Obstfeld, Shambaugh & Taylor (2005)

 Hypotheses Regimes with fixed exchange rates will experience less monetary policy autonomy. Regimes with restrictions on capital mobility will experience more monetary policy autonomy.

 The exchange rate is the price of one currency in terms of another. Appreciation: Increase in the value of a currency Depreciation: Decrease in the value of a currency.  Fixed vs. floating exchange rate regimes Advanced economies :: floating rates are the norm  Euro area is a notable exception Developing countries and emerging markets :: fixed exchange rate regimes still common.  This is true despite the potential for exchange rate crises.

 Fixed vs. floating exchange rate regimes

 Two key questions in the fixed versus flexible exchange rate debate: What are the costs of a fixed exchange rate? What are the benefits?  Three common policy objectives: 1. Low exchange rate volatility 2. International capital mobility 3. Autonomy to implement stabilization policy.

 Trilemma

 Trilemma :: theory tells us it is not possible to achieve all three objectives at once. Floating exchange rate regime implies policymakers forgo objective #1. Fixed exchange rate regime means giving up either #2 or #3.  Adjust interest rates to keep the exchange rate fixed, OR  Limit international capital flows, so restricting trade in the foreign exchange market.

 Uncovered Interest Rate Parity (UIP) Condition Assumption: capital flows freely across countries Idea: Expected return on bank deposits must be equal in same currency terms.  Arbitrage: If the returns were different, then investors would flock to the country where the expected return is higher, causing an appreciation in that country’s currency.

 Implications of UIP Fixed exchange rate regime (peg): i = i*  The central bank must adjust the interest rate to keep the exchange rate from changing.  Shocks to foreign interest rate are absorbed in the domestic interest rate, implying domestic monetary policy shocks (shifts in MP). Floating exchange rate regime (nonpeg)  Central bank free to adjust interest rate to stabilize output.  But, this means there is potential for larger changes in the exchange rate.

 According to UIP, what should we find in the data on different exchange rate regimes? Fixed exchange rate regime, free capital mobility  Changes in the foreign interest rate (base rate) should lead to one-for-one adjustments in the domestic rate. Fixed exchange rate regime, no capital mobility  Changes in the foreign interest rate (base rate) have low predictive power for domestic interest rates. Floating exchange rate regime, stabilization policy  Effects of changes in foreign interest rate are offset by changes in the domestic rate in the opposite direction.

 Variables: Dependent variable: Domestic interest rate Explanatory variable: Foreign interest rate (“base rate”) Variables are measured in changes because for some countries, interest rates may be nonstationary.  Baseline Specification: (1) R it = Interest rate in country i at time t R bit = Interest rate in country i ’s base country at time t

 Test: Fixed exchange rate regime, β = 1  If β < 1, then central bank uses monetary policy to offset the effects of base-rate shocks on output.  If β > 1, then central bank uses monetary policy to reinforce the effects of base-rate shocks on output.

 Panel datasets of interest rates Gold standard era  Sample: , 15 countries plus the United Kingdom  Source: Neal & Weidenmier (2003)  Base rate: U.K. (money market) Bretton Woods era  Sample: , 21 countries  Source: Average monthly data from International Finance Statistics, Global Financial Data, and FRED.  Base rate: U.S. (federal funds rate)

 Panel datasets of interest rates Post-Bretton Woods era  Sample: Average monthly money market rates,  Source: IFS, Global Financial Data, Datastream, and FRED  Base rate: varies by country (Germany, France, U.K., U.S.)

 Identification of regime type

Gold standard  Use both de jure (official) and de facto (in practice) classifications.  De facto test: Commitment to peg in practice (2% band for at least one year).  13 peg episodes, 7 nonpeg episodes  Assume capital mobility.

 Identification of regime type Bretton Woods  Nearly entire sample pegged according to de jure and de facto classifications.  20 peg episodes, 1 nonpeg episode  Cannot use this era to study within-era regime switches.  Assume no capital mobility.

 Identification of regime type Post-Bretton Woods  Shambaugh (2004) and de facto test applied to gold standard coding.  Robustness of results checked using a variety of methods:  de facto classifications from the IMF and Taylor (2002),  official de jure classifications, and  Reinhart and Rogoff (2004) classifications.  70 pegs, 25 occassional pegs, 32 nonpegs.  IMF coding for capital control status.

 Pegs versus nonpegs Estimate (1) for each group of countries in each era. Hypothesis: β = 1 for pegs, β < 1 for nonpegs.  Pooled estimation (2) with interaction term. Hypothesis: β 2 > 0

 Nonpegs have lower β and lower R 2, all eras. i not as closely linked to i*. Changes in the base rate have little predictive power for changes in the domestic rate. Having a floating exchange rate allows the country to pursue autonomous monetary policy.

 Bretton Woods: β < 0 and low R 2. Imposition of capital controls appears to have prevented one-for-one adjustments in the domestic rate. Use of capital controls could explain why pegs have a low R 2 relative to gold standard and modern eras.  Post-Bretton Woods: high β and low R 2. Nonpeg regimes more responsive to base rate changes compared with the gold standard nonpegs.

 Pooled estimates Regime choice affects no only intercept, but slope.  Peg regimes have a larger average change and are more responsive. Nonpegs in the post-Bretton Woods era are generally more responsive than nonpegs under the gold standard.

 Further disaggregate regime according to capital controls. Hypotheses:  Pegs: higher β and higher R 2  Capital controls: lower β and lower R 2

 Interaction terms for peg and capital controls PEG = 1 (if fixed exchange rate regime) CAP = 1 (if no capital controls) Hypotheses  β 2 > 0 :: pegs more responsive to changes in base rate  β 3 > 0 :: countries with capital mobility more responsive to changes in base rate  β 4 > 0 :: pegs and capital mobility mean country more responsive to changes in base rate

 Countries have historically faced the trilemma, and still do in the post-Bretton Woods era.  Measure of monetary policy autonomy: changes in interest rate relative to base rate. Countries with pegged exchange rates and capital mobility have larger interest rate changes and are more responsive to changes in the base rate. Theory predicts one-for-one adjustment for fixed regimes, but estimates are closer to 0.5.  True even for gold standard, widely viewed as a stricter than Bretton Woods or modern-day fixed regimes.

 Bretton Woods achieve policy autonomy and pegs through imposing capital controls. System broke down when capital controls relaxed in the 1960s.  In post-Bretton Woods era, countries more responsive to changes in base rate, even for nonpegs (vs. gold standard). Perhaps countries choose not to implement autonomous policies, even when floating.

 Possible to classify countries differently Peg, float, and managed float With the classifications used by Obstfeld, Shambaugh and Taylor (2005) and Shambaugh (2004), countries with managed floats might be counted as regime switches throughout the sample. What would this tell us?  Countries with managed float should be able to “hedge” the trilemma problem.

 Result that adjustment to base rate is less than one-for one is inconsistent with theory. Possible omitted variable from the UIP condition? Perhaps a risk premium, associated with credibility of the peg (currency risk) and probability of sovereign default (default risk).

 Possible bias in samples Fundamentally different countries across eras.  Gold standard and Bretton Woods samples are dominated by advanced economics.  Modern sample dominated by developing countries.  Implication If there were a risk premium, this would drive a wedge between the interest rate and the base rate, especially for developing countries, biasing the estimate of  downward in the post-Bretton Woods sample.