Flexible Exchange Rates Promote Growth
March 23, 2004
The international financial crises of the 1990s prompted a rethinking of appropriate exchange rate regimes for rich and poor countries. Should countries peg their currencies to a stable currency like the dollar or let their currency "float" in the international monetary system? A new paper from the National Bureau of Economic Research argues that countries would be better off with a combination of the two systems: a flexible exchange rate regime.
The authors studied exchange-rate regimes in 183 countries from 1974 to 2000. After controlling for factors such as education, corruption, and differences in gross domestic product, they find that economies with flexible exchange rates grow more rapidly than those with fixed regimes. The difference in the growth rate of gross domestic product GDP was 0.66 to 0.85 percentage points higher per year for countries with flexible systems.
Flexible exchange rates also perform better against extreme events that affect world trade (external trade shocks), like the 1998 Russian rubble devaluation. The report states:
- In a country with a pegged exchange rate, a 10 percent deterioration in international terms of trade has been associated with a decline in GDP per capita growth of 0.8 percent.
- In contrast, a flexible exchange rate system suffers only a 0.43 percent decline.
- The authors contend that a flexible system has the ability to adjust more smoothly to negative shocks via depreciation, while pegged systems are too rigid and slow to react efficiently.
Source: Carlos Lozada, "Flexible Exchange Rates Reduce Economic Volatility," NBER Digest, January 2004; based upon: Sebastian Edwards and Eduardo Levy Yeyati, "Flexible Exchange Rates as Shock Absorbers," National Bureau of Economic Research, Working Paper No. 9867, July 2003.
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