Thursday, October 17, 2013

Evidence on the (limited) power of exchange rates

The benefits and costs of different exchange rate regimes is one of the most debated topics in international macroeconomics and it is crucial for a very important decisions that policy makers regularly face on how to manage exchange rates. The launch of the Euro gave great impetus to this debate as some countries had to decide whether they wanted to be in or out and the rest of the world was looking at this experiment as a way to think about similar arrangement in other regions of the world. The 2008-09 crisis and the dismal performance of some Euro countries have reopened the debate about what life would have looked like for some of these countries if they had stayed out of the Euro.

I have written before my views that run contrary to the conventional wisdom. Many believe that while the Euro might make sense as part of a political process of European integration, it has had clear negative consequences on economic performance, consequences that are obvious when one looks at the effects of the current crisis in the Euro periphery countries. In several blog posts (here or here) I have provided anecdotal evidence that this conclusion is not supported by the data by comparing the performance of countries in and out of the Euro area and also by looking at the consequences of previous crisis when some of the Euro countries still had their exchange rate.

But what happens if one goes beyond the anecdotes and tries to systematically analyze the difference in performance of different exchange rate regimes? Unfortunately this is a difficult task. My own reading of the literature was that the evidence is mixed and inconclusive, there are no strong empirical results that prove that the exchange rate system has a significant effect on economic performance. But most of these academic papers were quite old.

Andrew Rose has just produced a study that looks at the performance of different exchange rate regimes during the global financial crisis. He includes as many countries as possible and he carefully controls for any potential determinant of economic performance (growth, inflation,...). His conclusion:

"Roughly similar countries are happy to maintain radically different monetary regimes. In this paper, I have found that this decision has been of little consequence for a variety of economic phenomena, at least lately. Growth, the output gap, inflation, and a host of other phenomena have been similar for hard fixers and inflation targeters in the period of and since the global financial crisis. That is, the "insulation value” of apparently different monetary regimes is similar in practice. Since the international finance literature has found few substantive macroeconomic differences across monetary regimes, I expect this result to be banal for some. Since this stylized fact is not well known outside international economics, I expect it to seem implausible to others."

He finds very little difference in performance when comparing across different exchange rate regimes. The exchange rate regime matters very little. I do not think the result is banal, as he argues, it is an important result that is necessary to check the validity of our priors and the theoretical predictions of our models. But I agree with him that some would consider the result implausible and would, unfortunately, continue with their current beliefs that exchange rate regime decisions have strong consequences on growth and volatility.

Antonio Fatás
on October 17, 2013 |   Edit