Estimation of De Facto Flexibility Parameter and Basket Weights in Evolving Exchange Rate Regimes

Working Paper
10-1
January 2010

The exchange rate regimes that countries follow in practice (de facto) often diverge from the regimes that they announce officially (de jure). Many countries that say they float in fact intervene heavily in the foreign exchange market, many that say they fix in fact devalue when trouble arises, and many that say they target a basket of major currencies in fact fiddle with the weights. Jeffrey Frankel and Shang-Jin Wei (2008) combined two techniques to offer a new approach to estimate countries' de facto exchange rate regimes. One technique is used to estimate implicit de facto weights when the hypothesis is a basket peg with little flexibility. The second is a technique to estimate the de facto degree of exchange rate flexibility when the hypothesis is an anchor to the dollar or some other single major currency, but with a possibly substantial degree of flexibility around that anchor. Because countries' exchange rate regimes keep evolving over time, it is important to have available a technique that covers both dimensions: inferring anchor weights and flexibility. In this working paper, Frankel and Daniel Xie test this synthesis technique on a variety of fixers, floaters, and basket peggers, finding that real world data demand a statistical technique that allows parameters and regimes to shift frequently. They embed the synthesis technique in Bai and Perron's (1998) multiple structural change model to track the shifts over time in five emerging-market countries' currency regimes: Mexico, Chile, Russia, Thailand, and India.