The Macroeconomic Consequences of Exchange Rate Depreciations

Layer 1 — Overview

Research Question

How does an exchange rate depreciation causally affect macroeconomic outcomes? The paper asks whether depreciations are expansionary or contractionary, and through which mechanism. The core identification challenge is endogeneity: exchange rate changes are driven by shocks that simultaneously affect output, making causal inference from unconditional variation misleading.

Empirical Strategy

The paper studies “regime-induced” exchange rate depreciations by comparing macroeconomic outcomes for countries that peg their currency to the US dollar versus countries whose currencies float against the US dollar, in response to movements in the US dollar’s value. The identifying variation arises from the interaction between a country’s pre-existing exchange rate regime (peg vs. float) and changes in the US dollar’s nominal effective exchange rate (NEER), as measured by the BIS trade-weighted index against 24 relatively advanced economies (which are excluded from the analysis). This variation — which amounts to roughly 8% of total exchange rate variation in the sample — isolates a component of bilateral exchange rate changes that is orthogonal to idiosyncratic domestic shocks. The empirical specification is a local projection (Jorda, 2005) on annual data from 1973 to 2019 with country fixed effects and region-by-time fixed effects (four regions: Europe, Americas, Africa, Asia/Oceania). The main estimating equation regresses cumulative changes in outcome variables on the interaction term Peg × ΔUSD at horizons h = 0 to 9. Standard errors are two-way clustered by time and country. Exchange rate regime classification follows Ilzetzki, Reinhart, and Rogoff (2019); observations classified in the most ambiguous intermediate categories (coarse category 3) are dropped from the baseline.

Main Empirical Findings

Regime-induced depreciations are strongly and persistently expansionary. In response to a 1% depreciation of the US dollar, the trade-weighted nominal effective exchange rate of pegger countries depreciates by 0.74% relative to floater countries on impact, rising to 0.9% before falling back to about 0.6% over years 3–5. The real effective exchange rate depreciates by a similar but slightly less persistent amount. The GDP response builds gradually, peaking after five years at approximately 0.4% per 1% US dollar depreciation. Expressed in terms of local currency depreciation, a 10% regime-induced depreciation results in a 5.5% increase in GDP over five years. Consumption rises by nearly 0.4% of GDP at peak. Investment also rises gradually, peaking after five years.

Two findings are particularly important for identifying the transmission mechanism. First, net exports fall in response to a regime-induced depreciation. Imports rise more than exports for several years following the depreciation, ruling out an export-led boom driven by expenditure switching as the primary driver. Second, the short-term nominal interest rate rises modestly in pegging countries relative to floaters (by less than 0.1 percentage point per 1% depreciation), and the ex-post real interest rate response fluctuates around zero and is statistically insignificant throughout. This rules out looser monetary policy in pegger countries as the driver of the boom. Together, these two findings rule out a large set of standard open-economy models (including those with expenditure switching, monetary easing, and s = 0 financial frictions).

The booms are concentrated in the service sector. Manufacturing, agriculture, and mining/construction responses are close to zero, indicating a domestic demand-led boom rather than an export-led one. The GDP response is entirely driven by countries with above-median capital account openness (as measured by the Chinn-Ito index); countries with below-median capital account openness show a similar exchange rate response but no significant output response. Results are similar across the early (1973–1995) and later (1996–2019) sub-periods.

The Plaza Accord of 1985 provides a concrete illustration: the log real exchange rate of peggers depreciated by 12% (SE 2.7%) relative to floaters in the first year, while log GDP of peggers was 7.4% (SE 3.1%) higher after five years, implying a GDP response to a 10% depreciation of 6.2%, broadly consistent with the baseline estimates.

Robustness checks controlling for Peg × US GDP growth, Peg × US inflation, Peg × US interest rate, Peg × commodity price changes, and Peg × global financial cycle (Miranda-Agrippino and Rey) leave results virtually unchanged.

Theoretical Framework

To explain these facts, the paper develops a four-region model (US, Euro Area, pegs to USD, pegs to euro) with imperfect financial openness. The model features (i) UIP deviations between the euro and US dollar driven by financial shocks (ψ_t), and (ii) sticky household portfolio shares, so that households invest a fixed fraction s of savings in foreign bonds and do not fully arbitrage cross-currency return differentials. When s = 0 (no household access to foreign assets), standard theory predicts that expenditure switching and real income channels dominate, yielding rising net exports — directly contradicting the data (Proposition 2). When s > 0, a “foreign credit channel” operates: following a regime-induced depreciation, expected future appreciation of the pegger currency makes foreign-currency borrowing cheaper, stimulating domestic consumption and investment, causing imports to rise more than exports (Proposition 3), consistent with the data.

The model also accounts for unconditional exchange rate disconnect and the Mussa facts. Two shocks — UIP shocks (which generate a positive exchange rate–output correlation) and domestic discount factor shocks (which generate a negative correlation, since demand contractions lead to currency depreciations via monetary easing) — together produce a low unconditional correlation between exchange rates and output even though the conditional effect of regime-induced depreciation is large. The same logic explains why switching from fixed to floating exchange rates raises exchange rate volatility dramatically without raising macroeconomic volatility commensurately: pegging eliminates UIP shock exposure (reducing output volatility) but removes the ability to use monetary policy to offset discount factor shocks (raising output volatility), and these two effects roughly offset each other in the quantitative model.

Layer 2 — Q&A

Q1: What is the core identification strategy, and what assumption is required for it to yield causal estimates?

A1: The strategy compares macroeconomic outcomes in countries pegged to the US dollar versus countries floating against the US dollar when the US dollar’s value changes. The identifying assumption is that peggers are not differentially exposed (relative to floaters) to aggregate shocks that are correlated with the US dollar exchange rate. If this holds, the direct effects of shocks driving the US dollar move pegs and floats symmetrically and are absorbed by region-by-time fixed effects, leaving only the regime-induced component. Differential exposure to US dollar-correlated shocks is the main threat to identification, but the paper shows robustness by controlling for interactions of the peg indicator with US GDP growth, US inflation, US interest rate changes, commodity price changes, and the global financial cycle.

Q2: How is “regime-induced” exchange rate variation defined, and how large is it relative to total variation?

A2: Regime-induced variation is the component of a country’s exchange rate change that arises from its pre-existing regime vis-à-vis the US dollar interacted with the change in the US dollar’s nominal effective exchange rate. It is identified via the interaction term Peg_i,t × ΔUSD_t in the local projection. This variation represents roughly 8% of total variation in exchange rates in the sample, so the strategy isolates a small but clean slice of total exchange rate movements.

Q3: How do nominal and real effective exchange rates respond for peggers versus floaters?

A3: In response to a 1% depreciation of the US dollar, the trade-weighted nominal effective exchange rate of peggers depreciates by 0.74% relative to floaters on impact, peaks around 0.9%, and then gradually declines to roughly 0.6% over years 3–5. The real effective exchange rate depreciates by a similar but slightly less persistent amount. The less-than-one-for-one response occurs because the classification includes imperfect pegs and imperfect floats; however, this misclassification attenuates both the first stage (exchange rate response) and the reduced form (output response) proportionally, so the ratio — the IV-style estimate — remains unbiased.

Q4: What is the quantitative magnitude of the output effect, and how is it computed?

A4: In response to a 1% US dollar depreciation, GDP of peggers rises by approximately 0.4% relative to floaters, peaking after five years and building gradually. To express this as a response to a 10% local currency depreciation: the average nominal exchange rate response over the first five years is roughly 0.7%, so the implied GDP response per 10% depreciation is 10 × 0.4 ÷ 0.7 ≈ 5.5%. The Plaza Accord case study yields a similar magnitude: a 12% first-year real exchange rate differential is followed by a 7.4% differential in log GDP after five years, implying 6.2% per 10% depreciation.

Q5: Why does the behavior of net exports rule out the expenditure-switching mechanism as the primary driver?

A5: Standard open-economy models predict that a depreciation improves competitiveness, boosting exports and reducing imports — generating an improvement in net exports as the engine of expansion. The paper finds the opposite: imports rise more than exports for several years following a regime-induced depreciation, so net exports fall. This is inconsistent with an export-led expenditure-switching boom. The finding is also inconsistent with the real income channel (as formalized in Proposition 2): even with s = 0, standard models predict rising net exports, but the data show the reverse.

Q6: Why does the behavior of interest rates rule out monetary policy easing as the driver?

A6: If the US dollar depreciated because of loose US monetary policy, countries with currencies pegged to the US dollar would share US monetary policy more strongly, and one would expect a relative decline in nominal interest rates for peggers. The opposite is found: the nominal interest rate of peggers rises slightly relative to floaters (by less than 0.1 percentage point per 1% depreciation), and the real interest rate response is statistically indistinguishable from zero throughout the nine-year horizon. This rules out the interpretation that the boom is driven by an easing of monetary conditions in the pegger countries.

Q7: What are ex-post UIP deviations, and what do they imply about the shock driving the variation?

A7: Ex-post UIP deviations measure the excess return to holding assets denominated in pegger currencies relative to floater currencies. After the initial depreciation of pegger currencies, those currencies subsequently appreciate and their nominal interest rates are (if anything) higher than floater interest rates. This means the ex-post return to holding pegger-currency assets is higher than for floater-currency assets — a positive UIP deviation that builds over several years after the shock. These deviations imply that the shocks driving the US dollar depreciation are financial in nature (UIP shocks), not changes in expected near-term monetary policy fundamentals.

Q8: What is the foreign credit channel, and how does it work in the model?

A8: The foreign credit channel (the second term in equation (18) of Proposition 1) operates through the cost of foreign-currency borrowing. When the pegger currency depreciates on impact and then is expected to appreciate subsequently, the exchange-rate-adjusted cost of borrowing in foreign currency falls — that is, expected future appreciation of the domestic currency reduces the real cost of foreign credit. To the extent that households have portfolio shares in foreign bonds (s > 0), this stimulates consumption via intertemporal substitution. The channel is operative only when s > 0; with s = 0 (no household access to foreign assets), net exports must rise rather than fall (Proposition 2), contradicting the data.

Q9: How does Proposition 1 establish that real interest rates and real exchange rates are sufficient statistics for the relative responses of all macroeconomic aggregates in this setting?

A9: Under Assumption 1 (pegs to the US dollar and pegs to the euro face symmetric non-monetary fundamental shocks), the relative responses of consumption, output, exports, and imports of USD-peggers versus euro-peggers are functions only of the relative path of the real interest rate and the real effective exchange rate. This is because the underlying shocks to the US economy and the Euro Area economy are common to both groups of peggers and cancel out in the comparison. The monetary regime of a country is fully summarized by the paths of the real interest rate and the real exchange rate. Since the estimated relative real interest rate response is close to zero, the paper infers that the observed output differential must arise from the real exchange rate path — hence the title.

Q10: Why does the output response differ by capital account openness but not by trade openness?

A10: The GDP response to a regime-induced depreciation is entirely driven by countries with above-median capital account openness (Chinn-Ito index). Countries below the median show a similar real exchange rate response but no significant output response. In contrast, splitting by trade openness (exports plus imports as a share of GDP) yields similar output responses in both sub-groups. This pattern is consistent with the model’s foreign credit channel, which operates through international capital flows (the parameter s representing financial openness). Countries with restricted capital accounts cannot borrow cheaply from abroad when their currencies become “cheap,” so the foreign credit channel is shut down. The result is inconsistent with the expenditure-switching channel, which would predict larger effects for more trade-open economies.

Q11: What is the sector composition of the output boom, and what does it imply about the transmission mechanism?

A11: The bulk of the output response is concentrated in the service sector. Manufacturing, agriculture, and the mining/construction/energy sectors show responses close to zero, with only a modest boom in the latter at very long horizons. Services are predominantly non-tradable, so this sectoral pattern is consistent with a domestic demand-led boom (via the foreign credit channel) rather than an export-led boom (via expenditure switching on tradable goods). The foreign credit channel stimulates domestic demand broadly, which disproportionately raises output in the non-tradable sector.

Q12: How does the model reconcile large conditional effects of exchange rates with unconditional exchange rate disconnect?

A12: The paper introduces two shocks: UIP shocks (ψ_t) and domestic discount factor shocks (β_t). UIP shocks cause the exchange rate to depreciate and output to rise (a positive conditional correlation). Discount factor shocks reduce domestic demand; monetary policy responds by lowering interest rates, which depreciates the exchange rate, but if the monetary response is insufficient to fully offset the shock, output falls — generating a negative conditional correlation between the exchange rate and output. The unconditional correlation between the exchange rate and output is a weighted average of these two conditional correlations. If these effects are of similar magnitude and opposite sign, the unconditional correlation can be close to zero even though each structural shock generates a large conditional response. This is directly analogous to how supply and demand shocks can generate a small unconditional price-quantity correlation in a standard market setting.

Q13: How does the model provide a new interpretation of the Mussa fact?

A13: The Mussa fact is that the collapse of Bretton Woods dramatically increased the volatility of real exchange rates in countries that switched to floating, without a corresponding increase in macroeconomic volatility. In the model, pegging has two opposing effects on output volatility: it insulates the economy from UIP shocks (reducing output volatility) but prevents the use of monetary policy to offset discount factor shocks (raising output volatility). In the quantitative model (Appendix D), these effects roughly offset each other, so moving from a peg to a float raises exchange rate volatility substantially while leaving macroeconomic volatility roughly unchanged — consistent with the Mussa fact. This contrasts with the Itskhoki-Mukhin interpretation, which attributes Mussa facts to exchange rates (driven by UIP shocks) having little effect on output; in the present paper, the conditional effects are large but cancel in the unconditional moments.

Q14: What does the paper imply for the tradeoffs associated with adopting a fixed versus flexible exchange rate regime?

A14: Traditional analyses of the monetary trilemma emphasize that pegging to the US dollar forces a country to follow US interest rate policy. The paper argues that a first-order consequence of pegging — one that may outstrip the traditional monetary policy tradeoff in importance — is that the country imports the financial shocks (UIP shocks) that drive the US exchange rate while potentially reducing its exposure to home-grown financial shocks. When the US dollar depreciates due to financial shocks, pegger countries experience a stimulatory foreign credit inflow. Conversely, when the US dollar appreciates due to financial shocks, pegger countries face tighter financial conditions. The importance of this financial shock trade-off, the paper argues, may greatly exceed the importance of the traditional monetary trilemma in environments where financial shocks are a dominant driver of exchange rate fluctuations.

Q15: How does the paper handle the potential concern that the peg classification is imperfect?

A15: The paper notes that misclassification of pegs and floats attenuates both the exchange rate response (first stage) and the output response (reduced form) proportionally. Since the ultimate quantity of interest is the ratio of the output response to the exchange rate response (analogous to an IV estimate), misclassification in both the numerator and denominator does not introduce bias. This is analogous to an instrumental variables regression where the first stage need not have a high R-squared for the IV estimate to be valid. The paper also shows robustness to alternative treatments of the ambiguous intermediate categories (Ilzetzki-Reinhart-Rogoff coarse category 3), including them as pegs or floats, with similar results in both cases.

Key Concepts

Regime-induced depreciation: A change in a country’s bilateral exchange rate that arises specifically because the country has a pre-existing peg (or float) to a reference currency, and that reference currency’s value changes in world markets. The variation is defined as the component of a country’s exchange rate movement driven by the interaction between its exchange rate regime vis-à-vis the US dollar and changes in the US dollar’s nominal effective exchange rate. This is distinguished from all other exchange rate variation, including that driven by domestic idiosyncratic shocks.

Foreign credit channel: The mechanism in the paper’s model through which a regime-induced depreciation stimulates domestic demand. When the domestic currency depreciates on impact and is expected to appreciate subsequently, the exchange-rate-adjusted cost of borrowing in foreign currency falls. Households with portfolio shares in foreign bonds (s > 0) borrow more cheaply from abroad, stimulating consumption via intertemporal substitution. This channel requires imperfect financial openness (s > 0 but not full UIP arbitrage) and predicts that the output boom is domestic-demand-led with falling net exports — consistent with the data.

UIP shock (ψ_t): An exogenous shock to uncovered interest parity between the US dollar and the euro, interpreted as arising from frictions in international financial markets or from exogenous shifts in demand for one currency over another. A positive ψ_t represents an increase in demand for the euro (relative to the US dollar), depreciating the US dollar. These shocks are the paper’s preferred interpretation of the financial shocks driving the US dollar exchange rate, consistent with the observed joint behavior of exchange rates and interest rates.

Imperfect financial openness (parameter s): The share of household savings invested in foreign bonds. At s = 0, households have no access to foreign assets (as in Gabaix-Maggiori and Itskhoki-Mukhin); at full financial integration with UIP holding (ψ_t = 0), there is no foreign credit channel. The paper’s model is intermediate: s > 0 but portfolio weights are sticky, so households do not fully arbitrage cross-currency expected return differentials. The foreign credit channel is operative only when s > 0, and the strength of the output boom is increasing in s/σ (the ratio of financial openness to the coefficient of relative risk aversion).

Sufficient statistics (real interest rate and real exchange rate): Under Proposition 1, conditional on Assumption 1 (symmetric non-monetary fundamental shocks across pegger groups), the relative responses of all macroeconomic aggregates for peggers to the US dollar versus peggers to the euro are functions only of the relative path of the real effective exchange rate and the relative path of the real interest rate. The full set of underlying shocks — monetary, financial, productivity, or discount factor — does not need to be separately identified; only the paths of these two prices matter for relative macroeconomic outcomes.

Exchange rate disconnect: The empirical finding, documented extensively since Meese and Rogoff (1983), that exchange rates have very low unconditional correlations with macroeconomic aggregates such as output and consumption. In the paper’s sample, real exchange rates of floating countries are three to four times more volatile than GDP and consumption, and the unconditional correlation of the real exchange rate with GDP is mildly negative (around −0.05 to −0.07). The paper offers a new explanation: this low unconditional correlation reflects the cancellation of large but opposite-signed conditional correlations from UIP shocks and discount factor shocks, rather than indicating that exchange rates have small effects on the economy.

Mussa fact: The empirical observation (Mussa, 1986) that when countries switched from fixed to floating exchange rates after the collapse of Bretton Woods, real exchange rate volatility increased dramatically — for floaters roughly 50–60% higher standard deviation in the paper’s sample than for peggers — but the volatility of GDP, consumption, and other macroeconomic aggregates did not increase correspondingly. The paper interprets this through its two-shock model as the result of two opposing effects of pegging: insulation from UIP shocks (which reduces macroeconomic volatility) versus inability to use monetary policy to offset discount factor shocks (which raises macroeconomic volatility), with the two effects roughly offsetting in the quantitative model.