Does the Choice of Exchange Rate Regime Affect the Economic Growth of Developing Countries?

By De Vita, Glauco; Kyaw, Khine Sandar | The Journal of Developing Areas, Fall 2011 | Go to article overview

Does the Choice of Exchange Rate Regime Affect the Economic Growth of Developing Countries?


De Vita, Glauco, Kyaw, Khine Sandar, The Journal of Developing Areas


ABSTRACT

This paper revisits, empirically, the question of whether the choice of exchange rate regime (floating currency, fixed rate or intermediate arrangement) has a direct effect on the long-term growth of developing countries. We use fixed effects panel estimation on a relatively large sample of 70 developing countries for the period 1981 to 2004. In addition to controlling for the level of income of these economies, we draw from alternative exchange rate regime classification schemes and account for the presence of an explicit monetary anchor to characterize policy. Our results indicate the absence of any robust relation between the choice of exchange rate regime and economic growth. The policy implication of these findings is clear. The choice of exchange rate policy has no direct impact on the long-term growth of developing countries.

JEL Classifications: O10, F31

Keywords: Exchange Rate Regimes, Economic Growth, Developing Countries

INTRODUCTION

Over the past decade, the question of the choice of exchange rate regime and the macroeconomic consequences of this choice, has received considerable attention. In addition to effects on trade flows (Rose, 2000; Rose and van Wincoop, 2001; Frankel and Rose, 2002; Glick and Rose, 2002; Rose and Stanley, 2005; Klein and Shambaugh, 2006; Adam and Cobham, 2007; etc.), recent literature identifies empirical regularities between exchange rate regimes and national price levels (Ghosh et al., 2002; Broda, 2006), the transmission of terms of trade shocks (Broda, 2004; Edwards and Levy-Yeyati, 2005), and foreign direct investment flows (Schiavo, 2007; Abbott and De Vita, 2008). In this paper, interest centers on the relationship between exchange rate regimes and economic growth, with a focus on the impact of the choice of regime on the long-term growth of developing countries.

At the theoretical level, the traditional view of the neutrality of money suggests that the exchange rate regime should be unimportant for long-term growth performance. Nevertheless, the literature highlights several mechanisms through which a link can be established. The first of such mechanisms can be traced back to the work of Milton Friedman (1953) who, in his essay on the case for flexible exchange rates, argues that flexible regimes are better suited to insulate the economy against economic shocks. Specifically, a flexible regime may foster growth by enabling an economy characterized by nominal rigidities to better absorb and adjust to real domestic and foreign shocks. This "business cycle mitigation' mechanism (see Barlevy, 2004) implies that fixed regimes induce greater output volatility which, in turn, is expected to affect negatively an economy's long-term growth performance (see Ramey and Ramey, 1995; Kneller and Young, 2001). However, it has also been contended that flexible rates are more prone to exchange rate shocks, exacerbating business cycles and dampening growth compared to a fixed regime, especially in the context of developing economies with a weak financial system (Bailliu et al., 2003). Although "credibility' arguments in favor of fixed exchange rates point to the reduction of a country's vulnerability to speculative currency attacks and to greater stability as factors conducive to stronger growth performance (see Calvo and Vegh, 1994; and Mundell, 1995), the real interest rate costs 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.

The theoretical ambiguity as to the sign of the relationship between exchange rate regimes and economic growth is compounded by the multiplicity of indirect channels through which exchange rate regimes could affect growth. These include the rate of physical capital accumulation (e.g. Aizenman, 1994), the degree of openness to capital flows (Bailliu, 2000) and the level of financial development (Levine, 1997; Aizenman and Hausmann, 2000; Flandreau and Bordo, 2003; Aghion et al. …

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