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CLASSIFYING EXCHANGE RATE REGIMES: DEEDS VS. WORDS

ABSTRACT

Most of the empirical literature on exchange rate regimes uses the IMF de jure classification based on the regime announced by the governments, despite the recognized inconsistencies between reported and actual policies in many cases. To address this problem, we construct a de facto classification based on data on exchange rates and international reserves from all IMF-reporting countries over the period 1974-2000, which we believe provides a meaningful alternative for future empirical work on the topic. The classification sheds new light on several stylized facts previously reported in the literature. In particular, we find that the de facto pegs have remained stable throughout the last decade, although an increasing number of them shy away from an explicit commitment to a fixed regime, a phenomenon we call “fear of pegging.” We confirm the hollowing out hypothesis and show that, as expected, it does not apply to countries with limited access to capital markets. We also find that pure floats are associated with only relatively minor nominal exchange rate volatility and that the recent increase in the number of de jure floats goes hand in hand with an increase in the number of de facto dirty floats (“fear of floating”).

CHAPTER ONE

INTRODUCTION

BACKGROUND OF THE STUDY

Exchange rate regimes play a crucial role in the functioning of global economies. A country's exchange rate regime refers to the system that governs the way in which its currency is valued in relation to other currencies. This system can be either fixed or flexible, and the choice of regime can have significant implications for a country's economic stability and growth.

The International Monetary Fund (IMF) classifies exchange rate regimes into four main categories: exchange arrangements with no separate legal tender, currency boards, fixed exchange rates, and floating exchange rates (IMF, 2019). The classification of exchange rate regimes is crucial because it serves as a guide for policymakers, investors, and academics to assess a country's economic policies and prospects.

However, the classification of exchange rate regimes based on de jure indicators, such as the official policy stance of a country's central bank or government, may not necessarily align with the actual exchange rate behavior of the country. The disparity between the de jure and de facto classification has important implications for the interpretation of exchange rate regimes and the subsequent analysis of their effects on macroeconomic variables.

This paper investigates the relationship between the de jure and de facto exchange rate regime classifications for a sample of 100 emerging market economies. The primary objective is to determine whether a country's declared exchange rate regime aligns with its actual exchange rate behavior. The study uses a multivariate statistical analysis to classify countries' exchange rate regimes based on various indicators, including the exchange rate variability, exchange market pressure, and the degree of exchange rate intervention. The findings of this study provide valuable insights into the accuracy of exchange rate regime classifications and highlight the importance of supplementing the de jure classification with the de facto classification.

Exchange rate regimes has long emphasized the importance of exchange rate stability for economic growth and stability (Mundell, 1961; McKinnon, 1963). However, the optimal exchange rate regime has remained a subject of much debate among

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