Exchange rate overshooting and the costs of floating

Nouriel Roubini (), Michele Cavallo and Kate Kisselev

No 766, 2004 Meeting Papers from Society for Economic Dynamics

Abstract: Currency crises are usually associated with large real depreciations. In some countries real depreciations are perceived to be very costly("fear of floating"). In this paper we try to understand the reasons behind this fear. We first look at episodes of currency crises in the '90s and establish that countries entering a crisis with high levels of foreign debt tend to experience large real exchange rate overshooting (devaluation in addition of the long run equilibrium level) and large output contractions. We develop a model of currency crises that helps explain this evidence. The key element of the model is the presence of a margin constraint on the domestic country. Real devaluations, by reducing the value of domestic assets relative to international liabilities, make countries with high foreign debt more likely to hit the constraint. When countries hit the constraint they are forced to sell domestic assets and this causes a further devaluation of the currency (overshooting) and a reduction of their stock prices (overreaction). This fire sale can have a significant negative wealth effect. The model highlights a key tradeoff when considering fixed v/s flexible regime; a fixed exchange regime can, by avoiding exchange rate overshooting, mitigate the negative wealth effect but at the cost of additional distortions and output drops in the short run. There are plausible parameter values under which fixed exchange rates dominate flexible

Keywords: Balance sheet effects; Currency Crises; Exchange rate policy (search for similar items in EconPapers)
JEL-codes: F31 F32 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-cba and nep-ifn
Date: 2004
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Related works:
Working Paper: Exchange rate overshooting and the costs of floating (2004)
Journal Article: Exchange rate overshooting and the costs of floating (2004)
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Persistent link: http://EconPapers.repec.org/RePEc:red:sed004:766

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