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A Theory of Fear of Floating

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  • Javier Bianchi
  • Louphou Coulibaly

Abstract

Many central banks whose exchange rate regimes are classified as flexible are reluctant to let the exchange rate fluctuate. This phenomenon is known as “fear of floating”. We present a simple theory in which fear of floating emerges as an optimal policy outcome. The key feature of the model is an occasionally binding borrowing constraint linked to the exchange rate that introduces a feedback loop between aggregate demand and credit conditions. Contrary to the Mundellian paradigm, we show that a depreciation can be contractionary, and letting the exchange rate float can expose the economy to self-fulfilling crises.

Suggested Citation

  • Javier Bianchi & Louphou Coulibaly, 2023. "A Theory of Fear of Floating," Working Papers 796, Federal Reserve Bank of Minneapolis.
    • Handle: RePEc:fip:fedmwp:95598
    DOI: 10.21034/wp.796
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    1. Parra-Polanía, Julián & Sánchez-Jabba, Andrés & Sarmiento, Miguel, 2024. "Are FX communications effective? Evidence from emerging markets," Emerging Markets Review, Elsevier, vol. 59(C).

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    More about this item

    Keywords

    Self-fulfilling financial crises; Exchange rates;

    JEL classification:

    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • F45 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Macroeconomic Issues of Monetary Unions
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics
    • G01 - Financial Economics - - General - - - Financial Crises
    • F36 - International Economics - - International Finance - - - Financial Aspects of Economic Integration
    • F33 - International Economics - - International Finance - - - International Monetary Arrangements and Institutions
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • F34 - International Economics - - International Finance - - - International Lending and Debt Problems

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