Currency Devaluation and the Credibility of Fixed versus Flexible Exchange Rate Regimes: The Case of Zimbabwe

Abstract

This paper evaluates Zimbabwe’s exchange rate policy before and during the post-1997 currency and economic crisis. This is achieved by conducting simulations of an exchange rate regime evaluation model that minimizes the conditional variance of real output following Agbeyegbe and Osakwe (2005). The model captures the link between deviations of the RER from its 'equilibrium' shadow price level and output volatility. The underlying hypothesis is that this ‘link,’ or relation, varies systematically with the exchange rate regime. Using the parallel market rate and an estimated equilibrium real exchange rate (RER) index as alternative shadow prices, the empirical exercise involves estimating the parameters of an aggregate demand and money demand model, and then to simulate the evaluation model to determine the optimal exchange rate regime. The findings show that a flexible rate regime systematically outperforms a fixed exchange rate in the Zimbabwean setting, resulting in more stable output under both measures, even after controlling for the most volatile period of the sample. In view of the emergence of chronic and rising RER overvaluation, and its negative association with output volatility, the paper can infer that the downfall of exchange reforms was that the Reserve Bank followed an inflexible approach to exchange rate management, even at a time when the currency was meant to be floating.

Keywords: Zimbabwe, Exchange Rate Misalignment, Devaluation, Overvaluation, Exchange Rate Regimes, Fixed Exchange Rate, Floating Exchange Rate

JEL Classification: E6