Economic Modeling White Papers

Living with the Fear of Floating: an Optimal Policy Perspective

• Tags:
• economic modeling,
• interest,
• rates,
• rate

Overview As documented in recent studies, developing countries (classified by the IMF as floaters or managed floaters) are extremely reluctant to allow for large nominal exchange rate fluctuations. This "fear of floating" is reflected in the fact that, in spite of being subject to larger shocks, developing countries exhibit lower exchange rate variability and higher reserve variability than developed countries. Moreover, there is a perspective correlation between changes in reserves and the exchange rate and interest rates and a negative correlation between both changes in reserves and the exchange rate and changes in interest rates and reserves. We build a sample model that rationalizes these key features as the outcome of an optimal policy response to monetary shocks. The model incorporates three key frictions: an output cost if nominal exchange rate fluctuations, an output cost if higher interest rates to defend the currency, and a fixed cost of intervention.

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