exchange rate regimes and policies thorvaldur gylfason

Exchange Exchange Rate Rate Regimes Regimes and and PoliciesPolicies

Thorvaldur Gylfason

OutlineOutline

1.1. Real versus nominal exchange Real versus nominal exchange ratesrates

2.2. Exchange rate policy and Exchange rate policy and welfarewelfare

3.3. The scourge of overvaluationThe scourge of overvaluation4.4. From exchange rate policy to From exchange rate policy to

economic growtheconomic growth5.5. Exchange rate regimesExchange rate regimes

To float or not to floatTo float or not to float

Real versus nominal Real versus nominal exchange ratesexchange rates1

*P

ePR

R = real exchange ratee = nominal exchange rateP = price level at homeP* = price level abroad

Increase in R means real appreciation

RealReal versus nominal versus nominal exchange ratesexchange rates

*P

ePR

R = real exchange ratee = nominal exchange rateP = price level at homeP* = price level abroad

Devaluation or depreciation of e makes R also depreciate unless P rises so as to leave R unchanged

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


Real exch

an

ge r

ate

Real exch

an

ge r

ate

Imports

Exports


Overvaluation

Deficit


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)


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)

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

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

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

HH

JJ

Market intervention and economic welfare

Shortage

Inflation and overvaluation

Inflation can result in an overvaluation of the national currencyRemember: R = eP/P*

Suppose e adjusts to P with a lagThen R is directly proportional to

inflationNumerical example


Time

Real exchange rate

100

110

105 Average

Suppose inflation is 10 percent per year


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 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 TLet’s do the arithmeticBottom line is:Devaluation improves the current

account as long as

1ba

Suppose prices are fixed

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

improves 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

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

ePR

From exchange rate policy to economic 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 rate policy to economic 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 reason why inflation hurts economic growthExports – and imports! – are good for

growth

Several other reasonsInflation distorts production and

impedes financial development

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 IdeasInformationKnow-howTechnology

Trade is educationWhich is also good for growth!

Efficiency is crucial for economic growth

Need economic policies that 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

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 and growth 1965-98: Evidence

-8

-6

-4

-2

0

2

4

6

-40 -30 -20 -10 0 10 20 30 40

Actual less predicted exports 1965-98 (% of GDP)

An

nu

al

gro

wth

of

GN

P p

er

cap

ita

196

5-98

, a

dju

ste

d f

or

init

ial

inco

me

(%

)

Malaysia

Belgium

Korea

Guinea Bissau

87

countrie

s

An increase in openness by 14% of GDP is associated with an increase in per capita growth by 1% per year.

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

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



Stability of Stability of trade and trade and investmentinvestment

Low inflationLow inflation


Benefits and costs





InefficiencyInefficiency

BOP deficitsBOP deficits

Sacrifice of Sacrifice of monetary monetary independenceindependence


Benefits and costs









EfficiencyEfficiency

BOP BOP equilibriumequilibrium

Benefits and costs









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 (2001)No national currency 39Currency board 8Adjustable pegs 50Crawling pegs 9Managed floating

33Pure floating 47 186

25%

25%

50%

There is a gradual tendency towards floating, from 10% of LDCs in 1975 to over 50% today

Bottom lineBottom line

The EndThe End

Exchange rate policy is important Exchange rate policy is important because trade is importantbecause trade is important

Need to maintain real exchange rates Need to maintain real exchange rates at levels that are consistent with BOP at levels that are consistent with BOP equilibrium, including sustainable equilibrium, including sustainable debtdebt Avoid overvaluation!Avoid overvaluation!

Need to adopt exchange rate regime Need to adopt exchange rate regime that is conducive to low inflation and that is conducive to low inflation and rapid growthrapid growth

exchange rate regimes and policies thorvaldur gylfason

Documents

nominal exchange rate

foreign exchange market

welfare slide

scarce foreign exchange

foreign exchange cheap

nominal exchange rates

price ceiling slide

real appreciation slide