to the whole sample (columns 1 and 2, indicating no significant difference between fixes and floats in terms of inflation rates. However, once we exclude high-inflation countries (defined as those with annual inflation rates above 50 percent), the fix dummy becomes negative and significant (and under the de facto classification, highly so), as shown in columns 3 and 4.17 This finding is confirmed when we exclude intermediates from the sample (column 5). Both results seem to imply that, for low- to moderate-inflation countries, fixed regimes appear to be associated with inflation rates about 1.8 percent lower than floats. Intermediates, on the other hand, display significantly higher inflation.

This association, however, does not apply evenly to the sample. In particular, the beneficial influence of fixed regimes on inflation appears to be significant only for low-volatility and nonindustrial countries (columns 7 and 8).18 In short, while there is some evidence of a link between regimes (in particular, pegs) and the inflation rate, this link appears to be more limited than is typically assumed.

The final column of Table 4 addresses an additional issue raised by our exchange rate classification procedure. The de facto methodology leaves unclassified a number of countries that display very little variability in both the nominal exchange rate and reserves. It could be argued that credible fixes are less likely to be tested by the market (hence exhibiting a lower volatility of reserves) and, possibly for the same reason, more likely to exhibit lower inflation rates. If so, by leaving out the so-called “inconclusives,” we would be ignoring this credibility dimension and discarding “good pegs,” thus biasing the results toward underestimating the beneficial effects of fixed regimes on inflation.

A natural way to address this concern is to include these “high credibility” pegs in our regressions. Because the de facto approach is silent as to the regime to be assigned to these observations, we simply added to the group of fixers all those de facto inconclusives that did not exhibit changes in their exchange rates. The last column of Table 4 reports the results of our baseline regression, where LYSFIX now represents the expanded group of pegs, and the dummy INCONC takes the value of one whenever an observation was originally classified as inconclusive. A simple comparison of these results with those in regression (4) indicates that the introduction of high credibility pegs does not alter the previous conclusions: all coefficients remain virtually unchanged and, in particular, the coefficient of INCONC, which should capture any additional credibility effect associated with the new pegs, is not significant.

Along the same lines, we further refine the tests in Table 4 by distinguishing between long and short pegs, according to whether or not they have been in place for at least five consecutive years. More precisely, we rerun regressions (4)–(9) of Table 4, splitting the fix group into long and short pegs (respectively, dummies LONG and LYSFIX–LONG). As mentioned in the introduction, this enables us to isolate the short-run impact of the implementation of a peg from the effects associated with the permanence of the regime, as well as to focus our attention on those countries capable of implementing sustainable pegs. As Table 5 shows, the distinction is highly relevant. A significant link with low inflation is found only for the group of long pegs, with the exception of industrial countries, for which, as before, regimes exhibit no significant impact.

Table 5.

Inflation: Long vs. Short Pegs

article image
Notes: ***, **, and * represent 99, 95, and 90 percent significance, respectively. Heteroscedasticity-consistent standard errors are in italics. Sample includes only low- to moderate-inflation countries (annual inflation below 50 percent).

Endogeneity

Underlying the previous tests was the presumption that the adherence to a fixed regime may lead to a lower average inflation rate. However, it is easy to conceive a different argument by which countries with greater price stability have better chances to implement a sustainable peg and, for this reason, are more likely to choose one in the first place. Thus, the finding that pegs are associated with lower inflation, at least for some groups of countries, is subject to a potentially serious endogeneity problem.

To address this issue we use a feasible generalized two-stage IV estimator (2SIV) suggested by White (1984), which allows us to correct simultaneously for endogeneity and heteroscedasticity.19 The results are presented in Table 6, where we apply this correction, in turn, to assess the inflation effect of conventional fixed regimes and long pegs. As can be seen from the table, only the impact of long pegs on inflation survives the endogeneity correction. This confirms that the negative link between inflation and pegs is weaker than casual observation seems to reveal, and appears to be largely confined to the case of long-standing pegs.

Table 6.

Inflation: Accounting for Endogeneitya

article image
Note: ***, **, and * represent 99, 95, and 90 percent significance, respectively. Heteroscedasticity-consistent standard errors are in italics.

The sample includes high credibility pegs.

Instruments: FIXFIT, where FIXFIT is the estimate of LYSFIX in a logit model over the sample excluding intermediates.

Instruments: LONGFIT, where LONGFIT is the estimate of LONG in a logit model over the sample excluding intermediates.

Money Growth

At the beginning of this section we mentioned that a typical argument supporting the connection between pegs and inflation points to the presence of a disciplinary effect on monetary policy. According to this view, de jure pegs, inasmuch as failing to comply with the legal commitment entails a significant political cost, should result in lower rates of money growth. The same can be said of de facto pegs.

To test this hypothesis, we run cross-section regressions of money growth on the regime dummies and the following additional explanatory variables: real GDP growth (ΔGDP1, lagged to reduce potential endogeneity problems), openness (OPEN), the ratio of the fiscal surplus to GDP (SUPGDP), the three regional dummies (LATAM, SAFRICA, and TRANS), and the lagged dependent variable (ΔM21).20 Our results, reported in Table 7, offer partial support for the hypothesis of the existence of a disciplining effect on money growth. Using either the IMF classification (column 1) or the de facto classification (column 2), the fixed regime dummy has the expected negative sign but is not significant. However, a significant relationship is detected when we look at long pegs separately (column 3), a result driven, once again, by the group of nonindustrials (column 5). Thus, for the group of long pegs, the regime has an effect on inflation through both enhanced credibility and a disciplining effect on monetary policy.

Table 7.

Money Growth

article image
Note: ***, **, and * represent 99, 95, and 90 percent significance, respectively. Heteroscedasticity-consistent standard errors are in italics.

Deeds vs. Words

The mismatch between the IMF and the LYS classification, and in particular the fact that in the past numerous countries repeatedly adopted de jure fixed regimes without implementing consistent monetary policies, opens the question of whether, for a given monetary policy, the announcement of a peg brings by itself a benefit in terms of lower inflation, thus providing a potential motivation for this seemingly inconsistent behavior.

In the “deeds” regression (Table 8, column 1), we control for the announced (de jure) regime, including the dummy FIXFIX that takes the value of one for observations identified as pegs by both classifications. In this way, we test whether the actual behavior of the economy (deeds) has any additional effect on inflation, above and beyond that resulting from the announcement of a peg. The coefficient of FIXFIX is highly significant and negative, suggesting that countries that announce a peg but in practice let the exchange rate fluctuate exhibit higher inflation levels, an unsurprising result that simply confirms the inflationary impact of (partially) unanticipated devaluations.

Table 8.

Inflation: Deeds vs. Words

article image
Note: ***, **, and * represent 99, 95, and 90 percent significance, respectively. Heteroscedasticity-consistent standard errors are in italics. The regression sample includes only low- to moderate-inflation countries (annual inflation below 50 percent).

Regarding words, in addition to controlling for the de facto regime (distinguishing between long and short pegs), we include two interaction terms that identify observations within each group that are also classified as de jure pegs. This allows testing whether the actual announcement of a peg (words) has any additional effect on inflation, above and beyond that resulting from the actual behavior of the economy. As can be seen in column (2) of Table 8, the announcement only lowers inflation rates for the case of long pegs.

The “deeds vs. words” comparison indicates that, for inflation, deeds appear to play a more important role. De jure pegs that do not behave as real pegs are obviously associated with higher inflation, because the announcement of a peg has no value in the face of recurrent devaluations. On the other hand, within de facto pegs, words appear to have no value in terms of inflation unless the country behaves in a manner consistent with maintaining a peg.

IV. Interest Rates

While much has been said of the impact of exchange rate regimes on real wages and employment, there is surprisingly little work on their effect on the cost of capital, which accounts for a larger share of production costs in most countries. Quite possibly, one reason for the scarcity of research on the issue is the difficulty in obtaining reliable interest rate data for a reasonably large number of countries, as in many cases interest rates were largely administered and thus unrepresentative of actual market rates.21 On the other hand, episodes of very high inflation are typically characterized by negative real rates, as the banking sector sometimes is not allowed to fully accommodate extremely high inflation expectations. Moreover, in a context of rapidly changing expectations, a small mismatch between the time at which inflation and the nominal interest rate are measured may derive in sizable distortions.

Measurement errors aside, the channels through which the exchange rate regime may influence the real rate are by no means obvious. Legal pegs are a case in point. Whereas they are prone to exhibit a “peso problem” that increases real interest rates, pegs on the other side may reduce inflation expectations and thus nominal (and real) rates.

More in general, the real rate should depend on the same fundamentals that determine the level of country risk that typically represents a lower bound for all domestic lending rates. Thus, a relatively larger amount of liquid international reserves, a buoyant economy, or a low level of indebtedness should help reduce the cost of capital for the economy inasmuch as open international markets tend to equalize the funding cost of countries of the same risk class. On the contrary, as long as there is some imperfect substitutability between domestic and foreign assets, increases in the government financing needs may crowd out domestic resources, pushing the domestic real rate higher. Alternatively, sluggish growth may provide incentives for short-term expansionary monetary policies with a view to lowering domestic financing costs.

With all these caveats in mind, we attempted to explore the issue using a relatively broad specification that captures some of the factors mentioned above. Thus, we include lagged GDP growth rate (ΔGDP1) to control for incentives to use monetary policy to lower the real rate, the ratio of net interest payments over GDP (INETGDP) as a proxy for the level of debt, the degree of openness (OPEN) to control for international arbitrage constraints, and the ratio of fiscal surplus over GDP (SUPGDP) as an (inverse) measure of government crowding out. We also included current inflation (INF) to control for potential measurement error due to differences in the sampling time or to financial repression, as well as the three regional dummies.22

Table 9 presents the results for the IMF classification. Given that this exercise has not been undertaken with either classification, we study alternative specifications for both. Using the IMF classification, we found that real rates are significantly lower under pegs, while both intermediate and floating regimes do not differ from each other (column 1). These results are even stronger during the 1990s, both for the whole sample and for nonindustrial countries (columns 3 and 5). However, the regime dummies are not significant during the 1970s and 1980s, either for the whole sample or for nonindustrial countries (columns 2 and 4), probably reflecting substantial measurement errors during those years.

Table 9.

Real Interest Rates: IMF Classification

article image
Note: ***, **, and * represent 99, 95, and 90 percent significance, respectively. Heteroscedasticity-consistent standard errors are in italics.

The previous results may be a consequence of the inclusion of failed pegs among the fixers in the IMF classification. More precisely, unexpected devaluations may induce negative real interest rates in the aftermath of the realignment of the nominal exchange rate. This hypothesis is consistent with a series of findings. First of all, the result applies to first-round (high volatility) observations (column 6) but not to second-round (low volatility) observations (column 7). Moreover, no systematic link is detected when using the LYS classification (Table 10).23

Table 10.

Real Interest Rates: LYS Classification

article image
Note: ***, **, and * represent 99, 95, and 90 percent significance, respectively. Heteroscedasticity-consistent standard errors are in italics.

This hypothesis is further confirmed by the results of Table 11, which indicate that while de jure fixes display significantly lower interest rates in general, the impact appears to be stronger for those of them that in practice let the exchange rate fluctuate (as shown by the coefficient of the regime dummy IMFFIX–FIXFIX in column 1). Alternatively, when looking at de facto regimes, we find an effect on real interest rates only for the case of short pegs (columns 2 and 3). Note that the last result is consistent with the presence of an announcement effect on inflation expectations, combined with the failure of short pegs to lower inflation as revealed in the previous section.

Table 11.

Interest Rates: Deeds vs. Words

article image
Note: ***, **, and * represent 99, 95, and 90 percent significance, respectively. Heteroscedasticity-consistent standard errors are in italics. The regression sample includes only low- to moderate-inflation countries (annual inflation below 50 percent).

VI. Growth

The literature has not considered the exchange rate regime as an important determinant of growth performance. This is probably due to the fact that we tend to associate only nominal effects to the choice of nominal variables. However, several arguments have been advanced to suggest a link between the two.

On the one hand, by reducing relative price volatility, a peg is expected to foster growth through its positive effect on investment and trade. Moreover, lower price uncertainty should lead to lower real interest rates, contributing to the same effect. On the other hand, the lack of exchange rate adjustments under a peg, coupled with some degree of short-run price rigidity, may result in price distortions and high unemployment in the face of external shocks. More important, the need to defend a peg in the event of negative external shocks entails a significant cost in terms of real interest rates, as well as increased uncertainty as to the sustainability of the regime. Calvo (1999) has suggested that the external shocks faced by a country are not independent of the exchange rate regime. Not surprisingly, as pointed out in Fischer (2001), all the countries that suffered from a currency crisis had fixed exchange rate regimes. However, while both the lack of adjustment argument and the frequent external shocks that characterize a peg imply a higher expected output volatility, their consequences in terms of long-run growth are less straightforward.

At an empirical level this relationship has been studied in a series of recent papers. Mundell (1995), for example, examines the growth performance of industrial countries before and after the demise of Bretton Woods, finding that the earlier period, characterized by the prevalence of fixed exchange rates, was associated with faster average growth. Ghosh and others (1997), using all IMF reporting countries for the period 1960–90, fail to find systematic evidence of an impact of the type of regime on growth. However, these results are challenged by Rolnick and Weber (1997), who find, using long-term historical data, that output growth was higher under fiat standards compared with commodity (e.g., gold) standards.

A similar conclusion is reached by Levy-Yeyati and Sturzenegger (2000b), who explore the relationship between exchange rate regimes and growth using annual data covering the period 1974–99. In a nutshell, their main findings are the following:

Levy-Yeyati and Sturzenegger (2000b) cast a relatively negative light on pegs. If policymakers worry about inflation and exchange rate stability because of their potential negative impact on economic growth, it appears that the beneficial effect of a peg in terms of price stability does not translate in the end into a stronger growth performance.

In this paper, we build on these results to explore two additional issues. First, we evaluate the announcement value of regimes in terms of growth performance, in light of the argument that legal pegs are more vulnerable to external shocks and speculative attacks that ultimately undermine their growth performance. In turn, in the next section, we examine whether the negative growth performance found to be associated with fixed regimes remains even when we focus on the subgroup of hard pegs as opposed to conventional fixes.

Fear of Pegging

The experience of the financial crisis of the 1990s has placed in the forefront of the exchange regime discussion the increasing vulnerability of fixed regimes to speculative attacks and financial contagion. This may be behind a phenomenon that could be labeled “fear of pegging,” namely the practice of de facto running a peg while avoiding a commitment to a fixed parity and the potential vulnerability to attacks that a legal peg may introduce.24

This issue is addressed in Table 12, where we test the consequences of the announcement of a peg on growth performance, after controlling for the de facto regime. Interestingly, when we split the group of pegs into short and long, we find that only the former are negatively affected by the announcement. This result seems to suggest that a commitment to a fixed parity increases the vulnerability of the country, except in those cases in which the regime has been in place long enough to strengthen its credibility. Thus, the evidence provides some support for the view that the adoption of a legal peg entails increased vulnerability, a fact that may underscore the finding of “fear of pegging.”

Table 12.

GDP Growth: Fear of Pegging

article image
Note: ***, **, and * represent 99, 95, and 90 percent significance, respectively. Heteroscedasticity-consistent standard errors are in italics.

VII. Are Hard Pegs Different?

The LYS classification works on the basis of facts, distinguishing between the broadly defined groups of fixed exchange rates, intermediate regimes (crawling pegs and dirty floats), and pure floats. However, some analysts, notably Eichengreen (1994) and, more recently, Fischer (2001), have argued in favor of the relative merits of extreme exchange rate regimes, drawing a line between conventional fixes and “hard pegs” that exhibit a stronger commitment to a fixed parity (as in a currency board) or directly relinquish control over their own currency (as in the case of countries with no separate legal tender). More precisely, it has been argued that, if the benefits of pegging accrue from increased credibility, conventional fixes may fall short on this ground and the stronger commitment that characterizes hard pegs may be necessary. In this section, we test whether and in which way this hypothesis is consistent with the data. To do so, we have a closer look at the group of hard pegs, defined as those countries classified by the IMF as having either a currency board or no separate legal tender.25

Before we present the econometric results, a few comments are in order. First, as many authors before us have stressed, with the exception of the European Economic and Monetary Union (EMU), and possibly Argentina and Hong Kong SAR, countries with hard pegs are relatively small. Moreover, the biggest countries in the group (Argentina, Bulgaria, Estonia, Ecuador, El Salvador, Lithuania, and countries in the euro area) have adopted a hard peg relatively recently, and in many cases there is not sufficient data to test the impact of the new regime empirically.

Second, most of the hard pegs for which there are data to conduct econometric tests have been around for a long enough time to dispel concerns about potential endogeneity problems. With the exception of Argentina and Bulgaria, all of the remaining countries in the list have had the same regime in place over the whole period included in our sample. On the other hand, long-standing currency boards include only Hong Kong SAR, Djibouti, and Brunei, which seriously limits the possibility of conducting meaningful tests of this type of regime in a separate way.

In view of the above, in what follows we treat hard pegs as a single group without discriminating according to their different varieties, bearing in mind the limits of extrapolating the experience of small countries and island economies to the rest of the sample. Moreover, because EMU observations are excluded from the LYS classification, no industrial country in our sample is classified as a hard peg. Therefore, we restrict our tests to the subgroup of nonindustrial economies.

Tables 13 and 14 offer a rough pass at the data by comparing the means and medians of the inflation rate, money growth (ΔM2), and the rate of growth of real per capita GDP (ΔGDPPC), for nonindustrial countries as a whole and for the subgroup of hard pegs.26 Simple inspection indicates that, while hard pegs appear to exhibit much lower inflation and money growth levels, their growth performance does not differ from the group of nonindustrial pegs as a whole.

Table 13.

Inflation and Money Growth: Conventional and Hard Pegs

(Nonindustrial countries)

article image
Source: IMF’s International Financial Statistics.Note: Exchange rate classifications: IMF de jure from IFS, LYS de facto from Levy-Yeyati and Sturzenegger (2000a).
Table 14.

GDP Growth: Conventional and Hard Pegs

(Nonindustrial countries)

article image
Source: IMF’s International Financial Statistics.Note: Exchange rate classifications: IMF de jure from IFS, LYS de facto from Levy-Yeyati and Sturzenegger (2000a).

To assess the relative merits of hard pegs in terms of inflation, we run econometric tests similar to those in Tables 4 and 5, this time including a hard peg dummy (HARDPEG). To compare with previous results in the literature, see Ghosh and others (2000), we first run the inflation regression including only the hard peg dummy. Column 1 in Table 15 confirms the negative correlation between hard pegs and inflation present in Table 13. Furthermore, as column 2 shows, hard pegs have an additional disinflationary effect relative to conventional fixes, a result that remains once we expand the sample to include high credibility pegs (column 3).27

Table 15.

Inflation: Are Hard Pegs Different?

(Nonindustrial countries)

article image
Notes: ***, **, and * represent 99, 95, and 90 percent significance, respectively. Heteroscedasticity-consistent standard errors are in italics.

Excluding Bulgaria.