Choosing an Exchange Rate Regime

Choosing an exchange rate regime is one of the most important decisions in macroeconomic policymaking. Some countries may peg their currency to gain credibility and control domestic inflation, while others may be more prone to float due to the larger incidence of real shocks. In spite of the abundant literature on the determinants of the exchange rate regime choice, the empirical literature has been unable to produce robust results on how countries select their exchange rate arrangements. Some argue that the problems of the empirical literature may rely on: (a) the failure of traditional measures of exchange rate regimes in capturing information of the regime in force (deeds) rather than the announced regime that is self-reported by countries (words). (b) The modeling of the dependent variable: whether the issue is to model the adoption of pegs (vis-à-vis floating) or choose within a wider array of regimes. (c) The use of a comprehensive set of determinants of exchange rate regime choice that takes into account factors associated to theories of choice determination (optimum currency area theory, financial approach, among others). This paper attempts to address the issues mentioned above using a sample of 110 countries with annual information over the period 1975-2005 using de facto exchange rate regime classifications and a comprehensive set of explanatory variables. We find the following stylized facts. First, factors associated with the optimum currency area approach are good predictors of adopting pegs: countries that are smaller in size and with stronger trade linkages are more likely to peg their currencies. Second, factors related to the financial approach are consistent with the impossible trinity: countries with higher openness and higher financial development are more likely to adopt floating regimes. Finally, we find that countries with high inflation and larger external and fiscal imbalances are more prone to adopt pegs.