Exchange Rate Regime Choice and Country Characteristics: an Empirical Investigation into the Role of Openness
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In choosing an exchange rate regime for a small open economy, the common wisdom (Friedman (1953), Meade (1950)) calls for a °oating regime to outperform a peg because of the ability of the former to cope with relative price changes without major output effects. With balance sheet effects in mind, doubts have been raised about it, though. I test for this, using a near VAR approach. The 32 country sample for the period 1980-2001 was split according to the degree of openness of the economy. The results show that for relatively open economies the common wisdom holds; on the contrary, for relatively closed economies it does not. In fact, the evidence documents that to absorb real shock, fixed exchange rate regimes perform better for relatively closed economies, while flexible exchange rate regimes do a better job for relatively open economies.