Real Effects of Collapsing Exchange Rate Regimes: An Application to Mexico

This paper examines the impact of a collapsing exchange rate regime on output in an open economy in which shocks to capital flows and exports predominate. A sticky-price rational expec-tations model is used to compare the variability of output under the collapsing regime to that under alternative fixed and flexible regimes. Output is found to be most stable under a flexible rate. A counterfactual exercise is performed for Mexico, using the parallel market exchange rate as a proxy for the shadow flexible rate. The main finding is that had Mexico been on a flexible rate for the past two decades, instead of a series of collapsing regimes, the variance of real output would have been reduced by half.