Optimal Fear of Floating: The Role of Currency Mismatches and Fiscal Constraints

Evidence suggests that developing countries are more concerned with stabilizing the nominal exchange rate than developed countries. Some papers show not only that nominal exchange rates are less volatile, but also that international reserves and domestic interest rates are significantly more volatile. This paper presents a model with flexible prices that introduces a new channel through which the fear of floating is generated. It departs from the previous research in an important dimension; fears will come from nominal, as supposed to real, exchange rate volatility. Also, the model is able to explain the whole range of observed policies. The trade-off proposed in the paper is driven by two facts that proved to be crucial in recent financial crises: emerging market countries face fiscal restrictions during turbulent times, and they tend to have a mismatch in the currency denomination of their assets and their liabilities. These features make both interventions and depreciations costly. Thus, faced with these costs policymakers have to choose the optimal policy mix, such that the costs are minimized. Based on these intervention and depreciation costs, the model is able to rationalize as the outcome of an optimal policy decision, the observation that emerging markets end up with higher inflation rates and lower fluctuations in the nominal exchange rate. The results suggest that the amount of intervention depends on the degree of currency mismatch, the degree of flexibility on the fiscal side, the elasticity of money demand, and the relative size of the financial system. Estimations of a stylized econometric model support the effect of these variables on the variability of the exchange rate. Variability is negative correlated with the mismatch, the fiscal and the size variables; and positive correlated with elasticity, being in all these cases highly significant across most specifications.exchange rates, floating, currency mismatch, optimal policy

The impact of policy announcements and news on capital markets : crisis management in Argentina during the Tequila Effect

Argentina was hit hard by the Mexican crisis of 1994-95. The Argentine peso came under attack and there was a run on bank deposits. Argentina'successfully announced a series of policies to mitigate the spillover effects, without abandoning its currency board. The authors show how capital markets reacted to each policy announcement and piece of breaking news. They find that Argentina's agreement with the International Monetary Fund, the dollarization of reserve deposits in the central bank, and the reduction in reserve requirements, among other things, had a strong positive impact on market returns. The market welcomed announcements that reflected the adoption of credible policies and demonstrated a firm commitment to the currency board. The authors also find that, after a period of higher volatility, the appointment of a new finance minister (after Domingo Cavallo left the finance ministry) calmed down stock and bond markets, significantly decreasing the variance in stock and bond market returns. On the other hand, the interest rate became more volatile after the appointment of the new finance minister and when reserve requirements were lowered.Economic Theory&Research,Banks&Banking Reform,Financial Intermediation,Environmental Economics&Policies,Financial Economics