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

The main hypothesis of the paper is that balance-of-payments policies, geared toward exchange rate regimes and capital account openness, influence output growth through two channels: 1. Directly, through their effect on the trade and financial sectors, and 2. Indirectly, through their impact on the probability of a balance-of-payments crisis. The empirical analysis demonstrates that the balance-of-payments policies significantly affect the probability of crises; and that the crisis probability, in turn, negatively affects output growth. Namely, the indirect effects of balance-of-payments policy on growth are substantial. By controlling for the crisis probability in the growth equation, the paper uncovers also the direct channel. The direct effects of balance-of-payments policies are also demonstrated to be substantial. Indeed, in benchmark OLS regressions, which abstract from the eefect on growth of crisis probabilities, effects of the balance-of-payments policy on output growth turn out to be negligible.The indirect channel is intrisincally non linear: there exists a range for the exogenous variables for which the effect of policy on the likelihood of a crisis is large; and another range, where the effect is rather small. As a consequence of the non linearity of the crisis probability function, overall growth effects of balance-of-payments policies depend crucially on the level of the crisis probability. Thus, the cost-benefit evaluation of balance-ofpayments policies depends on the special characteristics of the economy. We ∗Mario Henrique Simonsen Professor of Public Economics, Tel-Aviv University and Friedman Professor of International Economics, Cornell University. E-mail address: [email protected]. †Tel-Aviv University. E-mail: [email protected]