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Exchange Rate Regimes and External Adjustment: New Answers to an Old Debate

Recent research has found that current account balances under flexible regimes seem to be no less persistent than under fixed regimes. This result appears to undermine Milton Friedman’s well known — and commonly accepted — claim that flexible exchange rates facilitate the adjustment of external imbalances. Should we then dismiss Friedman’s case for flexible exchange rates as superficially plausible, but ultimately wrong? In this paper we argue that this would be premature, as the answer to the question of whether flexible regimes facilitate external adjustment appears to be sensitive to how exactly the question is asked. Are flexible exchange rate regimes associated with smaller external imbalances and more infrequent current account reversal than fixed exchange rate regimes? We find considerable evidence that large current account reversals very rarely occur under flexible regimes. Moreover, when these reversals take place they involve smaller imbalances than those reversals that take place under fixed regimes. This suggests that estimated current account persistence that does not control for these important threshold effects could be misleading.