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In this paper we demonstrate that exchange rate regime switching is compatible with optimal government policies. Nominal exchange-rate regimes are formalized as equilibrium commitments on future seigniorage policies, and the collapse of an exchange-rate peg as an excusable default which allows the government to lump-sum tax private sector money holdings. We demonstrate that a regime in which the exchange-rate peg is allowed to collapse when government spending is unusually high is a trigger-strategy equilibrium. Such a regime can be superior to both fixed and flexible exchange rate because it combines some of the flexibility of the floating exchange rates with some of the benefits of precommitment afforded by fixed rates.
The IMF Working Papers series is designed to make IMF staff research available to a wide audience. Almost 300 Working Papers are released each year, covering a wide range of theoretical and analytical topics, including balance of payments, monetary and fiscal issues, global liquidity, and national and international economic developments.
The study investigates whether a switch from exchange-rate targeting to inflation targeting will facilitate a more appropriate monetary policy and a more stable macroeconomic environment in developing economies. The research finds that the exchange-rate regime is not significant in explaining growth. The empirical evidence on its effect on output volatility suggests that a terms-of-trade shock larger than seven percentage points under a fixed exchange-rate regime will give higher output volatility compared to a float. Given these findings, the study suggests the exchange rate be made flexible and that the direct targeting of inflation is a rational choice in the aftermath of peg exit. To investigate whether monetary-policy responses change under such a regime switching, allowing for the possibility of an endogenous switch, the study estimates augmented Taylor rule with two approaches: a panel switching regression; and a Markov-switching VAR. Results from both suggest that inflation targeting represented a real switch in developing economies.
Most trade is invoiced in very few currencies. Despite this, the Mundell-Fleming benchmark and its variants focus on pricing in the producer’s currency or in local currency. We model instead a ‘dominant currency paradigm’ for small open economies characterized by three features: pricing in a dominant currency; pricing complementarities, and imported input use in production. Under this paradigm: (a) the terms-of-trade is stable; (b) dominant currency exchange rate pass-through into export and import prices is high regardless of destination or origin of goods; (c) exchange rate pass-through of non-dominant currencies is small; (d) expenditure switching occurs mostly via imports, driven by the dollar exchange rate while exports respond weakly, if at all; (e) strengthening of the dominant currency relative to non-dominant ones can negatively impact global trade; (f) optimal monetary policy targets deviations from the law of one price arising from dominant currency fluctuations, in addition to the inflation and output gap. Using data from Colombia we document strong support for the dominant currency paradigm.
This paper reviews recent developments in the theoretical and empirical analysis of balance-of-payments crises. A simple analytical model highlighting the process leading to such crises is first developed. The basic framework is then extended to deal with a variety of issues, such as: alternative post-collapse regimes, uncertainty, real sector effects, external borrowing and capital controls, imperfect asset substitutability, sticky prices, and endogenous policy switches. Empirical evidence on the collapse of exchange rate regimes is also examined, and the major implications of the analysis for macroeconomic policy discussed.
This paper develops a model of endogenous exchange rate pass through within an open economy macroeconomic framework, where both pass-through and the exchange rate are simultaneously determined, and interact with one another. Pass-through is endogenous because firms choose the currency in which they set their export prices. There is a unique equilibrium rate of pass-through under the condition that exchange rate volatility rises as the degree of pass-through falls. We show that the relationship between exchange rate volatility and economic structure may be substantially affected by the presence of endogenous pass-through. Our key results show that pass-through is related to the relative stability of monetary policy. Countries with relatively low volatility of money growth will have relatively low rates of exchange rate pass-through, while countries with relatively high volatility of money growth will have relatively high pass-through rates.
Norman Miller provides a fresh perspective on balance of payments and exchange rate theories, including intertemporal open economy models that focus on the optimum current account. To this end, he proves that any non-zero balance of payments must always be associated with a disequilibrium in either a commodity or an asset market. In this rigorous yet readable book, important welfare and policy implications are carefully examined. Norman Miller develops a new theory of the balance of payments associated with commodity market disequilibrium, a loanable funds theory of exchange rate and a modern foreign exchange market theory of the exchange rate that incorporates capital flows. The book also details 15 puzzling facts associated with open economies and the FX market. After reviewing existing explanations to these puzzles, the author shows how each of the above new theories provides new, often unified solutions to them. International finance practitioners, students and scholars of economics and finance, and MBA students will all find this book fresh and enlightening.
This paper develops a model of endogenous exchange rate pass-through within an open economy macroeconomic framework, where both pass-through and the exchange rate are simultaneously determined, and interact with one another. Pass-through is endogenous because firms choose the currency in which they set their export prices. There is a unique equilibrium rate of pass-through under the condition that exchange rate volatility rises as the degree of pass-through falls. We show that the relationship between exchange rate volatility and economic structure may be substantially affected by the presence of endogenous pass-through. Our key results show that pass-through is related to the relative stability of monetary policy. Countries with relatively low volatility of money growth will have relatively low rates of exchange rate pass-through, while countries with relatively high volatility of money growth will have relatively high pass-through rates.