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.