Exchange rate policy among trading partners: Does it pay to be different?
Most models of monetary coordination overlook two important aspects of exchange rate regimes in developing countries: countries generally peg to a single currency, and they may or may not adopt the same exchange rate regime as many of their trading partners, especially during periods of financial instability (such as the 1990s). This paper develops a model in which two trading partners initially peg their currency to that of a “large” country. Then we ask: does it matter if these countries adopt different currency regimes? We show that under certain circumstances the choice of a trading partner to float can impair the economic performance of the economy which maintains a hard peg. In other words, countries that maintain a pegged exchange rate can suffer welfare losses if their trading partners switch to more flexible forms of exchange rates. To test the empirical impact of these “third country” effects, we develop a new index of exchange regime “similarity” across trading partners using a variation of the de jure exchange rate regime derived from the IMF's Annual Report on Exchange Rate Arrangements and Restrictions. Estimates based on panels of 23 and 154 countries show the decision of one's trading partners to adopt “different” (more flexible) regimes imposes a statistically significant cost in terms of slower real growth and higher interest rates. Terms of trade shocks also impact pegged and different economies more, suggesting that flexible rate countries can shift some of the burden of adjustment to less flexible trading partners. The policy implications of these results are straight-forward: when trading partners float, the benefits of a pegged regimes diminish. An example of this phenomenon is Argentina during the late 1990s. Post 1994 both Argentina and Brazil linked their currencies to the dollar. In 1998 Brazil switched to floating rate regime while Argentina ignored the decision of her trading partner at considerable cost in lost output. The empirical results of this paper show that these “third country”, effects are common to other countries as well.
LaFleur, Marcelo T, "Exchange rate policy among trading partners: Does it pay to be different?" (2004). ETD Collection for Fordham University. AAI3125018.