## wp18213 - Section III–VI

## Source details

**Canonical URL:** [wp18213 - Section III–VI](https://www.imf.org/-/media/files/publications/wp/2018/wp18213.pdf)

## Other formats

- [Markdown version](/-/media/files/publications/wp/2018/wp18213.pdf.md)
- [Structured JSON version](/-/media/files/publications/wp/2018/wp18213.pdf.json)

---

### Literature review: expenditure-switching vs expenditure-changing
- Currency of price stickiness determines importance of nominal exchange rate movements: prices sticky in producing country currency (PCP) vs prices fixed in consumers' currencies (LCP).
- Under PCP: nominal exchange rate movements can change relative prices and produce expenditure switching; floating regimes are beneficial.
- Under LCP: exchange rate flexibility cannot achieve relative price adjustment, weakening the case for floating regimes and leading to deviations from the law of one price (Betts and Deveraux, 2000; Deveraux and Engel, 2003).
- Empirical aim: test whether expenditure-switching effects are stronger under more flexible exchange rate arrangements, across a large sample of small open economies.
- Main empirical claim: in a sample of 101 economies, the expenditure-switching effect is stronger in economies with more flexible exchange rate arrangements and increases monotonically with the degree of exchange rate flexibility.
- Relation to prior literature:
  - Some studies find flexible exchange rates reduce the real impact of terms-of-trade shocks.
  - Other studies find similar stabilization properties across float and peg when pass-through is limited or foreign currency debt is high.
  - This paper explicitly models dynamics of changes in imports, domestic demand, and the real effective exchange rate (REER) to terms-of-trade shocks across 101 economies.

### Data
- Sample: yearly data for 101 economies during 1990-2017.
- Exclusions and sample restrictions:
  - Excludes G7 countries and China.
  - Excludes euro area countries after 1998.
  - Uses only countries with PPP-adjusted GDP per capita greater than 1,000 U.S. dollars as of 2016.
  - Drops small countries with population less than one million.
  - Drops observations where annual change in domestic demand exceeds 20 percent.
  - Drops observations where annual changes in the real effective rate exceed 50 percent.
- Exchange rate regime classification: Ilzetzky, Reinhart, and Rogoff (2017) de facto database (IRR), country–year observations assigned to one of fifteen categories; observations in “freely falling” and “dual markets in which parallel market data is missing” are excluded.
- Key variables and sources:
  - Real domestic demand, real imports, and terms of trade: IMF’s World Economic Outlook database.
  - REER (CPI based): IMF’s Information Notice System.
  - Short-term external debt over total reserves: World Bank’s World Development Indicators (WDI); analysis uses log(1+debt) where debt is the debt-to-international reserves measure expressed in percentage points.
  - Import structure measure (share of primary commodities in total imports): sum of agricultural goods, fuels, ores, and metals over total imports from WDI; analysis uses log(1+RAW) where RAW is the import share of raw material in percentage points.

### Model and estimation strategy
- Framework: panel vector autoregression (PVAR) with interacted terms (Towbin and Weber, 2013).
- Endogenous variables: log terms of trade (TOT), log real domestic demand (DEM), log real effective exchange rate (REER), log real imports (IMP).
- Interaction structure:
  - Coefficients vary deterministically with the degree of exchange rate flexibility (IRR) and, in robustness checks, with short-term debt levels and import structure.
  - Interaction with IRR exchange rate classification (PEGit) ranging from 1 to 13 (IRR).
- Identification:
  - Terms of trade treated as exogenous shocks.
  - Impulse responses computed to a ten percent reduction in the terms of trade.
  - Impulse responses computed for levels of log domestic demand, log REER, log real exports and imports (using cumulative sum of growth rates up to horizon h), and cumulative change in real imports in period h.
- Estimation details:
  - Each equation estimated by ordinary least squares (OLS) with country fixed effects and two lags (Schwartz Criterion).
  - Interaction terms enter also in levels as exogenous controls.
  - Bootstrapping: Runkle (1987) bootstrapping method adjusted for panel format and interaction terms; 500 simulations; 90 percent confidence intervals drawn from simulated estimates.
  - To test differences across regimes, focus on de facto pegs (score of 4 in IRR) vs managed floating (score of 12 in IRR); report fraction of 500 simulations that lies above zero for differences.

### Results: responses to a 10 percent negative terms-of-trade shock
- Overall finding:
  - Composition of adjustment varies with exchange rate regime: larger expenditure-switching effects observed in economies under managed floating regimes compared to de facto pegs.
- Quantitative outcomes and exact figures:
  - Shock: ten percent reduction in the terms of trade; horizon considered: 10-year window.
  - REER response in managed floating regimes:
    - Currencies depreciate around two percent in real terms on impact and stabilize around 4 years after the initial shock.
  - Domestic demand:
    - The required initial decline in domestic demand is twice as large in rigid regimes (pegs) for the same adjustment to be observed.
    - In flexible regimes, the terms-of-trade shock has no effects on the level of domestic demand after three years.
  - Real imports:
    - In managed floating economies, decline in real imports is around 2 percent despite smaller contraction in domestic demand.
    - In pegs, the decline in imports is smaller due to real appreciation; adjustment falls more on domestic demand volumes.
  - Statistical significance across regimes:
    - Medium-term responses differ in at least 90 percent of the bootstrap simulations, except the adjustment in real imports which is different across the two regimes in 75 percent of the simulations.
- Exact cumulative response differences from Table 1 (responses to a negative ten percent terms-of-trade shock; difference = De Facto Peg minus Managed Floating):
  - Domestic Demand
    - 1st year: De Facto Peg = -0.73*** ; Managed Floating = -0.37** ; Difference = -0.36*
    - 3rd year: De Facto Peg = -1.70*** ; Managed Floating = -0.16 ; Difference = -1.54***
    - 5th year: De Facto Peg = -1.56*** ; Managed Floating = -0.10 ; Difference = -1.46***
  - REER
    - 1st year: De Facto Peg = 0.94*** ; Managed Floating = -2.22*** ; Difference = 3.16***
    - 3rd year: De Facto Peg = -0.35 ; Managed Floating = -1.23** ; Difference = 0.88*
    - 5th year: De Facto Peg = -0.33 ; Managed Floating = -1.62*** ; Difference = 1.29**
  - Imports
    - 1st year: De Facto Peg = -0.55* ; Managed Floating = -2.58*** ; Difference = 2.03**
    - 3rd year: De Facto Peg = -2.00** ; Managed Floating = -2.57*** ; Difference = 0.57*
    - 5th year: De Facto Peg = -1.35* ; Managed Floating = -2.47*** ; Difference = 1.12*
  - Note on significance markers: *, **, *** indicate that zero lies outside the 68, 90, 95% confidence bands, respectively.
- Spectrum of regimes:
  - Simulations across the full IRR classification: the magnitude of the expenditure-switching effect increases monotonically with the degree of exchange rate flexibility.
  - Depreciation of currencies in real terms in response to the shock increases with exchange rate flexibility, allowing larger external adjustment with less demand compression.
- Persistence and external imbalances:
  - Differences in medium-term persistence of external flow imbalances are less significant.
  - Initial magnitude of adjustment of flow imbalances immediately after the shock is larger under floating regimes; differences are less significant in medium-term responses.
  - Differences in magnitude of adjustment are significantly larger in floats with low foreign debt levels.

### 1. The role of foreign currency debt
- Exchange rate flexibility, liability dollarization, and expenditure-switching
  - Exercise: responses of domestic demand, relative prices, and real imports to a ten percent terms-of-trade shock as a function of exchange rate regime and short-term external debt (ratio of short-term external debt to total reserves) for emerging and developing countries.
  - Key empirical findings:
    - On impact, currencies depreciate by around 2.5 percent in flexible exchange rate regimes.
    - Medium-term reduction in relative prices is significantly larger in low debt economies under floating arrangements—consistent with less “fear of floating.”
    - Economies under pegs face a real appreciation of their currencies, especially for economies with high short-term external debt.
    - Flexible exchange rates better insulate domestic demand when foreign debt is high:
      - In the fifth year, the demand response under a float is not statistically significant.
      - Demand has declined by more than 2 percent under pegs (fifth year).
    - For low foreign currency debt:
      - The smaller demand response under a float no longer holds.
      - Reduction in imports is substantially larger for low debt economies under a float (almost 2.5 times larger).
      - For broadly the same amount of demand compression, exchange rate flexibility allows faster external adjustment.
  - Pairwise comparisons:
    - Significant differences between de facto pegs and managed floating regimes when foreign currency debt is high, but not when it is low.
    - For low debt economies, responses of the REER and real imports are significantly different across regimes, highlighting strong expenditure-switching under flexibility.
  - Interpretation:
    - Expenditure-switching effects dominate potential adverse balance-sheet effects from currency mismatches in economies with flexible exchange rate regimes following a real external shock.
    - Benefits of exchange rate flexibility are diminished but not eliminated in economies with high liability dollarization.

### 2. The role of import structure
- Exchange-rate pass-through, raw material import share, and adjustment
  - Exercise: responses to a ten percent terms-of-trade shock across exchange rate regimes and import composition (high vs low share of raw materials in total imports).
  - Key empirical findings:
    - Higher share of raw materials in total imports is associated with a larger exchange rate pass-through to domestic prices.
    - Expenditure-switching effects are stronger in economies under flexible exchange rate arrangements with a high share of raw materials in total imports.
    - In economies with a high raw-material import share and high pass-through:
      - Flexible exchange rates allow for a significant change in relative prices.
      - Consumers substitute away from imported goods toward domestic goods, lowering the burden on domestic demand.
      - Despite negligible effects of the external shock on domestic demand, contraction in real imports is larger than in pegs with a similar import structure.
    - When exchange-rate pass-through is low:
      - Benefits of exchange rate flexibility are somewhat lower because relative prices respond less to depreciation.
      - Nonetheless, the cost of adjustment remains lower than under pegs with low pass-through.
    - Dynamics of demand and imports:
      - On impact, reduction in domestic demand is larger for countries with managed floating arrangements, but medium-term effects on demand are negligible for floats while for pegs they strengthen and become more significant.
      - On impact, floats still experience significant depreciation (smaller than floats with high raw-material share), and combined with demand reduction, real imports decline significantly—almost three times as much as economies with a de facto peg or floaters with a high exchange-rate pass-through.
  - Cumulative fifth-year simulation:
    - Expenditure-switching effects and insulation ability of floats increase with raw material share.
    - Expenditure-switching effects are significant for floats immediately after the shock, allowing a smaller contraction in domestic demand in the fifth year relative to pegs with low pass-through.
    - External adjustment of imbalances is similar for the most flexible exchange rate arrangements regardless of import structure, and for pegs with a low import content of raw materials.

### Conclusions and policy-relevant implications
- Main conclusions:
  - Exchange rate flexibility allows significant adjustment in relative prices, lowering the burden on domestic demand and complementing expenditure-changing effects for faster and more durable external adjustment after a real external shock.
  - While currency mismatches and limited exchange-rate pass-through weaken the insulating capacity of floating rates, the expansionary expenditure-switching effect is still significant and tends to dominate balance-sheet effects and deleterious currency-mismatch effects.
- Policy implications:
  - Greater exchange rate flexibility can serve as an effective shock absorber in the presence of real external shocks, provided liability dollarization and exchange-rate pass-through considerations are taken into account.
  - Reducing short-term external debt exposures (liability dollarization) can enhance the benefits of exchange rate flexibility by mitigating balance-sheet risks and “fear of floating.”
  - Strengthening monetary policy frameworks and credibility (which can lower second-round pass-through to domestic prices) would reduce the costs of nominal depreciations converting into real depreciations and facilitate external adjustment.
  - Policymakers should consider import structure (raw materials vs other imports) when assessing the likely effectiveness of exchange rate flexibility as a tool for adjustment.

### Conceptual model — mechanisms and channels
- Supply side and production technologies:
  - Two-good economy: nontradable goods (N) and home tradable goods (H).
  - H production uses labor and imports, M; production function cases: Leontieff (constant proportions), Cobb-Douglas, linear (perfect substitutes).
  - Income and substitution effects vary by technology: e.g., Leontieff implies higher import prices reduce labor demand and wages, producing a negative income effect.
- Domestic demand and market clearing:
  - Representative agent consumes cN, cH, and cM; labor income is sole income source.
  - Market clearing: nontradable production exhausted by domestic consumption; home goods consumed domestically or exported.
  - Export demand X is decreasing in foreign/home relative price (pM/pH); pM is exogenously set.
- Response to a real depreciation (deterioration in terms of trade):
  - Real depreciation modeled as an increase in pM while pH is constant; corresponds to the ten percent terms-of-trade shock in empirical sections.
  - Two opposing effects:
    - Negative income effect: higher import prices reduce wages and income, lowering aggregate consumption and nontradable prices and production.
    - Expenditure-switching effect: relative price change increases demand for home goods from abroad (exports) and induces substitution away from imports toward domestic goods.
  - Net outcome depends on dominance:
    - If income effect dominates (e.g., Leontieff technology, significant currency mismatches), domestic demand and output decline.
    - If expenditure-switching dominates (facilitated by exchange rate flexibility and high pass-through to import prices), external adjustment can occur with smaller domestic demand contraction.
  - Financial channel amplification:
    - Higher U.S. interest rates and capital outflows can exacerbate real depreciation and depress domestic activity, especially with currency mismatches and credit market frictions.

*Source: wp18213 - Section III–VI*

### Section III. Section IV presents the empirical strategy that underlies our analysis. The results

### wp18213 - Section III. Section IV presents the empirical strategy that underlies our analysis. The results

### Literature review: expenditure-switching vs expenditure-changing
- The empirical importance of nominal exchange rate movements for real variables depends on the currency of price stickiness: prices sticky in producing country currency (PCP) vs prices fixed in consumers' currencies (LCP).
- Under PCP: nominal exchange rate movements can change relative prices and produce expenditure switching; floating regimes are beneficial.
- Under LCP: exchange rate flexibility cannot achieve relative price adjustment, weakening the case for floating regimes and leading to deviations from the law of one price (Betts and Deveraux, 2000; Deveraux and Engel, 2003).
- The paper contrasts these predictions by testing whether expenditure-switching effects are stronger under more flexible exchange rate arrangements.
- Main empirical claim: in a large sample of small open economies, the expenditure-switching effect is stronger in economies with more flexible exchange rate arrangements and increases monotonically with the degree of exchange rate flexibility.
- Relation to prior literature:
  - Some studies find flexible exchange rates reduce the real impact of terms-of-trade shocks (Edwards and Levy Yeyati, 2005; Broda, 2004; Broda and Tille, 2003).
  - Other studies find similar stabilization properties across float and peg when pass-through is limited or foreign currency debt is high (Towbin and Weber, 2013).
  - This paper fills a gap by explicitly modeling dynamics of changes in imports, domestic demand, and the real effective exchange rate (REER) to terms-of-trade shocks across 101 economies.

### Data
- Sample: yearly data for 101 economies during 1990-2017.
- Exclusions and sample restrictions:
  - Excludes G7 countries and China.
  - Excludes euro area countries after 1998.
  - Uses only countries with PPP-adjusted GDP per capita greater than 1,000 U.S. dollars as of 2016.
  - Drops small countries with population less than one million.
  - Drops observations where annual change in domestic demand exceeds 20 percent.
  - Drops observations where annual changes in the real effective rate exceed 50 percent.
- Exchange rate regime classification: Ilzetzky, Reinhart, and Rogoff (2017) de facto database (IRR), country–year observations assigned to one of fifteen categories; observations in “freely falling” and “dual markets in which parallel market data is missing” are excluded.
- Key variables and sources:
  - Real domestic demand, real imports, and terms of trade: IMF’s World Economic Outlook database.
  - REER (CPI based): IMF’s Information Notice System.
  - Short-term external debt over total reserves (measure of possible currency mismatches): World Bank’s World Development Indicators (WDI); analysis uses log(1+debt) where debt is the debt-to-international reserves measure expressed in percentage points.
  - Import structure measure (share of primary commodities in total imports): sum of agricultural goods, fuels, ores, and metals over total imports from WDI; analysis uses log(1+RAW) where RAW is the import share of raw material in percentage points.

### Model and estimation strategy
- Framework: panel vector autoregression (PVAR) with interacted terms (Towbin and Weber, 2013).
- Endogenous variables: log terms of trade (TOT), log real domestic demand (DEM), log real effective exchange rate (REER), log real imports (IMP).
- Interaction structure:
  - Coefficients vary deterministically with the degree of exchange rate flexibility and, in robustness checks, with short-term debt levels and import structure.
  - Interaction with IRR exchange rate classification (PEGit) ranging from 1 to 13 (IRR).
  - In robustness checks, equation extended to include debt levels and import content and their interactions with IRR.
- Identification:
  - Terms of trade treated as exogenous shocks.
  - Impulse responses computed to a ten percent reduction in the terms of trade.
  - Impulse responses computed for levels of log domestic demand, log REER, log real exports and imports (using cumulative sum of growth rates up to horizon h), and cumulative change in real imports in period h.
- Estimation details:
  - Each equation estimated by ordinary least squares (OLS) with country fixed effects and two lags (Schwartz Criterion).
  - Interaction terms enter also in levels as exogenous controls.
  - Bootstrapping: Runkle (1987) bootstrapping method adjusted for panel format and interaction terms; algorithm:
    1. Estimate equation (1) by OLS.
    2. Draw error ε̂it from N(0, Σ̂), where Σ̂ is estimated covariance matrix.
    3. Use ε̂it, observations at t-1 and t-2, and estimates of α̂l,itj,k (from equation (2) and exchange rate classification in t) to simulate next period observations for the four variables recursively.
    4. Interact simulated variables with interaction terms and repeat steps 2–3 for t=1,...,T and i=1,...,N.
    5. Re-estimate the system on artificial sample and compute cumulative IRFs.
    6. Repeat steps 2–5 500 times; draw 90 percent confidence intervals from simulated estimates.
  - To test differences across regimes, focus on de facto pegs (score of 4 in IRR) vs managed floating (score of 12 in IRR); report fraction of 500 simulations that lies above zero for differences.

### Results: responses to a 10 percent negative terms-of-trade shock
- Overall finding:
  - Composition of adjustment varies with exchange rate regime: larger expenditure-switching effects observed in economies under managed floating regimes compared to de facto pegs.
- Key quantitative outcomes and exact figures:
  - Sample and shock:
    - Impulse responses to a ten percent reduction in the terms of trade.
    - Horizon considered: 10-year window (impulse responses shown over 10 years).
  - REER response in managed floating regimes:
    - Currencies depreciate around two percent in real terms on impact and stabilize around 4 years after the initial shock.
  - Domestic demand:
    - The required initial decline in domestic demand is twice as large in rigid regimes (pegs) for the same adjustment to be observed.
    - In flexible regimes, the terms-of-trade shock has no effects on the level of domestic demand after three years.
  - Real imports:
    - In managed floating economies, decline in real imports is around 2 percent despite smaller contraction in domestic demand.
    - In pegs, the decline in imports is smaller due to real appreciation; adjustment falls more on domestic demand volumes.
  - Statistical significance across regimes:
    - Medium-term responses differ in at least 90 percent of the bootstrap simulations, except the adjustment in real imports which is different across the two regimes in 75 percent of the simulations.
- Exact cumulative response differences from Table 1 (responses to a negative ten percent terms-of-trade shock; difference = De Facto Peg minus Managed Floating):
  - Domestic Demand
    - 1st year: De Facto Peg = -0.73*** ; Managed Floating = -0.37** ; Difference = -0.36*
    - 3rd year: De Facto Peg = -1.70*** ; Managed Floating = -0.16 ; Difference = -1.54***
    - 5th year: De Facto Peg = -1.56*** ; Managed Floating = -0.10 ; Difference = -1.46***
  - REER
    - 1st year: De Facto Peg = 0.94*** ; Managed Floating = -2.22*** ; Difference = 3.16***
    - 3rd year: De Facto Peg = -0.35 ; Managed Floating = -1.23** ; Difference = 0.88*
    - 5th year: De Facto Peg = -0.33 ; Managed Floating = -1.62*** ; Difference = 1.29**
  - Imports
    - 1st year: De Facto Peg = -0.55* ; Managed Floating = -2.58*** ; Difference = 2.03**
    - 3rd year: De Facto Peg = -2.00** ; Managed Floating = -2.57*** ; Difference = 0.57*
    - 5th year: De Facto Peg = -1.35* ; Managed Floating = -2.47*** ; Difference = 1.12*
  - Note on significance markers: *, **, *** indicate that zero lies outside the 68, 90, 95% confidence bands, respectively.
- Spectrum of regimes:
  - Simulations across the full IRR classification: the magnitude of the expenditure-switching effect increases monotonically with the degree of exchange rate flexibility.
  - Depreciation of currencies in real terms in response to the shock increases with exchange rate flexibility, allowing larger external adjustment with less demand compression.
- Persistence and external imbalances:
  - Differences in medium-term persistence of external flow imbalances are less significant, consistent with Chinn and Wei (2013).
  - Initial magnitude of adjustment of flow imbalances immediately after the shock is larger under floating regimes; differences are less significant in medium-term responses.
  - Differences in magnitude of adjustment are significantly larger in floats with low foreign debt levels.

### Robustness checks: liability dollarization and exchange-rate pass-through
- Concerns tested:
  - High liability dollarization: depreciation can raise domestic leverage and borrowing costs, dampening investment and domestic demand.
  - Low exchange-rate pass-through: limited pass-through prevents expenditure switching because relative prices of domestic vs imported goods remain unchanged.
  - High exchange-rate pass-through to domestic prices: could offset nominal depreciation and dampen real exchange rate response.
- Method:
  - Responses allowed to vary with degree of liability dollarization and exchange-rate pass-through.
  - Variables evaluated at lower (20th) percentile and higher (80th) percentile values in robustness analysis.
- Summary statement:
  - Main findings are tested for sensitivity to these factors; methodology and evaluation percentiles specified for robustness checks (full quantitative robustness results reported in subsequent sections not included in this content unit).

*Source: wp18213 - Section III–VI (IMF working paper content provided).*

### 1. The role of foreign currency debt

### 1. The role of foreign currency debt

### Exchange rate flexibility, liability dollarization, and expenditure-switching
- Exercise: responses of domestic demand, relative prices, and real imports to a ten percent terms-of-trade shock as a function of exchange rate regime and short-term external debt (ratio of short-term external debt to total reserves) for emerging and developing countries.
- Key empirical findings:
  - On impact, currencies depreciate by around 2.5 percent in flexible exchange rate regimes.
  - Medium-term reduction in relative prices is significantly larger in low debt economies under floating arrangements—consistent with less “fear of floating.”
  - Economies under pegs face a real appreciation of their currencies, especially for economies with high short-term external debt.
  - Flexible exchange rates better insulate domestic demand when foreign debt is high:
    - In the fifth year, the demand response under a float is not statistically significant.
    - Demand has declined by more than 2 percent under pegs (fifth year).
  - For low foreign currency debt, the smaller demand response under a float no longer holds; however:
    - Reduction in imports is substantially larger for low debt economies under a float (almost 2.5 times larger).
    - For broadly the same amount of demand compression, exchange rate flexibility allows faster external adjustment.
- Pairwise comparisons:
  - Significant differences between de facto pegs and managed floating regimes when foreign currency debt is high, but not when it is low (Table 2).
  - For low debt economies, responses of the real effective exchange rate and real imports are significantly different across regimes, highlighting strong expenditure-switching under flexibility.
- Interpretation:
  - Expenditure-switching effects dominate potential adverse balance-sheet effects from currency mismatches in economies with flexible exchange rate regimes following a real external shock.
  - Benefits of exchange rate flexibility are diminished but not eliminated in economies with high liability dollarization.

*Italic final note: Source: wp18213 - 1. The role of foreign currency debt*

### 2. The role of import structure

### Exchange-rate pass-through, raw material import share, and adjustment
- Exercise: responses to a ten percent terms-of-trade shock across exchange rate regimes and import composition (high vs low share of raw materials in total imports).
- Key empirical findings:
  - Higher share of raw materials in total imports is associated with a larger exchange rate pass-through to domestic prices.
  - Expenditure-switching effects are stronger in economies under flexible exchange rate arrangements with a high share of raw materials in total imports (Table 3).
  - In economies with a high raw-material import share and high pass-through:
    - Flexible exchange rates allow for a significant change in relative prices.
    - Consumers substitute away from imported goods toward domestic goods, lowering the burden on domestic demand (expenditure-changing effects).
    - Despite negligible effects of the external shock on domestic demand, contraction in real imports is larger than in pegs with a similar import structure.
  - When exchange-rate pass-through is low:
    - Benefits of exchange rate flexibility are somewhat lower because relative prices respond less to depreciation.
    - Nonetheless, the cost of adjustment remains lower than under pegs with low pass-through.
  - Dynamics of demand and imports:
    - On impact, reduction in domestic demand is larger for countries with managed floating arrangements, but medium-term effects on demand are negligible for floats while for pegs they strengthen and become more significant.
    - On impact, floats still experience significant depreciation (smaller than floats with high raw-material share), and combined with demand reduction, real imports decline significantly—almost three times as much as economies with a de facto peg or floaters with a high exchange-rate pass-through.
- Cumulative fifth-year simulation (Figure 6):
  - Expenditure-switching effects and insulation ability of floats increase with raw material share.
  - Expenditure-switching effects are significant for floats immediately after the shock, allowing a smaller contraction in domestic demand in the fifth year relative to pegs with low pass-through.
  - External adjustment of imbalances is similar for the most flexible exchange rate arrangements regardless of import structure, and for pegs with a low import content of raw materials.

*Italic final note: Source: wp18213 - 1. The role of foreign currency debt*

### 3. Conclusions and policy-relevant implications

- Main conclusions:
  - Exchange rate flexibility allows significant adjustment in relative prices, lowering the burden on domestic demand and complementing expenditure-changing effects for faster and more durable external adjustment after a real external shock.
  - While currency mismatches and limited exchange-rate pass-through weaken the insulating capacity of floating rates, the expansionary expenditure-switching effect is still significant and tends to dominate balance-sheet effects and deleterious currency-mismatch effects.
- Policy implications:
  - Greater exchange rate flexibility can serve as an effective shock absorber in the presence of real external shocks, provided liability dollarization and exchange-rate pass-through considerations are taken into account.
  - Reducing short-term external debt exposures (liability dollarization) can enhance the benefits of exchange rate flexibility by mitigating balance-sheet risks and “fear of floating.”
  - Strengthening monetary policy frameworks and credibility (which can lower second-round pass-through to domestic prices) would reduce the costs of nominal depreciations converting into real depreciations and facilitate external adjustment.
  - Policymakers should consider import structure (raw materials vs other imports) when assessing the likely effectiveness of exchange rate flexibility as a tool for adjustment.

*Italic final note: Source: wp18213 - 1. The role of foreign currency debt*

### 4. Conceptual model — mechanisms and channels

### Supply side and production technologies
- Two-good economy: nontradable goods (N) and home tradable goods (H).
- H production uses labor and imports, M; production function properties discussed for:
  - Leontieff (constant proportions): higher import prices reduce labor demand and wages, producing a negative income effect.
  - Cobb-Douglas: impact of real depreciation on H production is ambiguous; domestic demand effect is always negative.
  - Linear (perfect substitutes): corner solutions possible; production may remain unaltered and export responses can raise output.

### Domestic demand and market clearing
- Representative agent consumes cN, cH, and cM; labor income is sole income source.
- Market clearing: nontradable production exhausted by domestic consumption; home goods consumed domestically or exported.
- Export demand X is decreasing in foreign/home relative price (pM/pH); pM is exogenously set.

### Response to a real depreciation (deterioration in terms of trade)
- Real depreciation modeled as an increase in pM while pH is constant; represents a ten percent terms-of-trade shock exercise in the empirical sections.
- Two opposing effects on domestic demand and output:
  - Negative income effect: higher import prices reduce wages and income, lowering aggregate consumption and nontradable prices and production.
  - Expenditure-switching effect: relative price change increases demand for home goods from abroad (exports) and induces substitution away from imports toward domestic goods.
- Net outcome depends on dominance:
  - If income effect dominates (e.g., Leontieff technology, significant currency mismatches), domestic demand and output decline.
  - If expenditure-switching dominates (facilitated by exchange rate flexibility and high pass-through to import prices), external adjustment can occur with smaller domestic demand contraction.
- Financial channel amplification:
  - Higher U.S. interest rates and capital outflows can exacerbate real depreciation and depress domestic activity, especially with currency mismatches and credit market frictions.

*Italic final note: Source: wp18213 - 1. The role of foreign currency debt*

### REFERENCES

### REFERENCES

### Theoretical foundations and classic works
- Friedman, Milton, 1953, “The Case for Flexible Exchange Rates,” In M. Friedman (eds.), Essays in Positive Economics, 157-203 (Chicago, IL: University of Chicago Press).
- Mundell, Robert A., 1961, “A Theory of Optimum Currency Areas,” American Economic Review, No. 51, pp. 657–665.
- Mundell, Robert, 1961, “A Theory of Optimum Currency Areas,” American Economic Review, vol. 51, November, pp. 509±17.
- Fleming, John, 1962, “Domestic Financial Policies Under Fixed and Flexible Exchange Rates,” IMF Staff Papers 9 (1962), pp. 369-79
- Graham, Frank, and Charles Whittlesey, 1934, “Fluctuating Exchange Rates, Foreign Trade and the Price Level,” American Economic Review 24: 401–16.

### Exchange rate regimes, regime choice, and external adjustment
- Lev y-Yeyati, Eduardo, and Federico Sturzenegger, 2005, “Classifying Exchange Rate Regimes: Deeds vs. Words,” European Economic Review, Vol. 49, No. 6, pp. 1603–1635.
- Ilzetzki, Ethan, Carmen Reinhart, and Kenneth Rogoff, 2017, “Exchange Arrangements Entering the 21st Century: Which Anchor Will Hold?” NBER Working Paper No. 23134 (Cambridge, MA: National Bureau of Economic Research).
- Devereux, Michael B., and Charles Engel, 1998, “Fixed vs. Floating Exchange Rates: How Price Setting Affects the Optimal Choice of Exchange-Rate Regime,” National Bureau of Economic Research Working Paper, no. 6867 (Cambridge, MA: National Bureau of Economic Research).
- Edwards, Sebastian, and Eduardo Levy Yeyati, 2005, “Flexible Exchange Rates as Shock Absorbers,” European Economic Review, Vol. 49, No. 8, pp. 2079–2105.
- Ghosh, Rex, Marco Terrones, and Jerome Zettelmeyer, 2010, “Exchange Rate Regimes and External Adjustment: New Answers to an Old Debate,” C. Wyplosz (Ed.), The New International Monetary System: Essays in Honor of Alexander Swoboda, Routledge, March 2010.
- Broda, Christian, 2004, “Terms of Trade and Exchange Rate Regimes in Developing Countries,” Journal of International Economics, Vol. 63, No. 1, pp. 31–58.
- Magud, Nicolas E., 2004, “Exchange Rate Regime Choice and Country Characteristics: an Empirical Investigation,” University of Oregon Working Paper, mimeo.
- Magud, Nicolas E., 2010, “Currency Mismatch, Openness, and Exchange Rate Regime Choice,” Journal of Macroeconomics, Vol. 32, No. 1, March, pp. 68–89.
- Magud, Nicolas E., Esteban R. Vesperoni., 2015, "Exchange Rate Flexibility and Credit During Capital Inflow Reversals: Purgatory ... Not Paradise," Journal of International Money and Finance, Elsevier, vol. 55(C), pages 88-110.
- Boz, Emine, Gita Gopinath, and Mikkel Plagborg-Møller, 2017, “Global Trade and the Dollar,” IMF Working Papers, WP/17/239 (Washington D.C.: International Monetary Fund).

### Terms-of-trade, external adjustment, and related empirical work
- Adler, Gustavo, Nicolas E. Magud, and Alejandro Werner, 2017, “Terms-of-Trade Cycles and External Adjustment.” International Review of Economics and Finance, Vol. 54, pp. 103-122.
- Broda, Christian and Cedric Tille, 2003, “Coping with Terms-of-Trade Shocks in Developing Countries,” Current Issues in Economics and Finance, 9 (11) (2003), pp. 1-7 (November).
- Schmitt-Grohé, Stephanie, and Martin Uribe. 2017. “How Important Are Terms-of-Trade Shocks?” International Economic Review, volume 59, issue 1, pages 85-111
- International Monetary Fund, 2017, Chapter 3, “External Adjustment to Terms-of-Trade Shifts,” In Regional Economic Outlook, Western Hemisphere, Washington DC, April.
- Eguren Martin, Fernando, 2016, “Exchange Rate Regimes and Current Account Adjustment: An Empirical Investigation," Journal of International Money and Finance, Elsevier, vol. 65(C), pages 69-93.
- Broda, Christian and Cedric Tille, 2003, “Coping with Terms-of-Trade Shocks in Developing Countries,” Current Issues in Economics and Finance, 9 (11) (2003), pp. 1-7 (November).

### Price setting, exchange rate pass-through, and international pricing
- Betts, Caroline, and Michael B. Devereux, 2000, “Exchange Rate Dynamics in a Model of Pricing-to-Market,” Journal of International Economics 50, 215-244.
- Campa, Jose Manuel and Linda S. Goldberg, 2005, “Exchange Rate Pass-Through into Import Prices,” The Review of Economics and Statistics, 87 (4), pp. 679-690.
- Gopinath, Gita, Oleg Itskhoki,, and Roberto Rigobon, 2010, “Currency Choice and Exchange Rate Pass-through,” American Economic Review, 100(1):306–336.
- Gopinath, Gita, 2015, “The International Price System,” In Jackson Hole Symposium, volume 27. Kansas City Federal Reserve.
- Carrière-Swallow, Yan, Gruss, Bertrand, Magud, Nicolas, and Valencia, Fabian, 2016. Monetary policy credibility and exchange rate pass-through. IMF Working Papers 16/240, (Washington D.C.: International Monetary Fund).
- Campa, Jose Manuel and Linda S. Goldberg, 2005, “Exchange Rate Pass-Through into Import Prices,” The Review of Economics and Statistics, 87 (4), pp. 679-690.
- Devereux, Michael and Charles Engel, 2003, “Monetary Policy in the Open Economy Revisited: Price Setting and Exchange Rate Flexibility,” Review of Economic Studies, 70:765–84.
- Devereux, Michael, Philip R. Lane, and Xu. Juanyi, 2006, “Exchange Rates and Monetary Policy in Emerging Market Economies,” Economic Journal, Vol. 116, No. 511, pp. 478–506.
- Carrière-Swallow, Yan, Gruss, Bertrand, Magud, Nicolas, and Valencia, Fabian, 2016. Monetary policy credibility and exchange rate pass-through. IMF Working Papers 16/240, (Washington D.C.: International Monetary Fund).

### Balance sheets, financial constraints, and external exposures
- Céspedes, Luis Felipe, Roberto Chang, and Andres Velasco, 2004, “Balance Sheets and Exchange Rate Policy,” American Economic Review, Vol. 94, No. 4, pp. 1183–1193.
- Gertler, Mark, Simon Gilchrist, and Fabio M. Natalucci, 2007, “External Constraints on Monetary Policy and the Financial Accelerator,” Journal of Money, Credit and Banking, Vol. 39, No. 2-3, pp. 295–330.
- Lane, Philip and Jay Shambaugh, 2010, “Financial Exchange Rates and International Currency Exposures,” American Economic Review, 100 (1) (2010), pp. 518-540
- Towbin, Pascal, and Sebastian Weber. 2013. “Limits of Floating Exchange Rates: The Role of Foreign Currency Debt and Import Structure.” Journal of Development Economics 101: 179–94.
- Magud, Nicolas E., Esteban R. Vesperoni., 2015, "Exchange Rate Flexibility and Credit During Capital Inflow Reversals: Purgatory ... Not Paradise," Journal of International Money and Finance, Elsevier, vol. 55(C), pages 88-110.

### Macroeconomic transmission, VARs, and empirical methods
- Obstfeld, Maurice, and Kenneth Rogoff, 1995, “Exchange Rate Dynamics Redux,” Journal of Political Economy 103, 624-660
- Runkle, David E., 1987, “Vector Autoregressions and Reality,” Staff Report 107, Federal Reserve Bank of Minneapolis.
- Svenson, Lars and Sweder van Wijnbergen,1989, “Excess Capacity, Monopolistic Competition, and International Transmission of Monetary Disturbances,” Economic Journal, 99, 785-805.
- Corsetti, Giancarlo, Luca Dedola, and Sylvian Leduc, 2010, “Chapter 16 - Optimal Monetary Policy in Open Economies?” volume 3 of Handbook of Monetary Economics, pages 861-933. Elsevier.

### Dominant currency, international role of the dollar, and global trade
- Casas, Camila, Federico Díez, Gita Gopinath, Pierre-Olivier Gourinchas, 2017, “Dominant Currency Paradigm,” NBER Working Paper Series, No. 22943 (Cambridge, MA: National Bureau of Economic Research).
- Goldberg, Linda and Cedric Tille, 2009, “Macroeconomic Interdependence and the International Role of the Dollar,” Journal of Monetary Economics, 56(7):990–1003.
- Boz, Emine, Gita Gopinath, and Mikkel Plagborg-Møller, 2017, “Global Trade and the Dollar,” IMF Working Papers, WP/17/239 (Washington D.C.: International Monetary Fund).

*Source: wp18213 - REFERENCES*

---


_Source: https://www.imf.org/-/media/files/publications/wp/2018/wp18213.pdf_