Transcript Exchange Rate Regimes and Policies

Thorvaldur Gylfason
Livingstone, Zambia
10-21 April 2006
Outline
1) Real vs. nominal exchange rates
2) Exchange rate policy and welfare
3) The scourge of overvaluation
4) From exchange and trade policies to
economic growth
5) Exchange rate regimes
 To float or not to float
Real vs. nominal
exchange rates
eP
Q
P*
Increase in Q
means real
appreciation
Q = real exchange rate
e = nominal exchange rate
P = price level at home
P* = price level abroad
Real vs. nominal
exchange rates
eP
Q
P*
Devaluation or
depreciation of e
makes Q also
depreciate unless P
rises so as to leave
Q unchanged
Q = real exchange rate
e = nominal exchange rate
P = price level at home
P* = price level abroad
Three thought
experiments
eP
Q
P*
1. Suppose e falls
Then more kwacha per dollar,
so X rises, Z falls
2. Suppose P falls
Then X rises, Z falls
3. Suppose P* rises
Then X rises, Z falls
Summarize all three by supposing Q falls
Then X rises, Z falls
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
R
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
Market intervention and
economic welfare
Price
Welfare
loss
A
J
F
B
E
Price ceiling imposes a
welfare loss that results
from shortage (e.g., deficit)
Price ceiling
H
G
C
Supply
Shortage
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
Inflation and
overvaluation
Inflation can result in an overvaluation
of the national currency
Remember: Q = eP/P*
Suppose e adjusts to P with a lag
Then Q 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
Q – provided inflation is kept under
control
Does devaluation improve the current
account?
The Marshall-Lerner condition
The Marshall-Lerner
condition: Theory
Valuation
effect
arises
from the
ability to
affect
foreign
prices
T = eX – Z
= eX(e) – Z(e)
Not obvious that a lower e helps T
Let’s do the arithmetic
Bottom line is:
Devaluation strengthens the current
account as long as
a  b 1
a = elasticity of exports
b = elasticity of imports
The Marshall-Lerner
+
condition
B  eX  Z B  eX (e)  Z (e)
dB
 dX  dZ
 X  e

de
 de  de
-a
dB
 dX
 X  e
de
 de
b
 e  X   dZ   e  Z 
    
   
 X  e   de   Z  e 
1
1
The Marshall-Lerner
condition
dB
 dX  e  X   dZ   e  Z 
 X  e
    
   
de
 de  X  e   de   Z  e 
dB
 X  aX  bX  1  a  b X
de
dB
0
de
if
a  b 1
X
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
Small countries:
A special case
Small countries are price takers abroad
Devaluation has no effect on the foreign
currency price of exports and imports
So, the valuation effect does not arise
Devaluation will, at worst, if exports and
imports are insensitive to exchange
rates (a = b = 0), leave the current
account unchanged
Hence, if a > 0 or b > 0, devaluation
strengthens the current account
The importance of
appropriate side measures
Remember:
eP
Q
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 and trade
policies to 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 and trade
policies to 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 additional reason why
inflation hurts economic growth
Exports and imports are good for growth
Several other reasons
Inflation distorts production and impedes
financial development, and scares
foreign investors away
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 help
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
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)
Annual growth of GNP per capita 1965-98,
adjusted for initial income (%)
Openness to Trade and
Growth 1965-98
r = 0.42
6
4
Korea
Malaysia
2
0
-40
-20
0
-2
Guinea
Bissau
-4
-6
20 Belgium 40
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)
Tariffs and Growth
1965-98
An increase in tariffs by
10% of imports is
associated with a
decrease in per capita
growth by 1% per year
Annual growth of GNP per capita 1965-98,
adjusted for initial income (%)
6
Botswana
4
2
0
0
-2
-4
10
20
30
India
40
Cote d'Ivoire
-6
r = -0.52
-8
Im port duties (% of im ports 1970-98)
MEFMI countries: Exports
1960-2002 (% of GDP)
45
Botswana
40
35
30
25
20
15
10
5
Mefmi countries
High-income countries
0
60 964 968 972 976 980 984 988 992 996 000
9
1
1
1
1
1
1
1
1
1
1
2
MEFMI countries: Exports
2002 (% of GDP)
Botswana
Swaziland
Angola
Les otho
Bots wana
Namibia
South Africa
Zambia
Kenya
Malawi
Zimbabwe
Tanzania
Uganda
0
20
40
60
80
100
MEFMI countries: GDP per capita
1960-2003 (USD at 2000 prices)
4000
3500
3000
2500
2000
1500
Angola
Botsw ana
Kenya
Lesotho
Malaw i
Mozambique
Namibia
Rw anda
Sw aziland
Tanzania
Uganda
Zambia
Zimbabw e
Botswana
1000
500
19
60
19
64
19
68
19
72
19
76
19
80
19
84
19
88
19
92
19
96
20
00
0
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 (e.g., EMU, CFA, EAC)
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 (2004, 193 countries)
No national currency
Other types of fixed rates
Dollarization
Currency board
Crawling pegs
Bilateral fixed rates
Managed floating
Pure floating
17%
23
5
4
3
3
26
19
100
There is a gradual tendency towards floating, from
10% of LDCs in 1975 to over 50% today
49%
51%
These slides will be posted on my website:
www.hi.is/~gylfason
Bottom line
Exchange rate policy is important because
external trade is important, also for growth
Need to maintain real exchange rates at levels
that are consistent with BOP equilibrium,
including sustainable debt
 Must avoid overvaluation!
Need to adopt exchange rate regime that is
conducive to moderate inflation and rapid
economic growth