Limits of Floating Exchange Rates: the Role of Foreign Currency Debt and Import Structure
IMF Working Papers, February 1, 2011
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- Limits of Floating Exchange Rates: the Role of Foreign Currency Debt and Import Structure
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Bibliographic details
- Authors: Pascal Towbin, Sebastian Weber
- Published: February 1, 2011
- Series: IMF Working Papers
- DOI: https://doi.org/10.5089/9781455219001.001
Summary
- Traditional argument: flexible exchange rates insulate output better from real external shocks by allowing the exchange rate to adjust and stabilize demand for domestic goods through expenditure switching.
- Countervailing factors identified: high foreign currency debt and low exchange rate pass-through to import prices weaken the insulation benefit of flexible exchange rates.
- This study evaluates the empirical relevance of foreign currency indebtedness and import structure for the transmission of real external shocks.
Methodology
- Empirical approach: Panel VAR for a broad sample of countries.
- Comparative framework: transmission of real external shocks under fixed and flexible exchange rate regimes.
- Heterogeneity: responses are allowed to vary with foreign currency indebtedness and import structure (import share of low pass-through goods).
Key Findings
- Flexible exchange rates do not necessarily insulate output better from external shocks when:
- the country imports mainly low pass-through goods; and
- foreign currency indebtedness is high.
- Flexible exchange rates can amplify the output response to external shocks if foreign indebtedness is high.
Policy implications and interpretation
- Exchange rate regime choice should account for balance-sheet exposures in foreign currency and the import structure of the economy.
- High foreign currency debt and predominance of low pass-through imports limit the protective role of exchange rate flexibility against external shocks.
- Policymakers should consider the interaction between external liabilities and import price pass-through when assessing the benefits of flexible exchange rates for output stabilization.