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Do Exchange Rate Regimes Matter for Inflation and Exchange Rate Dynamics? The Case of Central America

Published online by Cambridge University Press:  04 July 2011

RODRIGO CAPUTO G.  and
IGAL MAGENDZO
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Abstract

This paper makes an empirical contribution to discussion of the optimal exchange rate regime. Using a new dataset for Central American countries, we compare the dynamics of the real exchange rate (RER) between dollarised and non-dollarised countries. Our results show that the two dollarised countries in the region, El Salvador and Panama, are quite different in terms of RER dynamics. In El Salvador the RER spends more time away from its equilibrium level than in the non-dollarised countries in the region, while the contrary is true for Panama. We also find that inflation persistence is similar in El Salvador to the other countries, but smaller in Panama. This leads us to the conclusion that some degree of exchange rate flexibility helps countries to have a more aligned RER. Nevertheless, a long-lived, highly credible dollarised economy, like Panama, can reduce inflation persistence to such an extent that RER misalignments are in fact less frequent than in countries with more flexible exchange rate regimes.

Spanish abstract

Este artículo hace una contribución empírica a la discusión sobre el régimen óptimo del tipo de cambio. Utilizando una nueva tabla para países centroamericanos, comparamos las dinámicas del tipo de cambio real (TCR) entre los países dolarizados y los que no lo están. Nuestros resultados muestran que los dos países dolarizados en la región, El Salvador y Panamá, son un tanto diferentes en cuanto a las dinámicas del TCR. En El Salvador el TCR pasa más tiempo fuera del nivel de equilibrio que los países no dolarizados en la región, y lo contrario es cierto para Panamá. También encontramos que la persistencia de la inflación es similar en El Salvador al resto de países, pero más pequeña en Panamá. Esto nos lleva a la conclusión que cierto grado de flexibilidad en los tipos de cambio ayuda a los países a tener un TCR más alineado. Sin embargo, una economía dolarizada muy creíble y de larga vida, como la panameña, puede reducir la persistente inflación a tal grado que los desajustes del TCR son de hecho menos frecuentes que en los países con regímenes más flexibles de tipo de cambio.

Portuguese abstract

Oferece-se uma contribuição empírica à discussão acerca do regime ideal para a taxa cambial. Utilizando um novo agrupamento de dados para países da América Central, comparamos as dinâmicas da taxa de câmbio real (TCR) entre países dolarizados e não-dolarizados. Nossos resultados demonstram que os dois países dolarizados da região, El Salvador e Panamá, diferem bastante em dinâmicas de TCR. Em El Salvador a TCR passa mais tempo longe do nível de equilíbrio do que em países não-dolarizados da região, enquanto o contrário sucede com o Panamá. Também observamos que a persistência da inflação em El Salvador assemelha-se aos outros países, enquanto é menor no Panamá. Isto nos leva à conclusão de que certo grau de flexibilidade na taxa de câmbio ajuda os países ter uma TCR mais alinhada. No entanto uma economia como a do Panamá – dolarizada, de longa duração e altamente confiável – pode reduzir a persistência da inflação em medida suficientemente ampla para que desalinhamentos de TCR sejam de fato menos frequentes do que em países com regimes de taxa de câmbio flexíveis.

Keywords

dollarisationexchange rate regimesexchange rate determinationinflation dynamicsCentral AmericaEl SalvadorPanamadolarizaciónregímenes de tipo de cambiodeterminación del tipo de cambiodinámicas inflacionariasCentroaméricaEl SalvadorPanamádolarizaçãoregimes de taxa de câmbiodeterminação de taxa de câmbiodinâmicas da inflaçãoAmérica CentralEl SalvadorPanamá
Type
Research Article
Information
Journal of Latin American Studies , Volume 43 , Issue 2 , May 2011 , pp. 327 - 354
Copyright
Copyright © Cambridge University Press 2011

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References

1 For a good description of how support for intermediate regimes was stronger following the failure of inflation stabilisation plans in emerging countries, but then lost support after the East Asian, Russian and Brazilian crises, see Sebastián Edwards, ‘Exchange Rate Regimes in Emerging Economies’ (2000), paper prepared for the Meltzer Commission on the New Financial Architecture, available at www.anderson.ucla.edu/faculty/sebastian.edwards/systems.pdf.

2 See Corbo, Vittorio, ‘Is it Time for a Common Currency in the Americas?’, Journal of Policy Modeling, 23: 3 (2001), pp. 249–65Google Scholar; and Dornbusch, Rudiger, ‘Fewer Monies, Better Monies’, American Economic Review, 91: 2 (2001), pp. 238–42Google Scholar.

3 Clarida, Richard, Galí, Jordi and Gertler, Mark, ‘The Science of Monetary Policy: A New Keynesian Perspective’, Journal of Economic Literature, 37: 4 (1999), pp. 1661–707Google Scholar; and ‘Optimal Monetary Policy in Open versus Closed Economies: An Integrated Approach’, American Economic Review, 91: 2 (2001), pp. 248–52.Google Scholar

4 See Edwards, Sebastián, ‘Dollarization: Myths and Realities’, Journal of Policy Modeling, 23: 3 (2001), pp. 249–65CrossRefGoogle Scholar.

5 Pierre-Richard Agénor and Peter J. Montiel, Development Macroeconomics (Princeton, NJ: Princeton University Press, 1999).

6 See, for example, Summers, Lawrence H., ‘International Financial Crises: Causes, Prevention, and Cures’, American Economic Review, 90: 2 (2000), pp. 1–16CrossRefGoogle Scholar. When referring here to ‘dollarisation’ we mean a monetary regime in which a country gives up its own currency and uses a convertible currency instead, not necessarily the US dollar. This follows Sebastián Edwards and Igal Magendzo, ‘A Currency of One's Own? An Empirical Investigation on Dollarization and Independent Currency Unions’, National Bureau of Economic Research (henceforth NBER), Working Paper no. 9514, 2003.

7 See Calvo, Guillermo and Reinhart, Carmen, ‘Fear of Floating’, Quarterly Journal of Economics, 117: 2 (2002), pp. 379–408CrossRefGoogle Scholar.

8 Edwards and Magendzo, ‘A Currency of One's Own?’.

9 See Dornbusch, ‘Fewer Monies, Better Monies’; Rose, Andrew K., ‘One Money, One Market: Estimating the Effect of Common Currencies on Trade’, Economic Policy, 15: 30 (2000), pp. 7–45Google Scholar; Rose, Andrew K. and van Wincoop, Eric, ‘National Money as a Barrier to International Trade: The Real Case for Currency Union’, American Economic Review; 91: 2 (2001), pp. 386–90Google Scholar; and Edwards and Magendzo, ‘A Currency of One's Own?’.

10 If the cycles of the dollarised economy and the economy whose currency is being used are perfectly correlated, this shock can be minimised. This is the optimal currency area argument in Mundell, Robert, ‘A Theory of Optimum Currency Areas’, American Economic Review, 51: 3 (1961), pp. 657–65Google Scholar. This is not always the case, however, and shocks can even get amplified by lack of synchronisation.

11 Krugman, Paul, ‘Target Zones and Exchange Rate Dynamics’, Quarterly Journal of Economics, 106: 3 (1991), pp. 669–82CrossRefGoogle Scholar.

12 Ibid.

13 Svensson, Lars, ‘An Interpretation of Recent Research on Exchange Rate Target Zones’, Journal of Economic Perspectives, 6: 4 (1992), pp. 119–44CrossRefGoogle Scholar.

14 See Guillermo A. Calvo et al., ‘A Theory of Rational Inflationary Inertia’, in Philippe Aghion et al. (eds.), Knowledge, Information and Expectations in Modern Macroeconomics: In Honor of Edmund S. Phelps (Princeton, NJ: Princeton University Press, 2003), pp. 87–117.

15 For recent examples, see Levy-Yeyati, Eduardo and Sturzeneger, Federico, ‘To Float or to Trail: Evidence on the Impact of Exchange Rate Regimes’, American Economic Review, 93: 4 (2003), pp. 1173–93CrossRefGoogle Scholar; and Edwards and Magendzo, ‘A Currency of One's Own?’. Both papers find that hard pegs (dollarised economies in the case of the latter) are associated with more volatile output and, in some cases, with lower GDP growth.

16 For Panama and Nicaragua, we have annual data only from 1980 to 2007. Quarterly data, in the case of Panama, are available from 2000. Inflation results for Panama must be taken with a grain of salt because they are derived from a period of relative stability.

17 See Jun Il Kim and Laura Papi, ‘Regional Integration and Exchange Rate Arrangements’, in Markus Rodlauer and Alfred Schipke (eds.), Central America : Global Integration and Regional Cooperation (Washington, DC: International Monetary Fund, 2005), pp. 69–98.

18 If the conclusions from this study are to be generalised to high-inflation countries, consideration has to be given to the RER misalignment that could emerge from the inflation stabilisation process.

19 We refer to the IMF classification, which combines quantitative and qualitative information, including the de jure regime: see Kim and Papi, ‘Regional Integration’.

20 See Reinhart, Carmen and Rogoff, Kenneth, ‘The Modern History of Exchange Rate Arrangements: A Reinterpretation’, Quarterly Journal of Economics, 119: 1 (2004), pp. 1–48CrossRefGoogle Scholar.

21 One interpretation of RER misalignment is that this relative price deviates from the value predicted by the observed (contemporaneous) fundamentals. Another interpretation is that the relative price deviates from the value predicted by the long-run levels of the fundamentals. A problem of this latter approach is that it requires knowledge of the long-run levels of the fundamentals, which are unobservable variables. Hence, the misalignment concept used in this paper is related to the first approach.

22 This follows Faruqee, Hamid, ‘Long-Run Determinants of the Real Exchange Rate: A Stock-Flow Perspective’, IMF Staff Papers, 42: 1 (1995), pp. 80–107CrossRefGoogle Scholar.

23 We define the exchange rate as the price of foreign currency in terms of domestic currency. Hence, a decline in this price is an appreciation of the domestic currency.

24 Sebastián Edwards, ‘Tariffs, Terms of Trade, and the Real Exchange Rate in an Intertemporal Optimizing Model of the Current Account’, NBER Working Paper no. 2175, 1987.

25 See Steven Dunaway, Lamin Leigh and Xiangming Li, ‘How Robust are Estimates of Equilibrium Real Exchange Rates? The Case of China’, IMF Working Paper no. 06/220, 2006. See also Claudio Paiva, ‘Competitiveness and the Equilibrium Exchange Rate in Costa Rica’, IMF Working Paper no. 01/23, 2001; and ‘External Adjustment and Equilibrium Exchange Rate in Brazil’, IMF Working Paper no. 06/221, 2006. For Chile, see Calderón, César, ‘Un análisis del comportamiento del tipo de cambio real en Chile’, Economía Chilena, 7: 1 (2004), pp. 5–29Google Scholar; and Caputo, Rodrigo and Dominichetti, Bernardo, ‘Revisión metodológica en el cálculo del IPE e implicancias sobre los modelos de series de tiempo para el TCR’, Economía Chilena, 8: 1 (2005), pp. 77–88Google Scholar. For South Africa, see Jeffrey Frenkel, ‘On the Rand: Determinants of the South African Exchange Rate’, NBER Working Paper no. 13050, 2007. For developed economies, see Tamim Bayoumi, Hamid Faruqee and Jaewoo Lee, ‘A Fair Exchange? Theory and Practice of Calculating Equilibrium Exchange Rates’, IMF Working Paper no. 05/229, 2005.

26 Calderón, ‘Un análisis del comportamiento’, and Caputo and Dominicchetti, ‘Revisión metodológica’.

27 Engle, Robert and Granger, Clive, ‘Co-integration and Error Correction: Representation, Estimation, and Testing’, Econometrica, 55: 2 (1987), pp. 251–76CrossRefGoogle Scholar, available at econpapers.repec.org/RePEc:ecm:emetrp:v:55:y:1987:i:2:p: 251–76.

28 For Panama we only have data starting in 1982. This is unfortunate, and results must be compared taking this into account. Given the degree of stability Panama has shown throughout the years in terms of economic regime, we do not believe having data for the 1970s would change our results in any significant way.

29 Phillip Lane and Gian Maria Milesi-Ferretti, ‘The External Wealth of Nations Mark II: Revised and Extended Estimates of Foreign Assets and Liabilities, 1970–2004’, IMF Working Paper no. 06/69, 2006.

30 In order to determine the restricted versions of (1), we sequentially drop the β i that are not statistically different from zero.

31 We estimate the model for El Salvador between 1970 and 2000; the results are not statistically different from those obtained using the whole sample.

32 Kim and Papi, ‘Regional Integration’.

33 Goldfajn, Ilian and Valdés, Rodrigo, ‘The Aftermath of Appreciations’, Quarterly Journal of Economics, 114: 1 (1999), pp. 229–62CrossRefGoogle Scholar.

34 Ibid.

35 José R. Sánchez-Fung, ‘Money Demand, PPP and Macroeconomic Dynamics in a Small Developing Economy’, University of Kent, Department of Economics, Studies in Economics no. 0015, 2000.

36 Calvo, ‘A Theory of Rational Inflationary Inertia’.

37 See Christiano, Lawrence, Eichenbaum, Martin and Evans, Charles, ‘Nominal Rigidities and the Dynamic Effects of a Shock to Monetary Policy’, Journal of Political Economy, 113: 1 (2005), pp. 1–45Google Scholar, available at www.journals.uchicago.edu/loi/jpe; Galí, Jordi and Gertler, Mark, ‘Inflation Dynamics: A Structural Econometric Analysis’, Journal of Monetary Economics, 44: 2 (1999), pp. 195–222Google Scholar; and Jordi Galí, Monetary Policy, Inflation and the Business Cycle: An Introduction to the New Keynesian Framework (Princeton, NJ: Princeton University Press, 2008).

38 See Galí and Gertler, ‘Inflation Dynamics’; Juan Pablo Medina and Claudio Soto, ‘The Chilean Business Cycles through the Lens of a Stochastic General Equilibrium Model’, Central Bank of Chile, Working Paper no. 457, 2007; Lubik, Thomas and Schorfheide, Frank, ‘Do Central Banks Respond to Exchange Rate Movements? A Structural Investigation’, Journal of Monetary Economics, 54: 4 (2007), pp. 1069–87CrossRefGoogle Scholar; and Rodrigo Caputo and Felipe Liendo, ‘Monetary Policy, Exchange Rate and Inflation Inertia in Chile: A Structural Approach’, Central Bank of Chile, Working Paper no. 352, 2005.

39 The results are not presented here for reasons of space. They can be provided by the authors upon request.

40 Jesús Fernández-Villaverde and Juan F. Rubio-Ramírez, ‘How Structural are Structural Parameters?’, NBER Working Paper no. 13166, 2007, available at ideas.repec.org/p/nbr/nberwo/13166.html.