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Essays in Exchange Rate Dynamics

  • Author(s): Choi, Jae Hoon
  • Advisor(s): Kletzer, Kenneth
  • et al.
Abstract

This dissertation studies the dynamics of exchange rates and their effect on nominal and real macro variables and furthermore on policy choices.

The dissertation provides a theoretical framework where a policymaker can choose a path of international policy portfolio of capital controls and exchange rate regimes under financial frictions. The paper presents a novel theoretical approach to explain the coexistence of active use of capital controls and volatile exchange rates, which has become a robust feature in emerging market economies. Building upon the small open economy framework, I create an environment where the policymaker can decide the level of exchange rate regimes -- instead of a binary choice of exchange rate regime, fixed or floating -- in response to external shocks, where capital controls are introduced as a tax on international capital flows. I further assume that regime choice is subject to a financial friction; breaking the peg signals the country's economic instability, which raises the country's risk premium. Under this set-up, the floating exchange rate regime does not welfare-dominate the capital controls any longer because loosening/losing the controls over exchange rates may expose households to additional risk premium. The simulation results show that the coexistence of managed float and capital controls becomes optimal. Furthermore, this additional friction has a multiplying effect, which makes exchange rate stabilization become important to prevent a bigger welfare loss. It also captures that optimal capital controls indirectly manage exchange rate depreciation, which allow policymakers to put less resource to stabilize the exchange rates.

Considering the fact that the countries actively intervene in the foreign exchange market, the dissertation re-investigates one of classical puzzles in international economics using a new estimation technique and a modern data categorization methodology. The Purchasing Power Parity puzzle states that even though real exchange rates may converge to parity in the long run, the consensus emerging from an extensive literature appears to be that the rate of mean-reversion is slow, where a half-life mean-reversion is between 3 - 5 years; however, this is much too long to be compatible with arbitrage. This paper first proposes that investigating the periods of de facto floating regime will explain seemingly unrealistic persistence in real exchange rates by presenting lower persistence in real exchange rates than the estimates of previous studies, which include the periods de facto fixed regime in their data set by using de jure regimes. Secondly, previous studies have included the periods when real exchange rates that are within ``the regions of inaction''; because the trend of mean-reversion rates is non-linear, including the periods when real exchange rates are already converged to their means will bias the estimates toward zero, which are translated to the slow mean-reversion in real exchange rate estimates. Therefore, unbiased mean-reversion estimates can be estimated if I investigate the periods when the sample countries are under de facto float regimes and the periods when real exchange rates are statistically far from their means. Studying the data of nineteen goods CPI for eleven countries confirms these propositions. The mean group estimation decreases the half-life by 28.26% (half-life of 23.14 months) compared to fixed-effects estimation. The exchange rates regime dummy decreases the half-life estimate to 19.81 months and the region of inaction dummy decreases the estimates to 15.22 - 20.54 months. Using both dummy variables elicits the results that make the puzzle less puzzling; the half-life estimates are 9.30 - 13.89 months.

The dissertation also explores the exchange rate regime-elastic risk premium quantitatively. This paper takes foreign investor's perspective and studies how the trend of risk premium changes when the regime switches in ten emerging market economies through the event study framework. Using a daily data set, the events of de facto regime switching are identified following the comparable methodology used in Calvo and Reinhart (2002), and EMBI+ is used as a proxy for country risk. The results confirm that switching exchange rate regimes from fixed to floating incurs an abrupt increase in average risk premium. EMBI+ rises by 141.11 - 165.48 basis points (0.257 - 0.525 standard deviations) around the events and shows 205.72 - 340.30 basis points of 40-day average difference before and after the events. The abnormal return estimates during the events range from 0.0036 to 0.0075, which imply 8.31 - 225.85% increase in the returns of EMBI+ during the periods of breaking pegs.

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