Devaluation risk and the business-cycle implications of exchange-rate management

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Abstract

What is the mechanism driving the business cycle associated with stabilization policies anchored on managed exchange rates? Perfect-foresight models used extensively to try to answer this question have been unable to explain key quantitative features of the data. To do so it is necessary to consider devaluation risk in an environment of incomplete insurance markets in which stochastic price and wealth distortions operate. Simulations applied to Mexican data show that these distortions are large and socially costly, and that they rationalize several stylized facts. These findings suggest focusing the debate on exchange-rate regimes on the credibility of policymakers and the stance of fiscal policy.

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  • Cited by (0)

    Thanks to Guillermo Calvo, V.V. Chari, Michelle Connolly, Allan Drazen, Greg Huffman, Pat Kehoe, Tim Kehoe, Michael Klein, Vincenzo Quadrini, Pablo Sanguinetti, Sergio Rebelo, Stephanie Schmitt-Grohé, and Carlos Végh for valuable comments. Comments by seminar participants at the NBER, the University of Maryland, the University of Rochester, Universidad Nacional de La Plata (Argentina), the Bank of Canada, the Federal Reserve Bank of Minneapolis, and the Bank of Mexico are also gratefully acknowledged.

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