2 LIBERALIZATION, PRODUCTIVITY AND AGGREGATE EXPENDITURE: FUNDAMENTAL DETERMINANTS OF REAL EQUILIBRIUM EXCHANGE RATE Juan Benítez Gabriela Mordecki XI Arnoldshain, Antwerp June 2013

Presentation Outline  Objectives and justification  Theoretical framework  RER Fundamentals  Methodology  Main results  Final remarks

Objectives and justification  Uruguay is a small open economy  Between 2004 and 2010 the economy experienced a process of strong economic growth and appreciation of domestic currency  6% GDP annual growth  5.4% annual Global Real Exchange Rate (RER) appreciation  2.3% RER annual appreciation defined as TP/NTP  8.9% appreciation of extra-regional RER 4

In the period there has been a strong increase in commodity prices, particularly of food and oil 5

 Is the appreciation a long-term trend or short-term phenomenon? Changes in fundamentals: –Productivity – Weight of extra-regional trade – Aggregate expenditure 6

Theoretical framework  Purchasing Power Parity  Balassa-Samuelson Hypothesis RER: relative price of tradables, which prices are determined on the international market compared to non-tradables, which prices are determined by supply and demand in the domestic economy: 7 RER = TP/NTP

RER Fundamentals : Productivity differentials (-) Terms of trade (-) Capital inflow (-) Total consumption expenditure (-) Interest rate differential (-) Exports increase (-) 8

Methodology  Cointegration analysis through Johansen method  Variables included in the model: logtcr: RER Log, estimated as the coefficient of TP and NTP logpreleeuu: Log of the labor productivity gap between Uruguay and USA. logxx: Log of the share of extra-regional good exports over total good exports loggtot: Log of total expenditure  All variables have a unit root 9

Main results Long run relationship: Interest rates and terms of trade were not significant in the relationship The increase in productivity with respect to trading partners contributing to RER appreciation: Balassa-Samuelson effect Coherent with Aboal (2002) and Gianelli & Mednik (2006) 10

 The increase of extra-regional export flow appreciates domestic currency The increase in disposable income, with given world prices: demand shock in the non-tradable sector  According to Granger Test: The extra-regional insertion precedes the appreciation  The external integration intensifies in those goods that the economy has comparative advantages: primary products of agricultural origin, which causes a fall in relative prices and consequently in the price competitiveness of the economy. 11

 Productivity ratios and extra-regional exports are not significantly different from unity, so productivity increases completely impact on equilibrium RER appreciating currency 12

 In the short-term relationship, after one quarter RER adjusted 5.6%, productivity by 15.9% and 32.1% extra-regional exports. Adjustment coefficients of the variables to imbalances ΔlogtcrΔlogpreleeuuΔlogxx Error Correction Term T statistic[ ][ ][ ] 13

 The RER is set to its equilibrium value after 10 quarters, confirming that the RER, or its components of the tradable and non-tradable prices misalignment corrected more slowly than productivity and much less speed and extra-regional exports aggregate consumption 14

Impulse responses RER response to an impulse in Productivity 15

RER response to an impulse in extra-regional exports 16

RER response to an impulse in total consumption 17

Evolution of the trend and observed RER (Index, 1988.I = 100) 18

Final Remarks  RER misalignments between observed and its equilibrium level in the period of analysis are more minor than what could be feared. The variations observed in the RER in the analysis period are due primarily to movements in fundamentals 19

 The evolution of the fundamentals during the analysis support the expectation that the phenomenon of domestic appreciation continue  It is likely that the prices of exported goods continue to increase, intensifying the displacement from non-tradable sector resources towards the competitive sector 20

 RER fluctuations are less intense at the end of the analysis period, when the monetary authority ceased to have the exchange rate as a nominal anchor  The RER imbalances regarding its fundamentals have strong links with other relevant variables for the economy as the nominal exchange rate, the output gap and inflation 21

Thank you!!! 22