DP4475 Growth Effects of the Exchange-Rate Regime and the Capital Account Openness in A Crisis-Prone World Market: A Nuanced View

Author(s): Assaf Razin, Yona Rubinstein
Publication Date: July 2004
Keyword(s): capital account openness, domestic price crisis, exchange rate regime, sudden stop crisis
JEL(s): F10, F30
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=4475

It has been a remarkably difficult empirical task to identify clear-cut real effects of exchange-rate regimes on the open economy. Similarly, no definitive view emerges as to the aggregate effects of capital account liberalizations. The main hypothesis of the Paper is that a direct and an indirect effect of balance-of-payments policies, geared toward exchange rate regimes and capital account openness, exert a confounding overall influence on output growth, in the presence of sudden-stop crises. A direct channel works through the trade and financial sectors, akin to the optimal currency area arguments. An indirect channel works through the probability of a sudden-stop crisis. The empirical analysis disentagles these conflicting effects and demonstrates that: (i) the balance-of-payments policies significantly affect the probability of crises, and the crisis probability, in turn, negatively affects output growth; (ii) controlling for the crisis probability in the growth equation, the direct effect of balance-of-payments policies is large. Domestic price crises (high inflation above a 20% threshold) affect growth only indirectly, through their positive effect on the probability of sudden-stop crises.