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Exchange Exchange
Rate Rate Regimes Regimes
and and PoliciesPolicies
Thorvaldur GylfasonThorvaldur GylfasonLivingstone, ZambiaLivingstone, Zambia
10-21 April 200610-21 April 2006
OutlineOutline
1)1)Real vs. nominal exchange ratesReal vs. nominal exchange rates2)2)Exchange rate policy and Exchange rate policy and
welfarewelfare3)3)The scourge of overvaluationThe scourge of overvaluation4)4)From exchange and trade From exchange and trade
policies to economic growthpolicies to economic growth5)5)Exchange rate regimesExchange rate regimes
To float or not to floatTo float or not to float
Real vs. nominal Real vs. nominal exchange ratesexchange rates1
*P
ePQ
Q = real exchange ratee = nominal exchange rateP = price level at homeP* = price level abroad
Increase in Q means real appreciation
ee refers to
foreign currency
content of
domestic currency
RealReal vs. nominal vs. nominal exchange ratesexchange rates
*P
ePQ
Q = real exchange ratee = nominal exchange rateP = price level at homeP* = price level abroad
Devaluation or depreciation of e makes Q also depreciate unless P rises so as to leave Q unchanged
Three thought Three thought experimentsexperiments
*P
ePQ
1.1. Suppose e fallse fallsThen more kwacha per dollar, so X risesX rises, Z fallsZ falls
2.2. Suppose P fallsP fallsThen X risesX rises, Z fallsZ falls
3.3. Suppose P* risesP* risesThen X risesX rises, Z fallsZ falls
Summarize all three by supposing Q fallsQ falls Then X risesX rises, Z fallsZ falls
Foreign exchangeForeign exchange
Real exch
an
ge r
ate
Real exch
an
ge r
ate
Imports
Exports
Exchange rate policy Exchange rate policy and welfareand welfare2
Earnings from exports of goods, services, and capital
Payments for imports of goods, services, and capital
Equilibrium
Equilibrium between demand and supply in foreign exchange market establishesEquilibrium real exchange rateEquilibrium in the balance of
paymentsBOP = X + Fx – Z – Fz
= X – Z + F = current account + capital
account = 0
Exchange rate policy Exchange rate policy and welfareand welfare
Foreign exchangeForeign exchange
Real exch
an
ge r
ate
Real exch
an
ge r
ate
Imports
Exports
Exchange rate policy Exchange rate policy and welfareand welfare
Overvaluation
Deficit
RR R moves when e is fixed
Foreign exchangeForeign exchange
Pri
ce o
f fo
reig
n e
xch
ang
ePri
ce o
f fo
reig
n e
xch
ang
e
Supply (exports)
Demand (imports)
Exchange rate policy Exchange rate policy and welfareand welfare
Overvaluation
Deficit
Overvaluation works like a price ceiling
Market equilibrium and economic welfare
SupplySupply
DemandDemand
EE
ProducerProducersurplussurplus
ConsumeConsumerrsurplussurplus
Quantity
Price
AA
BB
CC
Total Total welfare gainwelfare gain associated associatedwith market equilibrium equalswith market equilibrium equalsproducer surplus (= ABE) plusproducer surplus (= ABE) plusconsumer surplus (= BCE)consumer surplus (= BCE)
R = 0, so R is
fixed when e floats
SupplySupply
DemandDemand
Price ceilingPrice ceiling
EE
FF
GG
Quantity
PriceWelfareWelfarelossloss
Price ceiling imposes aPrice ceiling imposes awelfare losswelfare loss equivalent to equivalent tothe triangle the triangle EFGEFG
AA
BB
CC
Consumer surplus = AFGHConsumer surplus = AFGH
HH
JJ
Market intervention and economic welfare Producer surplus = CGHProducer surplus = CGH
Total surplus = AFGC
SupplySupply
DemandDemand
Price ceilingPrice ceiling
EE
FF
GG
Quantity
PriceWelfareWelfarelossloss
Price ceiling imposes aPrice ceiling imposes awelfare losswelfare loss that results that results from shortage (e.g., deficit)from shortage (e.g., deficit)
AA
BB
CC
HH
JJ
Market intervention and economic welfare
Shortage
The scourge of overvaluation
Governments may try to keep the national currency overvaluedTo keep foreign exchange cheapTo have power to ration scarce
foreign exchangeTo make GNP look larger than it is
Other examples of price ceilingsNegative real interest ratesRent controls
3
Inflation and overvaluation
Inflation can result in an overvaluation of the national currencyRemember: Q = eP/P*
Suppose e adjusts to P with a lagThen Q is directly proportional to
inflationNumerical example
Inflation and overvaluation
Time
Real exchange rate
100
110
105 Average
Suppose inflation is 10 percent per year
Inflation and overvaluation
Time
100
120
Real exchange rate
110 Average
Hence, increased inflation increases the real exchange rate as long as the nominal exchange rate adjusts with a lag
Suppose inflation rises to 20 percent per year
How to correct overvaluation
Under a floating exchange rate regimeAdjustment is automatic: e moves
Under a fixed exchange rate regimeDevaluation 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
T = eeX – Z = eX(e) – Z(e)Not obvious that a lower e helps TLet’s do the arithmeticBottom line is:Devaluation strengthens the
current account as long as
1ba
Suppose prices are
fixed, so that e = Q
a = elasticity of exportsb = elasticity of imports
Valuation Valuation effecteffect arises arises from the from the ability to ability to affect affect foreign foreign pricesprices
The Marshall-Lerner condition
ZeXB )()( eZeeXB
de
dZ
de
dXeX
de
dB
e
Z
Z
e
de
dZ
e
X
X
e
de
dXeX
de
dB
1 1
-a b
- +
Export elasticityExport elasticity ImportImportelasticityelasticity
The Marshall-Lerner condition
e
Z
Z
e
de
dZ
e
X
X
e
de
dXeX
de
dB
XbabXaXXde
dB 1
0de
dB 1baif
X
Assume X = Z/e initially
The Marshall-Lerner condition: Evidence
Econometric studies indicate that the Marshall-Lerner condition is almost invariably satisfied
Industrial countries: a = 1, b = 1Developing countries: a = 1, b =
1.5Hence,
1ba Devaluation
strengthens the
current account
Empirical evidence from developing countries
Elasticity of Elasticity ofexports imports
Argentina 0.6 0.9Brazil 0.4 1.7India 0.5 2.2Kenya 1.0 0.8Korea 2.5 0.8Morocco 0.7 1.0Pakistan 1.8 0.8Philippines 0.9 2.7Turkey 1.4 2.7Average 1.1 1.5
Small countries: A special case
Small countries are price takers abroadDevaluation 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 measuresRemember:
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
*P
ePQ
From exchange and trade policies to growthGovernments may try to keep the
national currency overvaluedOr inflation may result in
overvaluationIn either case, overvaluation
creates inefficiency, and hurts growth
Therefore, exchange rate policy matters for growth
Need real exchange rates near equilibrium
4
From exchange and trade policies to growthHow 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 floatsThrough 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 growthExports and imports are good for
growth
Several other reasonsInflation distorts production and
impedes financial development, and scares foreign investors away
How trade increases efficiency and growth
Trade with other nations increases efficiency by allowing1. Specialization through
comparative advantage2. Exploitation of economies of scale3. 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 tantamount
to technological
progressTrade is education
Which is also good for growth!
Efficiency is crucial for economic growth
Need economic policies that help increase efficiencyProduce more output from given
inputs Takes fewer inputs to produce given
outputMore 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 Openness to FDIFDI and and growth 1965-98growth 1965-98
-8
-6
-4
-2
0
2
4
6
-4 -2 0 2 4 6 8
Actual less predicted FDI 1975-1998 (% of GDP, ppp)
An
nu
al g
row
th o
f G
NP
per
cap
ita 1
965-9
8,
ad
juste
d f
or
init
ial in
co
me (
%)
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
r = 0.62
85 countries
Botswana
Openness to Trade and Growth 1965-98
-8
-6
-4
-2
0
2
4
6
-40 -20 0 20 40
Actual less predicted exports 1965-98 (% of GDP)
An
nu
al g
row
th o
f G
NP
per
cap
ita 1
965-9
8,
ad
juste
d f
or
init
ial in
co
me (
%)
87 countries
An increase in openness by 14% of GDP is associated with an increase in per capita growth by 1% per year
r = 0.42
Guinea Bissau
Korea
Malaysia
Belgium
Tariffs and Growth 1965-98
82 countries
-8
-6
-4
-2
0
2
4
6
0 10 20 30 40
Import duties (% of imports 1970-98)
An
nu
al g
row
th o
f G
NP
per
cap
ita 1
965-9
8,
ad
juste
d f
or
init
ial in
co
me (
%)
An increase in tariffs by 10% of imports is associated with a decrease in per capita growth by 1% per year
r = -0.52
India
Cote d'Ivoire
Botswana
Average tariffs around the world
have decreased from 40% to 5%
since 1945
MEFMI countries:MEFMI countries: ExportsExports 1960-2002 1960-2002 (% of (% of GDPGDP))
Botswana
Weighted
average(unweighte
d average
is higher because US and Japan then
have lower
weights)
0
5
10
15
20
25
30
35
40
45
1960
1964
1968
1972
1976
1980
1984
1988
1992
1996
2000
Mefmi countries
High-income countries
Unweighte
d average
MEFMI countries:MEFMI countries: ExportsExports 2002 (% of 2002 (% of GDPGDP))
Botswana
0 20 40 60 80 100
Uganda
Tanzania
Zimbabwe
Malawi
Kenya
Zambia
South Africa
Namibia
Botswana
Lesotho
Angola
Swaziland
Average
MEFMI countries:MEFMI countries: GDP per GDP per capitacapita 1960-2003 1960-2003 (USD at 2000 (USD at 2000 prices)prices)
Botswana
0
500
1000
1500
2000
2500
3000
3500
4000
1960
1964
1968
1972
1976
1980
1984
1988
1992
1996
2000
AngolaBotsw anaKenyaLesothoMalaw iMozambiqueNamibiaRw andaSw azilandTanzaniaUgandaZambiaZimbabw e
Exchange rate regimes
The real exchange rate always floatsThrough 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
5
Exchange rate regimesThere is a range of options
Monetary union or dollarizationMeans giving up your national
currency or sharing it with others (e.g., EMU, CFA, EAC)
Currency boardLegal commitment to exchange
domestic for foreign currency at a fixed rate
Fixed exchange rate (peg)Crawling pegManaged floatingPure floating
Benefits and costs
BenefitsBenefits CostsCosts
Fixed Fixed exchange exchange ratesrates
Floating Floating exchange exchange ratesrates
Benefits and costs
BenefitsBenefits CostsCosts
Fixed Fixed exchange exchange ratesrates
Stability of Stability of trade and trade and investmentinvestment
Low inflationLow inflation
Floating Floating exchange exchange ratesrates
Benefits and costs
BenefitsBenefits CostsCosts
Fixed Fixed exchange exchange ratesrates
Stability of Stability of trade and trade and investmentinvestment
Low inflationLow inflation
InefficiencyInefficiency
BOP deficitsBOP deficits
Sacrifice of Sacrifice of monetary monetary independenceindependence
Floating Floating exchange exchange ratesrates
Benefits and costs
BenefitsBenefits CostsCosts
Fixed Fixed exchange exchange ratesrates
Stability of Stability of trade and trade and investmentinvestment
Low inflationLow inflation
InefficiencyInefficiency
BOP deficitsBOP deficits
Sacrifice of Sacrifice of monetary monetary independenceindependence
Floating Floating exchange exchange ratesrates
EfficiencyEfficiency
BOP BOP equilibriumequilibrium
Benefits and costs
BenefitsBenefits CostsCosts
Fixed Fixed exchange exchange ratesrates
Stability of Stability of trade and trade and investmentinvestment
Low inflationLow inflation
InefficiencyInefficiency
BOP deficitsBOP deficits
Sacrifice of Sacrifice of monetary monetary independenceindependence
Floating Floating exchange exchange ratesrates
EfficiencyEfficiency
BOP BOP equilibriumequilibrium
Instability of Instability of trade and trade and investmentinvestment
InflationInflation
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 circumstanceIf 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 17%Other types of fixed rates 23Dollarization 5Currency board 4Crawling pegs 3Bilateral fixed rates 3Managed floating 26Pure floating 19 100
51%
49%
There is a gradual tendency towards floating, from 10% of LDCs in 1975 to over 50% today
Bottom lineBottom line
The EndThe EndExchange rate policy is important Exchange rate policy is important
because external trade is important, because external trade is important, also for growthalso for growth
Need to maintain real exchange rates at Need to maintain real exchange rates at levels that are consistent with BOP levels that are consistent with BOP equilibrium, including sustainable debtequilibrium, including sustainable debt Must avoid overvaluation!Must avoid overvaluation!
Need to adopt exchange rate regime Need to adopt exchange rate regime that is conducive to moderate inflation that is conducive to moderate inflation and rapid economic growthand rapid economic growth
These slides will be posted on my website: www.hi.is/~gylfason