NCPA - National Center for Policy Analysis

Benefits of Reducing G-3 Currency Volatility

May 23, 2002

To varying degrees, a number of developing countries have tied their currencies to the U.S. dollar in order to reduce and maintain low inflation rates. Some analysts believe that exchange rate volatility among industrialized nations is at least partially to blame for the financial crises that plague emerging markets.

Those analysts argue that the Group of 3-- the United States, Japan and collectively the 12 nations that have adopted the euro -- could reduce the financial shock of fluctuations in exchange rates by adjusting interest rates so that their currencies trade within certain "target zones."

But one study found no evidence that limiting exchange rate volatility benefits emerging markets -- and could possibly hurt.

For decades, controls on international capital flows helped keep exchange rates stable, but were abandoned some years ago. Historically, financial crises have "been more frequent when G-3 exchange rates are more volatile," and keeping G-3 exchange rates within target zones could indeed lead to more stable prices in emerging markets. However, researchers argue:

  • A policy that seeks to limit currency fluctuations could end up fostering more instability in emerging markets because international interest rates would have to fluctuate more widely in order to maintain stable exchange rates among major currencies.
  • And over the past 27 years, foreign direct investment has also tended to be higher in times of currency instability among the G-3.
  • Also, volatile interest rates could make debt-servicing costs much more unpredictable, and could produce "income volatility" in developed countries that could decrease demand for emerging market exports.

Thus, trading exchange rate predictability among the G-3 with greater uncertainty in international interest rates would have been worse for developing countries.

Source: Matthew Davis, "No Gain from Reducing G-3 Currency Volatility," NBER Digest, January 2002; based on Carmen Reinhart and Vincent Reinhart, "What Hurts Most? G-3 Exchange Rate Or Interest Rate Volatility?" NBER Working Paper No. 8535, October 2001, National Bureau of Economic Research.

For NBER text


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