"Let it float: empirical evidence on de facto exchange rate regimes and output volatility in Latin America"

Abstract

We estimate the de facto exchange rate regimes for the seven most important Latin American economies (LA-7) between 1998 and 2011. We use the methodology developed by Zeileis, Shah and Patnaik (2010) because, unlike others, it captures the ‘fine’ structure behind the regimes and identifies structural breaks at sharp dates. This method allows us to build a series of the ‘exchange rate flexibility’, which we use to address two concerns, regarding the evolution of the exchange rates in Latin America. Firstly, we show that AL-7 economies have moved towards more flexible exchange rate systems, thus overcoming their ‘fear of floating’. Secondly, we estimate a non-linear panel data model to examine the threshold effects of the degree of flexibility of the exchange rate on output volatility. We find a negative link between the degree of inflexibility and output volatility: the higher the inflexibility of the exchange rate regime the lower the output volatility. This unusual result may be attributed to a ‘diminishing returns’ dynamics that would make higher inflexibility less effective to deter output volatility.