The Modern History of Exchange Rate Arrangements

THE QUARTERLY JOURNAL OF ECONOMICS Vol. CXIX February2004 Issue 1

THEMODERN HISTORY OFEXCHANGE RATE ARRANGEMENTS: AREINTERPRETATION*

CARMEN M. REINHART AND KENNETH S. ROGOFF

Wedevelopa novelsystem of reclassifyinghistorical exchange rate regimes. Onekey differencebetween our study andprevious classi cations is that we employmonthly data on market-determined parallel exchange rates going back to 1946for 153 countries. Our approachdiffers from the IMF ofcial classi cation (whichwe show to be only a littlebetter than random); it also differs radically fromall previous attempts at historicalreclassi cation. Our classication points toa rethinkingof economicperformance under alternative exchange rate regimes. Indeed,the breakup of BrettonWoods had less impact on exchangerate regimes thanis popularly believed.

I. INTRODUCTION Thispaper rewritesthe history of post-World WarII exchangerate arrangements, based onan extensivenew monthly data setspanning across153 countriesfor 1946 –2001. Ourap- proachdiffers notonly from countries’ of cially declaredclassi - cations(which weshowto be only a littlebetter than random);it alsodiffers radically fromthe small number of previous attempts at historicalreclassi cation. 1

*Theauthors wish to thank Alberto Alesina, Arminio Fraga, Amartya Lahiri, VincentReinhart, Andrew Rose,Miguel Savastano, participants at HarvardUni- versity’s Canada-US Economicand Monetary Integration Conference,Interna- tionalMonetary Fund-World Bank JointSeminar, National Bureau of Economic ResearchSummer Institute, New York University,Princeton University, and threeanonymous referees for useful comments and suggestions, and Kenichiro Kashiwase,Daouda Sembene, and Ioannis Tokatlidis for excellent research as- sistance.Data and background material to this paper are available at http://www.puaf.umd.edu.faculty/papers/reinhart/reinhart.htm. 1.The of cial classi cation is givenin theIMF’ s AnnualReport onExchange Rate Arrangements andExchange Restrictions, which,until recently, asked mem- berstates to self-declare their arrangement as belongingto one of four categories.

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As a rstinnovation, we incorporate data onparallel and dual exchangerate markets, which have been enormously important notonly in developingcountries but in virtually all the Europeancountries up until thelate 1950s, and sometimeswell beyond.We argue that any classi cationalgorithm that fails to distinguish betweenuni edrate systems (with oneof cial exchangerate and nosigni cant “black” orparallel market)and all othersis fundamentally awed.Indeed, in thevast majorityof multipleexchange rate or dual systems,the oatingdual or parallel rateis notonly a far betterbarometer of monetarypolicy than istheof cial exchangerate, it is oftenthe most economically meaningfulrate. 2 Veryfrequently —roughlyhalf thetime for ofcial pegs—we ndthat dual/parallel rateshave been used as a form of “back door” oating,albeit oneusually accompaniedby exchangecontrols. The second novelty in ourapproach is that we developextensive chronologies of the history of exchange ar- rangementsand relatedfactors, such as exchangecontrols and currencyreforms. Together with abatteryof descriptive statistics,this allows us todraw anuanceddistinction betweenwhat countriesdeclare as theirof cial dejure regime, and theiractual defacto exchange rate practices. To capture the wide rangeof arrangements,our approach allows forfourteen categories of exchangerate regimes, ranging fromno separate legal tender or astrictpeg to a dysfunctional “freelyfalling ” or “hyperoat.” Somehighlights fromour reclassi cationof exchange rate arrangementsare as follows. First, dual, ormultiple rates, and parallel marketshave prevailed far morefrequently than is commonlyacknowledged. In 1950, 45 percentof the countries in oursample had dual or multiplerates; many more had thrivingparallel markets.Among theindustrialized economies,dual ormultiple rates were the

Previousstudies have either extended the four-way of cial classicationinto a moreinformative taxonomy (see Ghosh et al.[1997]), or reliedlargely on statis- ticalmethods to regroup country practices(see Levy-Yeyati and Sturzenegger [2002]).The Fund, recognizing the limitations of itsformer strategy, revised and upgradedthe of cialapproach toward classifyingexchange rate arrangements in 1997and again in 1999. Notably, all these prior approaches to exchange rate regimeclassi cation,whether or not they accept thecountry ’sdeclaredregime, havebeen based solely on of cialexchange rates. 2.When we refer to multiple exchange rates in this context, we are focusing onthe cases where one or more of the rates is market-determined. This is very differentfrom the cases where the multiple of cialrates are all xedand simply act asa differentialtax ona varietyof transactions.Dual markets are typically legal,whereas parallel markets may or may not be legal. EXCHANGE RATEARRANGEMENTS 3 normin the1940s and the1950s, and in somecases, these lasted until muchlater. Our data lend strongsupport tothe view stressedby Bordo[1993] that BrettonWoods encompassed two very different kinds ofexchange rate arrangements in thepre- and postconvertibilityperiods and that theperiod of meaningful exchangerate stability was quiteshort-lived. In thedeveloping world,such practices remained commonplace through the 1980s and 1990s and intothe present. Weshow that market-determineddual/ parallel marketsare importantbarometers of underlying monetary policy. This may beobvious in casessuch as modern-dayMyanmar wherethe parallel marketpremium at thebeginning of 2003 exceeded700 percent.As weshow, however, the phenomenon is muchmore general,with theparallel marketpremium often serving as a reliableguide tothe direction of future of cial exchangerate changes.Whereas dual/ parallel marketshave been marginal over someepisodes, they have been economically important in others, and thereare many instances where only a fewtransactions take place at theof cial rate.To assess the importance of secondary (legal orillegal) parallel markets,we collecteddata that allow us toestimate export misinvoicing practices, in manycases going backto 1948. Theseestimates show that leakagesfrom the of cial marketwere signi cant in manyof the episodes when there were dual orparallel markets. Second, whenone uses market-determined rates in place of ofcial rates,the history of exchange rate policy begins to look verydifferent. For example, it becomesobvious that defacto oatingwas commonduring theearly years of theBretton Woods era of “pegged” exchangerates. Conversely, many “oats” of the post-1980s turnout to be (de facto) pegs,crawling pegs,or very narrowbands. Ofcountrieslisted in theof cial IMFclassi cation as managed oating,53 percentturned out to have de facto pegs, crawls,or narrow bands tosome anchor currency. Third, nextto pegs (which accountfor 33 percentof the observationsduring 1970 –2001 (accordingto our new “Natural” classication),the most popular exchangerate regime over modernhistory has beenthe crawling peg,which accounted for over 26 percentof theobservations. During 1990 to2001 this was the mostcommon type ofarrangementin emergingAsia and Western Hemisphere(excluding Canada and theUnited States), making up forabout 36 and 42 percentof the observations, respectively. Fourth, ourtaxonomy introduces a newcategory: freely fall- 4 QUARTERLY JOURNALOF ECONOMICS ing,or thecases where the twelve-month in ationrate is equalto orexceeds 40 percentper annum. 3 It turnsout to be a crowded categoryindeed, with about12 12 percentof the observations in oursample occurring in thefreely falling category.As aresult, “freelyfalling ” is aboutthree times as commonas “freely oating,” whichaccounts for only 4 12 percentof the total observations.(In theof cial classication,freely oatingaccounts for over30 percentof observations over the past decade.)Our new freelyfalling classi cationmakes up 22 and 37 percentof the observations,respectively, in Africa and WesternHemisphere (excluding Canada and theUnited States) during 1970 –2001. In the1990s freelyfalling accountedfor 41 percentof the observa- tionsfor the transition economies. Given the distortions associated with veryhigh in ation, any xed versus exibleexchange rateregime comparisons that donot break out the freely falling episodesare meaningless, as weshall con rm. Thereare many important reasons to seeka betterapproach toclassifying exchangerate regimes. Certainly, one is therecog- nitionthat contemporarythinking on the costs and bene ts of alternativeexchange rate arrangements has beenprofoundly in- uencedby thelarge number of studies onthe empirical differencesin growth,trade, in ation,business cycles, and commodity pricebehavior. Most have been based ontheof cial classications and all on ofcial exchangerates. In light ofthenew evidence we collect,we conjecture that thein uentialresults in Baxterand Stockman[1989] —that thereare no signi cant differencesin businesscycles across exchange arrangements —may be due to thefact that theof cial historicalgroupings of exchange rate arrangementsare misleading. Thepaper proceedsas follows.In thenext section we present evidenceto establish theincidence and importanceof dual or multipleexchange rate practices. In SectionIII wesketch our methodologyfor reclassifying exchange rate arrangements. Sec- tionIV addresses someof the possible critiques to our approach, comparesour results with the “ofcial history, ” and provides examplesof how our reclassi cationmay reshape evidence on the linksbetween exchange rate arrangements and variousfacets of economicactivity. The nal sectionreiterates some of the main

3.We also include in the freely falling category the rst sixmonths following anexchange rate crisis (see the Appendix for details), but only forthose cases wherethe crisis marked a transitionfrom a pegor quasi-peg to a managedor independent oat. EXCHANGE RATEARRANGEMENTS 5

ndings, whilebackground material to this paper providesthe detailed countrychronologies that underpin ouranalysis.

II. THE INCIDENCE AND IMPORTANCE OF DUAL AND MULTIPLE EXCHANGE RATE ARRANGEMENTS In this sectionwe document the incidence of dual orparallel markets(legal orotherwise)and multipleexchange rate practices during post-World WarII. Wethen present evidence that the market-determinedexchange rate is abetterindicator ofthe underlyingmonetary policy than theof cial exchangerate. Fi- nally,to provide a senseof the quantitative importancefor economicactivity ofthe dual orparallel market,we present estimates of “leakages” from the ofcial market.Speci cally, we providequantitative measuresof export misinvoicing practices. Weprimarily usemonthly data onof cial and market-determinedexchange rates for the period 1946 –2001. In somein- stances,the data forthe market-determined rate is onlyavailable fora shorterperiod and thebackground material provides the particulars onacountry-by-countrybasis. Thepre-1999 market- determinedexchange rate data comefrom various issues of Pick’s CurrencyYearbook, Pick’ s Black Market Yearbooks, and World CurrencyReports, and the ofcial ratecomes from the same sourcesand as wellas theIMF. The quotes are end-of-month exchangerates and arenot subject to revisions. For the recent period(1999 –2001) themonthly data onmarket-determined exchangerates come from the original country sources (i.e., the centralbanks), forthose countries where there are active parallel marketsfor which data areavailable. 4 Sinceour coverage spans morethan 50years,it encompassesnumerous cases of monetary reformsinvolving changes in theunits ofaccount, so the data werespliced accordinglyto ensure continuity. II.A.On thePopularity of Dual and Multiple ExchangeRate Practices FigureI illustratesde facto and dejure nonuni ed exchange rateregimes. The gureshows the incidence of exchange rate arrangementsover 1950 –2001, with and withoutstripping out

4.These countries include Afghanistan, Angola, Argentina, Belarus, Belize, Bolivia,Burundi, Congo (DCR), DominicanRepublic, Egypt, Ghana,Iran, Libya, Macedonia,Mauritania, Myanmar, Nigeria, Pakistan, Rwanda, Tajikistan, Turk- menistan,Ukraine, Uzbekistan, Yemen, Yugoslavia, and Zimbabwe. 6 QUARTERLY JOURNALOF ECONOMICS

FIGURE I TheIncidence of Dual or MultipleExchange Rate Arrangements, 1950 –2001: SimpliedIMFClassi cation Sources: InternationalMonetary Fund, AnnualReport onExchange Arrange- ments andExchange Restrictions andInternational Financial Statistics; Pick and Se´dillot[1971]; International Currency Analysis, World Currency Yearbook, various issues. Exchangerate arrangements classi ed as “Other” includethe IMF ’scategories of limited exibility,managed oating,and independently oating.

casesof dual marketsor multiple exchange rates. The IMF clas- sicationhas beensimpli edintowhat it was backin thedays of BrettonWoods —namely,Pegs and Other. 5 Thedark portionsof thebars representcases with uni edexchange rates, and the lightly shaded portionof each bar separatesout the dual, multiple,or parallel cases.In 1950 morethan half (53 percent)of all arrangementsinvolved two or more exchange rates. Indeed, the heyday ofmultiple exchange rate practices and activeparallel marketswas 1946 –1958, beforethe restoration of convertibility in Europe.Note also, that accordingto the of cial IMF classi - cation,pegs reigned supreme in theearly 1970s, accountingfor over90 percentof all exchangerate arrangements. In fact, over half of these “pegs” maskedparallel marketsthat, as weshall show,often exhibited quite different behavior.

5.For a historyof the evolution of theIMF ’s classicationstrategy, see the working paperversion of thispaper, Reinhart and Rogoff [2002]. EXCHANGE RATEARRANGEMENTS 7

II.B. TheMarket-Determined Exchange Rate as an Indicatorof MonetaryPolicy Whilethe quality ofdata onmarket-determined rates is likelyto vary across countries and time,we nevertheless believe thesedata tobe generally far betterbarometers of theunderlying monetarypolicy than areof cial exchangerates. For instance, if thelaxity in monetarypolicy is notconsistent with maintaining a xed ofcial exchangerate, one would expectthat themarket- determinedrate starts depreciatingahead ofthe inevitable de- valuation ofthe of cial rate.When the of cial realignmentoc- curs—it is simply avalidation ofwhat had previouslytranspired in thefree market. Indeed, this is thepattern shownin thethree panels ofFigureII forthe cases of Bolivia, Indonesia,and Iran — manymore such cases are displayed in the guresthat accom- pany the153 countrychronologies. 6 Thispattern alsoemerges oftenin thedeveloped European economies and Japan in the yearsfollowing World War II. Toillustrate more rigorously that themarket-based exchangerate is abetterindicator of the monetary policy stance than the ofcial rate,we performed two exercises for each country.First, we examined whether the market-determined exchangerate systematically predicts realignmentsin theof cial rate,as suggestedin FigureII. Todoso, we regressed a currency crashdummy on the parallel marketpremium lagged oneto six months,for each of thedeveloping countries in oursample. 7 If the marketexchange rate consistently anticipates devaluations ofthe ofcial rate,its coef cientshould bepositive and statistically signicant.If, in turn,the of cial exchangerate does not validate themarket rate, then the coef cienton the lagged marketex- changerate will benegative or simply notsigni cant.Table I summarizesthe results of the country-by-country time series probit regressions.In theoverwhelming number of cases (97 percent),the coef cienton themarket-determined exchange rate is positive.In about81 percentof the cases, the sign onthe coefcientwas positiveand statistically signi cant.Indeed, for

6. See “Part I.TheCountry Chronologiesand Chartbook, Background Mate- rialto A ModernHistory of ExchangeRate Arrangements: A Reinterpretation ” at http://www.puaf.umd.edu/faculty/papers/reinhart/reinhart.htm . 7. Two denitionsof currency crashesare used. A severecurrency crash refersto a 25percent or highermonthly depreciation which is at least10 percent higherthan the previous month ’sdepreciation.The “milder” versionrepresents a 12.5percent monthly depreciation which is at least10 percentabove the preceding month’sdepreciation;see details in the Appendix. 8 QUARTERLY JOURNALOF ECONOMICS

FIGURE II OfcialExchange Rates Typically Validate the Changes in the Market Rates Sources: Pick and Se´dillot[1971]; International Currency Analysis, World Cur- rency Yearbook, variousissues. EXCHANGE RATEARRANGEMENTS 9

TABLE I IS THE PARALLEL MARKET RATE A GOOD PREDICTOR OF CRASHES INTHE OFFICIAL EXCHANGE RATE? SUMMARY OFTHE PROBIT COUNTRY-BY-COUNTRY ESTIMATION

Regression, DO t 5 a 1 b DPt2 i 1 ut “Mild” crash

Percentof countriesfor which: b . 0 97.1 b . 0 and signicanta 81.4 b , 0 2.9 b , 0 and signicanta 1.4

Sources:Pick ’sCurrencyYearbook, World Currency Report, Pick ’sBlackMarket Yearbook, and the authors’ calculations. DOt is adummyvariable that takes onthe value of 1whenthere is arealignmentin the of cial exchangerate alongthe lines described below and 0 otherwise, a and b arethe intercept and slope coef cients, respectively(our nullhypothesis is b . 0), DPt2i is thetwelve-month change in the parallel exchange rate, lagged one to six months (thelags wereallowed to vary country by country, as therewas noprior reason to restrict dynamicsto be the same forall countries)and ut is arandomdisturbance. Two de nitionsof currency crashes are used in the spirit of Frankeland Rose [1996]. A “severe” currencycrash refersto a 25 percentor higher monthly depreciation, which is at least 10 percenthigher than the previous month ’sdepreciation.The “mild” versionrepresents a 12.5 percent monthlydepreciation, which is at least 10 percentabove the preceding month ’sdepreciation.Since both de ni- tions ofcrash yieldsimilar results, wereport here only those for the more inclusive de nition.The regression samplevaries by country and is determinedby data availability. a. At the10 percentcon dencelevel or higher.

WesternHemisphere as aregion,the coef cienton the parallel premiumwas signi cant forall thecountries in oursample. These ndings arein linewith thoseof Bahmani-Oskooee, Miteza, and Nasir[2002], whouse panel annual data for1973 – 1990 for49 countriesand employa completelydifferent approach. Theirpanel cointegrationtests indicate that theof cial ratewill systematicallyadjust tothe market rate in thelong run. Second,we calculated pairwise correlationsbetween in ation (measuredas thetwelve-month change in theconsumer price index) and thetwelve-month percent change in theof cial and marketexchange rates, six monthsearlier. If themarket rate is abetterpulse ofmonetary policy, it should be(a priori) more closelycorrelated with in ation.As shownin TableII, we nd that forthe majority of cases (about three-quartersof the countries)the changes in market-determinedexchange rates have highercorrelations with in ationthan do changesin theof cial rate.8 An interestingexception to this pattern ofhigher correla-

8.Note that, due to data limitations, we use of cialprices rather than black market or “street” pricesto measure in ationhere. Otherwise, the dominance of themarket-determined rates in this exercise would presumably be even more pronounced. 10 QUARTERLY JOURNALOF ECONOMICS

TABLE II INFLATION, OFFICIAL AND MARKET-DETERMINED EXCHANGE RATES: COUNTRY-BY-COUNTRY PAIRWISE CORRELATIONS

Percentof countriesfor which the correlations of:

Themarket-determined exchange rate and in ationare higher than the correlationsof the of cialrate and in ation 73.7 Themarket-determined exchange rate and in ationare lower than the correlationsof the of cialrate and in ation 26.3

Sources: InternationalMonetary Fund, InternationalFinancial Statistics, Pick ’sCurrencyYearbook, WorldCurrency Report, Pick ’sBlackMarket Yearbook, andthe authors ’ calculations. Thecorrelations reported are those of the twelve-month percent change in the consumer price index with thetwelve-month percent change in the relevant bilateral exchangerate lagged six months.

tionsbetween the market-determined exchange rate changes and inationis forthe industrial countriesin the “ConvertibleBret- ton Woods” period(1959 –1973), an issuethat meritsfurther study.

II.C. HowImportant Are Parallel Markets? Thereare cases where the parallel (orsecondary) exchange rateapplies onlyto a fewlimited transactions. An exampleis the “switch pound ” in theUnited Kingdom during September1950 throughApril 1967. 9 However,it is notunusual fordual or parallel markets(legal orotherwise) to account for the lion ’s shareof transactions with theof cial ratebeing little more than symbolic.As Kiguel,Lizondo, and O ’Connell[1997] note,the ofcial ratetypically diminishesin importancewhen the gap betweenthe of cial and market-determinedrate widens. Toprovidea senseof thecomparative relevance of thedual or parallel market,we proceed along two complementary dimensions.First, we include a qualitative descriptionin thecountry- specicchronologies(see background material) of what transac- tionstake place in theof cial marketversus the secondary market.Second, we develop a quantitative measureof the potential sizeof the leakages into dual orparallel exchangemarkets. 10

9.For example, while the United Kingdom of ciallyhad dual rates through April1967, the secondary rate was so trivial(both in termsof thepremium and thevolume of transactions it applied to) that it is classi edas a pegin our classicationscheme (see background material). In the next section we describe howour classi cationalgorithm deals with these cases. 10.For instance, according toClaessens [1997], export underinvoicing hit a historichigh in Mexico during 1982 —thecrisis year in which the dual market was EXCHANGE RATEARRANGEMENTS 11

FollowingGhei, Kiguel, and O ’Connell[1997], weclassify epi- sodeswhere there are dual/ parallel marketsinto three tiers accordingto the level (in percent)of theparallel marketpremium: low(below 10 percent),moderate (10 percentor above but below 50), and high (50 percentand above).For the episodes of dual/ parallel markets,we provide information about which category eachepisode falls in (by calculating theaverage premium for the duration oftheepisode). In addition totheinformation contained in thepremium, we constructed an extensivedatabase onexport misinvoicing,or the difference between what acountryreports as its exportsand what othercountries report as importsfrom that country,adjusted forshipping costs.Historically, there are tight linksbetween capital ight,export underinvoicing, and thepar- allelmarket premium. 11 As with theparallel marketpremium, wedivide theexport misinvoicing estimates into three categories (as apercentof the value of total exports): low (less than 10 percentof exports), moderate (10 to15 percentof exports), and high (above15 percent).For Europe, Japan, and theUnited States,misinvoicing calculations start in 1948, whilefor the remainingcountries these start in 1970. In theextensive backgroundmaterial to this paper, weshow,for each episode, which of thethree categories is applicable. Finally,we construct a score(1 forLow, 2 forModerate, and 3forHigh) forboth of theseproxies forleakages. The combined score on the estimated size of the leakages(these range from 2 to6) is alsoreported. 12 TableIII, whichshows the evolution of export misinvoicing (as apercentof thevalue of totalexports) and theparallel market premium(in percent)across regions and throughtime, provides a general avorof the size of potential leakages from the of cial market.According to our estimates of misinvoicing (top panel), theregional patterns showthe largest leakages for the Caribbean and non-CFA Sub-Saharan Africa 1970 –2001, with averagesin the30 to50 percentrange. The lowest estimates of misinvoicing (8 to11 percent)are for Western Europe, North America, and the

introduced.Similar statements can be made about other crisis episodes that involvedthe introduction of exchangecontrols and the segmentation of markets. 11.See Kiguel, Lizondo, and O ’Connell[1997] and the references contained therein. 12. See “Part II.ParallelMarkets and Dual and Multiple Exchange Rate Practices:Background Materialto A ModernHistory of ExchangeRate Arrange- ments:A Reinterpretation ” at http://www.puaf.umd.edu/faculty/papers/reinhart/reinhart.htm . 12 QUARTERLY JOURNALOF ECONOMICS

TABLE III LEAKAGES: EXPORT MISINVOICINGAND THE PARALLEL MARKET PREMIUM ABSOLUTE VALUE OF EXPORT MISINVOICING (ASAPERCENT OFTHE VALUEOF EXPORTS )

Descriptivestatistics Meanabsolute value (by decade)

Min.Max. St. dev 48 –49 50–59 60–69 70–79 80–89 90–01 70–01

World 7.039.8 8.4 12.8 10.9 9.9 24.7 22.1 26.0 24.4 NorthAfrica 2.559.9 10.3 ...... 7.2 8.3 16.1 10.9 CFA 12.648.3 8.4 ...... 28.5 21.7 21.5 23.8 Restof Africa 16.3201.9 33.5 ...... 23.4 23.4 53.6 34.1 MiddleEast and Turkey 9.145.4 9.6 ...... 30.7 16.7 17.4 21.5 Developing Asia and Pacic 9.579.1 16.9 ...... 31.4 14.9 24.1 23.5 IndustrializedAsia 3.7 18.2 3.3 11.2 14.2 13.9 14.6 12.0 10.3 12.2 Caribbean 9.7136.0 33.2 ...... 30.8 48.9 60.0 47.0 Centraland South America 12.049.6 8.2 ...... 26.1 36.0 30.4 30.8 Central and EasternEurope 2.5 50.0 18.3 ...... 46.6 15.4 7.4 22.1 WesternEurope 2.4 16.9 3.0 14.1 10.4 10.0 11.6 7.6 7.7 8.9 NorthAmerica 0.6 22.6 5.9 4.6 9.4 3.8 16.0 11.4 4.8 10.4

Monthlyaverage parallel market premium (excluding freelyfalling episodes,in percent) Descriptivestatistics Average(by decade)

Min.Max. St. dev 46 –49 50–59 60–69 70–79 80–89 90–98 46–98

World 11.6205.9 35.4 137.8 56.7 38.1 31.3 57.8 52.6 54.1 NorthAfrica 21.2164.8 41.4 ... 9.9 35.7 30.7 108.6 62.0 53.6 CFA 26.412.7 2.7 ...... 0.0 1.2 1.8 0.9 Restof Africa 1.7322.5 73.9 31.9 6.9 33.7 113.7 112.7 107.7 71.0 MiddleEast and Turkey 5.1493.1 99.6 54.6 81.0 26.0 21.4 146.5 193.2 88.6 Developing Asia and Pacic 23.7660.1 95.0 143.5 60.9 168.9 44.7 43.1 12.1 72.9 IndustrializedAsia 26.9815.9 107.6 324.4 43.0 12.0 3.6 1.3 1.5 36.1 Caribbean 223.8300.0 42.8 ...... 29.6 30.2 56.8 53.6 42.3 Centraland South America 3.0716.1 78.5 49.1 133.0 16.4 18.6 74.8 8.4 51.0 WesternEurope 25.6347.5 48.6 165.5 17.0 1.2 2.0 1.7 1.2 16.9 NorthAmerica 24.349.7 3.3 7.2 0.5 0.0 1.1 1.4 1.6 1.3

Sources: InternationalMonetary Fund, Directionof TradeStatistics, International Financial Statistics, Pick’sCurrencyYearbook, World Currency Report, Pick ’sBlackMarket Yearbook, and authors’ calculations. Tocalculate export misinvoicing, let XWi 5 importsfrom country i,as reportedby the rest ofthe world (CIFbasis), Xi 5 exportsto the world as reportedby country i, Z 5 importsCIF basis/importsCOB basis, thenexport misinvoicing 5 (XWi/Z) 2 Xi.Theaverages reported are absolute values as apercentof thevalue oftotal exports.The parallel premium is de ned as 100 3 [(P 2 O)/O)], where P and O arethe parallel and ofcial rates, respectively.The averages for the parallel premium are calculated for all thecountries in our samplein each region, as such,it includescountries where rates areuni edand the premium is zeroor nil. EXCHANGE RATEARRANGEMENTS 13

CFA FrancZone. It is alsonoteworthy that, although low by the standards ofother regions, the export misinvoicing average in 1970 –2001 forWestern Europe is half ofwhat it was in 1948 – 1949. Yettheseregional averages may understate the importance ofmisinvoicing in somecountries. For example, the maximum valuefor 1948 –2001 forWestern Europe (16.9 percent)does not reectthe fact that forSpain misinvoicingas apercentof the valueof exports amounted to 36 percentin 1950, acomparable valueto what wesee in someof thedeveloping regions. As tothe regional average parallel marketpremium shown in thebottom panel ofTable III, all regionsfall squarelyin the Moderate-to-Highrange (with theexception of North America, WesternEurope, and CFAAfrica). In thecase of developingAsia, theaverages are signi cantly raised by Myanmar and Laos.It is worthnoting the averages for Europe and industrialized Asia in the1940s arecomparable and evenhigher than thoserecorded formany developing countries, highlighting theimportance of acknowledgingand accountingfor dual marketsduring this period. Tosum,in this sectionwe have presented evidence that leads usto conclude that parallel marketswere both important as indicators ofmonetarypolicy and as representativeof the prices underlyingan importantshare of economic transactions. It is thereforequite reasonable to draw heavilyon thedual orparallel marketdata in classifying exchangerate regimes, the task to whichwe now turn.

III. THE “NATURAL” CLASSIFICATION CODE: A GUIDE Wewould describeour classi cationscheme as a “Natural” systemthat relieson a broad varietyof descriptivestatistics and chronologiesto group episodes into a much nergrid ofregimes, ratherthan thethree or fourbuckets of otherrecent classi cation strategies. 13 Thetwo most important new pieces of information webring tobear are our extensive data onmarket-determined dual orparallel exchangerates and detailed countrychronologies. Thedata, its sources,and countrycoverage are described along with thechronologies that map thehistory of exchange rate arrangementsfor each country in thedetailed backgroundmate-

13.In biology,a naturaltaxonomic scheme relies on thecharacteristics of a speciesto group them. 14 QUARTERLY JOURNALOF ECONOMICS rial tothis paper. Toverify and classify regimes,we also rely on avarietyof descriptive statistics based onexchange rate and inationdata from1946 onwards;the Appendix describesthese. III.A. TheAlgorithm FigureIII is aschematicsummarizing our Natural Classi - cationalgorithm. First, weuse the chronologies to sort out for separatetreatment countries with eitherof cial dual ormultiple ratesor active parallel (black) markets. 14 Second, if thereis no dual orparallel market,we check to see if thereis an of cial preannouncedarrangement, such as apegor band. If thereis, we examinesummary statistics toverify the announced regime, going forward fromthe date ofthe announcement. If theregime is veried (i.e.,exchange rate behavior accords with theprean- nouncedpolicy), it is thenclassi ed accordinglyas apeg,crawling peg,etc. If theannouncement fails veri cation(by far themost commonoutcome), we then seek a defacto statistical classi ca- tionusing thealgorithm described below, and discussed in greaterdetail in theAppendix. Third, if thereis nopreannounced path forthe exchange rate,or if theannounced regime cannot be veri edby thedata and thetwelve-month rate of in ationis below40 percent,we classify theregime by evaluating exchangerate behavior. As regardswhich exchange rate is used,we consider a varietyof potentialanchor currencies including theUS dollar,deutsche mark,euro, French franc, UK pound,yen, Australian dollar, Italian lira,SDR, SouthAfrican rand, and theIndian rupee.A reading ofthecountry chronologies makes plain that therelevant anchorcurrency varies not only across countries but sometimes within acountryover time. (For example, many former British coloniesswitched frompegging to the UK pound topegging to the US dollar.) Ourvolatility measureis based ona ve-yearmoving window (seethe Appendix fordetails), sothat themonthly exchange rate behaviormay be viewed as part ofalarger,continuous, regime. 15

14.See background material posted at http://www.puaf.umd.edu/faculty/ papers/reinhart/reinhart.htm . 15.If the classi cationis based on exchange rate behavior in a particular year,it ismore likely that one-time events (such as a one-timedevaluation and repeg)or aneconomicor politicalshock leads to labeling the year as achangein regime,when in effect there is no change. For example, Levy-Yeyati and Stur- zenegger[2002], who classify regimes one year at a time(with no memory), classiedallCFA zonecountries as having an intermediateregime in 1994, when EXCHANGE RATEARRANGEMENTS 15

FIGURE III ANaturalExchange Rate Classi cationAlgorithm

thesecountries had a one-timedevaluation in Januaryof thatyear. Our algorithm classiesthem as having pegs throughout. The ve-yearwindow also makes it lesslikely that we classify as a pegan exchange rate that did not move simply becauseit was a tranquilyear with no economicor politicalshocks. It isfar less probablethat there are no shocks over a ve-yearspan. 16 QUARTERLY JOURNALOF ECONOMICS

Wealso examined the graphical evidenceas acheckon the classication.In practice,the main reason for doing sois to separatepegs from crawling pegsor bands and tosort the latter intocrawling and noncrawlingbands. Fourth, as wehave already stressed,a straightforward but fundamental departurefrom all previousclassi cationschemes is that wecreate a newseparate category for countries whose twelve-monthrate of in ationis above40 percent.These cases are labeled “freelyfalling. ”16 If thecountry is inahyperin ation (accordingto the classic Cagan [1956] de nitionof 50 percentor more monthly ination),we categorize the exchange rate regime as a “hyperoat,” asubspeciesof freely falling. In FigureIV, bilateral exchangerates versus the US dollar areplotted fortwo countriesthat havebeen classi ed by theIMF (and all previous classicationefforts) as oatingover much of the postwar period—Canada and Argentina. 17 Tous, lumping theCanadian oatwith that ofArgentina during its hyperin ationseems, at a minimum,misleading. As FigureIV illustrates, oatingregimes lookrather different fromfreely falling regimes —witness the ordersof magnitudedifference in thescales between Canada (top ofpage) and Argentina(bottom). This difference is highlighted in themiddle panel,which plots theCanadian dollar-US dollar exchangerate against Argentina ’sscale;from this perspective,it looks like a xedrate! The exchange rate histories of othercoun- triesthat experiencedchronic high in ation bouts— evenif these did notreach the hyperin ation stage—lookmore similar to Ar- gentinain FigureIV than toCanada. 18 In ourview, regimes associatedwith an utterlack of monetary control and theatten- dant veryhigh in ationshould notbe automatically lumped underthe same exchange rate arrangement as lowin ation oating regimes.On thesegrounds, freely falling needsto be treated as aseparatecategory, much in thesame way that HighlyIn- debted PoorestCountries (HIPC) aretreated as aseparate “type” of debtor.

16.In the exceptional cases (usually the beginning of anin ationstabiliza- tionplan) where, despite in ationover 40 percent, the market rate nevertheless followsa con rmed,preannounced band or crawl, thepreannounced regime takes precedence. 17.For Argentina, this of courserefers to the period before the Convertibility Planis introducedin April 1991 and for Canada the post-1962 period. 18.Two-panel gures,such as that shown for Chile (Figure V), foreach country inthesample are found in thebackground material alongside the country-specicchronologies. EXCHANGE RATEARRANGEMENTS 17

FIGURE IV TheEssential Distinction between Freely Floating and Falling Sources: Pick and Se´dillot[1971]; International Currency Analysis, World Cur- rency Yearbook, variousissues. 18 QUARTERLY JOURNALOF ECONOMICS

In step 5wetake up thoseresidual regimesthat werenot classiedin steps 1through4. These regimes become candidates for “managed” or “freely” oating.19 Todistinguish betweenthe two,we perform some simple tests (see the Appendix) that lookat thelikelihood the exchange rate will movewithin anarrowrange, as wellas themean absolute value of exchange rate changes. Whenthere are dual orparallel marketsand theparallel market premiumis consistently10 percentor higher, we apply steps 1 through5 toour data onparallel exchangerates and reclassify accordingly,though in our ner grid.20

III.B. Usingthe Chronologies The153 individual countrychronologies are also a central point ofdeparturefrom all previousefforts to classify regimes.In the rstinstance the data areconstructed by cullinginformation fromannual issuesof varioussecondary sources, including Pick’s CurrencyYearbook, World Currency Yearbook, Pick ’s Black Mar- ketYearbook, International Financial Statistics, the IMF’s An- nual Reporton Exchange Rate Arrangements and ExchangeRe- strictions, and the UnitedNations Yearbook. Constructingour data setrequired us tosort and interpretinformation for every yearfrom every publication above.Importantly, we draw onna- tionalsources to investigateapparent data errorsor inconsisten- cies.More generally, we relyon thebroader economics literature toinclude pertinent information, such as thedistribution of transactionsamong of cial and parallel markets. 21 Thechronologies allow ustodate dual ormultiple exchange rateepisodes, as wellas todifferentiate between preannounced pegs,crawling pegs,and bands fromtheir de facto counterparts. Wethink it isimportantto distinguish between,say, de facto pegs orbands fromannounced pegs orbands, becausetheir properties arepotentially different. 22 At thevery least, we want toprovide futureresearchers with thedata neededto ask a varietyof questionsabout the role of exchange rate arrangements. The

19.Our classi cation of “freely oating” isthe analogue of “independently oating” in the ofcial classication. 20.When the parallel market premium is consistently (i.e., all observations within the ve-yearwindow) in single digits, we ndthat in nearly all thesecases the ofcialand parallel rates yield the same classi cation. 21.See Marion [1994], for instance. 22.Policy-makers may not be indifferentbetween the two. In theory, at least, announcementsof pegs, bands, and so oncanact asacoordinatingdevice which, byvirtue of beingmore transparent, could invite speculative attacks. EXCHANGE RATEARRANGEMENTS 19 chronologiesalso agthedates forimportant turning points, such as whenthe exchange rate rst oated,or when the anchor currencywas changed. TableIV givesan exampleof oneof our153 chronologies(see backgroundmaterial) for the case of Chile. The rstcolumn gives criticaldates. Note that weextendour chronologies as far backas possible(even though we can only classify from1946 onwards); in thecase of Chile wego back to 1932. Thesecond column lists howthe arrangement is classi ed. Primary classicationrefers to the classi cation accordingto our Natural algorithm, whichmay or may not correspond to the ofcial IMFclassi cation(shown in parenthesesin thesecond columnof Table IV). Secondary and tertiary classications are meantonly to provide supplemental information,as appropriate. So,for example, from November 1952 until April 1956, Chile ’s inationwas above40 percent,and hence,its primaryclassi cationis freelyfalling —that is,the only classi cationthat matters forthe purposes of theNatural algorithm. For those interested in additional detail, however,we also note in that columnthat the market-determinedexchange rate was amanaged oatalong the linesdescribed in detail in theAppendix (secondary)and that, furthermore,Chile had multipleexchange rates (tertiary). This additional informationmay be useful, for example, for research- erswho are not interested in treatingthe high in ation cases separately(as wehave done here). In this case,they would have sufcientinformation to place Chile in the1952 –1956 periodin the managed oatcategory. Alternatively, for those researchers whowish totreat dual ormultiple exchange rate practices as a separatecategory altogether (say, becausethese arrangements usually involvecapital controls),the second column (under sec- ondaryor tertiary classi cation)provides the relevant informa- tionto do that sortingaccordingly. As onecan see, although Chile uni ed rateson September 1999, it previouslyhad someform of dual ormultiple rates throughoutmost of its history.In thesecircumstances, we reit- eratethat ourclassi cationalgorithm relies on the market-determined,rather than theof cial exchangerate. 23 Over some

23.The other Chronologies do not contain this information, but the annual ofcialIMF classi cationfor the countries in the sample is posted at http:// www.puaf.umd.edu/faculty/papers/reinhart/reinhart.htm . 20 TABLE IV A SAMPLE CHRONOLOGY IN THE NATURAL CLASSIFICATION SCHEME: CHILE, 1932–2001

Classication primary/secondary/tertiary Date (ofcial IMF classication in parentheses) Comments

September 16, 1925–April 20, 1932 Peg Gold standard. Foreign exchange controls are introduced on UREL QUARTERLY July 30, 1931. April 20, 1932–1937 Dual market Pound Sterling is reference currency. Suspension of gold standard. 1937–February 1946 Managed oating/Multiple rates US dollar becomes the reference currency. March 1946–May 1947 Freely falling/Managed oating/Multiple rates June 1947–October 1952 Managed oating/Multiple rates ORA JOURNAL November 1952–April 16, 1956 Freely falling/Managed oating/Multiple rates April 16, 1956–August 1957 Freely falling/Managed oating/Dual market Rate structure is simplied, and a dual market is created. September 1957–June 1958 Managed oating/Dual market July 1958–January 1, 1960 Freely falling/Managed oating/Dual market January 1, 1960–January 15, 1962 Peg to US dollar The escudo replaces the peso. FOF January 15, 1962–November 1964 Freely falling/Managed oating/Multiple rates Freely falling since April 1962.

December 1964–June 1971 Managed oating/Multiple rates (Peg) ECONOMICS July 1971–June 29, 1976 Freely falling/Multiple exchange rates (Peg through On September 29, 1975, the peso replaced the escudo. 1973-managed oating afterwards) October 1973 classies as a hyperoat. June 29, 1976–January 1978 Freely falling/Crawling peg to US dollar (Managed oating) February 1978–June 1978 Preannounced crawling peg to US dollar/Freely falling The Tablita Plan. (Managed oating) July 1978–June 30, 1979 Preannounced crawling peg to US dollar (Peg) The Tablita Plan. June 30, 1979–June 15, 1982 Peg to US dollar (Peg) The second phase of the Tablita Plan. June 15, 1982–December 1982 Freely falling/Managed oating/Dual market January 1983–December 8, 1984 Managed oating/Dual market (Managed oating) Parallel market premium reaches 102 percent in early 1983. On March 1983 the intention to follow a PPP rule was announced. TABLE IV (CONTINUED)

Classication primary/secondary/tertiary Date (ofcial IMF classication in parentheses) Comments

December 8, 1984–January 1988 Managed oating/Dual market (Managed oating) PPP rule. The ofcial rate is kept within a 62% crawling EXCHANGE band to US dollar. February 1988–January 1, 1989 De facto crawling band around US dollar/Dual market PPP rule. 65% band. Ofcial preannounced 63% crawling (Managed oating) band to US dollar. While the ofcial rate remains within the preannounced band, parallel market premium remain in double digits.

January 1, 1989–January 22, 1992 Preannounced crawling band around US dollar/Dual PPP rule. Band width is 65%. RATE market (Managed oating) January 22, 1992–January 20, 1997 De facto crawling band around US dollar/Dual market PPP rule. Band is 65%. There is an ofcial preannounced (Managed oating) 610% crawling band to US dollar. Parallel premium falls ARRANGEMENTS below 15 percent and into single digits. January 20, 1997–June 25, 1998 De facto crawling band to US dollar/Dual market Ofcial preannounced crawling 612.5% band to US dollar; (Managed oating) de facto band is 65%. June 25, 1998–September 16, 1998 Preannounced crawling band to US dollar/Dual market 62.75% band. (Managed oating) September 16, 1998–December 22, 1998 Preannounced crawling band to US dollar/Dual market 63.5% band. (Managed oating) December 22, 1998–September 2, 1999 Preannounced crawling band to US dollar/Dual market 68% band. (Managed oating) September 2, 1999–December 2001 Managed oating (Independently oating) Rates are unied.

Reference currency is the US dollar. Data availability: Ofcial rate, 1900:1–2001:12. Parallel rate, 1946:1–1998:12. 21 22 QUARTERLY JOURNALOF ECONOMICS periodsthe discrepancy betweenthe of cial and parallel rate, however,proved to be small. For example, from January 1992 onwards theparallel marketpremium remained in singledigits, and ouralgorithm shows that it makeslittle difference whether the ofcial orparallel rateis used.In theseinstances, we leave thenotation in thesecond column that thereare dual rates(for informationpurposes), but alsonote in thethird columnthat the premiumis in singledigits. As noted,Chile has alsoexperienced severalperiods where the twelve-month monthly in ation ex- ceeded40 percent.Our algorithm automatically categorizes these as freelyfalling exchangerate regimes —unless there is a preannouncedpeg, crawling peg,or narrowband that is veri ed, as was thecase when the Tablita programwas introducedon February 1978. Thethird columnin ourchronology gives further sundry informationon theregime — e.g.,the width oftheannounced and defacto bands, etc.For Chile, which followed a crawling band policyover many subperiods, it is particularly interestingto note thechanges over time in thewidth ofthebands. Thethird column alsoincludes information about developments in theparallel marketpremium and currencyreform. As an exampleof the former,we note that since1992 theparallel premiumslipped into singledigits; an exampleof thelatter is givenfor Chile whenthe pesoreplaced the escudo in 1975. Thetop panel ofFigure V plots thepath ofthe of cial and market-determinedexchange rate for Chile from1946. It is evi- dentthat throughmuch of the period shown the arrangement was oneof a crawling pegor a crawling band, with therate of crawl varying throughtime and notably slowingas in ation beganto stabilize followingthe Tablita plan ofthe early 1980s. Thebottom panel plots theparallel marketpremium (in percent). Thispattern is representativeof many other countries in our sample;the premium skyrockets in theperiods of economic and political instability, declinesinto single digits as crediblepolicies areput in place and capital controlsare eased. As wewill discuss in thenext section, the Chilean caseis alsoillustrative, in that crawling pegs orbands arequite common. Figure VI, which showsthe path ofthe exchange rate for the Philippines, India, and Greece,provides other examples of the plethora of crawling pegs orbands in oursample. EXCHANGE RATEARRANGEMENTS 23

FIGURE V Chile: Ofcialand Market-Determined Exchange Rates and the Parallel MarketPremium January1946 –December1998 Sources: InternationalMonetary Fund, AnnualReport onExchange Arrangements andExchange Restrictions andInternational Financial Statistics; Pick and Se´dillot [1971];International Currency Analysis, World Currency Yearbook, variousissues. 24 QUARTERLY JOURNALOF ECONOMICS

FIGURE VI ThePrevalence of Crawling Pegs and Bands Sources: Pick and Se´dillot[1971]; International Currency Analysis, World Cur- rency Yearbook, variousissues. EXCHANGE RATEARRANGEMENTS 25

TABLE V THE FINE AND COARSE GRIDS OF THE NATURAL CLASSIFICATION SCHEME

Number assigned to category in:

Fine Coarse Naturalclassi cationbucket grid grid

Noseparate legal tender 1 1 Preannouncedpeg or currency boardarrangement 2 1 Preannouncedhorizontal band that is narrower than or equal to 62% 3 1 De facto peg 4 1 Preannouncedcrawling peg 5 2 Preannouncedcrawling bandthat is narrower than or equal to 62% 6 2 Defacto crawling peg 7 2 Defacto crawling bandthat is narrowerthan or equalto 62% 8 2 Preannouncedcrawling bandthat is wider than 62% 9 2 Defacto crawling bandthat is narrowerthan or equalto 65% 10 3 Noncrawlingband that is narrower than or equal to 62%a 11 3 Managed oating 12 3 Freely oating 13 4 Freelyfalling (includes hyper oat) 14 5

Source: Theauthors. a. Bycontrast tothe common crawling bands, anoncrawlingband refers to the relatively few cases that allow for both a sustainedappreciation and depreciation of the exchange rate over time. While the degree of exchangerate variability inthese cases is modestat higherfrequencies (i.e., monthly), lower frequency symmetricadjustment is allowedfor. TheAppendix provides a detaileddiscussion ofour classi cationalgorithm.

III.C. AlternativeTaxonomies: Comparing theBasic Categories Altogether,our taxonomy of exchange rate arrangements includesthe fourteen classi cationssketched in TableV (or f- teenif hyper oatsare treated as aseparatecategory). Of course, fourteen(or fteen)buckets are not exhaustive, for example, if onewishes to distinguish betweenforward- and backward-look- ing crawls orbands, alongthe lines of Cottarelli and Giannini [1998]. Giventhat weare covering the entire post-World WarII period,we did nothave enough information to make that kind of nerdistinction. Conversely, because we sometimeswant tocom- pareour classi cationregime with thecoarser of cial one, we alsoshow how to collapse our fourteen types ofarrangementsinto vebroader categories; see Table V, wherethe least exible arrangementsare assigned thelowest values in ourscale. 26 QUARTERLY JOURNALOF ECONOMICS

In the nergrid, we distinguish betweenpreannounced pol- iciesand theless transparent defacto regimes. Since the former involvean explicit announcementwhile the latter leave it to nancial marketanalysts todetermine the implicit exchangerate policy,in the ner classicationwe treat preannouncement as less exiblethan defacto. We accordinglyassign it alowernum- berin ourscale. Those not interested in testingwhether an- nouncementsserve as acoordinatingdevice (say, tomake a speculativeattack morelikely) and onlyinterested in sortingout thedegree of observed exchange rate exibility will preferthe coarsergrid. However, even in thecoarse grid, it is imperativeto treatfreely falling as aseparatecategory.

IV. THE “NATURAL” TAXONOMY: CRITIQUES AND COMPARISONS As theprevious section described, our classi cationstrategy reliesimportantly on theobserved behavior of themarket-determinedexchange rate. In this sectionwe rstaddress somepoten- tial critiquesof our approach, including whethera country ’s in- ternationalreserve behavior should affect its classi cation, and whetherwe may be mislabeling some regimes as pegs orcrawls simply dueto the absence of shocks.We thenproceed to compare ourresults with the “ofcial history, ” and provideexamples of howour reclassi cationmay reshape some of the existing evi- denceon the links between exchange rate arrangements and variousfacets of economic activity.

IV.A.The Trilogy: Exchange Rates, Monetary Policy, and Capital Controls Tocapture the nuances of any exchangerate arrangement, onemight also want informationon the presence and effective- nessof capital controls,the modalities of (sterilized orunsteril- ized) foreignexchange intervention, and theextent to which interestrates (or other less conventional types ofintervention) areused as ameansto stabilize theexchange rate. Since, for the purposesof universality, our classi cationrests squarely on the univariatetime series behavior of the nominal exchange rates (combinedwith historicalchronologies), in this subsectionwe address someof these limitations to our approach. Somestudies havereclassi ed exchangerate arrangements by alsofactoring in thebehavior of foreignexchange reserves as EXCHANGE RATEARRANGEMENTS 27 reportedby theIMF ’s International Financial Statistics. 24 How- ever,as Calvo and Reinhart [2002] note,using reserveshas seriouslimitations. In Brazil and in overtwo dozen other countries,foreign exchange market intervention is frequentlydone throughpurchases and salesof domestic dollar-linked debt. 25 Thisdebt is notre ectedin thewidely usedIFS reservedata, neitherwere the massive interventions of theThai authorities in theforward marketduring 1997 and in SouthAfrica thereafter. Furthermore,as nancial liberalization has spread throughout theglobe, there has beena widespread switch fromdirect inter- ventionin theforeign exchange market to the use of interestrate policyin the1990s as ameansto stabilize theexchange rate. 26 Pickingup onthis kind ofpolicyintervention requires having the policyinterest rate —theequivalent of the federal funds ratefor theUnited States —foreach country. Such data arevery dif cult tocome by, and noneof theother efforts at reclassi cation have dealt with issue. Otherissues arise in thecontext of thelinks between monetary,capital controls,and exchangerate policy. In particular, while xing theexchange rate (or having narrowbands, orcrawling pegs,or bands) largelyde nesmonetary policy, our two most exiblearrangement categories (managed orfreely oating) do not.Floating could be consistent with monetarytargets, interest ratetargets, or in ationtargeting, the latter being a relatively recentphenomenon. 27 Sinceour study dates backto 1946, it spans aseachange in capital controlsand monetarypolicy regimes,and it is beyondthe scope of this paper tosubdivide the monetarypolicy framework for the most exiblearrangements in

24.For instance, the algorithm used by Levy-Yeyatiand Sturzenegger [2002] alsouses (besides the exchange rate) reserves and base money. This gives rise to manycases of what theyrefer to as “one classicationvariable not available. ” This meansthat their algorithm cannot provide a classi cationfor the United Kingdom (whereit is hard to imagine such data problems) until 1987 and —in the most extremeof cases —somedeveloping countries cannot be classi edfor any year over their 1974–2000sample. 25.See Reinhart, Rogoff, and Savastano [2003] for a recentcompilation of dataon domestic dollar-linked debt. 26.There are plenty of recentexamples where interest rates were jacked up aggressivelyto fend off a sharpdepreciation in thecurrency. Perhapsone of the moreobvious examples is inthewake of the Russian default in August 1998,when manyemerging market currencies came under pressure and countries like Mexico respondedby doublinginterest rates (raising them to 40 percent)within a spanof acoupleof weeks. 27.Indeed, several of thein ationtargeters in oursample (United Kingdom, Canada,Sweden, etc.) are classi edasmanaged oaters.(However, it mustalso beacknowledged that there are many different variants of in ationtargeting, especiallyin emergingmarkets.) 28 QUARTERLY JOURNALOF ECONOMICS ourgrid. Apart fromexchange rate policy, however, our study shedsconsiderable light onthe third legof the trinity — capital controls.While measuring capital mobilityhas notbeen the goal ofthis paper, ourdata consistentlyshow that theparallel market premiumdwindles intoinsigni cancewith capital marketinte- gration,providing apromisingcontinuous measure of capital mobility.

IV.B. ExchangeRates and Real Shocks Ideally, onewould liketo distinguish betweenexchange rate stability arising fromdeliberate policy actions (whether its direct foreignexchange market intervention or interest rate policy, as discussed) and stability owingto the absence of economic or political shocks.In this subsectionwe provide evidence that, if the exchangerate is stable and it is accordinglytreated in ourde jure approach toclassi cation,it is typically notdue to an absenceof shocks. Termsof trade shocksare a natural sourceof potential shocks,particularly formany developing countries. Similarly, the presence(or absence) of shocks is likelyto be re ected in the volatility ofreal GDP. To investigate the incidence and sizeof termsof trade shocks,we constructed monthly terms of trade seriesfor 172 countriesover the period 1960 –2001.28 The terms oftrade seriesis ageometricweighted average of commodity prices (xedweights based onthe exports of 52 commodities). TableVI presentsa summaryby regionof the individual country ndings. The rstcolumn shows the share of commodi- tiesin totalexports, while s Dtot denotesthe variance of the monthlychange in theterms of trade ofthe particular region relativeto Australia. Australia is ourbenchmark, as it is botha countrythat isaprimarycommodity exporter and has a oating exchangerate that, by someestimates, approximates an optimal responseto terms of trade shocks(see Chen and Rogoff [2003]). Thenext three columns show the variance of themonthly change in theterms of trade oftheregion relative to Australia ( s Dtot), exchangerate of theindividual regionrelative to Australia ( s De) and thevariance of theannual changein realGDP oftheregion relativeto Australia ( s Dy).Thelast twocolumns show the

28.Table VI isbased on the more extensive results in Reinhart, Rogoff, and Spilimbergo[2003]. EXCHANGE RATEARRANGEMENTS 29

TABLE VI TERMS OF TRADE, OUTPUT, AND EXCHANGE RATE VARIABILITY VARIANCE RATIOS (NORMALIZEDTO AUSTRALIA AND EXCLUDES FREELY FALLING EPISODES)

s s s De s De Region Share s Dtot De Dy s Dtot s Dy

NorthAfrica 0.513.29 0.93 2.54 0.64 0.23 Restof Africa (excludingCFA) 0.562.92 2.87 2.50 1.29 1.38 Middle East 0.604.15 0.95 3.48 0.33 0.50 DevelopmentAsia/ Paci c 0.342.02 0.85 2.40 0.54 0.44 IndustrializedAsia 0.180.82 0.97 1.15 1.23 0.86 Caribbean 0.504.15 0.67 2.40 0.20 0.35 CentralAmerica 0.623.02 0.49 2.11 0.21 0.28 SouthAmerica 0.632.03 1.08 2.15 0.66 0.52 CentralEast Europe 0.240.60 1.03 1.51 1.66 0.78 WesternEurope 0.181.75 0.84 1.25 0.76 0.56 NorthAmerica 0.331.64 0.60 1.12 0.47 0.54

Source: Reinhart,Rogoff, and Spilimbergo [2003] and sources cited therein. Thevariable de nitionsare as follows:Share 5 shareof primary commodities to total exports;the next threecolumns show the variance of the monthly change in the terms of trade of the region relative to Australia (s Dtot),thevariance of themonthly change in the exchange rate of the individual region relative toAustralia ( s De),andthe variance of theannual change in real GDP ofthe region relative to Australia ( s Dy);thelast twocolumns show the variance of theexchange rate relative to the variance of theterms of trade (s De)/(s Dtot)andoutput ( s De)/(s Dy),respectively.

varianceof the exchange rate relative to the variance of theterms of trade (s De)/(s Dtot)and output ( s De)/(s Dy),respectively. Apriori,adverse terms of trade shocksshould beassociated with depreciationsand theconverse for positive terms of trade shocks;greater volatility in theterms of trade should gohand- in-hand with greatervolatility in theexchange rate. (In Chenand Rogoff [2003] thereis greatervolatility evenunder optimal policy.)Table VI revealsseveral empirical regularities: (a) most countries(regions) have more variable termsof trade than Aus- tralia—in somecases, such as theMiddle East and theCarib- bean,as muchas threeor four times as variable;(b) realGDP is alsocommonly far morevolatile than in Australia; (c) mostcoun- tries’ exchangerates appear tobe far morestable than Austra- lia’s,as evidencedby relativelylower variances for most of the groups;(d) followingfrom the previous observations, the last two columnsshow that formost of the country groupings that the varianceof exchange rate changes is lowerthan that ofchanges in theterms of trade orrealGDP. Takentogether, the implication of these ndings is that if theexchange rate is notmoving, it is 30 QUARTERLY JOURNALOF ECONOMICS notfor lack of shocks.Of course,terms of trade areonly one class ofshocks that cancause movement in theexchange rate. Thus, consideringother kinds ofshocks —political and economic,domestic, and international —would onlyreinforce the results presented here. IV.C. Factand Fiction:Natural and Articial? Weare now prepared tocontrast the of cial viewof the historyof exchangerate regimes with theview that emergesfrom employingour alternative methodology. To facilitate comparisons,we will focusmainly on the coarse grid versionof the Naturalsystem. FigureVII highlights someof thekey differences between the Naturaland IMFclassi cations.The dark portionsof the bars denotethe cases where there is overlapbetween the IMF and the Naturalclassi cation.29 Thewhite bar showsthe cases where the IMF labels theregime in oneway (say, apegin 1970 –1973) and theNatural labels it differently.Finally, the striped portionsof thebars indicate thecases where the Natural classi cationlabels theregime in oneway (say, freelyfalling, 1991 –2001) and the IMF labels differently (say, freely oating).As shownin Figure VII, accordingto our Natural classi cationsystem, about 40 percentof all regimesin 1950 werepegs (sincemany countries had dual/parallel ratesthat did notqualify as pegs).Figure VII alsomakes plain that someof the “pegs” in ourclassi cation were notconsidered pegs underthe of cial classication;in turn,our algorithmrejects almost half oftheof cial pegsas truepegs. Our reclassicationof the early postwar yearsimpacts notonly on developingcountries, but onindustrialized countriesas well; nearlyall theEuropean countries had activeparallel markets afterWorld War II. Asecondreason why ourscheme shows fewer pegs is that the IMF’spre-1997 schemeallowed countriesto declare their regimes as “peggedto an undisclosedbasket of currencies. ” Thisnotably nontransparentpractice was especiallypopular during the1980s, and it was alsounder this that agreatdeal ofmanaged oating, freely oating,and freelyfalling actually tookplace. Forthe period 1974 –1990 the ofcial classication has roughly60 percentof all regimesas pegs;our classi cation has onlyhalf as many.Again, as wesee in FigureVII, this comparison

29. Specically,both classi cationsassigned the regime for a particular country ina givenparticular year to the same category. EXCHANGE RATEARRANGEMENTS 31

FIGURE VII Comparisonof ExchangeRate Arrangements According tothe IMF Of cial and NaturalClassi cations,1950 –2001 Sources: InternationalMonetary Fund, AnnualReport onExchange Arrange- ments andExchange Restrictions andInternational Financial Statistics; Pick and Se´dillot[1971]; International Currency Analysis, World Currency Yearbook, various issues. Thedark barsshow the overlap between the IMF andNatural classi cation (i.e.,for that particular year the IMF andNatural classi cationscoincide); the whitebars show the cases where the IMF classi cationlabeled the regime in one way (say,a pegin 1974 –1990)and the Natural classi cationlabeled it differently; thestriped bars indicate the cases where the Natural classi cationlabeled the regimein one way (say,freely falling) and the IMF labeledit differently, (say, freely oating). understatesthe differences since some of ourpegs arenot of cial pegs and viceversa. For the years 1974 –1990, and 1991 –2001, onecan see two major trends. First, “freelyfalling ” continuesto be a signicant category,accounting for 12 percentof all regimes from 1974 –1990, and 13 percentof all regimesfrom 1991 –2001. Forthe transition economies in the1990s, over40 percentof the observationsare in thefreely falling category.Of course,what we arereporting in FigureVII is the incidence ofeach regime. Clearly,future research could use GDP weightsand —given that 32 QUARTERLY JOURNALOF ECONOMICS low-incomecountries are disproportionately represented in the freelyfalling category —this would reveala lowerimportance to this category. 30 Second,the Natural classi cationscheme reveals a bunching tothe middle in termsof exchange rate exibility,when com- pared with theof cial monetaryhistory of the world. Limited exibility—whichunder the Natural classi cationis dominated by de factocrawling pegs —becomesnotably moreimportant. Frombeing a verysmall class underthe of cial scheme,the Naturalclassi cationalgorithm elevates limited exibility tothe secondmost important grouping over the past decade,just behind pegs.Another startling differenceis thereduced importance of freely oating.According to the of cial classication,more than 30 percentof countrieswere independently oatingduring 1991 – 2001. Accordingto the Natural classi cation,less than 10 percent were freely oating.This is partly amanifestationof what Calvo and Reinhart[2002] term “fear of oating,” but equally because weassign high in ation oats(including onesthat areof cially “pegs”)toour new freely falling category.Indeed, more countries had freelyfalling exchangerates than had freely oating exchangerates! Thecontrast between the IMF and Naturalclassi cation systemsbecomes even more striking when one sees just how smallthe overlap is betweenthe two classi cationscountry by countryand yearby year.As shownin TableVII, if theIMF designationof the regime is apeg(1970 –2001), thereis a44 percentprobability that ouralgorithm will place it intoa more exiblearrangement. If theof cial regimeis a oat,there is a31 percentchance we will categorizeit as apegor limited exibility. If the ofcial regimeis amanaged oat,there is a53 percent chanceour algorithm will categorizeit as apeg orlimited exibility. Whetherthe of cial regimeis a oator peg,it is virtually acointoss whether the Natural algorithm will yield thesame result.The bottom of the table givesthe pairwise correlation betweenthe two classi cations,with theof cial classication runningfrom 1 (peg) to4 (independently oating),and theNat- ural classicationrunning from 1 (peg) to5 (freelyfalling). The simplecorrelation coef cientis only0.42. As onecan con rm from

30.GDP weightsand population weights would, of course, present very differentpictures. For example, the United States and Japan alone would increase the world’s share of oatersif it were GDP weights,while weight by population wouldincrease the weight of xersby China alone. EXCHANGE RATEARRANGEMENTS 33

TABLE VII FLOATING PEGS AND PEGGED FLOATS: REVISITINGTHE PAST, 1970–2001

In Conditionalprobability that the regime is: percent

“Other” according toNC a conditionalon beingclassi ed “Peg” by IMF 44.5 “Peg” or “LimitedFlexibility ” according toNC conditionalon being classied “ManagedFloating ” by IMF 53.2 “Peg” or “LimitedFlexibility ” according toNC conditionalon being classied “IndependentlyFloating ” by IMF 31.5 Pairwisecorrelation between IMF andNC classi cations 42.0

Sources: The authors’ calculations. a. NCrefersto the Natural Classi cation; “Other” accordingto NC includeslimited exibility,managed oating,freely oating,and freely falling.

thechronologies, the greatest overlap occurs in theclassi cation ofthe G3 currenciesand ofthe limited exibility Europeanar- rangements.Elsewhere, and especiallyin developingcountries, thetwo classi cationsdiffer signi cantly,as weshall see. IV.D.The Pegs That Float FigureVIII plots theparallel marketpremium since January 1946, in percent,for Africa, Asia, Europe,and WesternHemisphere. As is evidentfrom the Figure VIII, forall theregions except Europe, it would bedif cultto make the case that thebreakdown of Bretton Woodswas asingular event,let alone a seachange. 31 For the developingworld, the levels of pre- and post-1973 volatilitiesin the market-determinedexchange rate, as revealedby theparallel marketpremium, are remarkably similar. Note that forall regions,we excludethe freely falling episodesthat would signi cantly increase thevolatility but alsodistort the scale. To give a avor of the cross-countryvariation within regionand acrosstime, the dashed lineplots theregional average plus onestandard deviation(calculated acrosscountries and shownas a ve-yearmoving average). As regardsEurope, the story told by FigureVIII is consistent with thecharacterization of theBretton Woods system as aperiod ofwhen true exchange rate stability was remarkablyshort-lived. From1946 until thearrival ofthe late 1950s, whileEurope was not oatingin themodern sense —as mostcurrencies were not

31.We plot the premium rather than the market-determined rate, as it allowsus toaggregate across countries in comparableunits (percent). 34 QUARTERLY JOURNALOF ECONOMICS

FIGURE VIII AverageMonthly Parallel Market Premium: 1946 –1998 Sources: InternationalMonetary Fund, AnnualReport onExchange Arrange- ments andExchange Restrictions andInternational Financial Statistics; Pick and Se´dillot[1971]; International Currency Analysis, World Currency Yearbook, various issues. Thesolid line represents the average monthly parallel market premium while thedashed line shows the ve-yearmoving average of plus one standard deviation.The regional averages are calculated excluding the freely falling episodes. EXCHANGE RATEARRANGEMENTS 35 convertible —it had somevariant ofde facto oatingunder the guiseof pegged of cial exchangerates. Each timeof cial rates arerealigned, the story had already unfolded in theparallel market(as shownearlier in FigureII). Whilethe volatility ofthe gap betweenthe of cial rateand themarket exchange rate is not quitein theorder of magnitudeobserved in thedeveloping world, thevolatility ofthe parallel rateis quitesimilar to the volatility of today’smanagedor freely oatingexchange rates. 32 Thereare many cases that illustrateclearly that little changedbefore and afterthe breakup of Bretton Woods. 33 Clearly,more careful statistical testingis requiredto make cate- goricalstatements about when a structuralbreak took place; but it is obviousfrom the guresthat whateverbreak might have takenplace hardly livesup tothe usual imageof the move from xed to exiblerates.

IV.E. TheFloats That Peg FigureIX providesa general avorof how exchange rate exibility has evolvedover time and acrossregions. The gure plots ve-yearmoving averages of the probability that the monthlypercent change in theexchange rate remains within a2 percentband forAfrica, Asia, Europe,and WesternHemisphere (excluding onlythe United States). Hence, under a peggedar- rangement,assuming no adjustmentsto the parity, theseproba- bilities should equal100 percent.As before,we exclude the freely falling episodes.For comparison purposes, the guresplot the unweightedregional averages against theunweighted averages for the “committed oaters.” (Thecommitted oatersinclude the followingexchange rates against thedollar: Yen, DM (euro), Australian dollar,and theUK pound.) Thedashed lines,which showplus/ minusone standard deviationaround the regional averages,highlight thedifferences between the group of oaters and theregional averages. It is evidentfor all regions(this applies theleast to Africa) that themonthly percent variation in theexchange rate has

32.See Bordo [1993] on Bretton Woods and Bordo [2003] on a historical perspectiveon theevolution of exchangerate arrangements. 33.The country-by-country gures in “TheCountry Chronologiesand Chart- book,Background Materialto A ModernHistory of ExchangeRate Arrangements: AReinterpretation ” at http://www.puaf.umd.edu/faculty/papers/reinhart/ reinhart.htm areparticularly revealing in thisregard. 36 QUARTERLY JOURNALOF ECONOMICS

FIGURE IX AbsoluteMonthly Percent Change in theExchange Rate: Percent of Observationswithin a 62PercentBand ( ve-year movingaverage ) Sources: InternationalMonetary Fund, AnnualReport onExchange Arrange- ments andExchange Restrictions andInternational Financial Statistics; Pick and Se´dillot[1971]; International Currency Analysis, World Currency Yearbook, various issues. Thesolid line represents the average for the group whilethe dashed lines show plus/minusone standard deviation. The regional averages are calculated exclud- ingthe freely falling episodes. EXCHANGE RATEARRANGEMENTS 37 typically beenkept to a minimum —thereis agreatdeal of smoothingof exchangerate uctuationsin all regionswhen com- pared with theusual monthlyvariations of the committed oaters.The smoothing is mostevident in Asia wherethe index hoversaround 90 percentfor most of the period, versus 60 –70 percentfor the oaters.Hence, over time, the nature of the classicationproblem has evolvedfrom labeling somethingas a pegwhen it is not,to labeling somethingas oatingwhen the degreeof exchangerate exibility has in fact beenvery limited.

IV.F.Does the Exchange Rate Regime Matter? Thequestion of whether the exchange rate arrangement mattersfor various facets of economicactivity has,indeed, been a far-reaching issueover the years in theliterature on interna- tionaltrade and nance,and is beyondthe scope of this paper. In this subsectionwe present a fewsimple exercises that donot speakto possible causal patterns betweenexchange rate regimes and economicperformance, but aremeant as illustrativeof the potentialusefulness of our classi cation.First, consider Table VIII, whichseparates dual/ parallel marketsfrom all theother regimeswhere the “exchangerate is unitary, ” toemploy the languageof the IMF. The top rowshows average in ation rates and realper capita GDPgrowth for the period 1970 –2001 fordual arrangementsseparately from all otherregimes. This two-way split drastically altersthe picture presented by theIMF ’s classi- cationin thetop and fourthrows of Table IX, whichdoes not

TABLE VIII INFLATIONAND PER CAPITA REAL GDP GROWTH: A COMPARISONOF DUAL (OR MULTIPLE) AND UNIFIED EXCHANGE RATE SYSTEMS, 1970–2001

Averageannual Averageper capita Regime ination rate realGDP growth

Uniedexchangerate 19.8 1.8 Dual(or multiple) exchange rates 162.5 0.8

Sources: InternationalMonetary Fund, AnnualReport on Exchange Arrangements and Exchange Re- strictions and InternationalFinancial Statistics, Pick and Se´dillot[1971], International Currency Analysis, WorldCurrency Yearbook, variousissues. Theaverages for the two regime types (uni edand dual) are calculated on a country-by-countryand year-by-yearbasis. Thus, ifa countryhas auni edexchangerate for most of theyear, the observation for that yearis includedin the averages for uni edrates; ifin the following year that samecountry introduces a dual market(or multiple rate) for most of theyear, the observation for that yearis includedin the average for dual rates. This treatmentallows us todeal with transitions across regimetypes over time. 38 QUARTERLY JOURNALOF ECONOMICS

TABLE IX DO CLASSIFICATIONS MATTER? GROWTH, INFLATION, AND TRADE ACROSS REGIMES: 1970–2001

Limited Managed Freely Freely Classicationscheme Peg exibility oating oating falling

Averageannual in ation rate IMF Ofcial 38.8 5.3 74.8 173.9 n.a. Natural 15.9 10.1 16.5 9.4 443.3 Averageannual per capita real GDP growth IMF Ofcial 1.4 2.2 1.9 0.5 n.a. Natural 1.9 2.4 1.6 2.3 22.5 Exports plusimports as apercentof GDP IMF Ofcial 69.9 81.0 65.8 60.6 n.a. Natural 78.7 80.3 61.2 44.9 57.1

Source: InternationalMonetary Fund, WorldEconomic Outlook. Ann.a. denotes not available. The averages for each regime type (peg, limited exibility,etc.) are calculatedon a country-by-countryand year-by-year basis. Thus, ifa countryhas apeggedexchange rate for mostof theyear, the observation for that yearis includedin the averages for pegs; if in the following year that samecountry has amanaged oatfor most of theyear, the observation for that yearis includedin the average for managed oats. This treatmentallows us todeal with transitions across regimetypes over time.

treatdual marketsas aseparatecategory. Dual (ormultiple) exchangerate episodes are associated with an averagein ation rateof 163 percentversus 20 percentfor uni ed exchangemarkets—growthis onepercentage point lowerfor dual arrangements.The explanation forthis gap betweenthe outcomes shown in TableVIII and theIMF ’sin TableIX is twofold.First, 62 percentof thefreely falling casesduring 1970 –2001 wereassoci- ated with parallel marketsor dual ormultiple exchange rates. Second,the high in ationcases classi ed by theIMF as freely oatingwere moved to thefreely falling categoryNatural classication.Again, wecaution against overinterpretingthe results in TableVIII as evidenceof causality, as exchangecontrols and dual marketsare often introduced amid political and economiccri- ses—as therecent controls in Argentina(2001) and Venezuela (2003) attest. As TableIX highlights,according to the IMF, only limited exibility casesrecord moderate in ation.On theother hand, freely oatingcases record the best in ationperformance (9 percent)in theNatural classi cation.Freely falling regimesex- hibit an averageannual in ationrate 443 percentversus an inationaverage in the9 to17 percentrange for the other categories(Table IX). EXCHANGE RATEARRANGEMENTS 39

FIGURE X PPPAdjusted GDP perCapita across Regime Types: 1970 –2001 (averaging over all regions )

Thecontrast is alsosigni cant bothin termsof the level of percapita GDP(FigureX) and percapita growth(Figure XI and TableIX). Freelyfalling has thelowest per capita income(US $3,476) ofany category — highlighting that theearlier parallel to theHIPC debtoris an apt one —whilefreely oatinghas the highest(US $13,602). In theof cial IMF classi cation,limited exibility,which was almostentirely comprised of European countries,shows the largest per capita income. Growthis negativefor the freely falling cases( 22.5 percent) versusgrowth rates in the1.6 –2.4 percentrange for the other categories.Once freely falling is aseparatecategory, the differ- encesbetween our other classi cationspale relativeto the differ- encesbetween freely falling and all others(Table VIII). In the ofcial IMFclassi cation,freely oatingshows a meageraverage growthrate of 0.5 percentfor the independently oatingcases. Forthe Natural classi cation,the average growth rate quadru- ples for the oatersto 2.3 percent.Clearly, this exercisehigh- lights theimportance of treating the freely falling episodes separately. 40 QUARTERLY JOURNALOF ECONOMICS

FIGURE XI Realper Capita GDP Growth acrossRegime Types: 1970 –2001 (averaging over all regions ) Sources: InternationalMonetary Fund, AnnualReport onExchange Arrange- ments andExchange Restrictions andInternational Financial Statistics; Pick and Se´dillot[1971]; International Currency Analysis, World Currency Yearbook, various issues. Theaverages for each regime type (peg,limited exibility,etc.) are calculated ona country-by-country andyear-by-year basis. Thus, if a country hasa pegged exchangerate for most of theyear, the observation for that year is included in the averagesfor pegs; if inthe following year that same country hasa managed oat formost of the year, the observation for that year is included in the average for managed oats.This treatment allows us to deal with transitions across regime typesover time.

V. CONCLUDING REMARKS Accordingto our Natural classi cation,across all countries for 1970 –2001, 45percentof the observations of cially labeled as a “peg” should,in fact, havebeen classi edas limited exibility, managed orfreely oating— or worse, “freelyfalling. ” Post- BrettonWoods, a newtype ofmisclassi cationproblem emerged, and theodds ofbeingof cially labeled a “managed oat” when therewas adefactopeg orcrawling peg wereabout 53 percent. We thus nd that theof cial and otherhistories of exchange ratearrangeme nts canbe profoundly misleading,asastriking numberof pegs aremuch better described as oats,and vice versa. Thesemisclassi cationproblems may cloud our view of his- toryalong some basic dimensions.Using the IMF ’s classication EXCHANGE RATEARRANGEMENTS 41 forthe period 1970 to2001, forinstance, one would concludethat a freely oatingexchange rate is nota veryattractive option —it producesan averageannual in ationrate of 174 percentand a paltry averageper capita growthrate of 0.5 percent.This is the worstperformance of any arrangement.Our classi cation presentsa verydifferent picture:free oatsdeliver an averagein- ationthat is lessthan 10 percent(the lowest of any exchange ratearrangement), and an averageper capita growthrate of 2.3 percent.Equally importantly,we nd that uniedexchangerate regimesvastly outperformdual ormultiple exchange rate arrangements,although one cannot necessarily interpret these dif- ferencesas causal.While we have focused in this paper onthe exchangerate arrangement classi cationissue, the country his- toriesand data provided in this paper maywell have conse- quencesfor theory and empiricsgoing forward, especially the issueof accounting for dual an parallel markets. In herclassic historyof the IMF deVries [1969] lookedback at theearly years of the Bretton Woods regime and noted:

Multipleexchange rateswere one of the rstproblems that faced the Fund in 1946,and haveprobably been itsmost common problemin the eld of exchange rates.An impressive number and diversityof countriesin thelast twenty years have experimented with one formor another of whatthe Fund has called multiplecurrency practices,at leastfor afewif not mostof theirtransactions ...The problemof multiplerates, then, never seems entirely at an end. Thirty-fouryears have passed sincethis historywas written,and multipleexchange rate practices are showing no signs ofbecom- ing passe´.On December2001 Argentinasuspended convertibility and, in sodoing, segmented the market for foreign exchange, whileon February 7, 2003, Venezuelaintroduced strict new exchangecontrols —defacto creating a multipleexchange rate system.Some things neverchange.

APPENDIX: THE DETAILSOF THE “NATURAL” CLASSIFICATION Thisappendix describesthe details ofourclassi cationalgorithm,which is outlinedin SectionIII ofthe paper. Weconcen- trateon the description of the negrid as shownin TableV.

A.ExchangeRate Flexibility Indicesand ProbabilityAnalysis Ourjudgment about the appropriate exchangerate classi - cationis shaped importantlyby thetime-series of several mea- 42 QUARTERLY JOURNALOF ECONOMICS suresof exchangerate variability, based onmonthly observations and averagedover two-year and ve-yearrolling windows. The rstof these measures is theabsolute percent change in the monthlynominal exchange rate. We prefer the mean absolute changeto the variance to minimize the impact ofoutliers.These outliersarise when, for example, there are long periods in which theexchange rate is xedbut, nonetheless, subject to rare but largedevaluations. Toassess whether exchange rate changes are kept within a band, wecalculate the probabilities that theexchange rate remainswithin aplus/minus1, 2, and 5percent-wideband overany givenperiod. Two percent seems a reasonablecutoff todistinguish betweenthe limited exibility casesand more exible arrangements,as evenin theExchange Rate Mechanismarrange- mentin Europe 62 14 bands wereallowed. As with themean absolutedeviation, these probabilities arecalculated overtwo- year and ve-yearrolling windows. Unless otherwise noted in the chronologies,we use the ve-yearrolling windows as our primary measurefor the reasons discussed in SectionIII ofthe paper. Theserolling probabilities areespecially useful to detect implicit unannouncedpegs and bands.

B.DeJure and deFacto Pegs and Bands Wherethe chronologies show the authorities explicitly an- nouncinga peg,we shortcut the de facto dating schemedescribed belowand zeroin onthe date announcedas thestart ofthepeg. We then conrm(or not) the peg by examiningthe mean absolute monthlychange over the period following theannouncement. The chronologieswe develop, which give the day, month,and year whena pegbecomes operative, are essential to our algorithm. Thereare two circumstances where we needto go beyondsimply verifyingthe announced peg. The rstcase is whereour chronol- ogiesindicate that thepeg applies onlyto an of cial rateand that thereis an activeparallel (of cial orillegal) market.As shownin FigureIII, in thesecases we apply thesame battery of teststo the parallel marketexchange rate as wedo to the of cial ratein a unied market.Second, there are the cases where the of cial policyis apegto an undisclosed basketof currencies. In these cases,we verify if the “basket” pegis reallya defacto peg to a single dominantcurrency (or to the SDR). If nodominant currency can be identied,we do not label theepisode as apeg.Potentially, of course, EXCHANGE RATEARRANGEMENTS 43 wemay be missing some de facto basket pegs, though in practice, this is almostcertainly not a majorissue. Wenow describe our approach toward detectingde facto pegs.If thereis noof cially announcedpeg, we test for a “de facto” pegin twoways. First, we examine the monthly absolute percentchanges. If theabsolute monthly percent change in the exchangerate is equalto zero for four consecutive months or more,that episodeis classi ed(for howeverlong its lasts) as ade factopeg if thereare no dual ormultiple exchange rates. This allows us toidentify short-livedde facto pegs as wellas thosewith alongerduration. For instance, this lterallowed us toidentify thePhilippines ’ defacto peg tothe US dollar during 1995 –1997 in therun-up tothe Asian crisisas wellas thenumerous European de factopegs totheDM wellahead ofthe introduction of theeuro. Second,we compute the probability that themonthly exchange ratechange remains within a 1 percentband overa rolling ve-yearperiod: 34 P~e , 1%!, where e is themonthly absolute percentage change in theex- changerate. If this probability is 80 percentor higher, then the regimeis classi edas adefacto peg or crawling pegover the entire ve-yearperiod. If theexchange rate has nodrift, it is classied as a xedparity; if apositivedrift is present,it is labeled acrawling peg;and, if theexchange rate also goes throughperiods of both appreciation and depreciation,it is dubbed a “noncrawling ” peg.Our choice of an 80 percentthreshold is notaccidental, but ratherwe chose this valuebecause it appears todo a verygood job at detectingregimes one would want tolabel as pegs,without drawing in asigni cant numberof “false positives.” Ourapproach regardingpreannounced and defacto bands followsexactly the same process as that ofdetecting prean- nouncedand defacto pegs, we simply replacethe 61% band with a 62% band in thealgorithm. If aband is announcedand the chronologiesshow a uni edexchange market, we label theepi- sodeas aband unlessit had already beenidenti edas adefacto pegby thecriteria described earlier. But, importantly,we also verifywhether the announced and defacto bands coincide,espe-

34.There are a handfulof cases where a two-yearwindow is used. In such instances,it is noted in thechronologies. 44 QUARTERLY JOURNALOF ECONOMICS cially as thereare numerous cases where the announced (de jure) band is muchwider than thede factoband. 35 Todetectsuch cases, wecalculate the probability that themonthly exchange rate change remainswithin a 62% band overa rolling ve-yearperiod: P~e , 2%!. If this probability is 80 percentor higher, then the regime is classiedas adefacto narrow horizontal, crawling, or noncrawling band (which allows forboth a sustained appreciation and depreciation)over the period through which it remainscontinu- ouslyabove the 80 percentthreshold. In thecase where the preannounced bands arewide (mean- ing equal toor greaterthan 65%), wealso verify 65%bands. The specicsfor each case are discussed in thecountry chronologies. Forinstance, as shownearlier in TableIV, in thecase of Chile we found that thede facto band during 1992 –1998 was narrower (65%) than that whichwas announcedat thetime ( 610% and 612.5%). In thecase of Libya, which had an announced77 per- centwide band alonga xedcentralparity peggedto the SDR over theMarch 1986 –December2001, wedetected a 65% crawling band tothe US dollar.

C.FreelyFalling As weemphasize in thetext, there are situations, almost invariably dueto high in ationor hyperin ation,in whichthere aremega-depreciations in theexchange rate on a routineand sustained basis. Wehave argued that it is inappropriate and misleading tolump thesecases —whichis what all previousclas- sications(IMF orotherwise)do —with oatingrate regimes. We label episodes freelyfalling onthe basis oftwo criteria. First, periodswhere the twelve-month rate of in ationequals orex- ceeds40 percentare classi ed as freelyfalling unlessthey have been identied as someform of preannounced peg or prean- nouncednarrow band by theabove criteria. 36 The40 percent

35. Mexico’sexchangerate policy prior to the December 1994 crisis is one of numerousexamples of this pattern. Despite the fact thatthe band was widening overtime, as the oorof theband was xedand the ceiling was crawling, the peso remainedvirtually pegged to the US dollarfor extended periods of time. 36.It iscritical that the peg criteria supersede the high in ationcriteria in the classicationstrategy, since historically a majorityof in ationstabilization effortshave used the exchange rate as thenominal anchor and in many of these episodes inationrates at the outset of the peg were well above our 40 percent threshold. EXCHANGE RATEARRANGEMENTS 45 inationthreshold is notentirely arbitrary, as it has beeniden- tied as an importantbenchmark in theliterature on the deter- minantsof growth(see Easterly [2001]). As aspecial subcategory offreely falling, wedub as hyper oatsthose episodes that meet Cagan’s[1956] classic de nitionof hyperin ation(50 percentor more inationper month). Asecondsituation where we classify an exchangerate re- gimeas freelyfalling arethe six monthsimmediately following a currencycrisis —but onlyfor those cases where the crisis marks a transitionfrom a xedor quasi- xedregime to a managedor independently oatingregime. 37 Suchepisodes are typically characterizedby exchangerate overshooting. This is another situationwhere a largechange in theexchange rate does not owe toa deliberatepolicy; it is there ectionof alossof credibility and recurringspeculative attacks. To date thesecrisis episodes, we followa variant ofthe approach suggestedby Frankeland Rose [1996]. Namely,any monthwhere the depreciation exceeds or equals 12 12 percentand alsoexceeds the preceding month ’s depreciationby at least10 percentis identi ed as acrisis. 38 To makesure that this approach yields plausible crisisdates, we supplementthe analysis with ourextensive country chronologies, whichalso shed light onbalanceof paymentsdif culties.39 Since, as arule,freely falling is nottypically an explicit arrangementof choice,our chronologies also provide for all thefreely falling cases,the underlying de jure or defacto arrangement (for example,dual markets,independently oating,etc.). D.Managed and FreelyFloating Ourapproach toward identifying managedand freely oating episodesis basically tocreate these classes out of theresidual poolof episodes that, after comprehensive application ofour algorithm,have not been identi edas an explicit orimplicit peg orsome form of band, and that arenot included in thefreely

37.This rules out cases where there was a devaluationand a repegand cases wherethe large exchange rate swing occurred inthe context of analready oating rate. 38.Frankel and Rose [1996] do not date the speci cmonthof thecrisis but theyear; their criteria call for a 25percent(or higher) depreciation over the year. 39.For instance, the Thai crisis of July 1997 does not meet the modi ed Frankel-Rosecriteria. While the depreciation in Julyexceeded that of thepreced- ingmonth by more than 10 percent, the depreciation of the Thai Baht in that monthdid not exceed 25 percent.For these cases, we rely on the chronologies of events. 46 QUARTERLY JOURNALOF ECONOMICS falling category.To proxy the degree of exchange rate exibility underfreely oatingand managed oats,we construct a compos- itestatistic, e/P~e , 1%!, wherethe numerator is themean absolute monthly percent changein theexchange rate over a rolling ve-yearperiod, while thedenominator ags thelikelihood of smallchanges. For de jure orde facto pegs, this index will bevery low (close to or equal to zero),while for the freely falling casesit will bevery large. As noted,we only focus on this index forthose countries and periods whichare candidates forfreely or managed oating.We tabulate thefrequency distribution ofour index forthe currencies that are mosttransparently oating,these include US dollar/DM-euro, USdollar/yen,US dollar/UKpound,US dollar/Australian dollar, and USdollar/NewZealand dollar beginningon thedate in which the oatwas announced.We pool the observations (the ratio for rolling ve-yearaverages) for all the oaters.So, for example, sinceBrazil oatedthe real in January 1999, wewould calculate theratio only from that date forward.If Brazil ’sratiofalls inside the99 percentcon denceinterval (the null hypothesisis freely oatingand hencethe rejection region is locatedat thelower tail ofthe distribution ofthe oater’sgroup),the episode is charac- terizedas freely oating.If that ratiofalls in thelower 1 percent tail, thenull hypothesisof freely oatingis rejectedin favorof the alternativehypothesis of managed oat.It is importantto note that managedby this de nition does not necessarilyimply ac- tiveor frequent foreign exchange market intervention —it refers tothe fact that forwhatever reason our composite exchange rate variability index, e/P(e , 1%),doesnot behave like the indices forthe freely oaters.

E.Dual orMultiple ExchangeRate Regimes and Parallel Markets Dual ratesare essentially a hybrid arrangement.There are casesor periodsin whichthe premium is nil and stable sothat the ofcial rateis representativeof the underlying monetary policy. The ofcial exchangerate could be pegged, crawling, or main- tained within somebands, orin afewcases allowed to oat. But thereare countless episodes where the divergence between the ofcial and parallel rateis solarge that thepicture is incomplete withoutknowledge of what theparallel marketrate is doing.The EXCHANGE RATEARRANGEMENTS 47 countrychronologies are critical in identifying theseepisodes. In thecases where dual ormultiple rates are present or parallel marketsare active, we focus on the market-determined rates instead oftheof cial exchangerates. As shownin FigureIII, we subjectthe market-determined exchange rate (dual, multiple,or parallel) tothe battery of testsdescribed above. 40 Thisparticular categorywill especiallyreshape how we view the 1940s through the1960s, whereabout half thecases in thesample involved dual markets.

UNIVERSITY OF MARYLAND, COLLEGE PARK HARVARD UNIVERSITY

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