An empirical investigation into currency crashes, capital flight, and the inflation tax
Fisher, Andrew Robert
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This research consists of an analysis of the predictability of currency crashes using an econometric model based on publicly available macroeconomic and financial data. Also, included is an investigation into the causes of capital flight from developing countries with an emphasis on devaluation risk. The empirical relationship between capital controls and governments’ ability to increase revenue through the inflation tax is investigated. And a discussion of currency boards and dollarization is included. In the first section, I develop a simple hazard model for predicting currency crashes. The hazard model allows time-since-crash as an explanatory variable. I test the predictive power of this hazard model against two well-known econometric models and provide evidence that the length of time between crashes does assist in explaining and predicting future crashes. Next, I investigate the relationship between the probability of devaluation and capital flight. I show that devaluation probability, as measured by the output of an econometric model, exhibits a positive relationship with capital flight across countries. Previous studies have shown the existence of a relationship between some devaluation expectation and capital flight, in an individual country over time. The research discussed in this section provides evidence that the probability of devaluation does indeed explain differences in capital flight between countries. Then, I investigate the relationship between capital controls and the inflation tax, across countries. Countries that have adopted controls on capital outflows should have a higher seigniorage-maximizing rate of money supply growth. Capital controls will limit the available substitutes for domestic currency, artificially raising domestic money demand and seigniorage revenue to the domestic government. Statistical evidence is provided, showing that capital controls do explain differences in seigniorage across countries. Finally, I provide a discussion the currency board system and the policy of official dollarization. Argentina, after being on a currency board-like-system for a little more than a decade, devalued the peso in early 2002. Also included in this section is a short history of Argentina's exchange rate policy and a discussion of policies imposed by the Argentine government that were clearly inconsistent with the ideas behind a pure currency board system.