Division of Economics
A.J.PalumboSchool of Business Administration
DuquesneUniversity
Pittsburgh, Pennsylvania
AN ECONOMIC ANALYSIS OF THE EFFECTS OF EXCHANGE RATE REGIMES ON INTERNATIONAL TRADE
Colleen Gorman
Submitted to the Economics Faculty
in partial fulfillment of the requirements for the degree of
Bachelor of Science in Business Administration
December 2007
Faculty Advisor Signature Page
Mark T. GillisDate
Visiting Instructor of Economics and Quantitative Sciences
Jennifer P. BayleyDate
Assistant Professor of Economics
AN ECONOMIC ANALYSIS OF THE EFFECTS OF EXCHANGE RATE
REGIMES ON INTERNATIONAL TRADE
Colleen Gorman
DuquesneUniversity, 2007
For over a decade, China has fixed the nominal exchange rate between the dollar and the Yuan at a value that is widely believed to be lower than it otherwise would be. The intention of this policy is to give Chinese producers a competitive advantage over producers in other countries, including the United States. The extent to which such an exchange rate regime is actually beneficial for a country, however, is questionable. Consequently, the purpose of this analysis is to examine the relationship between a country’s exchange rate regime choice and several macroeconomic variables, such as exports, imports, and economic growth, over time. Furthermore, each exchange rate regime is represented in the model by its de facto degree of fixedness versus flexibility. Ultimately, this paper applies the outcomes of this model to China in order to estimate what effect the undervaluation of their currency is having on China’s economic outcomes, and what impact a change to a floating exchange rate would have.
In this analysis, I use a panel data econometric model to test the effect of exchange rate regime types on GDP per capita growth, exports as a share of GDP, imports as a share of GDP, and current account as a share of GDP, while taking into account other factors that are theoretically involved in determining this relationship. I find that, ceteris paribus, these exchange rate regimes have significant effects on these macroeconomic variables. Floating exchange rate regimes yield a greater GDP per capita growth, while a fixed exchange rate regime is correlated with higher exports and imports as a share of GDP. Furthermore, no particular exchange rate regime consistently increases or decreases the current account variable.
Table of Contents
Introduction...... 5
Literature Review...... 6
Data...... 12
Model...... 15
Results and Discussion...... 16
Conclusion...... 21
Future Research...... 22
References...... 24
Appendix...... 25
1. Introduction
The purpose of this paper is to analyze the impacts of different exchange rate regimes on trade and economic growth. In finding this impact, this paper examines a number of countries’ exchange rate regime choices and their imports, exports, real GDP, and real GDP per capita. Furthermore, this analysis determines which exchange rate regime produces the highest social welfare, which is represented by the growth of GDP per capita in each country.
This analysis requires four models, each having slight variations in their dependent and explanatory variables. All models include explanatory variables other than the exchange rate regime dummies. These variables are basic sources of economic growth such as technological advancement and the level of capital investment. Also, three of the models will examine the short-term effects of the exchange rate regime and the fourth modelexamines the long-term effects of exchange rate regimes on an economy.
During the final analysis, the primary focus is on China’s trade practices, and also on determining what the impact of their undervalued currency has on the Chinese economy itself, the US economy, and other trading countries’ economies.
2. Literature Review
Many notable researchers, who have created either theoretical or empirical models centered around this topic of exchange rate regime effects on economic growth, find some type of relationship between a flexible exchange rate and an increase in international trade. Even though this is so, there are other variables that need to be in place within an economy, such as strong monetary policies and institutions, especially in the cases of transition economies, and economies that have undervalued or overvalued their currency for a long period of time, in order for a flexible exchange rate to cause increases in international trade overall.
There have been several prominent studies which find a causal link between exchange rate regime choice and economic growth. Perhaps the most well-known of these was performed by a researcher from the University of California, Andrew K. Rose (2000). He found that two countries sharing the same currency trade three times as much as they would if they were using different currencies. Rose uses a panel data set that includes bilateral observations from the years 1970 through 1990 for 186 countries. He concludes that currency unions like the EMU could lead to a massive increase in international trade. His results are so strong, that other countries other than the European Union might find it beneficial to use a common currency, in order to benefit consumers within the currency union and also to take another important step towards increasing global integration.1 His findings support my hypothesis by showing the effects that exchange rate volatility have on trade.
1 Andrew K. Rose, “One Money, One Market: Estimating the Effect of Common Currencies on Trade,” Economic Policy (2000).
The results of Rose’s research suggest the use of undervaluation of currencies and pegging of currencies can decrease trade, and they support using common currencies in order to increase trade between countries. These policies can include maintaining small budget deficits, controlling inflation, and being open to global trade.[1]
Fred Hu (2004) also findsa negative effect associated with using fixed exchange rate regimes on economic growth. His study focused on China in particular, and the need for this country to liberalize their currency and capital control. He concludes that China must go through a gradual process that will ultimately lead them to a more liberalized system overall. First, they must remove the renminbi peg causing them to have a free floating exchange rate. This would cause them to enter a more balanced trading field among their major trading partners. Second, they need to introduce a sound banking reform program, which would stabilize their domestic financial system. Lastly, China should relax their capital control policies. This would assist them in avoiding financial crisis while simultaneously allow them to gain more capital freedom.[2]
Furthermore, the research done by Stilianos Fountas and Kyriaco Aristotelous (2003) closely resembles the purpose of my paper. They investigate the impacts of the different exchange rate regimes throughout the twentieth century on the bilateral exports between the United Kingdom and the United States. They find that fixed exchange rate regimes and managed float exchange rate regimes are equally favorable to trade, but, more importantly, freely floating exchange rate regimes produce more trade than fixed
exchange rate regimes.3
Similarly, a study done by Josef Brada and Jose Mendez (1988) examines the effects of exchange rate regimes on the volume of international trade. They found that bilateral trade flows between countries with floating exchange rates are greater than those in countries with fixed exchange rates. They conclude that “while exchange-rate risk does reduce the volume of trade among countries regardless of the nature of their exchange-rate regime, the greater risk faced by traders in floating exchange-rate countries is more than offset by the trade-reducing effects of restrictive commercial policies imposed by fixed exchange rate countries.” This not only shows the direct economic impact an exchange rate regime can have on economic growth, but more specifically, the underlying problems associated with fixed exchange rate countries that also affect their trade, which is their strict policies outside of their currency regulations.4
Balazs Egert and Amalia Morales-Zumaquero (2005) analyze the impact of exchange rate volatility and changes in the exchange rate regimes on export volume for ten Central and Eastern European transition economies. The first group of countries started their transition with pegged regimes and then moved towards flexibility. The second group of countries experienced no major changes in their exchange rate regimes in the past ten years. Their results indicate that an increase in the exchange rate volatility decreases exports, and this impact has a delay rather than being instantaneous.5
3Stilianos Fountas and Kyriaco Aristotelous, "Does the Exchange Rate Regime Affect Export Volumes? Evidence from Bilateral Exports in the US-UK Trade: 1900-1998," Department of Economics 43, NationalUniversity of Ireland, Galway (2003).
4 Josef Brada and Jose Mendez, “Exchange Rate Risk, Exchange Rate Regime and the Volume of International Trade” Kyklos 41 (1988): 263-80.
5 Balazs Egert and Amalia Morales-Zumaquero, “Exchange Rate Regimes, Foreign Exchange Volatility and Export Performance in Central and Eastern Europe: Just Another Blur Project?” 8 Bofit Discussion Papers (2005).
In another study, Guillermo A. Calvo and Frederic S. Mishkin (2003) take on a different view of exchange rate regimes. They argue that macroeconomic success in emerging market countries can be produced primarily through good fiscal, financial, and monetary institutions, and they believe that less emphasis should be placed on the flexibility of an exchange rate regime. They find that when choosing an exchange rate regime, not all countries are able to conform to one type. This is due to each countries particular needs and their economy, institutions, and political culture.6
John Williamson (1999) analyzes different exchange rate regimes that are being used within certain countries, specifically Asian countries. He proposes that if a country feels it is necessary to peg their currency, they should “adopt a sufficiently sophisticated management regime to allow adaptation to the pressures of capital mobility.”7 It is with this suggestion, that Williamson is in agreement with Fred Hu’s research, which is concentrated on relaxing capital controls in Asian countries that continue to peg their currency.
Another analysis, done by Mustapha Kamel Nabli and Marie-Ange Véganzonès-Varoudakis (2002), looks at the Middle East and North African (MENA) countries that were characterized by having an overvaluation of their currencies throughout the 1970s and the 1980s. They were able to compute this overvaluation through the use of an “indicator of misalignment.” A panel of 53 countries were used, and ten of these were MENA countries. Their research shows that manufactured exports were significantly
6Guillermo A. Calvo and Frederic S. Mishkin, “The Mirage of Exchange Rate Regimes for Emerging Market Countries” NBER Working Papers (June 2003).
7 John Williamson, “Future Exchange Rate Regimes for Developing East Asia: Exploring the Policy Options” Peterson Institute for International Economics (1999).
affected by the overvaluation of their currencies. In the 1990s, when overvaluation was decreased within the MENA countries overall, there was also “a continuous rise in the diversification of their manufactured exports.”8
Zdenek Drabek and Josef Brada (1998) argue that the flexible exchange rate regime is applicable and appropriate for six countries with transition economies. Within each of these economies, inappropriate exchange rate policies have led to an increase in protectionism by these governments. Because of these policies, the nominal exchange rate is not an indicator of comparative advantage, rather the true indicator is the level of the real effective exchange rate. Drabek and Brada conclude that these transition economies will have to eventually switch to a more flexible exchange rate in order to send more accurate signals to both foreign and domestic investors about the comparative advantages of their country.9
Jeffrey D. Sachs (1996)analyzes countries in Eastern Europe that are adapting to a fairly new, open, market-based international trade. These countries have had no prior experience with currency convertibility. Sachs suggests that during the beginning of these economies’ transitions, a pegged exchange rate regime is appropriate for one or two years during liberalization and stabilization of the economy. After this, the country should take on a more flexible regime. He argues that after initial transition years, the flexible exchange rate will reap economic benefits, such as an increase in exports, if the
“price stability is underpinned by strengthened domestic monetary targets and
8 Mustapha Kamel Nabliand Marie-Ange Véganzonès-Varoudakis, “Exchange Rate Regime and Competitiveness of Manufactured Exports: The Case of MENA Countries”World Bank (2002).
9 Zdenek Drabek and Josef Brada, “Exchange Rate Regimes and the Stability of Trade Policy in Transition Economies” WTO Economic Research and Analysis Division Working Paper (July 1998).
institutions.”10 This implies that a transition economy can be successful during liberalization by not only implementing a more flexible exchange rate, but also backing this regime with strong monetary policies and institutions.
In estimating a model to determine the effects of exchange rate regime choices on an economy, I build on the previously cited literature. Most literature focuses on economies in transition from a fixed to a more flexible exchange rate. While taking this into account in my model, I examine an array of countries with different levels of exchange rate fixedness and flexibility and growth patterns over the past 25 years in order to analyze effects of each exchange rate regime. The results of this analysis ultimately shed light on the current situation in China, where, for over the last ten years, the Chinese government has fixed the nominal exchange rate between their currency, the Yuan, and the Dollar at an undervalued amount. This policy is intended to give Chinese producers a competitive export advantage over producers in trading countries. What remains questionable, however, is how beneficial an exchange rate regime like theirs is for an economy and to what extent this type of regime can affect a country’s exports and imports. This analysis not only finds the general economic effects of an exchange rate regime, but more specifically, it applies the outcomes generated by a series of models to China. This is done in order to estimate the effect that the undervaluation of their currency is having on China’s economic outcomes and the impact that a change from a fixed exchange rate to a floating exchange rate would have on these economic outcomes.
10 Jeffrey D. Sachs“Economic Transition and the Exchange-Rate Regime” The American Economic Review (1996).
3. Methodology
3.1 Data Description
The analysis utilizes a panel dataset, which covers 172 countries ranging from low to high development.11 I restrict the range of this study to the period from 1980 through 2004. With 172 cross sections, there is a potential 4,300 observations over this time span. I collect the data in annual format from several sources. Most of the data come from the International Monetary Fund (IMF)12 and a de-facto classification of exchange rate regimes compiled by Eduardo Levy-Yeyati and Federico Sturzenegger.13 Each exchange rate regime is represented in my model by its de facto degree of fixedness versus flexibility. This is a five-way classification including inconclusive, float, dirty float, crawling peg, and fixed exchange rates, with a respective scale ranging from one, equating to inconclusive, to five, equating to fixed. It is important to use de facto exchange rate regimes as opposed to de jure because, for the purposes of this analysis, the de facto regimes provide for more practical data. This is due to the possibility of significant differences between the regime a country’s government announces they use and what a country is really using in practice with regards to their exchange rate control. Levy-Yeyati and Sturzenegger’s database of exchange rate classifications was compiled through analyzing changes in the nominal exchange rate, the volatility of these changes, and the volatility of international reserves. The application of these de facto classifications to my model allows this paper to differentiate itself from previous empirical research. Most of this past research on exchange rate regimes has used the
11See Appendix A for a list of included countries.
12Available at
13 Levy-Yeyati, Eduardo and Sturzenegger, Federico, “Classifying Exchange Rate Regimes: Deeds vs. Words,” European Economic Review, Vol. 49, Issue 6: Pages 1603-1635 (2005).
International Monetary Fund’s de jure classification system.
Furthermore, for the countries used in this analysis, yearly data on macroeconomic variables such as exports, imports, GDP, and GDP per capita growth are used. Table 1 below lists the variables included in this study and the source from which they are obtained:
Table 1: Data Sources
Variable / Unit / SourceCurrent Account / Share of GDP / IMF
Real Gross Domestic Product per Capita / Growth Rate / IMF
Exports / Share of GDP / IMF
Imports / Share of GDP / IMF
Inflation / Percentage rate of change in CPI / IMF
Real Exchange Rate / Currency in terms of US Dollars / IMF
Population / Growth Rate / IMF
Real Money Market Rate / Percentage / IMF
Government Deficit or Surplus / Share of GDP / IMF
Landlocked Dummy / 1 = Yes,
0 = Otherwise / IMF
Population Density / Millions per Square Kilometer / CIA World Factbook13
Country Size / Square Kilometers / CIA World Factbook
North America Dummy / 1 = Yes,
0 = Otherwise / CIA World Factbook
South America Dummy / 1 = Yes,
0 = Otherwise / CIA World Factbook
Asia Dummy / 1 = Yes,
0 = Otherwise / CIA World Factbook
Europe Dummy / 1 = Yes,
0 = Otherwise / CIA World Factbook
Africa Dummy / 1 = Yes,
0 = Otherwise / CIA World Factbook
Oceania Dummy / 1 = Yes,
0 = Otherwise / CIA World Factbook
OECD Dummy / 1 = Yes,
0 = Otherwise / Organization for Economic Cooperation and Development14
OPEC Dummy / 1 = Yes,
0 = Otherwise / Organization for Petroleum Exporting Countries15
Inconclusive Exchange Rate Classification / 1 = Yes,
0 = Otherwise / Levy-Yeyatiand Sturzenegger’s Exchange Rate Regime Classification System
Float Exchange Rate Classification / 1 = Yes,
0 = Otherwise / Levy-Yeyatiand Sturzenegger’s Exchange Rate Regime Classification System
Dirty Float Exchange Rate Classification / 1 = Yes,
0 = Otherwise / Levy-Yeyatiand Sturzenegger’s Exchange Rate Regime Classification System
Crawling Peg Exchange Rate Classification / 1 = Yes,
0 = Otherwise / Levy-Yeyatiand Sturzenegger’s Exchange Rate Regime Classification System
Fixed Exchange Rate Classification / 1 = Yes,
0 = Otherwise / Levy-Yeyatiand Sturzenegger’s Exchange Rate Regime Classification System
Country Dummies for all 172 Countries / 1 = Yes,
0 = Otherwise / -
Year Dummies for all
25 Years / 1 = Yes,
0 = Otherwise / -
The OECD and OPEC dummy variables are used in the analysis in order to view more specific effects that an exchange rate regime has on a particular group of countries. Similarly, the continent and landlocked dummies serve the purpose of illustrating and explaining effects on the macroeconomic variables within each model. The landlocked dummy indicates whether or not a country is completely surrounded on all borders by other countries, with no major access to water. Furthermore, the purpose of the 172 country dummy variables and the 25 year dummy variables is to allow the models in this analysis to employ three types of effects: random effects, which include no control for country or year, fixed effects for countries and fixed effects for years, which are used to capture systematic differences among the panel observations results for both country and year.