International fisher effect under exchange rate regime shifts: evidence from 10 examples
International fisher effect under exchange rate regime shifts: evidence from 10 examples

Summary/Abstract: A monetary union is classified by several authors as an extreme form of fixed exchange rate arrangement. Analyzing exits from monetary unions is, however, demanding. This paper studies the impact of inflation and interest rate differentials on the nominal exchange rate after leaving a form of peg arrangement and moving to a floating regime, as it may serve as a parallel for a monetary union break-up. The theoretical framework is provided by the theory of the International Fisher Effect. We find that countries with rigid exchange rate policy, less frequently adjusted central parity and narrow exchange rate bands experienced sharp depreciation after the shift, but the depreciation was only temporary. In this group of countries the exchange rate adjustment is weakly exogenous to inflation and interest rate differentials. We apply Johansen’s approach to cointegration, based on the estimation of the Vector Error Correction Model, and the Johansen constraint test of exogeneity. There is strong evidence that long-term depreciation could not be expected in a former euro area country after its possible break-up and that inflation and interest rate would not be the driving forces of exchange rate behavior. Finally, parallels between the local currency adoption within a euro area member state and the leaving of the peg arrangement are pointed out.

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