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Exchange Rate Policy in Small Rich Economies

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We look at the exchange rate policy choices and outcomes for small rich economies. Small rich economies face significant policy challenges due to proportionately greater economic volatility than larger economies. These economies usually choose some form of fixed exchange rate regime, particularly in the very small economies where the per capita cost of independent monetary policy is relatively high. When such countries do choose a free or managed floating regime, they appear to derive no benefit from those regimes; their exchange rate volatility seems to rise without any significant change in fundamental economic volatility. Thus, for these countries, floating exchange rates seem to create problems for policy makers without solving any.

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  1. We end up with a control group of 39 large rich economies ranging in population size from Uruguay (3.46 million) to USA (301 million) and ranging in income from Costa Rica ($11,833) to United Arab Emirates ($51,342).

  2. It would have been interesting to include data on employment volatility, but data problems prevented this.

  3. To do this, we first identified changes in regime by checking for changes in the behavior of exchange rate and reserves data over the extended sample that are large enough to move a country from one cluster to another and then double-checked these changes with changes in de jure regime and the RR classification. If these latter sources both contradicted the initial data assessment, the latter sources were preferred.

  4. We note in passing that other classifications exist as well, e.g., the official IMF classifications and the binary classification scheme of Shambaugh (2004). We choose not to use the former since it is based on declared official de jure policy rather than actual behavior. The latter is problematic since it is based on the official exchange rate.

  5. During this period of time, the official IMF de jure classification has Iceland as fixed, while Shambaugh’s classification has it as “non-pegged.”

  6. Gudmundsson et al. (2000) give a detailed historical account of Iceland‘s exchange rate arrangements. They also analyze the Optimal Currency Area (OCA) criteria for Iceland and, while acknowledging the limitation of the OCA criteria, they conclude that the analysis mainly points towards a flexible exchange rate arrangement for Iceland.

  7. It is worth noting that we tried a number of alternative specifications of these OCA variables including exports as a share of GDP for openness, a Herfindahl index of trading partner concentration for dominant trading partner and GDP growth correlation with world GDP growth for correlation. The results were similar with all these variants.

  8. We obtained more or less identical results for consumption as for output. The results are available from the authors at request.

  9. Using a signal-extraction approach to identify the non-fundamental part of exchange rate fluctuations, Pétursson (2010a) finds that an unusually large share of exchange rate fluctuations in Iceland are not related to economic fundamentals.

  10. Most modern “new open economy” macroeconomic models lead to equations very much like Eqs. 12.

  11. This straightforward intuition is the heart of Mundell’s “Incompatible Trinity” of fixed exchange rates, domestic monetary sovereignty and perfect capital mobility.

  12. Honjo and Hunt (2006) find that Iceland faces unusually unfavorable tradeoff between output and inflation fluctuations compared to many other inflation-targeting small open economies.

  13. Mussa’s “first important regularity” is: “The short term variability of real exchange rates is substantially larger when the nominal exchange rate between these countries is floating rather than fixed.”

  14. Certainly, Stockman (1983) and Aliber (1976) provide consistent earlier evidence. See also other references given by Black.

  15. Devereux and Engel (2002) add local currency pricing and heterogeneous international distribution of commodities to a model of noise traders and show that such a model can generate high exchange rate volatility, that is much larger than the volatility in underlying fundamentals and that this high exchange rate volatility has no implications for other macroeconomic variables.

  16. It is interesting to note that Plato’s logic was that 5,040 is divisible by all numbers 1 through 10. Indeed, 5,040 is a colossally abundant number; its factorization is 22*32*5*7;

  17. Jean Jacques Rousseau in The Government of Poland quoted at

  18. De l’Esprit des Lois Vol I, Book 8, p 131.

  19. There is also a modern strain of political thought which argues that larger countries are inferior; E. F. Schumacher and especially Leopold Kohr (especially in The Breakdown of Nations) are among the more well-known writers.


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Further Information on Data Sources

GDP, Inflation, M1, M2, Population, Exports and Imports: UN Data cross-referenced with World Development Indicators and International Financial Statistics. (though note that small vs. large country comparison based on world development indicators only

Exchange Rates: International Financial Statistics

Trade weights (for EER, REER etc.): Average import shares (1980–2008) from IMF direction of trade data (sometimes supplemented with local sources)

Exchange rate volatility: Standard deviation of monthly exchange rate changes

GDP and Inflation growth and volatility: Annual growth and standard deviation

GDP per capita: 2008 data from CIA world Factbook

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Authors and Affiliations


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Correspondence to Francis Breedon.

Additional information

Rose thanks the Bank of England and INSEAD for hospitality during the course of this work. Breedon is Professor at the School of Economics and Finance, Queen Mary University of London. Pétursson is Chief Economist and Director of the Economics Department at the Central Bank of Iceland. Rose is Rocca Professor of International Business at UC Berkeley, NBER Research Associate and CEPR Research Associate. Any views expressed do not necessarily reflect those of the Central Bank of Iceland.


Appendix 1: Why Might Country Size Matter?

Numerous theorists have discussed the effects of national size, especially in recent economics and not-so-recent political philosophy. Much recent economics focuses on “scale effects”, so that larger countries should be more successful countries. At the other extreme, a number of celebrated political philosophers argue that smaller countries make better states. There is also a strand of reasoning that articulates a tradeoff between the benefits and costs of size. We now review these briefly; the objective is simply to point out that size matters in a number of different literatures.

Bigger is Better

Size has an effect on output in a number of different recent literatures of interest in economics. Increasing returns remain an intrinsic part of the “new wave” trade theory that began in the 1980s, and lead to offshoots in economic geography and urban economics. Agglomeration effects are also an important element of endogenous macroeconomic growth. Finally, they are part of the political economy literature that focuses on the provision of public goods. There is also a long tradition in political philosophy arguing that size is positively disadvantageous.

Helpman and Krugman (1985) analyze the impact of increasing returns on trade, and discuss economies of scale both internal and external to the firm. The former can be due to plant-runs or dynamic scale economies; while the latter can be due to an effect of scale on the variety of intermediate inputs, effects on market structure, or information spillovers. When there are increasing returns to scale and transportation costs, countries also exert a “home market effect” (Krugman 1980). Agglomeration effects are also used in modeling urban dynamics as part of the new economic geography (e.g., Fujita et al. 1999). Indeed, the importance of numerous “border” effects is consistent with the fact that a number of economic relations are more efficient within a single country than in separate countries (Drazen 2000).

The literature on scale effects in macroeconomics stretches back a long way to Adam Smith’s idea that the specialization of labor is limited by the extent of the market. Robinson (1960) lists a number of reasons why there might be scale effects across countries, including: enhanced intra-national integration (of capital, goods, and especially labor and services markets); higher productivity due to enhanced specialization or longer production runs; a scale effect on competition; and greater ability to respond flexibly to technological progress.

Much recent work in growth theory has formalized such scale effects. Many models rely on learning by doing and/or knowledge spillovers, and result in the conclusion that larger countries should grow faster: e.g., Barro and Sala-i-Martin (1995). Indeed, scale effects are generic to endogenous growth models (Aghion and Howitt 1998, p 28). Jones (1999, p 143) discusses three classes of endogenous growth models and shows that they all have a scale effect: “the size of the economy affects either the long-run growth rate or the long-run level of per capita income” since larger countries can support more research which delivers a higher level or growth rate of productivity. Ventura (2005, p 92) refers to “the standard idea that economic growth in the world economy is determined by a tension between diminishing returns and market size effects to capital accumulation.”

The most authoritative work of relevance in public economics is the recent book by Alesina and Spolaore (2003), hereafter AS. They list (pp 3–4) five benefits of large population size: 1) lower per-capita costs of public goods (monetary and financial institutions, judicial system, communication infrastructure, police and crime prevention, public health, etc.) and more efficient tax systems; 2) cheaper per-capita defense and military costs; 3) greater productivity due to specialization (though access to international markets may reduce this effect); 4) greater ability to provide regional insurance; and 5) greater ability to redistribute income within the country.

Tradeoffs Exist

In all this work, larger countries are predicted to be richer or more efficient. There is little analysis of the costs of size. AS discuss two costs of larger country size. A minor consideration is the potential for administrative and/or congestion costs. The only real issue of importance is that larger countries have more diverse preferences, cultures, and languages. The AS hypothesis (p 6) is that “on balance, heterogeneity of preferences tends to bring about political and economic costs that are traded off against the benefits of size.” This reasoning is not new. In chapter XVII of the Leviathan, Hobbes argued that small populations were insufficient to deter invasion and provide security, while excessively large countries would be incapable of the common defense because of lack of a common purpose and internal distractions. Olson (1982) argues that small homogenous societies are less burdened by the logic of collective action and have more capacity to create prosperity; see also Robinson (1960) and Wei 1991, unpublished. Drazen (2000) provides an excellent critique, and emphasizes (among other things) that public goods can be supplied by clubs instead of countries.

Small is Beautiful

In arguing that size has its costs, AS join a long tradition of political philosophers, many of whom believe that small is beautiful. Plato quantified the optimal size of a city-state at 5,040 households.Footnote 16 Similarly in Politics, Aristotle argued that a country should be small enough for the citizens to know (and hear!) each other; the entire territory should be small enough to be surveyed from a hill. More recently, Rousseau stated:

“Large populations, vast territories! There you have the first and foremost reason for the misfortunes of mankind, above all the countless calamities that weaken and destroy polite peoples. Almost all small states, republics and monarchies alike, prosper, simply because they are small, because all their citizens know each other and keep an eye on each other, and because their rulers can see for themselves the harm that is being done and the good that is theirs to do and can look on as their orders are being executed. Not so the large nations: they stagger under the weight of their own numbers, and their peoples lead a miserable existence – either, like yourselves, in conditions of anarchy, or under petty tyrants that the requirements of hierarchy oblige their kings to set over them.”Footnote 17

This line of reasoning stretches all the way to at least Myrdal (1968).

Montesquieu believed that republican countries were necessarily small in both territory and population. His logic was that large countries were necessarily diverse and thus required strong governments, resulting in monarchies or even despots (for very large countries). Small countries without excessive wealth were the most democratic. He famously wrote:

“In a large republic, the common good is sacrificed to a thousand considerations; it is subordinated to various exceptions; it depends on accidents. In a small republic, the public good is more strongly felt, better known, and closer to each citizen; abuses are less extensive, and consequently less protected.”Footnote 18

Interestingly, Montesquieu’s logic was inverted by David Hume (1752), who argued in “Idea of a Perfect Commonwealth” that

“in a large government, which is modeled with masterly skill, there is compass and room enough to refine the democracy, from the lower people, who may be admitted into the first elections or first concoction of the commonwealth, to the higher magistrate, who direct all the movements. At the same time, the parts are so distant and remote, that it is very difficult, either by intrigue, prejudice, or passion, to hurry them into any measure against the public interest.”

Madison used this logic to argue that large countries were less likely to be affected by factions in The Federalist Papers 10.Footnote 19

1.1 Previous Empirics

To our knowledge, there has been only almost no work on a national scale effect on the level of economic well-being (Drazen 2000 argues that the reverse is also true), aside from Rose (2006). A number of different studies in Robinson (1960) tested for economies of scale and found them to be mostly unimportant. They also considered the impact of country size on national patterns of specialization, diversification, and competition, usually with a similar lack of success. Furceri and Karras (2007) have convincingly shown that size has a large negative effect on business cycle volatility.

By way of contrast, there has been much work done which searches for a scale effect in economic growth. Barro and Sala-i-Martin (1995) are typical of the literature and provide limited evidence of a scale effect on growth. Alesina et al. (2000, 2005) focus on whether the effect (if any) of size on growth is mediated through openness; they find moderately supportive results using a panel of data and IV techniques.But most of the focus in AS is on the causes and determination of country size rather than its effects.

Appendix 2: A Sketch of a Theoretical Model of Non-fundamental FX Volatility

In this appendix, we outline a simple theoretical model that removes the strong linkage between fundamental macroeconomic volatility and exchange rate volatility. This is motivated by the absence of any strong linkage as shown in Fig. 2 and Table 6.

Flood and Rose (1999) developed a non-linear model of the exchange rate which links it to expectations about both the future level and volatility of the exchange rate. This non-linearity induces multiple equilibria and results in regime- and equilibrium-dependent coefficients; it is important in two ways. First, when exchange rate variability disappears, certain shocks (to portfolios) effectively disappear. Second, the non-linearity in the models produces the possibility of multiple equilibria. When the exchange rate is flexible, the model can produce several perfectly viable equilibria. These equilibria may correspond to exchange rate regimes with differing volatility; but movements across these equilibria could also produce exchange rate volatility without corresponding changes in fundamentals.

A credibly fixed exchange rate has neither volatility nor an expected rate of change. Accordingly, the foreign exchange risk premium disappears in the model, and the domestic interest rate is equal to the foreign rate. So, one of the equilibria corresponds to a credible stable fixed rate regime.

The situation is dramatically different when the exchange rate either floats explicitly, or is fixed unreliably so that speculative attacks are possible. In this case, expected volatility is non-zero, so that in the presence of risk-averse agents, forces other than those from money and goods markets drive the foreign exchange market. These shocks enter the risk premium non-linearly; its importance for the exchange rate is proportional to perceived exchange-rate variance. The “portfolio-balance” shock has no role in determining the balance of payments under reliably fixed rates, but it plays a major exchange rate role in a float. Thus, the shift from fixed to flexible rates is an essential shift in market structure. If the variance of portfolio balance shocks is large compared to the other disturbances, then the exchange rate becomes very much a non-monetary phenomenon.

This sort of non-monetary approach to the exchange rate is helpful when the money market disturbances are small compared to portfolio balance disturbances. Of course, there is no reason why portfolio balance shocks need always be large compared to other shocks. For instance during periods of high inflation, the money market reasserts itself. If inflationary changes in money, bonds, and domestic interest rates are large relative to portfolio shocks, macroeconomic variables will have a lot of explanatory power. But during ordinary periods of tranquility, nominal variables are relatively stable and so do not explain exchange rate changes. The same is true at low frequencies.

This model allows one to understand why exchange rate volatility can change across regimes without noticeable differences in macroeconomic phenomena. It can handle either pegged or flexible interest rates; the monetary authorities can conduct essentially any interest rate policy independent of the exchange rate. Since there are no constraints on international capital flows, this model violates Mundell’s “Incompatible Trinity” of fixed exchange rates, monetary sovereignty, and capital mobility. As the endogenous risk premia can adjust to accommodate monetary policy, the central bank has almost complete freedom to manipulate interest rates. When the interest rate is pegged and exchange rates float, the portfolio-balance shocks that might otherwise be absorbed by the interest rate are instead shunted off into the exchange rate. This can magnify the effects of the “taste disturbances” on exchange rates as compared with completely market-responsive interest rates. But the portfolio balance structure is regime-dependent. When interest and exchange rates are fixed simultaneously, the variance created by portfolio balance shocks does not move from the interest rate locus to the exchange rate or the balance of payments. It simply disappears.

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Breedon, F., Pétursson, T.G. & Rose, A.K. Exchange Rate Policy in Small Rich Economies. Open Econ Rev 23, 421–445 (2012).

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