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
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
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
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)
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
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 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
a = elasticity of exportsb = elasticity of imports
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 to trade 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 countries
An increase in openness by 14% of GDP is associated with an increase in per capita growth by 1% per year.
r = 0.40
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
1965
-98,
ad
just
ed f
or
init
ial
inco
me
(%)
Botswana
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
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
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 (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 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