Exchange rate adjustment after leaving peg arrangement: Parallels with the euro area

Saturday, 6 April 2013: 9:30 AM
Petr Korab, Mgr. , Finance, Mendel University in Brno, Brno, Czech Republic
Svatopluk Kapounek, Ph.D. , Faculty of Business Economics, Research Center, Mendel University–Brno, Brno, Czech Republic
Objective: The objective of the paper is to study the behaviour of nominal exchange rate, inflation rate and short-term interest rate on the sample of countries which shifted their exchange rate regime from a form of fixed regime (peg, crawling peg, moving band, etc.) to floating (managed floating, freely floating).

Background: Several authors (e.g. Frankel (1999), and Frankel (2003)) state a monetary union is a form of fixed exchange rate arrangement. The literature suggests that benefits of fixing the national currency are comparable with Optimum Currency Area properties. The importance of the research is not only from the historical point of view but also has implications for current Eurozone problems.

Current debt crisis revealed several weak points in architecture of European monetary union. Common monetary policy and inability to devalue the currency may have contributed to competitiveness problems of Portugal, Italy, Spain and, mainly, Greece. Though the consequences of exits from monetary unions were paid attention (e.g. Rose, 2007), we are convinced that drawing on historical experience of defixing the national currency from peg arrangement in favour of floating may help predict the behaviour of inflation rate and interest rate  of a country leaving the monetary union.

The paper also provides one of the first empirical attempts to deal with the topic of introduction of a parallel currency in the Eurozone, as we argue that the newly introduced currency should float.

Method and Data: The model is based on the International Fisher effect theory which postulates that currencies with higher interest rates will depreciate because the higher rates reflect higher expected inflation.  Investors therefore hope to capitalize on a higher foreign interest rate and should earn a return equal to what they would have earned domestically.

To test the stationarity we employ Augumented Dickey Fueller test, Johnsen‘s version of Vector Error Correction Model (VECM) by maximum likelihood under various assumptions about the trend or intercept parameters and the number of cointegrating vectors, and then conduct likelihood ratio tests as states Johansen (1988), Johansen (1991) and Johansen (1994). This approach reflects that all variables are possibly endogenous.

Our dataset consists of 10 cases of leaving the peg of 9 countries (Chile, Brasil, Mexico, Germany, Switzerland, Czech Republic, Australia, Indonesia and South Korea) employing monthly observations since the end of Bretton-Woods monetary system. We draw on International Monetary Fund, OECD and central banks’ dataset sources.

Expected results: The results suggest that there was no significant depreciation after the defixing, and with 7 out of 10 cases the nominal exchange rate is exogenous to changes in inflation and interest rate. This may imply that exit from the Eurozone may not cause a significant depreciation of the national currency and that the exit may be, in the context of the support of aggregate demand, less reasonable.