Fear of Appreciation and Current Account Adjustment

This paper finds that limited exchange rate flexibility in the form of “fear of appreciation” slows adjustment of current account imbalances, providing a novel perspective on Friedman’s conjecture regarding exchange-rate flexibility. We present evidence that countries classified as more flexible have faster convergence than peggers for current account deficits, but not so for surpluses. An implication is that current account surpluses are more persistent than deficits on average. Evidence indicates that this asymmetry is associated with a one-sided muting of exchange rate appreciations. We develop a multi-country DSGE model augmented with a “fear of appreciation” policy rule, solved as an occasionally binding constraint. It can explain greater persistence of current account surpluses compared to deficits in general equilibrium where surpluses and deficits must cancel in aggregate.