Official Exchange Rate Arrangements and Real Exchange Rate Behavior

Article excerpt

We study the behavior of real exchange rates under various official designations of exchange rate arrangements. Examining many currencies, we find important differences across the designations. Most notably, real exchange rate mean reversion is fastest when nominal exchange rates are officially pegged. We also find a large nonlinear effect: adjustment is fastest when the real exchange rate deviates greatly from its mean. This nonlinear effect is also most striking among officially pegged currencies. Finally, we find that nominal exchange rates, rather than prices, do most of the adjusting.

IN MANY PARTS OF THE WORLD, exchange rate arrangements are as hotly debated as they ever have been. Underlying the controversy is the sense that exchange rate arrangements matter, whether for prices, the terms of trade, or economic activity. Yet, how they matter remains an open question. In this study, we explore one important aspect of that question--the empirical link between official exchange rate arrangements and the behavior of real exchange rates themselves.

Our work is in the tradition of Mussa (1986), who stressed the differences in the behavior of exchange rates under alternative arrangements. Mussa argued that the exchange rate float had brought extremely high nominal and real exchange rate variability to many countries. Since then, Grilli and Kaminsky (1991) and Engel and Kim (1999) have reexamined the role of exchange rate arrangements using a century of British and U.S. data. Grilli and Kaminsky found that the float's high volatility seemed to be an artifact of the particular historical period that Mussa studied, rather than a result of floating exchange rates. However, differences across arrangements seemed to reemerge when Engel and Kim separated the permanent and transitory components of the real exchange rate. The transitory component (the most volatile component) was indeed much more volatile when the pound floated than when it was pegged.

The present paper builds on these studies by systematically examining the link between exchange rate arrangements and the real exchange rate using a large panel of countries. Our work also builds on the now numerous panel studies of real exchange rates, including Frankel and Rose (1996) and Taylor (1996), who carefully divide their panels into various subperiods to determine the potential importance that exchange rate arrangements may have on their main findings. However, even within their fairly narrow subperiods, aggregating across countries has meant aggregating across differing kinds of exchange rate arrangements. Here, we classify the arrangements of each individual country in each year. We then study the real exchange rate under the alternative designations of the exchange rate arrangements.

We begin with some summary statistics. We find that the magnitude of the real exchange rate, defined in terms of absolute price levels, is roughly comparable across the designated arrangements. However, we note that its variability differs markedly, though not as greatly as has been commonly supposed. Next, we test for the presence of a unit root in the real exchange rate, and we compare estimates of the speed of its mean reversion under the alternative designations. We find faster reversion in those countries with a dollar peg than in those without one. We also find that the speed of reversion depends positively on the size of the deviation from the mean. The extent of this nonlinearity also differs across the various arrangements, with the adjustment under a peg being the most nonlinear. Finally, we use an error correction framework to examine separately the adjustment of the nominal exchange rate and of relative prices. While we find that both exchange rates and prices adjust, we find that exchange rates carry out the lion's share of the adjustment. This result holds across all of the exchange rate arrangements that we examine, including-most strikingly-those classified as maintaining a peg. …