- Smaller economies in Latin America and the Caribbean tend to use de facto fixed exchange rates, while larger economies more often let their currencies float to preserve flexibility when shocks occur.
- In practice, however, that flexibility does not appear to deliver consistently better outcomes: floating regimes tend to bring higher inflation, but broadly similar growth, debt, and current account balances.
- Overall, the evidence points beyond the regime itself, highlighting the importance of good policies, strong institutions, human capital, and fiscal buffers.
As shocks become increasingly frequent, governments across Latin America and the Caribbean make difficult policy choices. This often brings them back to a longstanding question: when an economy comes under pressure, is it better to have a fixed exchange rate or one that floats?
This is a central policy issue because the exchange rate shapes trade, external financial transactions, inflation, and the tools available to respond when conditions deteriorate. Fixed regimes can provide stability and predictability, while floating or managed regimes allow greater adjustment. Each involves trade-offs.
This prompts two questions: do countries with different exchange rate regimes perform differently when shocks occur? And does one regime consistently deliver better economic outcomes beyond periods of crisis?
Three Regimes, Different Trade-offs
Exchange rate regimes generally fall into three categories. Under a flexible regime, the currency’s value is determined by market supply and demand, while under a fixed regime, it remains set by the government. A managed regime lies between the two: the exchange rate is allowed to move, but only within a defined range.
In Latin America and the Caribbean, smaller economies—most of them in the Caribbean—have generally adopted de facto fixed exchange rate regimes (Figure 1). While their currencies may officially be classified as floating, in practice they move very little. These countries also tend to have smaller central banks, shallow financial markets, and a high dependence on imports.
Fixing the exchange rate to an external currency—most often the U.S. dollar—has helped Caribbean central banks build policy credibility, contributing to low inflation, lower trade transaction costs, and greater predictability for households and firms. However, this choice has also required Caribbean countries to maintain high levels of foreign reserves, while limiting the policy tools available to respond to external shocks.
Why Larger Economies Tend to Float
In contrast, larger economies in Latin America and the Caribbean have generally adopted freely floating or managed float regimes. These arrangements offer greater flexibility to adjust to shocks such as natural disasters or oil price spikes, while also helping reduce currency risk and reserve requirements. The trade-off, however, is the possibility of higher inflation and greater inflation volatility, as widely discussed in the economic literature.
As global shocks become increasingly frequent, the question of whether countries should fix or float has gained new urgency. Countries that give up monetary autonomy by fixing their exchange rate can respond to shocks primarily through fiscal policy. In theory, this more limited flexibility can contribute to higher debt, weaker GDP growth, and current account deficits—particularly in economies that depend heavily on a seasonal sector such as tourism to generate foreign reserves.
What Happens When Shocks Hit?
The first question is whether countries with flexible exchange rate regimes achieve better macroeconomic outcomes when shocks occur. It turns out they do not. Across Latin America and the Caribbean, there are no significant differences in overall macroeconomic performance between countries operating under different regimes during periods of shock.
Countries with floating or managed regimes tend to experience higher inflation, yet their GDP growth is broadly similar to that of countries with fixed exchange rates. With only two exceptions, average debt levels and current account balances also show no significant differences, regardless of whether a country fixes or floats.
And What Happens Beyond Periods of Shock?
The second question is whether countries with flexible exchange rate regimes generally achieve better macroeconomic outcomes when shocks are set aside. Here, too, the data do not provide a clear answer, although the comparison should be interpreted with caution given the uneven number of countries across exchange rate categories.
This mixed picture is confirmed by Figure 2, which compares macroeconomic outcomes across Latin America and the Caribbean by exchange rate regime over the past 45 years. Countries with fixed exchange rates have recorded lower inflation and higher GDP growth, but also moderate to high debt ratios and larger current account deficits. By contrast, countries with floating regimes have experienced higher inflation and lower average GDP growth, while tending to maintain lower debt-to-GDP ratios and healthier current account balances.
Looking Beyond the Regime
The evidence therefore points to a broader conclusion: economic fundamentals matter more than the choice of exchange rate regime. The absence of clear differences in macroeconomic outcomes during shocks suggests that good policies, strong institutions, and human capital are ultimately more important than whether a country fixes or floats.
In particular, countries need fiscal policies that allow them to build adequate buffers and respond countercyclically when shocks occur. The exchange rate regime still matters, but it cannot substitute for the underlying capacity to absorb pressure and support the economy when conditions deteriorate.