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 volatility2.International capital mobility3.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)

• Rit = Interest rate in country i at time t• Rbit = 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: 1870-1914, 15 countries plus the United Kingdom Source: Neal & Weidenmier (2003) Base rate: U.K. (money market)

• Bretton Woods era Sample: 1959-1970, 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, 1973-2000 Source: IFS, Global Financial Data, Datastream, and FRED Base rate: varies by country (Germany, France, U.K., U.S.)

Identification of regime type

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: β2 > 0

Nonpegs have lower β and lower R2, 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 R2.• 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 R2 relative to gold standard and modern eras.

Post-Bretton Woods: high β and low R2.• 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 R2

Capital controls: lower β and lower R2

Interaction terms for peg and capital controls• PEG = 1 (if fixed exchange rate regime)• CAP = 1 (if no capital controls)• Hypotheses

β2 > 0 :: pegs more responsive to changes in base rate β3 > 0 :: countries with capital mobility more

responsive to changes in base rate β4 > 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.