International Fisher Effect under Exchange Rate Regime Shifts: Evidence from 10 Examples

This paper studies the behaviour of inflation rate, short-term interest rate and nominal exchange rate after leaving fixed exchange rate arrangement and move to floating. We find that countries with rigid exchange rate policy, less frequently adjusted central parity and narrow exchange rate bands experienced sharp depreciation after leaving peg, but the depreciation was only temporary with no long trend. In this group of countries the exchange rate adjustment is weakly exogenous to inflation and interest rate differentials and the theory of International Fisher Effect was not mostly confirmed. On the contrary, countries with flexibly adjusted central parity and wider exchange rate bands did not experience rapid depreciation. We applied Johansen's approach to cointegration (Johansen 1988, 1991 and 1994), based on estimation of the Vector Error Correction (VEC) Model, and the Johansen constraint test of exogeneity. Finally, we are discussing a parallel between leaving the peg and leaving the currency union. Since both are considered fixed exchange rate arrangements we argue that leaving the Eurozone by a member state may cause immediate depreciation without long trend and the adjustment would not be caused by inflation and interest rate changes. Classification-JEL: F41, E26, E42