Corner Solutions, Crises, and Capital Controls: A Theory and an Empirical Analyas on the Optimal Exchane Rate Regime in Emerging Economies

Yasuyuki Swada and Pan Yotopoulos
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Yasuyuki Swada: University of Tokyo
Pan Yotopoulos: Stanford University
Authors registered in the RePEc Author Service: Yasuyuki Sawada

No 04-037, Discussion Papers from Stanford Institute for Economic Policy Research

Abstract: In a regime of free foreign exchange markets and free capital movements the reserve (hard) currencies are likely to substitute for the local soft currency in agents’ portfolia that include currency as an asset. This argument implies a process of cumulative circular causation with currency substitution leading to devaluation of soft currencies which in turn induces further currency substitution. At the theoretical level, the “fundamentals model” of currency crisis is formally extended by incorporating currency substitution in an inter-temporally optimizing framework. Next the model is implemented empirically by constructing a currency-softness index as a causal proxy of currency substitution and it is tested in an international cross section sample of countries. Two empirical findings emerge. First, there is a negative relationship between the currency-softness index and the degree of nominal-exchange-rate devaluation. Second, there is a systematic negative relationship between the softness of a currency and the level of economic development. Hence, a unipolar corner solution of floating exchange rate would not be sustainable for low-income countries with soft currencies. Rather a unipolar regime with a hard fixed exchange rate or even a middle-ground solution of fixed but adjustable exchange rate becomes optimal as long as the mobility of financial capital is restricted. Moreover, the optimal choice of exchange rate regime should be systematically linked with the level of development.

Keywords: exchange-rate regime; financial crises; currency substitution; exchange rate and capital liberalization in developing countries (search for similar items in EconPapers)
JEL-codes: F31 F41 G15 (search for similar items in EconPapers)
Date: 2005-08
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Citations: View citations in EconPapers (1)

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