Examining the Effective Factors in Exchange Rate Regimes in Developing Countries

اقتصاد پولی مالی

Article 8, Volume 25, Issue 16, October 2018, Pages 225-250   

Document Type: پژوهشی

DOI: 10.22067/pm.v25i15.50904

Authors

Ali Feghe majidi^* ; zahra zarouni

University of Kurdistan

Abstract

Introduction
The choice of exchange rate regimes has always represented a significant challenge for all countries and has been evolved significantly over the years, because, choosing exchange rate regime can play a crucial role in the current and future situation of economy in any country by affecting many economic variables. Furthermore, an exchange rate regime has an important impact on macroeconomic policies within developing countries. The key advantage of fixed exchange rate is their role in reducing transaction costs. Meanwhile, a major disadvantage relates to the fact that in a world where there are implications regarding wages and prices, the benefits from reduced transaction costs, can diminish the importance of costs by a more volatile output and employment level. A second issue relates to whether the exchange rate regime provides protection against financial shock or financial imbalances and monetary policy independence. Under a fixed exchange rate regime, monetary policy is coordinated, and can provide effective protection against fluctuations in monetary joint bid, but not to variations in specific countries. Under floating exchange rates, fluctuations in specific countries could be offset by an independent monetary policy (Fejzaj, 2014).
Theoretical Framework
Standard theory suggests that the choice between a regime of fixed and floating exchange rate should be guided by the desire to minimize inconsistencies in the level of output and employment. Theories of exchange rate regime choice can be grouped under three broad headings: the OCA theory initiated in the early 1960’s, the political economy theory and the currency crisis (capital account openness) approach. OCA theory suggests that the balance of advantages and disadvantages between fixed and flexible exchange rates varies according to the manner and extent of economic integration between countries. In essence, it relates the choice of an exchange rate regime to some structural characteristics, criteria or properties that are relatively stable over time. The political economy theory of exchange regime choice was developed mainly from the concept of “time inconsistency” first introduced by Kydland and Prescott (1977). This stand of literature emphasizes the role of credibility and political factors in the choice of an exchange rate regime. According to the currency crisis or the capital account openness hypothesis countries are (or should sooner or later be) moving to the corner solutions. They are said to be opting either,, on the one hand, for full flexibility, or, on the other hand, for rigid institutional commitments to fixed exchange rates, in the form of currency boards or full monetary union (Daly, 2007).

Methodology
In order to study the choice of the exchange rate regime, it is necessary to employ the proper classification of exchange rate systems. The vast majority of previous studies have attempted to explain exchange rate regime choice as self-reported by countries in the IMF’s annual report on Exchange Arrangements and Exchange Restriction, in this study such methods are employed, too. From a technical point of view, given that the dependent variable (the exchange rate regime choice) is a qualitative variable that can assume two or more values according to the different theoretical hypothesis, Probit models are used. Our analysis of the potential determinants of exchange regime choice involves many of the explanatory variables that have been suggested by theory and used in previous studies.

Results and Discussion
In this study, we begin by estimating binary probit models dividing the sample into floats and pegs. Before turning to the regression analysis, we examine the correlation matrix for the potential determinants of exchange rate regimes. We begin by using only structural (OCA) variables and macroeconomic variables as regressors, then we introduce in turn political variables. A positive sign of a coefficient means that an increase of the associated variable raises the probability of adopting a flexible exchange rate regime. The results show that OCA factors are effective in choosing exchange rate regimes in tow groups. Also, economy size, inflation rate and financial development increase the probability of choosing a flexible exchange rate regime and economic development, while trade openness and monetary shocks reduce the probability of choosing it. Based on the results, we can say that, economic development in both groups of developing countries have the greatest influence in the choice of fixed exchange rate regime. Moreover, trade in lower middle income countries and monetary shocks in upper middle income countries, have the least influence on the choice of a fixed exchange rate regime.
The results from multinomial probit regressions, are completely in line with our previous findings. Indeed, in the majority of estimations, the coefficient of the variable have the same sign.

Conclusions and Suggestions
This study aims to examine the effective factors of exchange rate regimes in developing countries, upper and lower middle income, during 2014-1990 using the logit and probit models. In general, the prevailing theories in Exchange Rate Regime are the optimal Exchange area OAC, the theory of political economy and Exchange crisis hypothesis which in this research focuses on OCA theory and political economy approach. Our estimations show that the variables suggested by the optimum currency area and political economy approach are adequate and robust predictor of exchange regime choice in the developing countries. In general, the determination of an exchange rate regime somehow represents a difficult choice for developing countries that still face economic issues and are seeking the best solutions to absorb crises negative effects. Thus, macroeconomic analyses would be needed to better face the economic, fiscal and monetary changes.

Keywords

Exchange Rate Regimes; developing countries; OAC theory; Logit

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