Obstfeld, Shambaugh & Taylor (2005)

 Hypotheses
• Regimes with fixed exchange rates will experience less monetary policy autonomy.
• Regimes with restrictions on capital mobility will experience more monetary policy autonomy.

 The exchange rate is the price of one currency in terms of another.
•
•
Appreciation: Increase in the value of a currency
Depreciation: Decrease in the value of a currency.
 Fixed vs. floating exchange rate regimes
• Advanced economies :: floating rates are the norm
 Euro area is a notable exception
• Developing countries and emerging markets :: fixed exchange rate regimes still common.
 This is true despite the potential for exchange rate crises.

 Fixed vs. floating exchange rate regimes

 Two key questions in the fixed versus flexible exchange rate debate:
• What are the costs of a fixed exchange rate?
• What are the benefits?
 Three common policy objectives:
1.
2.
3.
Low exchange rate volatility
International capital mobility
Autonomy to implement stabilization policy.

 Trilemma

 Trilemma :: theory tells us it is not possible to achieve all three objectives at once.
• Floating exchange rate regime implies policymakers forgo objective #1.
• Fixed exchange rate regime means giving up either #2 or #3.
 Adjust interest rates to keep the exchange rate fixed, OR
 Limit international capital flows, so restricting trade in the foreign exchange market.

 Uncovered Interest Rate Parity (UIP) Condition
• Assumption: capital flows freely across countries
• Idea: Expected return on bank deposits must be equal in same currency terms.
 Arbitrage: If the returns were different, then investors would flock to the country where the expected return is higher, causing an appreciation in that country’s currency.

 Implications of UIP
• Fixed exchange rate regime (peg): i = i*
 The central bank must adjust the interest rate to keep the exchange rate from changing.
 Shocks to foreign interest rate are absorbed in the domestic interest rate, implying domestic monetary policy shocks
(shifts in MP).
• Floating exchange rate regime (nonpeg)
 Central bank free to adjust interest rate to stabilize output.
 But, this means there is potential for larger changes in the exchange rate.

 According to UIP, what should we find in the data on different exchange rate regimes?
• Fixed exchange rate regime, free capital mobility
 Changes in the foreign interest rate (base rate) should lead to one-for-one adjustments in the domestic rate.
• Fixed exchange rate regime, no capital mobility
 Changes in the foreign interest rate (base rate) have low predictive power for domestic interest rates.
• Floating exchange rate regime, stabilization policy
 Effects of changes in foreign interest rate are offset by changes in the domestic rate in the opposite direction.

 Variables:
• Dependent variable: Domestic interest rate
• Explanatory variable: Foreign interest rate (“base rate”)
• Variables are measured in changes because for some countries, interest rates may be nonstationary.
 Baseline Specification: (1)
•
• R it
= Interest rate in country i at time t
R bit
= Interest rate in country i ’s base country at time t

 Test: Fixed exchange rate regime, β = 1
 If β < 1, then central bank uses monetary policy to offset the effects of base-rate shocks on output.
 If β > 1, then central bank uses monetary policy to reinforce the effects of base-rate shocks on output.

 Panel datasets of interest rates
• Gold standard era
 Sample: 1870-1914, 15 countries plus the United Kingdom
 Source: Neal & Weidenmier (2003)
 Base rate: U.K. (money market)
• Bretton Woods era
 Sample: 1959-1970, 21 countries
 Source: Average monthly data from International Finance
Statistics, Global Financial Data, and FRED.
 Base rate: U.S. (federal funds rate)

 Panel datasets of interest rates
• Post-Bretton Woods era
 Sample: Average monthly money market rates, 1973-2000
 Source: IFS, Global Financial Data, Datastream, and FRED
 Base rate: varies by country (Germany, France, U.K., U.S.)

 Identification of regime type

 Identification of regime type
• Gold standard
 Use both de jure (official) and de facto (in practice) classifications.
 De facto test: Commitment to peg in practice (2% band for at least one year).
 13 peg episodes, 7 nonpeg episodes
 Assume capital mobility.

 Identification of regime type
• Bretton Woods
 Nearly entire sample pegged according to de jure and de facto classifications.
 20 peg episodes, 1 nonpeg episode
 Cannot use this era to study within-era regime switches.
 Assume no capital mobility.

 Identification of regime type
• Post-Bretton Woods
 Shambaugh (2004) and de facto test applied to gold standard coding.
 Robustness of results checked using a variety of methods:
 de facto classifications from the IMF and Taylor (2002),
 official de jure classifications, and
 Reinhart and Rogoff (2004) classifications.
 70 pegs, 25 occassional pegs, 32 nonpegs.
 IMF coding for capital control status.

 Pegs versus nonpegs
•
•
Estimate (1) for each group of countries in each era.
Hypothesis: β = 1 for pegs, β < 1 for nonpegs.
 Pooled estimation (2) with interaction term.
• Hypothesis: β
2
> 0

 Nonpegs have lower β and lower R 2 , all eras.
• i not as closely linked to i*.
• Changes in the base rate have little predictive power for changes in the domestic rate.
• Having a floating exchange rate allows the country to pursue autonomous monetary policy.

 Bretton Woods: β < 0 and low R 2 .
• Imposition of capital controls appears to have prevented one-for-one adjustments in the domestic rate.
• Use of capital controls could explain why pegs have a low R 2 relative to gold standard and modern eras.
 Post-Bretton Woods: high β and low R 2 .
• Nonpeg regimes more responsive to base rate changes compared with the gold standard nonpegs.

 Pooled estimates
• Regime choice affects no only intercept, but slope.
 Peg regimes have a larger average change and are more responsive.
• Nonpegs in the post-Bretton Woods era are generally more responsive than nonpegs under the gold standard.

 Further disaggregate regime according to capital controls.
• Hypotheses:
 Pegs: higher β and higher R 2
 Capital controls: lower β and lower R 2

 Interaction terms for peg and capital controls
• PEG = 1 (if fixed exchange rate regime)
•
•
CAP = 1 (if no capital controls)
Hypotheses
 β
2
 β
3
> 0 :: pegs more responsive to changes in base rate
> 0 :: countries with capital mobility more responsive to changes in base rate
 β
4
> 0 :: pegs and capital mobility mean country more responsive to changes in base rate

 Countries have historically faced the trilemma, and still do in the post-Bretton Woods era.
 Measure of monetary policy autonomy: changes in interest rate relative to base rate.
• Countries with pegged exchange rates and capital mobility have larger interest rate changes and are more responsive to changes in the base rate.
• Theory predicts one-for-one adjustment for fixed regimes, but estimates are closer to 0.5.
 True even for gold standard , widely viewed as a stricter than
Bretton Woods or modern-day fixed regimes.

 Bretton Woods achieve policy autonomy and pegs through imposing capital controls.
• System broke down when capital controls relaxed in the 1960s.
 In post-Bretton Woods era, countries more responsive to changes in base rate, even for nonpegs (vs. gold standard).
• Perhaps countries choose not to implement autonomous policies, even when floating.

 Possible to classify countries differently
• Peg, float, and managed float
• With the classifications used by Obstfeld, Shambaugh and Taylor (2005) and Shambaugh (2004), countries with managed floats might be counted as regime switches throughout the sample.
• What would this tell us?
 Countries with managed float should be able to “hedge” the trilemma problem.

 Result that adjustment to base rate is less than one-for one is inconsistent with theory.
• Possible omitted variable from the UIP condition?
• Perhaps a risk premium, associated with credibility of the peg (currency risk) and probability of sovereign default (default risk).

 Possible bias in samples
• Fundamentally different countries across eras.
 Gold standard and Bretton Woods samples are dominated by advanced economics.
 Modern sample dominated by developing countries.
 Implication
• If there were a risk premium, this would drive a wedge between the interest rate and the base rate, especially for developing countries, biasing the estimate of b downward in the post-Bretton Woods sample.