Fear of appreciation and current account adjustment

Abstract

This paper finds that one-sided nominal exchange rate intervention in the form of “fear of appreciation” slows adjustment of current account surpluses, providing novel support for Friedman's claims of faster adjustment under flexible exchange rates. We find evidence that countries classified as more flexible have faster convergence than peggers for current account deficits, but not so for surpluses. This asymmetry is associated with a one-sided muting of exchange rate appreciations among some countries. We then develop a multi-country monetary model augmented with a “fear of appreciation” policy rule governing foreign exchange intervention, solved as an occasionally binding constraint. The model demonstrates a mechanism by which government capital flows supporting exchange rate regimes can impinge on international financial adjustment. The model accounts for substantial asymmetries in the speed of current account adjustment, based on exchange rate regime and current account sign.