To Float Or To Fix: Evidence On The Impact Of Exchange Rate Regimes On Growth

To Float or to Fix: Evidence on the Impact of Exchange Rate Regimes on Growth
By EDUARDO LEVY-YEYATI
AND

FEDERICO STURZENEGGER*

We study the relationship between exchange rate regimes and economic growth for a sample of 183 countries over the post-Bretton Woods period, using a new de facto classification of regimes based on the actual behavior of the relevant macroeconomic variables. Incontrast with previous studies, we find that, for developing countries, less flexible exchange rate regimes are associated with slower growth, as well as with greater output volatility. For industrial countries, regimes do not appear to have any significant impact on growth. The results are robust to endogeneity corrections and a number of alternative specifications borrowed from the growth literature.(JEL F31, F41)

The choice of exchange rate regime and its impact on economic performance is probably one of the most controversial topics in macroeconomic policy. However, while the implications regarding inflation and policy credibility have received considerable attention, the impact of regimes on economic growth has been the subject of surprisingly little work, probably due to the fact thatnominal variables are typically considered to be unrelated to longer-term growth performance.1 Even when the economic literature does suggest a link between exchange rate regimes and growth, it does not provide unambiguous implications as to its sign. On the one hand, the lack of exchange rate adjustments under a peg, coupled with some degree of short-run price rigidity, results in pricedistortions and misallocation

of resources (notably, high unemployment) in the event of real shocks. This mechanism underscores the view that fixed exchange rate regimes induce higher output volatility.2 In addition, as suggested by Guillermo Calvo (1999) and others, the need to defend a peg in the event of a negative external shock implies a significant cost in terms of real interest rates, as well asincreasing uncertainty as to the sustainability of the regime, potentially harming investment prospects. While the implications of these channels in terms of long-run growth performance are not obvious, there is some evidence of a negative link between output volatility and growth.3 On the other hand, by reducing relative price volatility, a peg is likely to stimulate investment and trade, thusincreasing growth.4 Lower price
2 The view that flexible regimes are better suited to insulate the economy against real shocks goes back to Milton Friedman (1953) and William Poole (1970), among others. This view has found support in the empirical literature. See, e.g., Michael Mussa (1986), Marianne Baxter and Alan Stockman (1989), Tamim Bayoumi and Barry Eichengreen (1994), Atish Ghosh et al. (1997),and Christian Broda (2001). 3 See Garey Ramey and Valerie A. Ramey (1995). Alternatively, Joshua Aizenman (1994) argues, in the context of a theoretical model, that higher output volatility as a result of the adoption of a peg may foster investment and growth. 4 A survey of the literature on the effects of exchange rate volatility on trade can be found in Hali J. Edison and Michael Melvin (1990).See also Jeffrey Frankel and

* Business School, Universidad Torcuato Di Tella, Minones 2177 (1428) Buenos Aires, Argentina (e-mail: Levy˜ Yeyati: ely@utdt.edu; Sturzenegger: fsturzen@utdt.edu). We thank Rudiger Dornbusch, Martın Gonzalez Rozada, ´ Jerry Hausman, Miguel Kiguel, Valerie Ramey, Andrew Rose, two anonymous referees and participants at the 2001 International Finance andMacroeconomics NBER Summer Camp for useful comments. The usual caveat applies. We are also grateful to Iliana Reggio, Vicente Martinez and Luciana Monteverde for their outstanding research assistance. 1 A notable exception is the inflation rate. See, e.g., Jose ´ De Gregorio (1993) and Nouriel Roubini and Xavier Salai-Martin (1995) for theoretical models, and Ross Levine and David Renelt (1992), Robert Barro...