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.