thorvaldur gylfason joint vienna institute course on macroeconomic policies in times of high capital...

Thorvaldur GylfasonJoint Vienna Institute Course on

Macroeconomic Policies in Times of High Capital Mobility

Vienna, AustriaMay 16–20, 2011

1. Real exchange rates versus nominal exchange rates

2. Exchange rate policy, overvaluation, and welfare

3. Exchange rate regimes To float or not to floatTo float or not to float

4. How many monies do we need?

11

*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

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

*P

ePQ

*P

ePQ

1.1. Suppose ee falls fallsThen more rubles per dollar, so XX rises rises, ZZ falls falls

2.2. Suppose PP falls fallsThen XX rises rises, ZZ falls falls

3.3. Suppose P*P* rises risesThen XX rises rises, ZZ falls falls

Capture all three by supposing QQ fallsfalls

Then XX rises rises, ZZ falls falls

Remember:

Devaluation needs to be accompanied by fiscal and fiscal and monetary restraint monetary restraint to prevent prices from rising and thus eating up the benefits of devaluation

To work, nominal devaluation must result in realreal devaluation

*P

ePQ

Foreign exchangeForeign exchange

Real exch

an

ge r

ate

Real exch

an

ge r

ate

ImportsImports

ExportsExports

22

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 balance of

paymentsBOP = X + FBOP = X + Fxx – Z – F – Z – Fz z

= X – Z + F= X – Z + F = current account + capital

account = 0 X – Z = current account

F = capital and financial account


Real exch

an

ge r

ate

Real exch

an

ge r

ate

ImportsImports

ExportsExports

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)Supply (exports)

Demand (imports)Demand (imports)

Overvaluation

Deficit

Overvaluation works like a price ceiling

Appreciation of currency in real terms, either through inflation or nominal appreciation, leads to a loss of export competitiveness

In 1960s, Netherlands discovered natural resources (gas deposits)Currency appreciated Exports of manufactures and services

suffered, but not for long Not unlike natural resource discoveries,

aid inflows could trigger the Dutch disease in receiving countriesSee my “Dutch Disease” in New

Palgrave Dictionary of Economics

Online

Foreign exchange

Real exch

an

ge r

ate

Imports

Exports without oil

Exports with oil

A

C BOil discovery

leads to appreciation

, and reduces nonoil exports

Compositi

on of exports

matters

Foreign exchange

Real exch

an

ge r

ate

Imports

Exports without aidaid

Exports with aidaid

A

C B

Foreign aid

leads to appreciation

, and reduces exports (e.g., Zambia)

Trade vs.

aid

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 in cities

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

Suppose ee adjusts to PP with a lag

Then QQ is directly proportional to inflation

Numerical 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 lifts the

realreal exchange rate

as long as the

nominal exchange

rate adjusts with a

lag

Suppose inflation rises to 20 percent per year

Under floatingfloatingDepreciation is automatic: ee

movesBut depreciation may take time

Under a fixed exchange rate fixed exchange rate regimeregimeDevaluation will lower e and

thereby also QQ – provided inflation is kept under control

Does devaluation improve the current account?The Marshall-Lerner condition

B = eeX – Z = eX(e) – Z(e)Not clear that a lower ee helps BB

because decrease in ee lowerslowers eXeX if XX stays put

Let’s do the arithmeticBottom line is:Devaluation strengthens current

account as long as1ba

Suppose prices are

fixed, so that e = Q

aa = elasticity of exports

bb = elasticity of imports

ValuatioValuation effect n effect arises arises from the from the ability ability to affect to affect foreign foreign pricesprices

Lower ee raises XX

Lower ee reduces

ZZ

ZeXB )()( eZeeXB

de

dZ

de

dXeX

de

dB

e

Z

Z

e

de

dZ

e

X

X

e

de

dXeX

de

dB

1 1

- +

Export elasticityExport elasticityImportImport

elasticityelasticity-a b

Lower ee raises XX

Lower ee reduces

ZZ

e

Z

Z

e

de

dZ

e

X

X

e

de

dXeX

de

dB

XbabXaXXde

dB 1

0de

dB 1baif

XX

Assume X = Z/e initially

Appreciation weakens current

account

-a b

Econometric studies indicate that the Marshall-Lerner condition is almost invariably satisfied

Industrial countries: a = 1, b = 1

Developing countries: a = 1, b = 1.5

Hence, 1ba Devaluation

strengthens the

current account

Elasticity ofElasticity of Elasticity ofElasticity ofexportsexports importsimports

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 are price takers price takers abroadDevaluation has no effect on the

foreign currency price of exports and imports

So, the valuation effect does notnot 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

For an emerging country with … Initial trade balance Initial trade balance Export-to-GDP ratio of 40%Export-to-GDP ratio of 40%

… nominal depreciation by 10% permanently improves trade balance by 1½% to 2% of GDP in medium term

Effect depends on class of Effect depends on class of exporterexporter

Oil, non-oil, manufacturesMost of the effect is through Most of the effect is through imports and is felt within 3 to 5 imports and is felt within 3 to 5 yearsyears

The real exchange rate always always floatsfloatsThrough nominal exchange rate

adjustment or price change

Even so, it matters 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

33

There is a range of optionsMonetary union or dollarization

Means 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

Currency union or dollarization Currency board

Peg FixedFixed Horizontal bandsHorizontal bands

Crawling peg Without bandsWithout bands With bandsWith bands

Floating ManagedManaged

IndependentIndependent

FIXEDFIXED

FLEXIBLFLEXIBLEE

DollarizationUse another country’s currency as sole legal tender

Currency unionShare same currency with other union members

Currency boardLegally commit to exchange domestic

currency for specified foreign currency at fixed rate

Conventional (fixed) pegSingle currency pegCurrency basket peg

Flexible pegFixed but readily adjusted

Crawling pegComplete

Compensate for past inflation

Allow for future inflation

PartialAimed at reducing inflation, but real appreciation results because of the lagged adjustment

Fixed but adjustable

Managed floatingManagement by sterilized intervention

I.e., by buying and selling foreign exchange

Management by interest rate policy, i.e., monetary policy E.g., by using high interest rates to

attract capital inflows and thus lift the exchange rate of the currency

Pure floating

FREE CAPITAL MOVEMENTS

FIXEDEXCHANGE

RATE

MONETARYINDEPENDENCE

MonetaryMonetaryUnion (EU)Union (EU)

Free to choose

only two of three

options; must

sacrifice one of the

three


FIXEDEXCHANGE

RATE

MONETARYINDEPENDENCECapital controls Capital controls

(China)(China)

Free to choose

only two of three

options; must


three


FIXEDEXCHANGE

RATE


Flexible Flexible exchange exchange rate (US, UK, Japan)rate (US, UK, Japan)

Free to choose

only two of three

options; must


three


FIXEDEXCHANGE

RATE


MonetaryMonetaryUnion (EU)Union (EU)

Flexible Flexible exchange exchange rate (US, UK, Japan)rate (US, UK, Japan)

Capital controls Capital controls (China)(China)

Free to choose

only two of three

options; must


three

If capital controls are ruled out in view of the proven benefits of free trade free trade in goods, services, labor, and also capital (four freedomsfour freedoms), …

… then long-run choice boils down to one between monetary independencemonetary independence (i.e., flexible exchange rates) vs. fixed ratesflexible exchange rates) vs. fixed rates Cannot have both!Cannot have both!

Either type of regime has advantages as well as disadvantages

Let’s quickly review main benefits and costs

BenefitsBenefits CostsCosts

Fixed Fixed exchange exchange ratesrates

Floating Floating 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










EfficiencyEfficiency

BOP BOP equilibriumequilibrium









EfficiencyEfficiency

BOP BOP equilibriumequilibrium

Instability of Instability of trade and trade and investmentinvestment

InflationInflation

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 circumstance If inefficiencyinefficiency and slow growth due to

currency overvaluation are the main problem, floating rates can help

If high inflationinflation is the main problem, fixed exchange rates can help, at the risk of renewed overvaluation

Ones both problems are under control, time may be ripe for monetary union

What do countries do?

To eliminate high

inflation, need fixed

exchange rate for a

time

46Source: Annual Report on Exchange Arrangements and Exchange Restrictions database.

What countries actually do (Number of countries, April What countries actually do (Number of countries, April 2008) 2008)

(3)

(12)

(22)

(5) (2)(66)

(44) (40)

(76)

(84)

(10)

No national currency 6%Currency board 7%Conventional fixed rates

36%Intermediate pegs 5%Managed floating 24%Pure floating 22% 100%

46%

54%

There is a gradual tendency towards floating, from 10% of LDCs in 1975 to almost 50% today, followed by increased interest in fixed ratesincreased interest in fixed rates through economic and monetary unions

In view of the success of the EU and the euro, economic and monetary unions appeal to many other countries with increasing force

Consider four categoriesExisting monetary unionsDe facto monetary unionsPlanned monetary unions Previous – failed! – monetary unions

44

CFA franc14 African countries

CFP franc3 Pacific island states

East Caribbean dollar8 Caribbean island states

Picture of Sir W. Arthur Lewis, the great Nobel-prize winning development economist, adorns the $100 note

Euro, more recent16 EU countries plus 6 or 7 others

Thus far, clearly, a major success in view of old conflicts among European nation states, cultural variety, many different languages, etc.

Australian dollar Australia plus 3 Pacific island states

Indian rupee India plus Bhutan (plus Nepal)

New Zealand dollar New Zealand plus 4 Pacific island states

South African rand South Africa plus Lesotho, Namibia, Swaziland –

and now Zimbabwe Swiss franc

Switzerland plus Liechtenstein US dollar

US plus Ecuador, El Salvador, Panama, and 6 others

East African shilling (2009) Burundi, Kenya, Rwanda, Tanzania, and

Uganda Eco (2009)

Gambia, Ghana, Guinea, Nigeria, and Sierra Leone (plus, perhaps, Liberia)

Khaleeji (2010) Bahrain, Kuwait, Qatar, Saudi-Arabia, and

United Arab Emirates Other, more distant plans

Caribbean, Southern Africa, South Asia, South America, Eastern and Southern Africa, Africa

Danish krone 1886-1939 Denmark and Iceland 1886-1939: 1 IKR = 1 DKR 2009: 2,500 IKR = 1 DKR (due to inflation in

Iceland) Scandinavian monetary union 1873-1914

Denmark, Norway, and Sweden East African shilling 1921-69

Kenya, Tanzania, Uganda, and 3 others Mauritius rupee

Mauritius and Seychelles 1870-1914 Southern African rand

South Africa and Botswana 1966-76 Many others

No significant

divergence of

prices or currency

rates following

separation

99.95%

CentripetalCentripetal tendency to joinjoin monetary unions, thus reducing number of currencies To benefit from stable exchange rates stable exchange rates at the

expense of monetary independence CentrifugalCentrifugal tendency to leaveleave monetary

unions, thus increasing number of currencies To benefit from monetary independence monetary independence often,

but not always, at the expense of exchange rate stability

With globalization, centripetal tendencies appear stronger than centrifugal onesThe EndThe End

thorvaldur gylfason joint vienna institute course on macroeconomic policies in times of high capital...

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