Flexible Exchange Rates Reduce Economic Volatility

Summary of working paper 9867
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Under flexible exchange rates the effects of terms-of-trade shocks on growth are approximately one half that under pegged regimes.

The international financial crises of the 1990s -- spanning Latin America, Asia, and Russia -- prompted a rethinking of appropriate exchange rate regimes for rich and poor countries alike. In recent years, fixed-but-adjustable regimes have fallen out of favor, and many economists seem to prefer either hard pegs or floating regimes (the so called "two corners" debate). Supporters of hard pegs contend that such arrangements foster increased economic stability, while floating-regime advocates maintain that their option helps countries adjust more quickly to external shocks such as terms of trade shocks.

In Flexible Exchange Rates as Shock Absorbers (NBER Working Paper No. 9867), co-authors Sebastian Edwards and Eduardo Levy Yeyati examine the impact of terms-of-trade shocks on economies with different exchange rate regimes. While many studies have looked at the relationship between terms of trade and economic growth, the authors explain, few have studied how the choice of exchange rate system mediates that relationship.

Edwards and Levy Yeyati seek to redress that deficiency by posing three questions. First, do terms of trade shocks truly have less traumatic effects on GDP (gross domestic product) growth in countries with flexible exchange rate systems? Second, do negative and positive shocks have an asymmetric effect on growth, and if so, is the difference contingent on the type of exchange rate regime? And third, do countries with flexible regimes grow faster than those with fixed regimes, or vice versa?

To answer these questions, the authors use a sample of annual observations for 183 countries over the 1974-2000 period. Edwards and Levy Yeyati also construct four indexes of exchange rate regimes (pegged, hard, intermediate, and flexible) for each year in the sample, since they maintain that the official International Monetary Fund classification of such regimes across countries tends to be "misleading."

Using a long-run GDP growth equation, the authors confirm past findings regarding the standard factors explaining differences in GDP growth per capita, such as initial GDP, education, openness, and government spending. After controlling for such factors, Edwards and Levy Yeyati find that economies with flexible exchange rates grow more rapidly than those with fixed regimes. The difference in the rate of growth of GDP per capita is substantial, on the order of 0.66 and 0.85 percentage points more per year for countries with flexible systems.

Focusing on external shocks, Edwards and Levy Yeyati find that terms of trade shocks are exacerbated -- in terms of the impact on economic growth -- in countries with more rigid exchange rate systems. For instance, in a country with a pegged exchange rate, a 10 percent deterioration in the international terms of trade has been associated, on average, with a contemporaneous decline in GDP per capita growth of 8/10 of one percentage point, compared to a reduction of only 43/100 of one percentage point in countries with a flexible system. Therefore, the authors explain, "under flexible exchange rates the effects of terms-of-trade shocks on growth are approximately one half that under pegged regimes." (These results hold even when the authors divide the sample into industrialized and emerging economies.)

Edwards and Levy also find evidence of an asymmetry in terms-of-trade shocks: output growth is more sensitive to negative than to positive shocks, and the sensitivity increases the more inflexible the exchange rate regime. The advantage of flexible systems resides in their ability to adjust more smoothly to negative shocks via depreciations in the real exchange rate. In pegged systems, a depreciation of the real exchange rate requires a decline in nominal prices; if these are too rigid, negative terms of trade shocks will produce unemployment and a slower rate of economic growth.

The authors conclude by emphasizing the practical importance and policy relevance of their findings. Since the economic contraction associated with a terms-of-trade shock "nearly doubles" under a pegged system, "the choice of exchange rate regime has important implications in terms of output volatility," they explain. Moreover, pegged systems are also associated with "deeper and longer contractions" in economic performance.

-- Carlos Lozada