Explaining the Duration of Exchange-Rate Pegs

Abstract

This paper is a theoretical and empirical investigation into the duration of exchange-rate pegs. The theoretical model considers a policy-maker who must trade off the economic costs of real exchange-rate misalignment against the political cost of realignment. The optimal time to spend on a peg is derived and factors that influence peg duration are identified. The predictions of the model are tested using logit analysis with a data set of exchange-rate pegs for sixteen Latin American counu-ics and Jamaica during the 1957-199 1 period. We find that the real exchange rate is a significant detemiinant of the likelihood of a devaluation. Structural variables, such as the openness of the economy and its geographical trade concenhation, also significantly affect the likelihood of a devaluation. Finally, political events that change the political cost of realignment, such as regular and inegular executive transfers, are empirically important detemiinants of the likelihood of a devaluation.

Pegs, Risk Management, and Financial Crises

“…After the election the probability of devaluation increases by 4 percent. Klein and Marion (1997) also show, for a different sample of 17 Latin American countries, that a peg is more likely to be abandoned right after a change in the executive.…”

The Monetary Model Strikes Back: Evidence From the World

“…Obstfeld and Rogoff (1995) point out that aside from a few minor tourist economies, oil sheikdoms, and heavily dependent principalities, only a very small number of fixed exchange rates survive intact for several years. Klein and Marion (1997) showed that the average duration of pegs in the Western Hemisphere countries was only 10 months. Second, the extant literature on industrial country exchange rates have often ignored the long stretches of links to the Deutche mark in studying the "floating period."…”

The Duration of Fixed Exchange Rate Regimes

“…We argue that the time spent within a given regime is likely to determine the probability that a regime will end. Klein and Marion (1997) and Duttagupta and Otker-Robe (2003) introduce duration as an explanatory variable in a logit specification. The statistical significance of the attached regression coefficient indicates that time matters, and its sign whether it contributes positively or negatively to the probability of an exit.…”