Sources of economic fluctuations in Latin America and implications for choice of exchange rate regimes

This paper studies the sources of economic fluctuations in three key Latin American countries (Argentina, Brazil, and Mexico) using a dynamic panel model, distinguishing between external and domestic shocks. The primary motivation is to examine the implications for the choice of monetary and exchange rate regimes, including dollarization. The results do not provide a strong, clear case in favor of a particular policy choice. On the one hand, foreign output shocks, including those of the U.S., appear to have a quite limited role in driving output fluctuations in these Latin countries; this absence of common shocks undermines the case for a rigidly fixed exchange rate regime. On the other hand, the historical experience of these countries indicates that real exchange rates are not very responsive to external shocks, in general, and that exchange rate depreciations tend to be contractionary in the short run. This suggests that rigidity of exchange rates may not be as costly for these countries as economic theory leads us to expect. Although the historical experience of these countries is certainly relevant, the caveat that it is characterized by several failed fixed exchange rate regimes, thereby making it a less-than-ideal testing ground for evaluating a pure floating exchange rate system, should be noted.