Living with the Fear of Floating: An Optimal Policy Perspective

Amartya Lahiri and Carlos Vegh

No 8391, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: As documented in recent studies, developing countries (classified by the IMF as floaters or managed floaters) are extremely reluctant to allow for large nominal exchange rate fluctuations. This 'fear of floating' is reflected in the fact that, in spite of being subject to larger shocks, developing countries exhibit lower exchange rate variability and higher reserve variability than developed countries. Moreover, there is a positive correlation between changes in the exchange rate and interest rates and a negative correlation between both changes in reserves and the exchange rate and changes in interest rates and reserves. We build a simple model that rationalizes these key features as the outcome of an optimal policy response to monetary shocks. The model incorporates three key frictions: an output cost of nominal exchange rate fluctuations, an output cost of higher interest rates to defend the currency, and a fixed cost of intervention.

JEL-codes: E52 F41 (search for similar items in EconPapers)
Date: 2001-07
New Economics Papers: this item is included in nep-ifn
Note: IFM
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Citations: View citations in EconPapers (61)

Published as Living with the Fear of Floating: An Optimal Policy Perspective , Amartya Lahiri, Carlos A. Végh. in Preventing Currency Crises in Emerging Markets , Edwards and Frankel. 2002

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