MEASURING EXCHANGE RATE FLEXIBLITY: A TWO-PARAMETER EXCHANGE MARKET PRESSURE APPROACH

Recognition that official classifications of exchange rate regimes are often misleading has led to considerable interest in behavioral measures. Many of these measures are related to the concept of exchange market pressure that shows how policy interventions affect how much a given change in excess demand in the foreign exchange market shows up changes in reserves versus changes in the exchange rate. We argue that this is the correct conceptual approach to measuring the degree of exchange rate flexibility of a regime, but that several of the most popular applications of this approach use functional forms that destroy useful information. One important problem that has been overlooked is that the approach is clearly defined only for leaning against the wind intervention and we find that fairly often changes in reserves and exchanges do not fit with this type of intervention. A second important issue is that where there are trends the interpretation of these types of measures becomes more difficult. We suggest that to deal with this issue a two parameter approach is needed rather than the one parameter measure that have been used in most of the previous literature. We illustrate the approach with an application to Japan.