Academic journal article Federal Reserve Bank of Atlanta, Working Paper Series

Optimal Fear of Floating: The Role of Currency Mismatches and Fiscal Constraints

Academic journal article Federal Reserve Bank of Atlanta, Working Paper Series

Optimal Fear of Floating: The Role of Currency Mismatches and Fiscal Constraints

Article excerpt

Abstract: Evidence suggests that developing countries are much more concerned with stabilizing the nominal exchange rate than developed countries. This paper presents a model to explain this observation, based on the hypotheses that both interventions and depreciations are costly. Interventions are costly because they generate a financial need in a fiscally constrained government that relies solely on distortionary taxes. Depreciations are costly because the country, in particular its financial sector, is exposed to a currency mismatch between its assets and its liabilities that is not effectively hedged. The results suggest that the amount of intervention will depend on the degree of currency mismatch between assets and liabilities, the elasticity of money demand, and the relative size of the financial system. It would be expected that countries with a high degree of currency mismatch and large financial sectors would intervene heavily in foreign exchange markets, as long as the money demand is not too sensitive to the nominal interest rate.

JEL classification: E5, F3, F41

Key words: exchange rates, floating, currency mismatch, fiscal constraint, optimal policy

1. Introduction

Evidence suggests that developing countries are much more concerned with stabilizing the nominal exchange rate than developed countries. Some recent papers show not only that nominal exchange rates are less volatile in developing countries, but also that their international reserves and domestic interest rates are significantly more volatile (Calvo and Reinhart (2002), (2000), Hausmann, Panizza, and Stein (2001), Levy-Yeyati and Sturzenegger (2002)). Why do we observe this fear of floating in emerging markets? What is the underlying rationale for this behavior?

Assuming sluggishness in price adjustment, some papers essay an answer to those questions (Lahiri and Vegh (2001), Parrado and Velasco (2002), Caballero and Krishnamurthy (2001)). Nobody, however, has thus far been able to provide an explanation for the whole range of exchange rate policies that is observed in the real world. The spectrum goes from countries that fully intervene to keep the exchange rate stable to those that engage in clean flotation--not intervening at all--with many others intervening to various degrees and thus lying somewhere in between these two extremes.

This work provides a model with flexible prices that introduces a new channel through which the fear of floating is generated. It departs from the previous research in an important dimension; fears will come from nominal, as supposed to real, exchange rate volatility. Also, the model is able to explain the whole range of observed policies. The trade-off proposed in the paper is driven by two facts that proved to be crucial in recent financial crises: emerging market countries face fiscal restrictions during turbulent times, and they tend to have a mismatch in the currency denomination of their assets and their liabilities. These features make both interventions and depreciations costly. Thus, faced with these costs policymakers have to choose the optimal policy mix, such that the costs are minimized.

This paper models intervention and depreciation costs explicitly. Having exogenous costs may hide differences across countries that could be essential explain the diversity of policy responses. Therefore, making the costs endogenous will allow us to determine how costs are related to the structure of the economy.

The intervention cost is based on the idea that governments have to use scarce resources to intervene in the exchange rate market. Interventions consume reserves, which generates a financial need. If there is nothing but distortionary instruments to raise resources, then the government will be reducing the welfare of the society to finance the intervention. (1) This idea is very general and would work for any distortionary tax or subsidy. …

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