Currency Regime and Monetary Autonomy. Empirical Evidence Using Recent and Global Data from 1990 to 2007

Abstract

This paper analyzes the exchange rate regimes from the perspective of monetary independence. To be specific, using recent and global data, we examine the sensitivity of domestic interest rates to the international interest rate, by conducting co-integration tests and by estimating the adjustment speeds through error-correction model, for different de facto currency regimes and for different types of capital markets. Our estimation results basically support the traditional views of ‘impossible trinity’, as far as the cases with open capital markets are concerned. The floating regime shows the less sensitivity of domestic interest rates to the international interest rate than the fixed regime does, which implies some capacity for domestic monetary autonomy under the floating regime. The cases with closed capital markets, on the other hand, include the cases showing high sensitivity of interest rates in some emerging market economies, which might imply the ‘fear of floating’ hypothesis.

Keywords:

• Exchange rate regime
• monetary autonomy
• co-integration
• error correction model

JEL CLASSIFICATIONS :

• F31
• F33
• C23
• E52

Notes

¹As an example, Hausmann et al. (1999) treated Mexico as a country with freely floating exchange rate arrangement following the IMF classification, but Reinhart and Ilzetzki (2009) classifies it as a country with managed floating.

²If the data in question have unit roots (interest rate data is often proved to have a unit root) and are not co-integrated, regressions on levels may generate incorrect results. Although it is true that differencing the data removes the problem of spurious correlations, a regression on differences alone would lose information regarding the long-run relationship.

³The risk premium may vary over time, especially under a turbulent period such as a financial crisis. Since it is difficult to estimate the risk premium directly, we take the second-best approach, that of excluding all the turbulent periods from the estimation in the later sections, whereas we keep the assumption of the constant risk premium. The turbulent periods were identified by the chronology of Reinhart and Ilzetzki (2009).

⁴As Frankel et al. (2004) suggested, we must notice that it is not only the currency regimes but also the degree of international business cycle synchronization that affects the movement of the interest rate differential; even under full monetary independence, the observed path of the domestic and international interest rates might show co-movement.

⁵The EViews 6 Users’ Guide includes one more test of Hadri (2000). This test is, however, said to over-reject the null of stationarity, and may yield results that directly contradict those obtained using alternative test statistics (see Hlouskova & Wagner, 2006). Therefore, we did not adopt the Hadri test here.

⁶For example, Taylor (2003) criticizes the panel unit root tests with the null hypothesis of joint non-mean reversion.

⁷Caner and Kilian (2001) criticizes the KPSS test by stating that it may too often reject the null of stationarity if the true process is highly persistent.

⁸Although there are other indexes to measure the intensity of capital control, such as Quinn (1997) and Miniane (2004), their coverage is too small in terms of countries and time period to correspond to our entire sample. Chinn and Ito (2007) proved the robust correlations of their index with other indexes.