External Sector Policies Thorvaldur Gylfason

Outline 1.Real versus nominal exchange rates 2.Exchange rate policy and welfare 3.The scourge of overvaluation 4.From exchange rate policy to economic growth 5.Exchange rate regimes nTo float or not to float

Real versus nominal exchange rates 1 R = real exchange rate e = nominal exchange rate P = price level at home P* = price level abroad Increase in R means real appreciation e e refers to foreign currency content of domestic currency

Real versus nominal exchange rates R = real exchange rate e = nominal exchange rate P = price level at home P* = price level abroad Devaluation or depreciation of e makes R also depreciate unless P rises so as to leave R unchanged

Foreign exchange Real exchange rate Imports Exports Exchange rate policy and welfare 2 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 establishes Equilibrium real exchange rate Equilibrium in the balance of payments BOP = X + F x – Z – F z = X – Z + F = current account + capital account = 0 Exchange rate policy and welfare

Foreign exchange Real exchange rate Imports Exports Exchange rate policy and welfare Overvaluation Deficit

Foreign exchange Price of foreign exchange Supply (exports) Demand (imports) Exchange rate policy and welfare Overvaluation Deficit Overvaluation works like a price ceiling

Market equilibrium and economic welfare Supply Demand E Producersurplus Consumersurplus Quantity Price A B C Total welfare gain associated with market equilibrium equals producer surplus (= ABE) plus consumer surplus (= BCE)

Supply Demand Price ceiling E F G Quantity Price Welfareloss Price ceiling imposes a welfare loss equivalent to the triangle EFG A B C Consumer surplus = AFGH H J Market intervention and economic welfare Producer surplus = CGH Total surplus = AFGC

Supply Demand Price ceiling E F G Quantity Price Welfareloss Price ceiling imposes a welfare loss that results from shortage (e.g., deficit) A B C H J Market intervention and economic welfare Shortage

The scourge of overvaluation Governments may try to keep the national currency overvalued To keep foreign exchange cheap To have power to ration scarce foreign exchange To make GNP look larger than it is Other examples of price ceilings Negative real interest rates Rent controls 3

Inflation and overvaluation Inflation can result in an overvaluation of the national currency Remember: R = eP/P* Suppose e adjusts to P with a lag Then R is directly proportional to inflation Numerical example

Inflation and overvaluation Time Real exchange rate Average Suppose inflation is 10 percent per year

Inflation and overvaluation Time Real exchange rate 110Average 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 regime Adjustment is automatic: e moves Under a fixed exchange rate regime Devaluation 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 e T = eX – Z = eX(e) – Z(e) Not obvious that a lower e helps T Let’s do the arithmetic Bottom line is: Devaluation improves the current account as long as Suppose prices are fixed, so that e = R a = elasticity of exports b = elasticity of imports Valuation effect arises from the ability to affect foreign prices

The Marshall-Lerner condition: Evidence 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, Devaluation improves the current account

Empirical evidence from developing countries Elasticity of exportsimports Argentina Brazil India Kenya Korea Morocco Pakistan Philippines Turkey Average1.11.5

Small countries: A special case Small countries are price takers abroad Devaluation 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 measures Remember: 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

From exchange rate policy to economic growth Governments may try to keep the national currency overvalued Or inflation may result in overvaluation In 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 growth How 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 floats Through 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 growth Exports – and imports! – are good for growth Several other reasons Inflation distorts production and impedes financial development

How trade increases efficiency and growth Trade with other nations increases efficiency by allowing 1.Specialization through comparative advantage 2.Exploitation of economies of scale 3.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 education Which is also good for growth!

Efficiency is crucial for economic growth Need economic policies that increase efficiency Produce more output from given inputs Takes fewer inputs to produce given output More 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 : Evidence 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 FDI and growth 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 = countries

African countries: Exports 2001 (% of GDP) Botswana Average

AFRITAC countries: Exports (% of GDP) Botswana Weighted averages. Unweighted averages are higher: 33% for Africa and 42% for world as a whole.

Exchange rate regimes The real exchange rate always floats Through 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 regimes There is a range of options Monetary union or dollarization Means giving up your national currency or sharing it with others Currency board Legal commitment to exchange domestic for foreign currency at a fixed rate Fixed exchange rate (peg) Crawling peg Managed floating Pure floating

Benefits and costs BenefitsCosts Fixed exchange rates Floating exchange rates

Benefits and costs BenefitsCosts Fixed exchange rates Stability of trade and investment Low inflation Floating exchange rates

Benefits and costs BenefitsCosts Fixed exchange rates Stability of trade and investment Low inflation Inefficiency BOP deficits Sacrifice of monetary independence Floating exchange rates

Benefits and costs BenefitsCosts Fixed exchange rates Stability of trade and investment Low inflation Inefficiency BOP deficits Sacrifice of monetary independence Floating exchange rates Efficiency BOP equilibrium

Benefits and costs BenefitsCosts Fixed exchange rates Stability of trade and investment Low inflation Inefficiency BOP deficits Sacrifice of monetary independence Floating exchange rates Efficiency BOP equilibrium Instability of trade and investment Inflation

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 circumstance If 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 currency39 Currency board 8 Adjustable pegs50 Crawling pegs 9 Managed floating33 Pure floating % 50% There is a gradual tendency towards floating, from 10% of LDCs in 1975 to over 50% today

Bottom line The End Exchange rate policy is important because trade is important Need to maintain real exchange rates at levels that are consistent with BOP equilibrium, including sustainable debt  Avoid overvaluation! Need to adopt exchange rate regime that is conducive to low inflation and rapid growth These slides will be posted on my website: