exchange rate regimes and policies
DESCRIPTION
Exchange Rate Regimes and Policies. Thorvaldur Gylfason. Outline. Real versus nominal exchange rates Exchange rate policy and welfare The scourge of overvaluation From exchange rate policy to economic growth Exchange rate regimes To float or not to float. 1. - PowerPoint PPT PresentationTRANSCRIPT
Exchange Exchange Rate Rate Regimes Regimes and and PoliciesPolicies
Thorvaldur Gylfason
OutlineOutline1.1. Real versus nominal exchange Real versus nominal exchange
ratesrates2.2. Exchange rate policy and Exchange rate policy and
welfarewelfare3.3. 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
*PePR
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
*PePR
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
exc
hang
e ra
teRe
al e
xcha
nge
rate
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
exc
hang
e ra
teRe
al e
xcha
nge
rate
Imports
Exports
Exchange rate policy Exchange rate policy and welfareand welfare
OvervaluationDeficit
Foreign exchangeForeign exchange
Price
of f
orei
gn e
xcha
nge
Price
of f
orei
gn e
xcha
nge
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)
SupplySupply
DemandDemand
Price ceilingPrice ceilingEE
FF
GG
Quantity
Price WelfareWelfarelossloss
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 overvaluationGovernments 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 ceilingEE
FF
GG
Quantity
Price WelfareWelfarelossloss
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 overvaluationInflation 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
Inflation and overvaluation
Time
Real exchange rate
100
110105 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 overvaluationUnder 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: TheoryT = 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: EvidenceEconometric 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 of
exports importsArgentina 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
*PePR
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 growthWe 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
growthSeveral other reasons
Inflation distorts production and impedes financial development
How trade increases efficiency and growthTrade 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 growthTrade also encourages international
exchange of IdeasInformationKnow-howTechnology
Trade is educationWhich is also good for growth!
Efficiency is crucial for economic growthNeed 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 educationTrade increases efficiency and
thereby also economic growth
Trade and growth in Africa in the 1990sAverage 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)
Annu
al g
row
th o
f GNP
per
cap
ita 1
965-
98, a
djus
ted
for
initi
al in
com
e (%
)
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 regimesThe real exchange rate always
floatsThrough nominal exchange rate
adjustment or price changeEven 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 othersCurrency board
Legal commitment to exchange domestic for foreign currency at a fixed rate
Fixed exchange rate (peg)Crawling pegManaged floatingPure floating
Benefits and costsBenefitsBenefits CostsCosts
Fixed Fixed exchange exchange ratesrates
Floating Floating exchange exchange ratesrates
Benefits and costsBenefitsBenefits CostsCosts
Fixed Fixed exchange exchange ratesrates
Stability of Stability of trade and trade and investmentinvestmentLow inflationLow inflation
Floating Floating exchange exchange ratesrates
Benefits and costsBenefitsBenefits CostsCosts
Fixed Fixed exchange exchange ratesrates
Stability of Stability of trade and trade and investmentinvestmentLow inflationLow inflation
InefficiencyInefficiencyBOP deficitsBOP deficitsSacrifice of Sacrifice of monetary monetary independenceindependence
Floating Floating exchange exchange ratesrates
Benefits and costsBenefitsBenefits CostsCosts
Fixed Fixed exchange exchange ratesrates
Stability of Stability of trade and trade and investmentinvestmentLow inflationLow inflation
InefficiencyInefficiencyBOP deficitsBOP deficitsSacrifice of Sacrifice of monetary monetary independenceindependence
Floating Floating exchange exchange ratesrates
EfficiencyEfficiencyBOP BOP equilibriumequilibrium
Benefits and costsBenefitsBenefits CostsCosts
Fixed Fixed exchange exchange ratesrates
Stability of Stability of trade and trade and investmentinvestmentLow inflationLow inflation
InefficiencyInefficiencyBOP deficitsBOP deficitsSacrifice of Sacrifice of monetary monetary independenceindependence
Floating Floating exchange exchange ratesrates
EfficiencyEfficiencyBOP BOP equilibriumequilibrium
Instability of Instability of trade and trade and investmentinvestmentInflationInflation
Exchange rate regimesIn 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 importantNeed 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