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Corner Solutions, Crises, and Capital Controls: A Theory and an Empirical Analysis on the Optimal Exchange Rate Regime in Emerging Economies

Aug 2005
Working Paper
04-037
By  Yasuyuki Sawada, Pan Yotopoulos
In a regime of free foreign exchange markets and free capital movements the reserve (hard) currencies are likely to substitute for the local soft currency in agents’ portfolia that include currency as an asset. This argument implies a process of cumulative circular causation with currency substitution leading to devaluation of soft currencies which in turn induces further currency substitution. At the theoretical level, the “fundamentals model” of currency crisis is formally extended by incorporating currency substitution in an inter-temporally optimizing framework. Next the model is implemented empirically by constructing a currency-softness index as a causal proxy of currency substitution and it is tested in an international cross section sample of countries. Two empirical findings emerge. First, there is a negative relationship between the currency-softness index and the degree of nominal-exchange-rate devaluation. Second, there is a systematic negative relationship between the softness of a currency and the level of economic development. Hence, a unipolar corner solution of floating exchange rate would not be sustainable for low-income countries with soft currencies. Rather a unipolar regime with a hard fixed exchange rate or even a middle-ground solution of fixed but adjustable exchange rate becomes optimal as long as the mobility of financial capital is restricted. Moreover, the optimal choice of exchange rate regime should be systematically linked with the level of development.