Limits of Floating Exchange Rates: The Role of Foreign Currency Debt and Import Structure

52 Pages Posted: 28 Feb 2011

See all articles by Pascal Towbin

Pascal Towbin

Banque de France

Sebastian Weber

International Monetary Fund (IMF)

Date Written: February 2011

Abstract

A traditional argument in favor of flexible exchange rates is that they insulate output better from real shocks, because the exchange rate can adjust and stabilize demand for domestic goods through expenditure switching. This argument is weakened in models with high foreign currency debt and low exchange rate pass-through to import prices. The present study evaluates the empirical relevance of these two factors. We analyze the transmission of real external shocks to the domestic economy under fixed and flexible exchange rate regimes for a broad sample of countries in a Panel VAR and let the responses vary with foreign currency indebtedness and import structure. We find that flexible exchange rates do not insulate output better from external shocks if the country imports mainly low pass-through goods and can even amplify the output response if foreign indebtedness is high.

Keywords: Currency pegs, Economic models, Exchange rate regimes, External debt, External shocks, Flexible exchange rates, Floating exchange rates, Imports

Suggested Citation

Towbin, Pascal and Weber, Sebastian, Limits of Floating Exchange Rates: The Role of Foreign Currency Debt and Import Structure (February 2011). IMF Working Paper No. 11/42, Available at SSRN: https://ssrn.com/abstract=1770368

Pascal Towbin (Contact Author)

Banque de France ( email )

Paris
France

Sebastian Weber

International Monetary Fund (IMF) ( email )

700 19th Street, N.W.
Washington, DC 20431
United States

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