Exchange Rate Economics: Theories and Evidence

Introduction 37
of papers have used the structural vector autoregression methods of Blanchard
and Quah (1989) to assess this issue for groups of ERM countries. For example,
using this methodology Cohen and Wyplosz (1989) show that symmetric shocks to
France and Germany are permanent.
A large number of studies have attempted to empirically test the determinants
of exchange rate regimes using the traditional OCA criteria,discussed earlier,and
also other macroeconomic fundamentals such as monetary,foreign price shocks
and a country’s inflationary potential (see, inter alia,Heller 1978; Melvin 1985;
Cuddington and Otoo 1990; Frieden et al. 2001). Most of such studies use a de jure
exchange rate classification and Rogoff et al. (2004) survey this extensive literature
and report that the results do not appear to be robust with respect to country
coverage,sample period and regime classification: ‘For example,openness – the
most frequently analysed variable – is found to be significantly associated with
floating rate regimes by three studies,significantly associated with fixed rate regimes
by three studies and not significantly associated with any particular regime by
another five studies.’ The only terms which did produce a consistent relationship
with the exchange rate regime were economy size and inflation.
1.12 Currencyinvoicing patterns and vehicle
currencyissues
As we shall see on a number of occasions in this book,particularly in our discussion
of PPP and the effects of monetary and fiscal policy in an open economy context,an
important issue in the economics of exchange rates is the currency used
by exporters to invoice their products. In this regard,there are essentially three
choices: the exporter can invoice in her own currency – referred to as producer’s
currency pricing or PCP – in the currency of the importer – labelled local currency
pricing,LCP – or in a third currency,which is termed vehicle currency pricing,
VCP. In an early contribution,Swoboda (1968,1969) argued that transaction
costs would be an important determinant of whether a currency would be used
as an international medium of exchange – low transaction costs,signifying a high
degree of liquidity would make a currency more likely to be used as a vehicle currency
(see Rey 2001 for a recent theoretical exposition of this view). McKinnon
(1979) focussed on industry characteristics as being an important determinant of a
vehicle currency: goods that are homogeneous and traded in specialised markets
are likely to be invoiced in a single low transaction cost currency. Krugman (1980)
argued that intertia was an important determinant of a vehicle currency. That is,
once a dominant currency has become established as a key vehicle currency in a
specific market a firm in that market will have no incentive to use an alternative
currency as it would incur higher transaction costs. More recent work has focussed
on macroeconomic variability as the key determinant of a vehicle currency and
some of this work is considered in chapter 11 (see,for example,Giovannini 1988;
Devereux et al. 2001; Bacchetta and van Wincoop 2002; Goldberg and Tille 2005).
Goldberg and Tille (2005) exploit data on invoice currency use in exports and
imports for 24 countries to show that the US dollar is the currency of choice for