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Exchange Rate Regimes and Business Cycles: An Empirical Investigation

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Abstract

This paper empirically investigates the impacts of domestic and external factors along with exchange rate regimes (ERRs) on business cycles in a large panel of advanced and emerging market economies (EME). The results for classical business cycles suggest that EME tend to experience much deeper recessions and relatively steeper expansions during almost the same duration. The probability of expansions significantly increases with ERR flexibility. Our results strongly support floating ERR for both advanced and EME other than the East Asian countries. The impacts of external real and financial shocks and domestic variables are significantly greater under managed regimes as compared to floats. Consistent with an argument that high saving rates enhance the ability of a country to maintain an ERR, managed regimes performs better only in the East Asian countries. Supporting the de-coupling literature, external cycles become insignificant for growth under flexible ERR. Our results strongly suggest that the evolution and determinants of both classical business and growth cycles are not invariant to the prevailing ERR.

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Notes

  1. It may be argued that a stationary business cycle may not be a generally accepted empirical regularity. The results by Aguiar and Gopinath (2007) suggest that, shocks to trend growth are the primary source of fluctuations in EME. In the same vein, total factor productivity (TFP), which is often taken as the main driver of business cycles, may follow a random walk process (Schmitt-Grohé and Uribe 2011).

  2. The classical cycles are computed using quarterly real GDP data which are expressed in local currency at constant prices. All quarterly real GDP series are seasonally adjusted using X-12 ARIMA method. Our sample contains 23 advanced and 27 emerging market countries as listed by Table 6. The data for real GDP are from IMF-IFS and OECD. Table 1 is based on quarterly data from 1960 to 2013 for advanced countries and post-1980 for most of the EME. For the Eastern Europe countries, we have data only after the mid 1990’s. To obtain comparable results, we consider the classical cycles of AEs also for the post-1980 sample. The results for the post-1980 sample, were essentially the same, and thus not reported to save the space. Individual country estimates are reported by an earlier version of this paper (Erdem and Özmen, 2014).

  3. The full list of countries, including their regional and income classifications as well as the sample periods, is presented by Table 6. Note that the BBQ algorithm is unable to find turning points in the real GDP data for Iceland, Bolivia and Slovakia potentially due to the short span of the data.

  4. The IRR data are available over the period 1946 to 2010. For the post-2010 sample the De Facto ERR classification by the IMF is used.

  5. See Tavlas et al., (2008) for a critical review of the de facto ERR classifications. As argued by Tavlas et al., (2008, p.944), “the key distinctive characteristic of a regime is the extent to which it constraints domestic monetary policy”. Consequently, there is a need for an ERR classification based on the degree of monetary policy independence rather than relying basically on exchange rate fluctuations. The choice of de facto regimes, on the other hand, may not be independent of the de jure regimes (von Hagen and Zhou 2009).

  6. We considered also the external financial shocks proxied by VIX. As the results are found to be essentially the same those with YC US, we prefer not to report them to save the space.

  7. The equations for AE do not contain FF as there is indeed no episode of freely falling for them. The sample for the equations with the US cycle variable does not contain the US data.

  8. We are grateful to an anonymous referee for raising this crucially important issue. The referee stressed the roles of the external balance and saving ratio of a given economy in its ability to maintain a given exchange rate regime.

  9. The PARDL model is valid even if the regressors are not weakly-exogenous (Chudik and Pesaran, 2013). In an earlier version of this paper (Erdem and Özmen, 2014), the PARDL equations contained also the current values of the potentially endogenous domestic variables. The results were essentially the same with those in this paper and thus not reported to save the space.

  10. As noted by Pagan and Robinson (2014), the series obtained by filtering procedures such as HP may better be called growth cycles rather than business cycles. As shown by Harding and Pagan (2005), ∆yt is indeed a special case of the cycles estimated by filtering procedures.

  11. The results are found to be essentially the same for the EME and not reported to save the space.

  12. For our whole sample of countries, flexible ERR episodes increased from 27 % in 1960–84 to 40 % in the 1985–2013 period. Compared with the 1980–1995 period, the flexible ERR episodes increased from 33 % to 45 % for the EME sample. For the East Asian EME sample, this increase is from 20 % to 50 %. Ghosh et al., (2014) reports that the proportion of floating (independent and managed) regimes in EME has substantially increased during the recent decades.

  13. We initially estimated (3) with the PARDL lag length chosen as 2, and by applying a sequential reduction of statistically insignificant variables, we obtained the parsimonious panel fixed effect estimation results reported by Table 5. The results tend to be robust to alternative conditioning for the domestic variables.

  14. We are grateful to an anonymous referee for this interpretation.

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Authors and Affiliations

  1. Communications and International Relations Department, Central Bank of the Republic of Turkey, Ankara, Turkey

    Fatma Pınar Erdem

  2. Department of Economics, Middle East Technical University, Ankara, Turkey

    Erdal Özmen

Authors
  1. Fatma Pınar Erdem
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  2. Erdal Özmen
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Correspondence to Fatma Pınar Erdem.

Additional information

We are grateful to George S. Tavlas (the Editor) and two anonymous referees for many penetrating comments and suggestions. Our paper also benefited from the contributions of Fatih Özatay, Elif Akbostancı and Kağan Parmaksız. We thank them all. The usual disclaimers apply. The views expressed in the paper are those of the authors and should not be attributed to their institutions.

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Erdem, F.P., Özmen, E. Exchange Rate Regimes and Business Cycles: An Empirical Investigation. Open Econ Rev 26, 1041–1058 (2015). https://doi.org/10.1007/s11079-015-9361-0

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