As documented in recent studies, developing countries (classified by the IMF as floaters or managed floaters) are extremely reluctant to allow for large nominal exchange rate fluctuations. This 'fear of floating' is reflected in the fact that, in spite of being subject to larger shocks, developing countries exhibit lower exchange rate variability and higher reserve variability than developed countries. Moreover, there is a positive correlation between changes in the exchange rate and interest rates and a negative correlation between both changes in reserves and the exchange rate and changes in interest rates and reserves. We build a simple model that rationalizes these key features as the outcome of an optimal policy response to monetary shocks. The model incorporates three key frictions: an output cost of nominal exchange rate fluctuations, an output cost of higher interest rates to defend the currency, and a fixed cost of intervention.
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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number
8391.
Length: Date of creation: Jul 2001 Date of revision: Publication status: published relationship to a non-chapter. This should not happen. Please contact NBER. Handle: RePEc:nbr:nberwo:8391
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Find related papers by JEL classification: F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
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Guillermo A. Calvo & Carmen M. Reinhart, 2000.
"Fear of Floating,"
NBER Working Papers
7993, National Bureau of Economic Research, Inc.
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Other versions:
Reinhart, Carmen & Calvo, Guillermo, 2002.
"Fear of floating,"
MPRA Paper
14000, University Library of Munich, Germany.
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