Living with the Fear of Floating: An Optimal Policy Perspective

56 Pages Posted: 23 Jul 2001

See all articles by Amartya Lahiri

Amartya Lahiri

University of British Columbia (UBC) - Department of Economics

Carlos A. Vegh

Johns Hopkins University - Paul H. Nitze School of Advanced International Studies (SAIS); University of Maryland - Department of Economics; University of California at Los Angeles; National Bureau of Economic Research (NBER)

Multiple version iconThere are 2 versions of this paper

Date Written: June 2001

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.

Keywords: Fear of floating, optimal policy, interest rate policy

JEL Classification: F41, E52

Suggested Citation

Lahiri, Amartya and Vegh, Carlos A., Living with the Fear of Floating: An Optimal Policy Perspective (June 2001). Available at SSRN: https://ssrn.com/abstract=275679 or http://dx.doi.org/10.2139/ssrn.275679

Amartya Lahiri

University of British Columbia (UBC) - Department of Economics ( email )

997-1873 East Mall
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Canada
604.822.8606 (Phone)

HOME PAGE: http://www.econ.ubc.ca/alahiri/

Carlos A. Vegh (Contact Author)

Johns Hopkins University - Paul H. Nitze School of Advanced International Studies (SAIS) ( email )

1740 Massachusetts Avenue, NW
Washington, DC 20036-1984
United States

University of Maryland - Department of Economics ( email )

College Park, MD 20742
United States

University of California at Los Angeles ( email )

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Los Angeles, CA 90095-1477
United States
310-825-7371 (Phone)
310-825-9528 (Fax)

HOME PAGE: http://vegh.sscnet.ucla.edu

National Bureau of Economic Research (NBER)

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