Robert M. La Follette School of Public Affairs
Thursday, March 14, 2013

Analysis debunks currency policy tenet

Menzie Chinn

The argument that more flexibility in the exchange rate regime speeds up current account adjustment is not true, recent analysis by economist Menzie Chinn suggests.

Chinn and co-author Shang-Jin Wei of Columbia University report their findings in an article to be published by the Review of Economics and Statistics. Their study is available as La Follette School Working Paper No. 2008-019.

The exchange rate regime is how a country manages its currency's value in relation to other currencies. A country's current account is the difference between the values of imports and exports, plus net income from abroad.

Based on 1971-2005 data for more than 170 countries, Chinn and Wei examine whether the rate of current account reversion depends upon the de facto degree of exchange rate fixity. "We find that there is no strong, robust or monotonic relationship between exchange rate regime flexibility and the rate of current account reversion, even after accounting for the degree of economic development, the degree of trade and capital account openness," Chinn says.

The findings are significant because poli­cymakers and economic analysts around the world generally assume that if a country's exchange rate is flexible, then current account imbalances will typically be corrected fairly quickly, Chinn says. A current account deficit occurs when the value of a country's imports is greater than the combined value of exports and net income from abroad. The current-account deficit is a broader measure than a country's trade deficit because, in addition to imports and exports, it includes income from assets abroad after payments for liabilities owed to foreigners are subtracted out.

"For example," Chinn says, "Egypt and China have a relatively rigid exchange rate regimes, meaning they do not adjust the value of their currencies. Yet, Egypt has a relatively fast current account convergence, meaning it rarely has a large and persistent deficit or surplus, but China does not."