Exchange Rate Overshooting and the Costs of Floating

FRB of San Francisco Working Paper No. 2005-07

32 Pages Posted: 13 Jun 2005

See all articles by Michele Cavallo

Michele Cavallo

Board of Governors of the Federal Reserve System - Division of Monetary Affairs

Kate Kisselev

Citigroup

Fabrizio Perri

Leonard N. Stern School of Business - Department of Economics; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR)

Nouriel Roubini

New York University - Leonard N. Stern School of Business - Department of Economics; National Bureau of Economic Research (NBER)

Date Written: May 2005

Abstract

Currency crises are usually associated with large nominal and real depreciations. In some countries 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 1990s and establish that countries entering a crisis with high levels of foreign debt tend to experience large real exchange rate overshooting (devaluation in excess of the long-run equilibrium level) and large output contractions. We then develop a model of a small open economy that helps to 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 versus flexible exchange rate regimes; 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 exchange rates from a welfare perspective.

Keywords: Balance sheet effects, currency crises, exchange rate policy

JEL Classification: E60, E62, F41

Suggested Citation

Cavallo, Michele and Kisselev, Kate and Perri, Fabrizio and Roubini, Nouriel, Exchange Rate Overshooting and the Costs of Floating (May 2005). FRB of San Francisco Working Paper No. 2005-07. Available at SSRN: https://ssrn.com/abstract=741205 or http://dx.doi.org/10.2139/ssrn.741205

Michele Cavallo (Contact Author)

Board of Governors of the Federal Reserve System - Division of Monetary Affairs ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States
+1 (202) 452-2607 (Phone)

Kate Kisselev

Citigroup ( email )

399 Park Avenue
New York, NY 10043
United States

Fabrizio Perri

Leonard N. Stern School of Business - Department of Economics ( email )

269 Mercer Street
New York, NY 10003
United States
212-998-0251 (Phone)
212-995-4218 (Fax)

HOME PAGE: http://www.stern.nyu.edu/~fperri/

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Nouriel Roubini

New York University - Leonard N. Stern School of Business - Department of Economics ( email )

269 Mercer Street
New York, NY 10003
United States
212-998-0886 (Phone)
212-995-4218 (Fax)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Register to save articles to
your library

Register

Paper statistics

Downloads
317
Abstract Views
2,258
rank
93,653
PlumX Metrics