TY  - JOUR
AU  - Lahiri, Amartya
AU  - Vegh, Carlos A
TI  - Living with the Fear of Floating: An Optimal Policy Perspective
JF  - National Bureau of Economic Research Working Paper Series
VL  - No. 8391
PY  - 2001
Y2  - July 2001
DO  - 10.3386/w8391
UR  - http://www.nber.org/papers/w8391
L1  - http://www.nber.org/papers/w8391.pdf
N1  - Author contact info:
Amartya Lahiri
Vancouver School of Economics
University of British Columbia
6000 Iona Drive
Vancouver, BC V6T 1Z1
CANADA
Tel: 604-822-8606
E-Mail: amartyalahiri@gmail.com

Carlos A. Vegh
School of Advanced International Studies (SAIS)
Johns Hopkins University
1717 Massachusetts Avenue, NW
Washington, DC 20036
Tel: 202-663-7787
E-Mail: cvegh1@jhu.edu
M1  - published as Amartya Lahiri, Carlos A. Végh. "Living with the Fear of Floating: An Optimal Policy Perspective," in Sebastian Edwards and Jeffrey A. Frankel, editors, "Preventing Currency Crises in Emerging Markets" University of Chicago Press (2002)

AB  - As documented in recent studies, developing countries (classified by the IMF as floaters or managed floaters) are extremely reluctant to allow for large nominal exchange rate fluctuations. This 'fear of floating' is reflected in the fact that, in spite of being subject to larger shocks, developing countries exhibit lower exchange rate variability and higher reserve variability than developed countries.  Moreover, there is a positive correlation between changes in the exchange rate and interest rates and a negative correlation between both changes in reserves and the exchange rate and changes in interest rates and reserves. We build a simple model that rationalizes these key features as the outcome of an optimal policy response to monetary shocks. The model incorporates three key frictions: an output cost of nominal exchange rate fluctuations, an output cost of higher interest rates to defend the currency, and a fixed cost of intervention.
ER  -