Floating Exchange Rates Can Cause Big Trouble

In the eyes of the International Monetary Fund, a country that allows the value of its currency to be determined by supply and demand is demonstrating financial maturity. “Emerging market countries need to consider adopting more flexible exchange rate regimes as they develop economically and institutionally,” said a 2004 IMF paper whose lead author was the organization’s former chief economist, Kenneth Rogoff of Harvard. The IMF’s World Economic Outlook, released this month, says the commodity price bust has been harder on commodity exporters with pegged currencies than on ones with flexible exchange rates, which were able to shore up their economies without running up budget deficits or running down currency reserves.

Yet a new paper by Harvard economist Gita Gopinath argues that some of the benefits of flexible exchange rates have been overstated. The conventional thinking is that a small country can boost growth by letting its currency depreciate because doing so makes its goods cheaper in world markets. But Gopinath cited new research showing that’s mostly not the case, at least in the short run, given that exports tend to be invoiced in dollars rather than the local currency. As a result, the argument for letting currencies float is “worse than you think,” Gopinath said in presenting her research at an Oct. 14 conference organized by the Peterson Institute for International Economics.