Essays on Exchange Rate Regime Choice for Emerging Market Countries

This thesis includes two essays which attempt to investigate what type of exchange rate regime is more desirable in welfare terms when there are balance sheet constraints in emerging market countries (EMCs). This is accomplished through a rigorous welfare-based comparison of fixed and flexible exchange rate regimes in the context of different dynamic stochastic general equilibrium small open economy models which incorporate some characteristics designed for the emerging market environment: balance sheet effects, foreign currency debt, and vulnerabilities to external shocks. More specifically, this thesis investigates whether and how (i) the level of foreign currency debt and (ii) the degree of exchange rate volatility affect balance sheets and welfare under different exchange rate regimes.

Chapter 2 investigates the effects of debt levels on balance sheets and welfare. This chapter evaluates the welfare properties of exchange rate regimes by employing the model of Devereux et al. (2006). In contrast to the ‘Fear of Floating’ view highlighted by Calvo and Reinhart (2002), our results show that the float welfare-dominates the peg for a broad range of debt levels. In addition, as the level of foreign currency debt rises, the welfare difference between the two regimes becomes wider – the float becomes more desirable. Moreover, the results hold irrespective of the degree of exchange rate pass-through.

In Chapter 3, we extend the model of the previous chapter to investigate how the degree of exchange rate volatility affects the choice of exchange rate regime. The main feature of the extended model is to introduce an exogenous shock to the UIP (uncovered interest parity) condition under flexible exchange rates, which allows the model to generate more realistic exchange rate volatility. 　Using the extended model, we compare the peg with several types of floats in terms of welfare. The main findings are: (a) the peg welfare-dominates strict CPI-inflation targeting under plausible calibrations of exchange rate volatility and the welfare difference between the two regimes becomes larger as exchange rate volatility increases - the peg becomes more desirable; (b) the peg is welfare-superior to strict domestic-inflation targeting when exchange rate volatility is high. The results are basically consistent with the 'Fear of Floating’ view.