the determinants of exchange rate flexibility: an empirical investigation

The Determinants of Exchange Rate Flexibility: An Empirical InvestigationAuthor(s): Paul Holden, Merle Holden and Esther C. SussSource: The Review of Economics and Statistics, Vol. 61, No. 3 (Aug., 1979), pp. 327-333Published by: The MIT PressStable URL: http://www.jstor.org/stable/1926061 .

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The Review of Economics and Statistics VOL. LXI AUGUST 1979 NUMBER 3

THE DETERMINANTS OF EXCHANGE RATE FLEXIBILITY: AN EMPIRICAL INVESTIGATION

Paul Holden, Merle Holden, and Esther C. Suss*

I. Introduction

T HE variety of exchange rate policies adopted by various countries since the

breakdown of the Bretton Woods Arrangements has intensified interest in identifying the relevant determinants of exchange rate policy. The theory of optimum currency areas is one potentially fruitful approach to the examination of the question. "The theory of optimum currency areas provides theoretical insights that . . . force researchers to attack the issues not in the abstract all-or-none terms of much of the debate over fixed ver?us floating rates, but rather in terms of the search for the major factors that influence the relative de'sirability of alternative exchange rate systems" (Tower and Willett, 1976, p. 84). It is only recently, however, that any attempt has been made to test empirically optimum currency area propositions. Holden (1976), Holden and Holden (1976), Heller (1977, 1978), and Dreyer (1976) all use the International Monetary Fund's (IMF) classification of the exchange rate policies of member countriesl to analyze actual exchange rate practices.2 However, the relationship be-

tween actual exchange rate policies and the IMF taxonomy is at best tenuous.3 It is, therefore, clear that before further progress can be made in identifying empirically the determinants of exchange rate behavior, a more analytically mean- ingful method of describing exchange rate policy must be developed. In this paper we suggest such a measure and use it to ascertain whether variables that optimum currency area considerations suggest should be of importance have actually influenced the choice of exchange rate policy.

II. An Exchange Rate Flexibility Index

In order to measure the flexibility of exchange rate policy we need to ascertain the extent to which exchange market intervention arrangements are being used to offset market forces. Thus, possible measures might be either the change in the exchange rate, or the amount of intervention that occurs. However, neither would by itself provide an accurate depiction of exchange rate policy. The amount of intervention is only relevant when it is examined relative to the pressure on the exchange rate. Similarly, ex-

Received for publication November 28, 1977. Revision ac- cepted for publication April 24, 1978.

* International Monetary Fund, George Mason University, and International Monetary Fund, respectively.

The views expressed in this paper do not necessarily reflect those of the International Monetary Fund. We would like to thank Dragica Pilipovic-Chaffey and Patricia Ryan for helpful research and clerical assistance. Comments from the referees are gratefully acknowledged.

I The IMF has classified the exchange rate policies of members into five groups consisting of (a) countries pegged to a single currency; (b) countries pegged to some "basket" of currencies; (c) countries that float jointly; (d) countries that float independently; and (e) countries that change their currencies on the basis of a predetermined formula. Under the Fund classification scheme the independent floaters make up a residual group in which countries whose exchange rate policies are difficult to define are placed.

2 Holden, and Holden and Holden use discriminant analysis, a multivariate technique for testing group differences to ascertain how well variables suggested by optimum currency area theory distinguish between countries in the various ex-

change rate groups of the Fund classification. Heller uses discriminant analysis and optimum currency area variables to assess the "appropriateness" of countries' exchange rate policies in terms of the Fund classification. Dreyer assigns numerical values to each of the Fund exchange rate catego- ries and uses probit analysi~s on optimum currency area variables to analyze exchange rate policies of developing countries.

3 The 1976 Annual Report of the International Monetary Fund states, "Such classification can be a misleading guide to the actual policy being followed. Currencies that are officially floating are often managed (sometimes at the cost of large changes in reserves) to achieve a result that may be little different from formal pegging. Conversely, with countries that maintain a formal peg, frequent adjustments . . . may be used to obviate policy changes that might otherwise have been necessary to maintain the pegged value" (p. 24). Recent work by Holden and Suss (1977) illustrates some of the deficiencies of the classification scheme in reflecting actual exchange rate policies.

[ 327 ]



328 THE REVIEW OF ECONOMICS AND STATISTICS

change rate changes by themselves give no indication of the efforts by the monetary authorities to defend a particular rate.

An indicator of the flexibility of exchange rate policy should reflect both reserve and exchange rate movements. We therefore measure the index of exchange rate flexibility of country i (Fi) by the ratio of the sum of the absolute value of monthly percentage changes4 in the trade- weighted exchange rate to the sum of the absolute changes in official holdings of foreign ex- change5 expressed in U.S. dollars divided by the sum of imports plus exports. For the ith country:

23 [ E(t-k) -E(t-k)-l ]

= Z L Ek= (t-k)-1

23 IR(t-k) - R(t-k)-11

E, 11 [ I (X(t-k)-J + I(t-k)-j)

Lj=O

where

Et an index of the trade-weighted exchange rate of country i at time t,

Rt U.S. dollar value of country i's holdings of foreign exchange at time t,

Xt U.S. dollar value of exports of country i in month t, and

It= U.S. dollar value of imports of country i in month t.

A 24-month sum is used to calculate F to eliminate the effects of short-run fluctuations in either reserves or exchange rates that do not accurately reflect longer run exchange rate policy. We use monthly data because the month is the shortest interval over which both reserve and exchange rate data are available for large num- bers of countries. Because the price at which gold stocks should be valued is unclear, and because they are effectively illiquid, they have been netted from reserves. Our index is dimensionless because reserve changes are expressed as a ratio with trade as the denominator6 to eliminate a possible bias arising from variations in the size of

countries' external sectors. F' assumes values ranging from infinity to zero, with the limits being defined by a completely intervention-free exchange rate policy at the one end and a perfectly pegged policy at the other.

The rationale for using this ratio as an indicator of exchange rate policy is that if IARI is high in relation to JAEI (and therefore P is comparatively small) the monetary authorities are intervening relatively heavily to offset market forces. Clearly, P has significance only in a comparative sense.

Several factors could prevent the flexibility index from reflecting actual exchange rate policy.7 Reserve data could be distorted by valuation changes8 and official borrowing, and no al- lowance is made for intervention by other countries which may negate the need for exchange market action by the authorities of the country under consideration. Also, there may not be a linear relationship between changes in exchange rates and reserves at all points along the ratio scale-proportionately more intervention may be necessary when the size of the exchange rate disequilibrium is large than when it is small.

Flexibility scores, calculated for 76 countries9 for the 24 months to December 1975, range in value from greater than unity for the United States to 0.01 for some small developing economies (and Italy), which is broadly in accord with a priori impressionistic expectations regarding exchange rate policies. The flexibility scores are used as the dependent variable in the model that is developed in the next section.

III. The Choice of an Exchange Rate Regime

This section identifies the variables that might make one exchange rate policy preferable to an- other for a specific country. These are taken from the optimum currency area literature, and we suggest, in addition, a variable that could be of

4 Percentage changes in end-of-month values. - Including the reserve position in the IMF and Special Drawing Rights (SDR) holdings.

6 It should be noted that in the denominator reserve changes in month t - k are divided by exports plus imports in the year ending in month t - k, and summed over 24 months.

7See Holden and Suss (1977) for a more complete discussion of the flexibility index. Although the measure used in this paper is slightly modified, the discussion applies to both forms of the flexibility index.

8 Although the denominator of the index is expressed in terms of U.S. dollars, the direct bias resulting from fluctuations in the U.S. dollar rate is reduced because both reserves and trade data are expressed in U.S. dollars. However, some valuation bias is inevitable, whatever numeraire is used.

9 The countries analyzed were chosen on the basis of data availability. The countries included in the sample are listed in the appendix.



EXCHANGE RATE FLEXIBILITY 329

importance, but which appears to have been overlooked hitherto. Only brief mention is made of some of the broader issues regarding the effect of the variables on the choice of exchange rate policy. An extensive discussion of the criteria relevant to judging the relative desirability of alternative exchange rate systems can be found in Tower and Willett (1976). The precise definition of the variables and the data sources appear in the appendix.

A. The Openness of the Economy (OI)

As openness increases, exchange rate illusion will decline, and if an inflation-unemployment trade-off exists it will be increasingly between domestic unemployment and the rate of change of prices expressed in foreign currency.

Also, as openness increases, for a given size and degree of diversification of the economy, it has been shown that the greater must be the change in the exchange rate to produce the changes in the balance of trade that are likely to be desired (Tower and Willett, 1976, p. 40). It would therefore appear that exchange rate flexibility should depend negatively on openness. We measure openness (OI) by the ratio of imports plus exports to gross domestic product.

B. Capital Mobility (CM)

It is more difficult to draw clear-cut conclu- sions for openness of capital markets. It has been pointed out (by Mundell (1960), for example) that if capital were highly mobile under flexible exchange rates, the trade account would have to adjust to capital flows, causing domestic re- source allocation costs. On the other hand, high capital mobility under fixed rates reduces or eliminates domestic monetary independence. Furthermore, in some cases it can be shown that capital mobility enhances macroeconomic stabil- ity under flexible rates. "In summary, it is difficult to derive broad generalizations about the effects of the degree of capital mobility on the desirability of fixed versus floating exchange rates" (Tower and Willett (1976), p. 31).

Openness of the capital account (CM), is measured by the average of the ratio of annual gross private capital flows to gross domestic product. 10

C. The Diversification of the External Sector (PC)

For a given degree of economic openness, the more diversified the external sector, the more external disturbances are likely to cancel out. Thus, a policy of non-intervention in the foreign exchange market will result in a relatively low variance of exchange rate movements. On the other hand, countries with highly undiversified external sectors tend to experience sharp fluctuations in foreign exchange earnings that would result in large and potentially disruptive exchange rate changes if not financed. Product diversification should therefore be positively related to exchange rate flexibility.11

It was decided to use the indirect measure of the degree of diversification of the economy suggested by Adelman and Morris (1967), which indicates the degree to which exports are concen- trated in a single closely related group of prod- ucts. The product concentration of exports (PC) is measured by the percentage of total exports accounted for by the largest export in terms of the two digit Standard International Trade Classification (SITC).

D. Geographical Concentration of Trade (GC)

A further measure of diversification is included, namely, the geographical concentration of trade. If a large proportion of a small country's trade is -with one large trading partner, this should provide an incentive for the smaller country to peg its currency to that of the larger country.

In examining the data, it is apparent that the geographical distribution of many countries' sources of imports is wider than the geographical distribution of their export markets. There are many developing countries that maintain special trading arrangements with individual developed

10 Ideally, CM should be measured by the ratio of gross international capital flows to internal financial flows. Since

this is not available, GDP is used as a proxy although, as Goldsmith (1966) has indicated, this may produce a down- ward bias in capital market openness for developing countries and an upward bias for developed countries. We would like to thank one of the referees for pointing this out.

II Kenen (1969) has suggested that countries that are relatively diversified make the best candidates for currency area membership, i.e., for pegging their exchange rates. However, Tower and Willett (sections 5.1 and 5.6) point out that this conclusion depends on how external and internal disturbances are correlated and that Kenen's proposition relates to openness rather than diversification.




countries. In some cases, the special treatment has been widened, as with the relationship of the former French West African colonies and the EEC. The measure of geographical concentration (GC) used is the percentage of total exports accounted for by exports to the largest market.

E. Degree of Economic Development (PCGDP)

We would generally expect that the lower the level of economic development, the less developed and efficient would be both the goods market and the factor markets. Domestic substitutes for imported goods are not available so that import demand elasticities are low. In addition, there is little potential for shifting the supply of traded goods between domestic and foreign markets. There thus would appear, ceteris paribus, to be reasons why the desirable degree of exchange rate flexibility might vary directly with the degree of economic development. 12 Per capita gross domestic product (PCGDP) is used as a measure of economic development.

F. Divergence between Rates ofInflation (ID)

Because payments imbalances are usually the result of divergent trends in national inflation rates, both Fleming (1962) and Haberler (1970) have suggested that similarity in the rates of inflation is at least as important as any other factor in determining whether countries should form a currency area (i.e., permanently fix their exchange rates). The divergences are, in turn, due to differences in trade union aggressiveness, productivity trends, and national monetary policies. This notion that countries that have inflation rates that differ to any significant extent from those of their trading partners need to adjust their exchange rates more frequently has strong intuitive appeal.13

To measure the divergence between rates of inflation we use a trade-weighted inflation differential, so that for country i the inflation differential (ID) is

n

IDi= APi - L aijAPj, jti, j=l

where APi is the inflation rate of country i; APj is the inflation rate in country j; and aij is the proportion of country i's total trade that occurs with country j. We would expect that the greater the difference between country i's inflation rate and that of its trading partners, the more flexible will be its exchange rate policy.

IV. The Model: Estimation and Results

The model that we estimate has the following form:

P = f(OI, CM, PC, GC, PCGDP, ID).

The expected signs of the coefficients are

fOI, fPC, fGC < 0

fPCGDP, fID > 0

fc 0.

We estimate the equation in linear form using ordinary least squares on the cross-sectional data for 75 countries.'4 The results are shown in table 1; overall they are encouraging. The explanatory power of the equation as measured by the R2 statistic indicates that some 42% of the inter- country variance of the flexibility index is explained by the variables included in the regression. The level of significance of the equation as measured by the F-statistic exceeds 99o.

The signs of the estimated parameters on all the variables are in accordance with a priori expectations. Four variables, openness (OI), diversification (PC), degree of development (PCGDP), and the inflation differential (ID) are statistically significant at the 95% confidence level. The capital account openness variable,

12 This variable appears to have been overlooked in the optimum currency area literature. The possible importance of the degree of economic development on the choice of exchange rate policy was first pointed out in Holden (1976) and was used as a discriminant analysis variable by Holden and Holden (1976).

13 It is possible that the direction of causation could run in the opposite direction; adopting a flexible exchange rate policy provides policymakers with the option of continuously inflating the domestic currency. However, such a "taste" for inflation implies a "taste" for exchange rate flexibility; monetary policy and exchange rate policy are not independent instruments.

14 The sample size was determined by using the maximum number of countries for which the necessary data were available. However, the United States was omitted on the grounds that it is essentially the "residual country" in that its exchange rate over the period studied was determined by the exchange rate policies of the other major industrial countries.

Potentially, multicollinearity between the variables could be a problem. While low single correlation coefficients are not necessarily an indication of absence of multicollinearity in a multivariate regression, it is worth noting that the largest correlation coefficient is 0.37.



EXCHANGE RATE FLEXIBILITY 331

TABLE 1.-REGRESSION RESULTS

Standard Beta Variable Coefficient Error t-statistic Coefficient

Constant .19306 .0412 4.686 OI (openness) -.03616 .0171 2.109 .1978 PC (product concentration) - .00134 .5880(-3) 2.278 .2363 ID (inflation differential) .96875(-3) .2529(-3) 3.830 .3676 PCGDP (economic development) .48189(-4) .1346(-4) 3.581 .3687 GC (geographical concentration) -.85573(-3) .8007(-3) 1.068 .1029 CM (capital mobility) - .01066 .0279 0.382 .0357

R2 = .4195; SEE = .1030; F(6, 68) = 8.189; F Probability = .9999

though not significant, has a negative sign, tenta- tively implying that policymakers have at- tempted to offset the effect of capital movements on the trade account.

The beta coefficients (the coefficients obtained on standardized variables) can be, used to ascertain the relative importance of each explanatory variable on the degree of exchange rate flexibility. These coefficients show that the development and inflation differential variables contribute the most to the explanation of the variance of F, followed by the product concentration and openness--variables. The geographical concentration of trade and the openness of the capital account do not appear to have contributed heavily to the explanation of exchange rate flexibility.

The high beta coefficient of ID implies that exchange rate policy actions have been in accordance with the view that the 'more a country's inflation rate diverges from the world rate, the more appropriate a flexible exchange rate policy is. The importance of the development variable (PCGDP) indicates that economies with relatively developed goods markets have been more prepared to follow a flexible exchange rate policy. The 01 variable has the lowest relative importance of the statistically significant variables. This is surprising in view of the importance that the optimum currency area literature accords openness in the determination of exchange rate policy. There are a number of possible explana- tions. The variable could be incorrectly measured. The ratio of traded to nontraded goods may be a better measure than the ratio of foreign trade to GDP but data for a large number of countries are unavailable. Alternatively, it is possible that in the optimum currency area debate insufficient consideration has been given to separating precisely the interrelated effects of openness and the magnitude of the elasticities of foreign and domestic excess supplies and de- mands.

This point highlights a potential criticism of the equation that we have estimated, namely, that the possible effect of size on the flexibility of exchange rate. policy has not been allowed for. However, the most obvious, and only available measure, GDP, does not indicate the extent to which a country can influence its terms of trade. For example, Belgium, which in terms of GDP is one of the largest countries in our sample, probably has less influence over its terms of trade than Brazil. Ideally, the size variable should provide an indicator of the monopoly power of the country's exporters or the monopsony power of its importers. Since GDP does not do this and its variance is much higher than that of any, of the variables that we include, omitting size distorts the results less than including it.15

15 We nevertheless estimated the equation including a size (GDP) variable, obtaining the following equation.

F = .17992 - .02929 OI + .28930 (-6) GDP - .00125 PC (4.32) (1.67) (1.57) (2.13)

+ .00099 ID + .03699 (-3) PCGDP - .00071 GC (3.94) (3.58) (.89)

- .01053 CM (.38)

*2 = .4403; SEE = .1022 F (7, 67) = 7.53; F Probability = .9999.

The explanatory power of the equation rises slightly. The size variable is not significant, while OI, PC, ID, and PCGDP variables are significant at the 95% confidence level.

By including the flexibility score of the United States along with the size variable, the following results were obtained.

F = .15901- .023730 Ol + .64981 (-6) GDP (3.92) (1.31) (7.46)

- .00119 PC + .00101 ID + .03141 (-3) PCGDP (1.94) (3.95) (1.92)

-.00054 GC - .00898 CM (.62) (0.4)

*2 = .6979; SEE = .1041 F (7, 68) = 22.71; F Probability = .9999.

In terms of size, the United States is such an extreme observation, as indicated by the large change in the R2 and significance of the other variables, that its inclusion in the




The regression equation was estimated using alternative subsets of the data and the results were found to be robust and not sensitive to omission of observations, contrasting with the discriminant analysis approach of earlier studies of this question. Holden and Holden (1976) re- ported that their analysis was sensitive to inclusion or exclusion of observations. Similarly, using Heller's (1977) data, we found that his con- clusions were not robust across subsets of the data.

From the residuals of the regression equation, those countries which have exchange rate policies that differ substantially from that indicated by the fitted regression line can be identified. Of those which appear to be following a "too flexible" policy, the difference between the predicted and actual values of the flexibility scores is greatest for Costa Rica, Greece, Iceland, Korea, and South Africa. Of those which are following a "too fixed" policy, the percentage deviation between actual and predicted flexibility scores is greatest for Austria, Fiji, Italy, Portugal, and Syria.16 It is interesting to note that, with the exception of Germany and the Netherlands, the residuals of the F scores of the "snake" countries are all relatively large and indicate that the exchange rate policies of these countries are in- sufficiently flexible, which could explain some of the strains on the joint float.

V. Conclusion

In this paper we have developed an indicator of the flexibility of exchange rate policy which provides an analytical rather than an institutional description of the extent to which monetary authorities finance payments imbalances and disturbances rather than allowing the exchange rate to be determined by market forces. We use this index to test whether a number of factors that optimum currency area theory indicates should be of importance in determining exchange rate policy have influenced actual policy choices. While only a first step, the results that we obtain are encouraging. In a cross-sectional analysis, we find that 42% of the variance of the flexibility

measure is explained by the variables that we have included, and the direction of influence of all the variables included is as predicted by the theory. The results provide empirical support for the theoretically founded contention that the optimum currency area approach to the question of exchange rate flexibility can contribute important insights into the formulation of exchange rate policy.

Several avenues for further research are suggested by the results. A better defined measure of economic diversity needs to be developed since the one used in this paper is quite crude.17 If a better measure were obtained it would probably also encompass the development variable. The relatively low significance of the openness variable suggests that a better measure is probably also needed and, possibly, that the effect of openness on exchange rate policy may not be as strong as predicted by the theory.

APPENDIX

Definition of Variables and Data Sources

Unless otherwise indicated the data source is International Monetary Fund (IMF), International Financial Statistics, and the units are millions of U.S. dollars.

The Trade-Weighted Exchange Rate (E): The percentage change in the end of month values of the trade-weighted exchange rate. The weights are calculated from import trade data in 1974. Source: International Monetary Fund, Data Fund.

Foreign Exchange Reserves (R): End of month official holdings of foreign exchange plus SDR holdings and the reserve position in the IMF.

Imports and Exports (I, X): Both are on an f.o.b. basis. Openness (OI): The ratio of imports plus exports to gross

domestic product averaged over 1974 and 1975 using annual data.

Capital Mobility (CM): The ratio of gross private capital flows to gross domestic product. Gross private capital flows are defined as the sum of private capital account debits and credits. The CM ratio is the average of 1974 and 1975 annual data.

Geographical Concentration of Trade (GC): The percentage of total exports accounted for by exports to the largest market calculated on the basis of annual data and averaged over 1974 and 1975. Source: International Monetary Fund, Direction of Trade.

Degree of Economic Development (PCGDP): The average annual per capita gross domestic product over 1974 and 1975.

Inflation Differential (ID): Calculated from average annual percentage increases in consumer prices in 1974 and 1975.

Diversification of the External Sector (PC): The average of the annual percentage of total exports accounted for by the

sample causes the size variable to dominate the effects of the other variables.

16 A table showing the actual and predicted values of F is omitted because of space limitations. It can be obtained from the authors upon request.

17 One possibility would be to construct a Herfindahl concentration index. This index could also be used to obtain an alternative measure of geographical concentration. We would like to thank Sandy Galambos for this suggestion.



EXCHANGE RATE- FLEXIBILITY 333

largest export in terms of the two digit SITC classification in 1974 and 1975. Source: United Nations, Yearbook of Interna- tional Trade Statistics.

Countries in the Sample

Argentina, Austria, Bahrain, Barbados, Belgium, Bolivia, Brazil, Cameroon, Canada, Central African Empire, Chile, Colombia, Costa Rica, Cyprus, Denmark, Dominican Repub- lic, Egypt, El Salvador, Ethiopia, Fiji, Finland, France, Ga- bon, Gambia, Germany, Ghana, Greece, Guatemala, Guyana, Honduras, Iceland, Indonesia, Iraq, Ireland, Iran, Ivory Coast, Israel, Italy, Jamaica, Japan, Jordan, Kenya, Korea, Libya, Madagascar, Malawi, Malaysia, Malta, Mexico, Morocco, Netherlands, Niger, Nigeria, Norway, Pakistan, Paraguay, Philippines, Portugal, Rwanda, Saudi Arabia, Sierra Leone, South Africa, Spain, Sudan, Sweden, Syria, Tanzania, Thailand, Togo, Trinidad, Tunisia, United Kingdom, Venezuela, Yugoslavia, and Zambia.

REFERENCES

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the determinants of exchange rate flexibility: an empirical investigation

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