Can flexible exchange rates still "work" in financially open economies?

Abstract

Recent studies have shown that exchange rates in developing countries have limited flexibility. In this paper we review the existing explanations for this stylized fact, using a simple framework of monetary policy in a world where firms face balance sheet effects and the economy has a high pass-through from depreciation to inflation. We estimate a panel regression using quarterly data in the period 1990–1999 for a sample of 46 countries (19 industrial and 27 developing), and find that the use of the exchange rate to buffer external shocks depends crucially on (i) on the degree of integration with capital markets, and (ii) the quality of external financing. We conclude that flexible regimes are viable in financially open economies, provided external financing is not based on very volatile capital. This, of course, is dependent on the establishment of credible macroeconomic policies.

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