Exchange Rate Regimes and Economic Performance

Exchange rate and Economic performance: the effects of exchange rate regime on Economic Growth and Economic Policies

The analysis of exchange rate regimes and their implications for key micro and macroeconomic variables and for the efficacy of alternative types of economic policies has occupied a central place in the development of modern economics over the past two hundred years. If you find yourself struggling with this complex topic, seeking economics dissertation help can provide valuable insights. The fact that the debate over the central issues continues, and perhaps may be more intense now than ever, is a testimony both to the importance of the issues as well as to the lack of resolution that the analysis has so far given rise to.

Over the past couple of decades, the choice of a country’s exchange rate regime has been heavily scrutinized due to possible implications on the country’s economic growth. In turn, this has lead to numerous economists supplying conflicting theories and contrasting empirical evidence by gathering data of advanced, industrial or developing countries. The choice of whether to fix or float a country’s exchange rate may also determine monetary policy options as well as the ability to maintain open capital market. In this paper, I focus on the impact of the choice of regime on the long-term growth of developing countries as well as their respective choices of economic policy. The idea of ‘neutrality of money’ implies that economic growth should be indifferent to a country’s choice in exchange rate regimes. In other words, an increase or decrease in money supply can influence the price level but not the output or structure of the economy. However, many a previous literature has tried to align a link between the two variables in question in order to complement its empirical findings. The earliest of such mechanisms can be traced back to the work of Milton Friedman (1953) who, in his support for flexible exchange rates, argues that flexible regimes are better suited to shield the economy against economic shocks. An economy characterized by nominal rigidities is better able to absorb and adjust to real domestic and foreign shocks. However, Bailliu et al (2003) counter acts Friedman’s argument by claiming that flexible rates are more prone to exchange rate shocks, exacerbating business cycles and dampening growth compared to a fixed regime, in particular in the context of developing economics with a weak financial system. Calvo, Mundel (1995) claim that real interest costs are associated with the need to defend a peg in the event of a negative external shock and the consequent uncertainty as to the sustainability of such a regime, are generally considered to be deleterious to growth. In many ways the choice of a country’s exchange rate regime is one that is seen as the pivotal choice with regards to having an influential ‘domino like’ effect on further fiscal and monetary choices. Despite the importance of this choice, previous research of the topic has led to conflicting theories over the implications of a pegged currency, specifically, whether any economy outside the four or five most powerful actually has any monetary freedom. This is crucial since if this notion is indeed true, then the choice of exchange rate regime would not generate a loss of monetary flexibility and thus would not have freedom even if they possessed a floating exchange rate. It then seeks to understand the effect fixing the exchange rate has on monetary policy by establishing the extent to which interest rate in pegged countries follow base country interest rates and whether this is any different for countries without fixed rates.

Prior to analysing previous journals on this controversial topic, it is important, I feel, to justify a country’s decision in adopting a pegged or floating exchange rate. One of the main reasons a country adopts a fixed exchange rate is for the purpose of exportation and trade. By controlling its domestic currency a country can and more often than not keep its exchange rate low. This in turn helps to instil the competiveness of its goods, since purchasing countries would be attracted by the exporting country’s low price. The real advantage, however, is found among the trade relationships between countries that possess low costs of production and economies with stronger comparative currencies. An example of this would be Chinese and Vietnamese manufacturers, who, when converting their profits back to their respective currencies, find that there is an even greater amount of profit that is made through the exchange rates. Therefore, as well as the ‘insulation of exchange rate’ argument initially proposed by Bailliu et al (2003) keeping the exchange rate low through a pegged policy can ensure domestic product’s competitiveness abroad as well as profitability at home. However, there is a price that comes with a pegged exchange rate regime. In order to maintain the pegged exchange rate, deep amounts of currency reserves are essential as the country’s government or central bank is constantly buying selling the domestic currency. As highlighted by Guillermo Calvo (1999) among others, the importance of defending a peg in the event of a negative external shock implies a significant cost of real interest rates as well as increasing uncertainty as to the sustainability of the regimes, potentially harming investment projects. While the implications of these channels in terms of long run performance may not be direct, there lies some evidence of a negative relationship between output volatility and growth. On the other hand, by reducing relative price volatility, a peg is likely to stimulate investment and trade, thus increasing growth. Lower price uncertainty, usually associated with fixed exchange rate regimes, should also lead to lower real interest rates, adding to the same effects.

Issue of classifying exchange rate regimes: the fixed-floating spectrum

The issue of classifying exchange rate regimes has significantly come into fruition over the past decade or so. Prior to this, most of the empirical literature on the evolution and implications of alternative exchange rate regimes group data according to a ‘de jure’ classification. Baxter and Stockman (1989), for example, predominantly perceived regimes in industrial countries as either simply fixed or floating. Further analysis, and indeed Baxter and Stockman’s concluding remarks recognized that countries’ regimes are often neither completely one nor the other. As Williamson (2000) has argued, such ‘intermediate’ regimes could, hypothetically speaking, allow countries to reap the benefits of both fixed and flexible policies whilst also not incurring some of their costs. The ‘de jure’ is based on the regime that governments claim to have in place as reported by the IMF in its International Financial Statistics. This possibly may be different to what the actual regime of the country in question may be or in simple terms, a ‘de facto’ classification since the IMF classification approach ignores the fact that many alleged floating governments intervene to mitigate exchange rate volatility while some pegged governments devalue their currency to account for their independent monetary policies. Ghosh et al (1996) initially highlighted this issue claiming that ‘beyond the traditional fixed-floating dichotomy lies a spectrum of exchange rate regimes. The de factor behaviour of an exchange rate, more over may diverge from its de jure classification.’ This was further backed up by Rose (2011) in his paper titled Exchange Rate Regimes in the Modern Era, who concluded that ‘it is often hard to figure at what the exchange rate regime of a country is in practice, since there are multiple conflicting regime classifications.’ LYS use a de facto classification that groups countries annual observations according to the behaviour of three specific dimensions of exchange rate policy. Thus to summarise, the paragraph above points to two key issues that in turn lead to significant measurement problems. The first issue is that among a spectrum that starts from a strictly fixed rate all the way to a floating regime lies many a differing and highly specific regime that each country adopts. The question is where should one draw the line as highlighted by Backus (2005). This dilemma is of greater significance when one analyses that, especially in developing and emerging markets, countries’ regimes are often of the intermediate type (Williamson, 2000). Although it is often contended that intermediate regimes are not sustainable over the long run, as they lack credibility and make economies more susceptible to speculative currency attacks and economic crises (Eichengreen, 1994 and 2000; Fischer, 2001; Glick, 2001; Summers, 2000), Williamson (2000) suggests that intermediate regimes will continue to be seen as a viable option to try to reap the benefits of both exchange rate regimes. The second issue lies in the fact that the ‘de facto’ regimes now applied by many journals have low coloration between each other. Ideally, when comparing empirical findings, you would want the method of classification published by each journal to be identical. This divergence curtails from the fact that the way in which ‘arbitrary correction rules attempt to adjust for the bias between countries’ publicly stated commitment to a given regime and the observed volatility of the exchange rate. For example, while Levy-Yeyati and Sturzenegger (2003 and 2005) use cluster analysis techniques to group countries' regimes on the basis of the volatility of the exchange rate, of exchange rate changes and of reserves, Bailliu et al. (2003) develop a two-step mechanical rule whereby countries' regimes are grouped according to a flexibility index for each country based on its degree of exchange rate volatility relative to the group average for each year.

Literature Review

The vast array of differing theoretical ideologies over the relationship between the choice of exchange rate regime and economic growth has shown in the complementary empirical work. Using data based on 136 countries over the period 1960-1989, Ghosh et al. (1997) classifies countries using the traditional MF ‘de jure’ classification and control for pegged, intermediate and flexible exchange rate regimes. They find no significant differences in growth rates across the exchange rates that were examined. Ghosh et al (2002) further extends the sample period from 1970 to 1999 and controls the endogeneity of the regime through a treatment effects model yet, however, obtain similar results.

Vita and Kyaw (2011) use three different classification techniques in order to defuse the ambiguity among past empirical findings. Focus of this paper stems from the impact of the choice of exchange rate regime on the long-term growth of developing countries. Their results indicate the absence of any robust relation between the choice of exchange rate regime and economic growth, meaning exchange rate policies has no direct impact of the long-term growth of developing countries. One of the classification techniques acquired by Vita and Kyaw (2011) was one, which was initially introduced by Levy-Yeyati and Sturzenegger (2003) (henceforth LYS) who constructed a de facto exchange rate regime that is based on three different aspects; exchange rate volatility, volatility of exchange rate changes and volatility of reserves. Thus, using a new de facto classification of regimes based on the actual behaviour of the relevant macroeconomic variables LYS find that for developing countries’ ‘less flexible exchange rate regimes are associated with slower growth as well as with greater output volatility (LYS). These results prove robust to several alternative specifications (pooled annual data, pooled five-year data and cross-sectional regressions) and pass a number of sensitivity checks.

Husain et al (2004), based on their empirical findings, conclude that it is a countries specific wealth and financial development that is instrumental in defining which exchange rate policy is successful for economic growth. Countries that are wealthier and more financially developed would benefit from a flexible exchange rate system whilst ‘developing countries with little exposure to international capital markets’ would benefit from a pegged exchange rate due to their ‘ durability and relatively low inflation’ (Husain et al, 2004).

Using a panel of 60 industrialized and developing countries from the period 1973-1998, Bailliu et al (2003) examine the impact of exchange rate regime on growth by means of dynamic GMM estimation. Along with the traditional tripartite scheme of regime classification (floating, pegged and intermediates) they use an expanded one, which further distinguishes between intermediate and floating regimes based on the presence of a nominal policy anchor. The exchange rate regime is classified according to both the de jure and de facto classification, which is constructed by them and corrects for observed volatility in the actual behaviour of the exchange rate. Bailliu et at (2003) conclude, through their empirical findings, that a pegged regime is positively linked to growth, an intermediate regime without an anchor is negatively associated with growth, and all other regime types have no discernible impact on growth.

Edwardsa and Yeyati (2004) analyse empirically, using the data set provided by LYS, the effect of terms of trade shocks on economic performance under differing exchange rate regimes. They demonstrate particular interest in investigating whether terms of trade disturbances have a smaller effect on growth in countries with a flexible exchange rate arrangement as well as analysing whether positive and negative signs of trade shocks have asymmetric effects on growth and whether the magnitude of these asymmetries depends on the exchange rate regime. After controlling for other factors, countries with more flexible exchange rate regimes grow faster than countries with fixed exchange rate regimes. As well as this, Edwardsa and Yeyati (2004) find empirical evidence that suggest terms of trade shocks have a more powerful effect on countries that posses a more rigid exchange rate regime where the output response is larger for negative shocks than positive ones.

Miles (2006) replicates the LYS growth regressions with a panel of annual data (1976-2000) across a developing countries' subset of the LYS original sample. The innovation here consists in the inclusion of a measure of the black market premium on foreign exchange, a variable meant to capture macroeconomic imbalances. His results indicate that once such a measure of domestic distortions is added to the model, exchange rate regimes exert no independent impact on the economic growth of developing countries. More recently, Bleaney and Francisco (2007) use the official (IMF) and four alternative de facto exchange rate regime classifications to examine the relationship with inflation and growth in 91 developing countries over the period 1984-2001. With the exception of the results obtained from the Reinhart and Rogoff (2004) regime classification, which produce quite unfavorable outcomes for flexible regimes (higher inflation and lower growth), their estimates across the other classification schemes suggest that floats have very similar growth rates to 'soft' (easily adjustable) pegs while 'hard' pegs (currency unions and currency boards) have slower growth than other regimes (though the latter result may - by their own admission - be due to fixed country effects). However, it should be noted that they only include a few growth determinants in their regressions, and do not attempt to control for endogeneity. Evidently, the conflicting evidence warrants further empirical research.

Shambough’s (2004) paper aims to dissect how a fixed exchange rate affects monetary policy. The paper simply classifies countries as either pegged or floating and examines whether a pegged country must follow the interest rate change s in the base country. Despite recent research which hints that all countries, not just pegged countries lack monetary freedom, the evidence shows that pegs follow base country interest rates more than non pegs. This study uses actual behaviour, not declared status, for regime classification; expands the sample inducing base currencies other than the dollar; examines the impact of capital controls, as well as other control variables; considers the time series properties of data carefully; and uses cointegration and other levels- relationship analysis to provide additional insights.

For the purpose of this discussion, I believe it is not too crude a generalization to suggest that the foundations of support for flexible exchange rates rest essentially on two propositions. First, it is important to highlight the fact that a hard floating exchange rate regime is the only regime under which complete autonomy is guaranteed for domestic authorities to purse whatever monetary, fiscal or other macroeconomic policies they desire for their independent national interests. This policy, if followed correctly with no intervention from central banks to manipulate their country’s exchange rates, provides freedom of manoeuvre for its government. The elimination of the balance of payments constraint on policy choices means that domestic authorities are more able to act so as to maximize the welfare. The second argument lies in the fact, conditional upon the evolution of efficient forward markets, it is the only system under which international trade will be free to function without any interference. That is, flexible exchange rates are seen as necessary to preserve an environment for free trade, since, in the absence of balance of payments problems, policy makers will not find it necessary to impose tariffs, quotas, exchange rate controls, or other such ‘non-optimal’ policies. There also has been an outcry by international monetary authorities for countries to acquire flexible exchange rate regimes; recent theoretical findings suggest that under fixed exchange rates central banks are nothing more than cashiers exchanging domestic currency for foreign while only under flexible rates is there a role for independent monetary policy. Thus, from a central bankers perspective, adopting a flexing exchange rate regime may strengthen the importance of their role. There is a sense however, that the two arguments put into question are mutually contradicting and inconsistent. This stems from the fact that there is no behavioural analysis of government activity. In fact only very recently has any theoretical research come to fruition with regards to how exchange rate regime may influence the choice of policies actually perused. As well as highlighting the two main benefits of floating exchange rates, it is important to stress on the fact the government would take into account any policy actions that previously would have had balance of payments repercussions under fixed rates would have exchange rate repercussions under flexible. Perhaps the most important policy freedom claimed for flexible exchange rates is that it gifts a country the right to conduct independent monetary policy. However, Robert Mundell, proposed the argument that flexible exchange rates lead to inflationary consequences since once monetary authorities are freed from the balance of payments constraint, they will tend to polices that are much more expansionary in risk and value. Jude Wanniski (1975) counteracts

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