Real Exchange Rate Overshooting in Large Depreciations: Determinants and Consequences

May 22, 2020

Preview Citation

Format: Chicago

Alexander Culiuc. Real Exchange Rate Overshooting in Large Depreciations: Determinants and Consequences, (USA: International Monetary Fund, 2020) accessed November 21, 2024

Disclaimer: IMF Working Papers describe research in progress by the author(s) and are published to elicit comments and to encourage debate. The views expressed in IMF Working Papers are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management.

Summary

The consequences of large depreciations on economic activity depend on the relative strength of the contractionary balance sheet and expansionary expenditure switching effects. However, the two operate over different time horizons: the balance sheet effect hits almost immediately, while expenditure switching is delayed by nominal rigidities and other frictions. The paper hypothesizes that the overshooting phase—observed early in the depreciation episode and driven by the balance sheet effect—is largely irrelevant for expenditure switching, which is more closely aligned with ex-post equilibrium depreciation. Given this, larger real exchange rate overshooting should signal a relatively stronger balance sheet effect. Empirical findings support this hypothesis: (i) overshooting is driven by factors associated with the balance sheet effect (high external debt, low reserves, low trade openness), (ii) overshooting-based measures of the balance sheet effect foreshadow post-depreciation output losses, and (iii) the balance sheet effect is strongest early on, while expenditure switching strengthens over the medium term.

Subject: Currency mismatches, Depreciation, Exchange rates, External debt, Financial sector policy and analysis, Financial statements, Foreign exchange, National accounts, Public financial management (PFM)

Keywords: Balance sheet effect, Currency mismatches, Debt intolerance, Depreciation, Depreciation episode, Equilibrium depreciation, Exchange Rate, Exchange rates, Expenditure switching effect, External Debt, Financial statements, Global, Open Economy Growth, Output loss, Risk premium, Short-term debt, WP

Publication Details

Pages:

48
Volume:

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DOI:

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Issue:

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Series:

Working Paper No. 2020/060
Stock No:

WPIEA2020060
ISBN:

9781513545226
ISSN:

1018-5941

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