external sector policies

External External

Sector Sector 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 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 versus nominal Real versus 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 versus nominal versus 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 Three experimentsexperiments

*P

ePQ

1.1. Suppose e fallse fallsThen more shillings 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


Real exch

an

ge r

ate

Real exch

an

ge r

ate

Imports

Exports


Overvaluation

Deficit

RR R moves when e is fixed


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

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


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 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 improves 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

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

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 improves 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 (% of 1960-2002 (% 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

Angola

Botswana

Lesotho

Malawi

Namibia

South Africa

Swaziland

Tanzania

Uganda

Zambia

Zimbabwe

Average

MEFMI countries:MEFMI countries: GDP per GDP per capitacapita 1960-2002 (USD at 1960-2002 (USD at 1995 prices)1995 prices)

Botswana

0

1000

2000

3000

4000

5000

6000

Angola

Botsw ana

Lesotho

Malaw i

Namibia

South Africa

Sw aziland

Tanzania

Uganda

Zambia

Zimbabw 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



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 EndExchange rate policy is important Exchange rate policy is important

because trade is importantbecause trade is important

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 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

These slides will be posted on my website: www.hi.is/~gylfason

external sector policies

Documents

nominal exchange ratep

nominal exchange ratesq

nominal exchange rates1q

foreign exchange cheapto

x z f

e fallsthen

p fallsthen x

price level abroaddevaluation