Exchange Rate Economics: Theories and Evidence

Introduction 33
that this seems to support Friedman’s advocacy of the superior properties of floating
rate regimes.
Edwards and Yeyati (2003) empirically examine two of the arguments in favour
of flexible exchange rates,namely,their role as absorbers of real shocks and
the link between this role and the presence of downward rigid prices. Using a
de facto classification,rather than the IMF de jure classification,they find that flexible
exchange rate arrangements do help to reduce the impact of terms of trade
shocks on GDP growth in both emerging and industrial countries,and found that
real output growth is more sensitive to negative than to positive shocks.
There is a large literature which seeks to empirically assess the benefits of,
and effects on,macroeconomic performance of different types of exchange rate
regimes,particularly fixed versus flexible exchange rate regimes (see,for example,Ghosh
et al. 1997,2003; Levy-Yeyati and Sturzeneger 2002). Rogoff et al.
(2004),using the de facto exchange rate classification of Rheinhart and Rogoff,provide
a nice overview of the performance of different exchange rate regimes. Their
key findings may be summarised as follows. First,mature economies with mature
institutional frameworks have the best hope of enjoying the advantages of flexible
exchange rates without suffering a loss of credibility. Specifically,their review of
the extant studies shows that free floats have registered faster growth combined
with relatively low inflation for such countries. This is not so,however,for emerging
markets and non-emerging market developing countries,the other country
category groups considered by Rogoff et al. Since non-emerging market developing
countries are not well-integrated into international capital markets,they are
probably best able to buy credibility with a fixed exchange rate and,indeed,it
would seem that such countries have enjoyed relatively fast growth and low inflation
when they have pegged their currencies. However,fixity is not seen as an
option for emerging markets and,indeed,the evidence shows that such regimes
have had a higher degree of crisis with fixed rate regimes,as noted earlier. This
is because emerging markets have strong links with international capital markets,
which are similar in nature to mature economies,but this is combined with institutional
weaknesses (which shows up in higher inflation,fragile banking systems and
debt sustainability) which make their policy makers less than fully credible and so
some form of float,such as a crawling peg,is their best option while they learn how
to float freely. The analysis of Rogoff et al. also shows that macroeconomic performance
under all forms of de facto regimes was weaker in countries with dual or
multiple exchange rates that deviated from official rates,suggesting that important
gains may be had from exchange rate unification.
Razin and Rubinstein (2005) argue that in trying to detect the effect of an
exchange rate regime on macroeconomic performance,specifically output growth,
it is important to include a term which captures the probability of a crisis. They
show using a panel data set of 100 low- and middle-income countries that the
nature of the exchange rate regime,and also the degree of capital liberalisation,
has a negligible effect on a country’s economic growth,but that the probability of
a crises term has a significantly negative impact on economic growth and that the
probability of a crises increases with the switch to a fixed exchange rate.