Working Paper

A Theory of Fear of Floating

Abstract: Many central banks whose exchange rate regimes are classified as flexible are reluctant to let the exchange rate fluctuate. This phenomenon is known as “fear of floating”. We present a simple theory in which fear of floating emerges as an optimal policy outcome. The key feature of the model is an occasionally binding borrowing constraint linked to the exchange rate that introduces a feedback loop between aggregate demand and credit conditions. Contrary to the Mundellian paradigm, we show that a depreciation can be contractionary, and letting the exchange rate float can expose the economy to self-fulfilling crises.

Keywords: Self-fulfilling financial crises; Exchange rates;

JEL Classification: E52; F45; F41; G01; F36; F33; E44; F34;

https://doi.org/10.21034/wp.796

Bibliographic Information

Provider: Federal Reserve Bank of Minneapolis

Part of Series: Working Papers

Publication Date: 2023-02-03

Number: 796