Obstfeld, Shambaugh & Taylor (2005)

1. The Trilemma in History: Tradeoffs Among Exchange Rates, Monetary Policies, and Capital Mobility Obstfeld, Shambaugh & Taylor (2005)

2. Overview • Hypotheses • Regimes with fixed exchange rates will experience less monetary policy autonomy. • Regimes with restrictions on capital mobility will experience more monetary policy autonomy.

3. Motivation • The exchange rate is the price of one currency in terms of another. • Appreciation: Increase in the value of a currency • Depreciation: Decrease in the value of a currency. • Fixed vs. floating exchange rate regimes • Advanced economies :: floating rates are the norm • Euro area is a notable exception • Developing countries and emerging markets :: fixed exchange rate regimes still common. • This is true despite the potential for exchange rate crises.

4. Motivation • Fixed vs. floating exchange rate regimes

5. Motivation • Two key questions in the fixed versus flexible exchange rate debate: • What are the costs of a fixed exchange rate? • What are the benefits? • Three common policy objectives: • Low exchange rate volatility • International capital mobility • Autonomy to implement stabilization policy.

6. Motivation Trilemma

7. Introduction • Trilemma :: theory tells us it is not possible to achieve all three objectives at once. • Floating exchange rate regime implies policymakers forgo objective #1. • Fixed exchange rate regime means giving up either #2 or #3. • Adjust interest rates to keep the exchange rate fixed, OR • Limit international capital flows, so restricting trade in the foreign exchange market.

8. Economic Model • Uncovered Interest Rate Parity (UIP) Condition • Assumption: capital flows freely across countries • Idea: Expected return on bank deposits must be equal in same currency terms. • Arbitrage: If the returns were different, then investors would flock to the country where the expected return is higher, causing an appreciation in that country’s currency.

9. Economic Model • Implications of UIP • Fixed exchange rate regime (peg): i = i* • The central bank must adjust the interest rate to keep the exchange rate from changing. • Shocks to foreign interest rate are absorbed in the domestic interest rate, implying domestic monetary policy shocks (shifts in MP). • Floating exchange rate regime (nonpeg) • Central bank free to adjust interest rate to stabilize output. • But, this means there is potential for larger changes in the exchange rate.

10. Economic Model • According to UIP, what should we find in the data on different exchange rate regimes? • Fixed exchange rate regime, free capital mobility • Changes in the foreign interest rate (base rate) should lead to one-for-one adjustments in the domestic rate. • Fixed exchange rate regime, no capital mobility • Changes in the foreign interest rate (base rate) have low predictive power for domestic interest rates. • Floating exchange rate regime, stabilization policy • Effects of changes in foreign interest rate are offset by changes in the domestic rate in the opposite direction.

11. Methodology • Variables: • Dependent variable: Domestic interest rate • Explanatory variable: Foreign interest rate (“base rate”) • Variables are measured in changes because for some countries, interest rates may be nonstationary. • Baseline Specification: (1) • Rit = Interest rate in country i at time t • Rbit = Interest rate in country i’s base country at time t

12. Methodology • Test: Fixed exchange rate regime, β = 1 • If β < 1, then central bank uses monetary policy to offset the effects of base-rate shocks on output. • If β > 1, then central bank uses monetary policy to reinforce the effects of base-rate shocks on output.

13. Data • Panel datasets of interest rates • Gold standard era • Sample: 1870-1914, 15 countries plus the United Kingdom • Source: Neal & Weidenmier (2003) • Base rate: U.K. (money market) • Bretton Woods era • Sample: 1959-1970, 21 countries • Source: Average monthly data from International Finance Statistics, Global Financial Data, and FRED. • Base rate: U.S. (federal funds rate)

14. Data • Panel datasets of interest rates • Post-Bretton Woods era • Sample: Average monthly money market rates, 1973-2000 • Source: IFS, Global Financial Data, Datastream, and FRED • Base rate: varies by country (Germany, France, U.K., U.S.)

15. Data • Identification of regime type

16. Data • Identification of regime type • Gold standard • Use both de jure (official) and de facto (in practice) classifications. • De facto test: Commitment to peg in practice (2% band for at least one year). • 13 peg episodes, 7 nonpeg episodes • Assume capital mobility.

17. Data • Identification of regime type • Bretton Woods • Nearly entire sample pegged according to de jure and de facto classifications. • 20 peg episodes, 1 nonpeg episode • Cannot use this era to study within-era regime switches. • Assume no capital mobility.

18. Data • Identification of regime type • Post-Bretton Woods • Shambaugh (2004) and de facto test applied to gold standard coding. • Robustness of results checked using a variety of methods: • de facto classifications from the IMF and Taylor (2002), • official de jure classifications, and • Reinhart and Rogoff (2004) classifications. • 70 pegs, 25 occassional pegs, 32 nonpegs. • IMF coding for capital control status.

19. Estimation :: Peg versus Nonpeg • Pegs versus nonpegs • Estimate (1) for each group of countries in each era. • Hypothesis: β= 1 for pegs, β < 1 for nonpegs. • Pooled estimation (2) with interaction term. • Hypothesis: β2 > 0

20. Results :: Pegs vs. Nonpegs

21. Results :: Pegs vs. Nonpegs • Nonpegs have lower βand lower R2, all eras. • i not as closely linked to i*. • Changes in the base rate have little predictive power for changes in the domestic rate. • Having a floating exchange rate allows the country to pursue autonomous monetary policy.

22. Results :: Pegs vs. Nonpegs • Bretton Woods: β < 0 and low R2. • Imposition of capital controls appears to have prevented one-for-one adjustments in the domestic rate. • Use of capital controls could explain why pegs have a low R2 relative to gold standard and modern eras. • Post-Bretton Woods: high βand low R2. • Nonpeg regimes more responsive to base rate changes compared with the gold standard nonpegs.

23. Results :: Pegs vs. Nonpegs • Pooled estimates • Regime choice affects no only intercept, but slope. • Peg regimes have a larger average change and are more responsive. • Nonpegs in the post-Bretton Woods era are generally more responsive than nonpegs under the gold standard.

24. Estimation :: Post-Bretton Woods • Further disaggregate regime according to capital controls. • Hypotheses: • Pegs: higher βand higher R2 • Capital controls: lower βand lower R2

25. Estimation :: Post-Bretton Woods

26. Estimation :: Post-Bretton Woods • Interaction terms for peg and capital controls • PEG = 1 (if fixed exchange rate regime) • CAP = 1 (if no capital controls) • Hypotheses • β2 > 0 :: pegs more responsive to changes in base rate • β3 > 0 :: countries with capital mobility more responsive to changes in base rate • β4 > 0 :: pegs and capital mobility mean country more responsive to changes in base rate

27. Estimation :: Post-Bretton Woods

28. Conclusion • Countries have historically faced the trilemma, and still do in the post-Bretton Woods era. • Measure of monetary policy autonomy: changes in interest rate relative to base rate. • Countries with pegged exchange rates and capital mobility have larger interest rate changes and are more responsive to changes in the base rate. • Theory predicts one-for-one adjustment for fixed regimes, but estimates are closer to 0.5. • True even for gold standard , widely viewed as a stricter than Bretton Woods or modern-day fixed regimes.

29. Conclusion • Bretton Woods achieve policy autonomy and pegs through imposing capital controls. • System broke down when capital controls relaxed in the 1960s. • In post-Bretton Woods era, countries more responsive to changes in base rate, even for nonpegs (vs. gold standard). • Perhaps countries choose not to implement autonomous policies, even when floating.

30. Possible Extensions • Possible to classify countries differently • Peg, float, and managed float • With the classifications used by Obstfeld, Shambaugh and Taylor (2005) and Shambaugh (2004), countries with managed floats might be counted as regime switches throughout the sample. • What would this tell us? • Countries with managed float should be able to “hedge” the trilemma problem.

31. Possible Extensions • Result that adjustment to base rate is less than one-for one is inconsistent with theory. • Possible omitted variable from the UIP condition? • Perhaps a risk premium, associated with credibility of the peg (currency risk) and probability of sovereign default (default risk).

32. Possible Extensions • Possible bias in samples • Fundamentally different countries across eras. • Gold standard and Bretton Woods samples are dominated by advanced economics. • Modern sample dominated by developing countries. • Implication • If there were a risk premium, this would drive a wedge between the interest rate and the base rate, especially for developing countries, biasing the estimate of b downward in the post-Bretton Woods sample.