Cataclysms and Currencies: Does The Exchange Rate Regime Matter for Real Shocks?, Issues 2005-2085
International Monetary Fund, Research Dept., 2005 - Business & Economics - 35 pages
Does the choice of exchange rate regime affect the way an economy's adjustment to real shocks? Exploiting the randomness of natural shocks, this paper assesses empirically the often contrasting answers found in the theoretical literature. The evidence supports key themes in this literature, and points to an important tradeoff between regimes. First, adverse natural shocks are associated with both higher investment and foreign direct investment (FDI) only in developing countries with fixed rate regimes. Second, over a 24-month horizon, growth rebounds earlier in flexible rate regimes. Third, in the long run, more adverse shocks are associated with higher growth and investment only in predominantly fixed regimes. Thus, while claims of faster adjustment to real shocks under flexible rate arrangements have merit, so does the idea that exchange rate variability can impede investment. And the benefits from faster adjustment may come at the cost of foregoing the long run productivity benefits embodied in the larger investment response in fixed rate regimes.
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adjustment process advanced and developing advanced economies capita income 1961 choice of exchange choice of regime Column countries respectively—see Table countries with fixed country fixed country level currency democracy index depreciation developing countries respectively—see Economic Growth ependant errors in parenthesis exchange rate regime fixed effects fixed exchange rate fixed rate regimes flexible rate regimes flexible regimes Foreign Direct Investment GDP Growth government consumption growth Gross Capital Formation gross national income Growth Dependant Variable Huber White robust impact of windstorms include per capita indicates significance initial per capita Inventories investment level Kenneth Rogoff lagged government consumption Levy-Yeyati natural shocks percent levels respectively percent of urban points of GDP Polity IV population density R-squared Ratio of Gross Regression residual terms regressions linearly include robust standard errors selection bias significant impact Sit+i terms are clustered terms of trade trade growth trade openness urban population White robust standard windstorm occurs World Bank 2003