Liberalized Markets Have More Stable Exchange Rates: Short-Run Evidence From Four Transition Countries
IMF Working Papers, February 1, 2004
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Bibliographic details
- Authors: Aleš Bulíř
- Published: February 1, 2004
- Series: IMF Working Papers
- DOI: https://doi.org/10.5089/9781451845389.001
Summary
- Hypothesis: Financial market liberalization generates "endogenous liquidity"—stabilizing flows of liquidity in response to deviations of exchange rates from equilibrium—thus supporting exchange rate flexibility and making pegs harder to sustain.
- Sample and approach: Analysis of a sample of four transition economies, comparing exchange rate behavior relative to Hodrick-Prescott-based equilibrium values.
- Core result: Exchange rates tend to return faster to their Hodrick-Prescott-based values in environments where markets are liberalized.
Key Findings
- Liberalized financial markets are associated with faster adjustment of exchange rates to shocks.
- Early and successful foreign exchange liberalization increases market depth and thereby accelerates exchange rate mean reversion.
- The evidence supports the "endogenous liquidity" mechanism whereby market openness produces stabilizing order flow in response to deviations from equilibrium.
Policy Implications and Recommendations
- Central banks in transition economies should not be overly concerned with short-run volatility of national exchange rates because liberalized markets exhibit self-correcting tendencies.
- Pursuing early and successful foreign exchange liberalization can yield payoffs in terms of market depth and exchange rate stability.
Methodology and Technical Notes
- Equilibrium benchmark: Hodrick-Prescott filter-based exchange rate values.
- Emphasis on short-run dynamics and mean reversion of exchange rates.
- The paper examines nonlinearity, order flow, and error-correction mechanisms as relevant concepts in interpreting the results.
Subjects and Keywords
- Subjects: Asset and liability management, Currency markets, Exchange rate arrangements, Exchange rates, Financial markets, Foreign exchange, Liquidity
- Keywords: coefficient of determination, Currency markets, endogenous liquidity, error-correction mechanism, Euro exchange rate return, Europe, exchange rate, Exchange rate arrangements, exchange rate volatility, Exchange rates, Hungarian forint, Liquidity, market, market liquidity, mean reversion, nonlinearity, order flow, U.S. dollar, Western Europe, WP