On becoming more flexible: Exchange rate regimes in Latin America and the Caribbean

Abstract

This paper examines the shift from fixed to more flexible exchange rate regimes among countries in Latin America and the Caribbean. In contrast to most traditional approaches, the one followed here recognizes that fixed rates can be and often are adjusted — but argues that policy makers incur a political cost from devaluation. At the same time, flexible exchange rates (even “managed” ones) may be very volatile, with persistent misalignment. A stylized model of regime choice is developed, based on the perceived losses from exchange rate misalignment incurred under fixed versus more flexible regimes. The model is estimated for a sample of 24 countries over the period 1978–1992 and empirical results are quite supportive. Misalignments (proxied by current account deficits and moderate to high rates of inflation) were associated with a move to more flexible rates during 1978–1986. Misalignment indicators appear to have mattered less during 1987–1992. However, there appears to have been a major reduction in the perceived difficulty of managing flexible rates during this period. The paper then cautions against attributing differences in economic growth between groups of countries to their exchange regime. The central point here is that the endogeneity of regime choice introduces selection biases into the samples of countries with fixed and with more flexible exchange regimes.

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