Transcript Exchange Rate Regimes and Policies

Exchange
Rate
Regimes
and Policies
Thorvaldur Gylfason
Outline
1. Real versus nominal exchange rates
2. Exchange rate policy and welfare
3. The scourge of overvaluation
4. From exchange rate policy to
economic growth
5. Exchange rate regimes
 To float or not to float
Real versus nominal
exchange rates
eP
R
P*
Increase in R
means real
appreciation
R = real exchange rate
e = nominal exchange rate
P = price level at home
P* = price level abroad
Real versus nominal
exchange rates
eP
R
P*
Devaluation or
depreciation of e
makes R also
depreciate unless P
rises so as to leave
R unchanged
R = real exchange rate
e = nominal exchange rate
P = price level at home
P* = price level abroad
Exchange rate policy and
welfare
Payments for imports of
Real exchange rate
goods, services, and
capital
Imports
Earnings from exports of
goods, services, and
capital
Exports
Foreign exchange
Exchange rate policy and
welfare
Equilibrium between demand and
supply in foreign exchange market
establishes
Equilibrium real exchange rate
Equilibrium in the balance of payments
BOP = X + Fx – Z – Fz
=X–Z+F
= current account + capital account
=0
Real exchange rate
Exchange rate policy and
welfare
Deficit
Imports
Overvaluation
Exports
Foreign exchange
Price of foreign exchange
Exchange rate policy and
welfare
Overvaluation works
like a price ceiling
Supply (exports)
Overvaluation
Deficit
Demand (imports)
Foreign exchange
Market equilibrium and
economic welfare
Price
A
B
C
Consumer
surplus
E
Producer
surplus
Supply
Total welfare gain associated
with market equilibrium equals
producer surplus (= ABE) plus
consumer surplus (= BCE)
Demand
Quantity
Market intervention and
economic welfare
Price
Welfare
loss
A
J
F
B
E
Total surplus = AFGC
Supply
Price ceiling imposes a
welfare loss equivalent to
the triangle EFG
Price ceiling
H
G
C
Consumer surplus = AFGH
Producer surplus = CGH
Demand
Quantity
The scourge of
overvaluation
Governments may try to keep the
national currency overvalued
To keep foreign exchange cheap
To have power to ration scarce foreign
exchange
To make GNP look larger than it is
Other examples of price ceilings
Negative real interest rates
Rent controls
Market intervention
and economic welfare
Price
Welfare
loss
A
J
F
B
E
Price ceiling imposes a
welfare loss equivalent to
the triangle EFG
Price ceiling
H
G
C
Supply
Shortage
Demand
Quantity
Inflation and
overvaluation
Inflation can result in an overvaluation
of the national currency
Remember: R = eP/P*
Suppose e adjusts to P with a lag
Then R is directly proportional to
inflation
Numerical example
Inflation and
overvaluation
Real exchange rate
Suppose inflation is
10 percent per year
110
105
100
Average
Time
Inflation and
overvaluation
Real exchange rate
Suppose inflation rises
to 20 percent per year
Hence, increased
inflation increases
the real exchange
rate as long as
the nominal
exchange rate
adjusts with a lag
120
110
Average
100
Time
How to correct
overvaluation
Under a floating exchange rate regime
Adjustment is automatic: e moves
Under a fixed exchange rate regime
Devaluation will lower e and thereby also
R – provided inflation is kept under
control
Does devaluation improve the current
account?
The Marshall-Lerner condition
The Marshall-Lerner
condition: Theory
T = eX – Z
= eX(e) – Z(e)
Not obvious that a lower e helps T
Let’s do the arithmetic
Bottom line is:
Devaluation improves the current
account as long as
a  b 1
a = elasticity of exports
b = elasticity of imports
The Marshall-Lerner
condition: Evidence
Econometric studies indicate that the
Marshall-Lerner condition is almost
invariably satisfied
Industrial countries: a = 1, b = 1
Developing countries: a = 1, b = 1.5
Hence,
a  b 1
Empirical evidence from
developing countries
Argentina
Brazil
India
Kenya
Korea
Morocco
Pakistan
Philippines
Turkey
Average
1.4
Elasticity of
exports
0.6
0.4
0.5
1.0
2.5
0.7
1.8
0.9
2.7
1.1
Elasticity of
imports
0.9
1.7
2.2
0.8
0.8
1.0
0.8
2.7
1.5
The importance of
appropriate side measures
Remember:
eP
R
P*
It is crucial to accompany devaluation
by fiscal and monetary restraint in
order to prevent prices from rising
and thus eating up the benefits of
devaluation
To work, nominal devaluation must
result in real devaluation
From exchange rate policy
to economic growth
Governments may try to keep the
national currency overvalued
Or inflation may result in overvaluation
In either case, overvaluation creates
inefficiency, and hurts growth
Therefore, exchange rate policy
matters for growth
Need real exchange rates near
equilibrium
From exchange rate policy
to economic growth
How do we ensure that exchange rates
do not stray too far from equilibrium?
Either by floating …
Then equilibrium follows by itself
… or by strict monetary and fiscal
discipline under a fixed exchange rate
The real exchange rate always floats
Through nominal exchange rate adjustment
or price change, but this may take time
Why inflation is bad for
growth
We saw before that inflation leads to
overvaluation which hurts exports
So, here is one reason why inflation
hurts economic growth
Exports – and imports! – are good for
growth
Several other reasons
Inflation distorts production and impedes
financial development
How trade increases
efficiency and growth
Trade with other nations increases
efficiency by allowing
1. Specialization through comparative
advantage
2. Exploitation of economies of scale
3. Promotion of free competition
Not only trade in goods and services,
but also in capital and labor
“Four freedoms”
How trade increases
efficiency and growth
Trade also encourages international
exchange of
Ideas
Information
Know-how
Technology
Trade is education
Which is also good for growth!
Efficiency is crucial for
economic growth
Need economic policies that increase
efficiency
Produce more output from given inputs
Takes fewer inputs to produce given output
More efficiency, better technology are two
ways of increasing output per unit of input
So is more and better education
Trade increases efficiency and thereby
also economic growth
Trade and growth in
Africa in the 1990s
Average ratio of exports to GDP in Africa
was 30% against 40% outside Africa
Current account deficit in Africa was 7%
of GDP against 4% outside Africa
Real effective currency depreciation in 15
African countries was 16%
Per capita growth in Africa was 0.2% per
year against 1.3% elsewhere
Openness to trade and
growth 1965-98: Evidence
Annual growth of GNP per capita 1965-98, adjusted for
initial income (%)
6
r = 0.40
4
Korea
2
Malaysia
Belgium
0
-40
-30
-20
-10
0
10
20
30
40
-2
Guinea Bissau
-4
-6
An increase in openness by
14% of GDP is associated
with an increase in per capita
growth by 1% per year.
-8
Actual less predicted exports 1965-98 (% of GDP)
Openness to FDI and
growth 1965-98
Annual growth of GNP per capita 1965-98, adjusted for
initial income (%)
6
r = 0.62
Botswana
4
2
0
-4
-2
0
2
4
6
8
-2
-4
-6
An increase in openness to FDI by
2% of GDP is associated with an
increase in per capita growth by
more than 1% per year.
-8
Actual less predicted FDI 1975-1998 (% of GDP, ppp)
Exchange rate regimes
The real exchange rate always floats
Through nominal exchange rate
adjustment or price change
Even so, it makes a difference how
countries set their nominal exchange
rates because floating takes time
There is a wide spectrum of options,
from absolutely fixed to completely
flexible exchange rates
Exchange rate regimes
There is a range of options
Monetary union or dollarization
Means giving up your national currency or
sharing it with others
Currency board
Legal commitment to exchange domestic for
foreign currency at a fixed rate
Fixed exchange rate (peg)
Crawling peg
Managed floating
Pure floating
Benefits and costs
Benefits
Fixed
exchange
rates
Floating
exchange
rates
Costs
Benefits and costs
Benefits
Fixed
exchange
rates
Floating
exchange
rates
Stability of trade
and investment
Low inflation
Costs
Benefits and costs
Benefits
Fixed
exchange
rates
Floating
exchange
rates
Costs
Stability of trade Inefficiency
and investment BOP deficits
Low inflation
Sacrifice of
monetary
independence
Benefits and costs
Benefits
Fixed
exchange
rates
Floating
exchange
rates
Costs
Stability of trade Inefficiency
and investment BOP deficits
Low inflation
Sacrifice of
monetary
independence
Efficiency
BOP equilibrium
Benefits and costs
Benefits
Fixed
exchange
rates
Floating
exchange
rates
Costs
Stability of trade Inefficiency
and investment BOP deficits
Low inflation
Sacrifice of
monetary
independence
Efficiency
Instability of
BOP equilibrium trade and
investment
Inflation
Exchange rate regimes
In view of benefits and costs, no single
exchange rate regime is right for all
countries at all times
The regime of choice depends on time
and circumstance
If inefficiency and slow growth are the
main problem, floating rates can help
If high inflation is the main problem,
fixed exchange rates can help
What countries actually
do (2001)
No national currency
Currency board
Adjustable pegs
Crawling pegs
Managed floating
Pure floating
39
8
50
9
33
47
186
There is a gradual tendency towards floating,
from 10% of LDCs in 1975 to over 50% today
25%
50%
25%
These slides will be posted on my website:
www.hi.is/~gylfason
Bottom line
Exchange rate policy is important because
trade is important
Need to maintain real exchange rates at levels
that are consistent with BOP equilibrium,
including sustainable debt
 Avoid overvaluation!
Need to adopt exchange rate regime that is
conducive to low inflation and rapid growth