Terms of Trade and Exchange Rate Regimes in Developing Countries∗

Since Friedman (1953) and Poole (1970), an advantage often attributed to ßexible exchange rate regimes relative to Þxed regimes is their ability to better insulate the economy against real shocks. I use a post-Bretton Woods sample (1973-1996) of 74 developing countries to assess whether the business cycle response of real GDP, real exchange rates and inßation to terms of trade shocks differ systematically across exchange rate regimes. I Þnd that real GDP growth responses and the time path of the real exchange rate are signiÞcantly different across regimes. In response to a negative terms of trade shock Þxed regimes have large and signiÞcant losses in terms of real GDP growth and their real exchange rate begins to depreciate after two years. Flexible regimes, on the other hand, are associated with small growth losses and immediate large real depreciations. Negative shocks are inßationary in ßoats and deßationary in pegs, though differences are not always signiÞcant. The picture that emerges is consistent with the conventional wisdom that ßexible exchange rate regimes are able to buffer real shocks better than Þxed regimes. ∗I would like to thank Andrew Berg, Olivier Blanchard, Eduardo Borensztein, Rudi Dornbusch, Anne Krueger, Guido Kuersteiner and John Romalis for their helpful comments. I am especially grateful to Ariel Burstein and Jaume Ventura for enriching discussions. I also beneÞted from comments of participants at the MIT International breakfast, Money Lunch and the Conference on Currency Unions at the Hoover Institution (Stanford University). All errors are, of course, mine. †Department of Economics, MIT. 50 Memorial Drive, Cambridge, MA 02142. Email: [email protected]