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No. 10 - Exchange Rate Regimes and Economic Performance: The Italian Experience

Using a de facto classification of the exchange rate regimes adopted in Italy since national unification, this paper examines the influence of different exchange rate policies on the country’s economic performance. For perhaps the first time, a principal component analysis is used to obtain a composite indicator of the exchange rate policy de facto pursued by the monetary authorities. The study finds a significant association between exchange rate regimes and inflation and growth performance. In particular, the analysis reveals that Italy has performed best, in terms of output growth rate, under “soft peg” regimes, for example when the exchange rate was de facto pegged but the authorities were not legally committed to a fixed exchange rate or when rates were fixed but capital controls and adjustable pegs gave the authorities the opportunity to pursue independent macroeconomic policies. This result is at odds with recent literature according to which “corner solutions” — hard pegs or freely floating exchange rates — are the only viable exchange rate regimes (the so called “hollowing out” hypothesis). However, a closer inspection shows that this association between regimes and performance may actually reflect reverse causation, that is, a relationship that runs from the macroeconomic conditions of the country to the choice of an appropriate exchange rate regime rather than in the opposite direction. This does not exclude that exchange rate policy may play an important role in maintaining conditions of sustainability of economic growth.