1. Thorvaldur Gylfason Joint Vienna Institute/ Institute for Capacity Development Distance Learning Course on Financial Programming and Policies Vienna, Austria N OVEMBER 26–D ECEMBER 7, 2012

2. 1.Balance of payments accounts 2.Balance of payments analysis 3.Exchange rates 4.Exchange rate policy 5.Exchange rate regimes To float or not to float To float or not to float 6. How many monies do we need?

3. Accounting system for macroeconomic analysis in four parts 1.Balance of payments 2.National income accounts 3.Fiscal accounts 4.Monetary accounts Now look at balance of payments accounts per se, looked before at linkages in a separate lecture

4. statistical statement specific period of time economic transactions of an economy with the rest of the world The balance of payments is a statistical statement which systematically summarizes, for a specific period of time, the economic transactions of an economy with the rest of the world

5. external position The information on the economic transactions and financial flows between a country and the rest of the world, systematically summarized in its balance of payments, is necessary to analyze the external position of the country, including its debt

6.  Double entry accounting  Every transaction must result in two entries of equal amounts, one on the credit side and one on the debit side positive credit negative debit  Typically, a positive sign (+) is associated with an amount recorded on the credit side and a negative sign (-) is associated with an entry on the debit side Creditasset Credit refers to the lender whose loan to the debtor is an asset Debitliability Debit refers to the debtor whose debt to the lender is a liability Creditasset Credit refers to the lender whose loan to the debtor is an asset Debitliability Debit refers to the debtor whose debt to the lender is a liability

7. creditdebit By convention, some transactions are recorded as credit items(+) and others as debit items (-)  Exports of goods and services Credit (+)  Imports of goods and servicesDebit (-)  Income and transfers receivedCredit (+)  Income and transfers paid outDebit (-)  Increase in foreign liabilitiesCredit (+)  Increase in foreign assetsDebit (-)

8.  A reduction in foreign liabilities is recorded on the debit side, with a negative sign (-)  A reduction in foreign assets is recorded on the credit side, with a positive sign (+)  Due to this convention,  An increase in foreign reserves is recorded on the debit side, i.e., with a negative sign (-)  A reduction in reserves is recorded on the credit side, i.e., with a positive sign (+) We “pay” for increased reserves like we pay for imports Likewise, a decrease in reserves generates “receipts”

9. Transactions in two major categories 1.Real transactions  Goods, services, and income Current account Current account of the BOP flows Involve flows 2.Financial transactions  Reflect changes in foreign assets and liabilities Capital and financial account Capital and financial account of the BOP stocks Involve changes in stocks Flows involve changes in underlying stocks: X – Z + F =  R X = exports, Z = imports, F = capital account, R = reserves, F =  D F with D F = net foreign debt X = exports, Z = imports, F = capital account, R = reserves, F =  D F with D F = net foreign debt

10.  Double-entry recording  The sum of credit entries must equal the sum of debit entries  The sum of all transactions is zero  Practical problems lead to errors and omissions  Diversity of data sources  Missing data: e.g., financial transactions outside banking system (informal sector)  Under- or overvaluation of transactions Smuggling

11.  Current account  Transactions related to goods, services, income, and current transfers between residents and non-residents Transactions related to goods are those relative to the movements of merchandise Exports and imports of goods Transactions involving services include different categories, e.g., transport, travel, etc. Exports and imports of services

12.  Transactions related to income involve the remuneration of labor, capital, and land  E.g., compensation paid to trans-border workers, interest payments on external debt, etc.  Transfers are unrequited transactions  Public and private  In cash or in kind  E.g., foreign aid

13.  Since the sums of credits and debits offset one another, how can there be an "imbalance" in the external accounts?  Advantage of analytical presentation  It shows significant balances that are useful for economic analysis and shows a possible external imbalance

14. surplusdeficit line  The overall balance of payments can be in surplus or in deficit once we distinguish transactions into two sub- groups and draw a line between these two subgroups above the line below the line  When transactions above the line sum up to a deficit, transactions below the line will sum up to a corresponding surplus, and vice versa

15.  Trade balance  Difference between exports and imports of goods (net exports)  Current account balance  Difference between amounts recorded on the credit and debit side of goods, services, income, and current transfers  Overall balance  Current account balance plus capital and financial operations account balance considered not to be “financing” items

16. GoodsServicesCapitalExports XgXgXgXg XsXsXsXs FxFxFxFx Imports ZgZgZgZg ZsZsZsZs FzFzFzFz Examples Real Real transactions Financial Financial transactions

17. Balance of payments  BOP = X g + X s + F x – Z g – Z s – F z  = X – Z + F  = current account + capital account  Here  X = X g + X s  X = X g + X s Exports of good and services  Z = Z g + Z s  Z = Z g + Z s Imports of good and services  F = F x – F z  F = F x – F z Net exports of capital = Net capital inflow =  D F Also called capital and financial account The term “capital account” is 1.Old language (BPM4) 2.Shorthand for new language (BPM5) The term “capital account” is 1.Old language (BPM4) 2.Shorthand for new language (BPM5)

18. Balance of payments  BOP = X g + X s + F x – Z g – Z s – F z  = X – Z + F  = current account + capital account  Here  X = X g + X s  X = X g + X s Exports of good and services  Z = Z g + Z s  Z = Z g + Z s Imports of good and services  F = F x – F z  F = F x – F z Net exports of capital = Net capital inflow

19. Balance of payments  BOP = X g + X s + F x – Z g – Z s – F z  = X – Z + F  = current account + capital account  Here  X = X g + X s  X = X g + X s Exports of good and services  Z = Z g + Z s  Z = Z g + Z s Imports of good and services  F = F x – F z  F = F x – F z Net exports of capital = Net capital inflow

20. Balance of payments  BOP = X g + X s + F x – Z g – Z s – F z  = X – Z + F  = current account + capital account  Here  X = X g + X s  X = X g + X s Exports of good and services  Z = Z g + Z s  Z = Z g + Z s Imports of good and services  F = F x – F z  F = F x – F z Net exports of capital = Net capital inflow

21. Again  BOP = X – Z + F =  R where  R = reserves  Note:  X, Z, and F are flows  R is a stock,  R is a flow  R = R – R -1

22.  BOP = X – Z + F =  R where  R = R – R -1  Implications X  R F  R Z  R In practice Z F or  R

23. nTrade balance  TB = X g + X nfs – Z g – Z nfs X nfs = X s – X fs = exports of nonfactor services Z nfs = Z s – Z fs = imports of nonfactor services nBalance of goods and services  GSB = TB + Y f Y f = X fs – Z fs = net factor income nCurrent account balance  CAB = GSB + TR = TB + Y f + TR TR = net unrequited transfers from abroad Intermediate concept GSB

24. Net factor income from labor  Compensation of domestic guest workers abroad (e.g., Pakistanis in the Gulf) minus that of foreign workers at home Net factor income from capital  Interest receipts from domestic assets held abroad minus interest payments on foreign loans (e.g., Argentina)  Includes also profits and dividends Transfers are unrequited transactions  Public or private, disbursed in cash or in kind (e.g., foreign aid) Y f > 0 in Pakistan Y f < 0 in Argentina Y f > 0 in Pakistan Y f < 0 in Argentina

25. Two parts 1.Capital account 1.Capital account (esp., capital transfers) 2.Financial account 1.Direct investment Involves influence of foreign owners 2.Portfolio investment Includes long-term foreign borrowing Does not involve influence of foreign owners 3.Other investment Includes short-term borrowing 4.Errors and omissions Statistical discrepancy Is the world’s BOP = 0?!

26.  Foreign direct investment (FDI)  Investments that a non-resident entity realizes with the aim of acquiring a durable interest in a resident enterprise (long-term relationship and influence on the enterprise’s management)  The investor holds at least 10% of the shares or the voting rights in the enterprise

27.  Portfolio investments  Equity participation instruments and debt instruments, money market instruments Financial derivatives: separate functional category  Other investments  Trade credits, short-term and long-term loans, including loans from World Bank  Typically recorded on the basis of the instrument or on the basis of their maturity (short term vs. long term)

28.  Reserve assets  Financing items  Financing items below the line in the balance of payments finance the balance of payments  Transactions involving the assets of which monetary authorities consider that they dispose in order to finance the balance of payments, including IMF loans E.g., to maintain adequate foreign exchange reserves Most successful IMF loans are never “used”

29. Four main items below the line 1.Gold 2.SDRs 3.Reserve position in IMF 4.Foreign exchange Three-month Rule cover three months of imports Three-month Rule: Gross foreign reserve holdings should suffice to cover three months of imports of goods and services Giudotti-Greenspan Rule not decrease below short-term foreign commercial bank liabilities or total liabilities Giudotti-Greenspan Rule: Central Bank foreign reserves should not decrease below short-term foreign commercial bank liabilities or total liabilities Also included in capital and financial account

30.  Changes in reserve position in IMF  Recorded in financial operations account under reserve assets, below the line  Use of IMF resources  Purchase of foreign currency from IMF leads to Increase in foreign assets of the Central Bank (-, negative sign) Financial liability to the IMF (+, positive sign) Gross reserves go up, net reserves stay put  Use of SDRs  Recorded in financial account as reserve asset flows

31. Current account A. Goods Exports Imports Trade balance Trade balance B. Services Transport Travel C. Income Compensation of workers Investment income D. Current transfers General government Other sectors Current transactions balance = (X-Z) + Y F + TR F = (X-Z) + Y F + TR F C apital and financial operations account A. Capital Capital transfers Purchases/sales of nonproduced nonfinancial assets B. Financial operations Direct investment Portfolio investment Other investment C. Errors and omissions Overall Balance D. Net foreign assets E. Exceptional financing X-Z YFYFYFYF TR F FDI NFL NFA

33. Y = C + I + G + X – Z E + X – Z  = E + X – Z E = C + I +G  where E = C + I +G CAB = X – Z = Y – E  Ignore Y f and TR for simplicity S = I + G – T + X – Z CAB = S – I + T – G CAD = Z – X = E – Y = I – S + G – T Private sector deficit Public sector deficit

34. Y = C + I + G + X – Z GDP = C + I + G + TB GNP = C + I + G + CAB GNP – GDP = CAB – TB = Y f (if TR = 0) GNP = GDP + Y f GNP > GDP GNP > GDP in Pakistan GNP < GDP GNP < GDP in Argentina GNDI = GNP + TR = GDP + Y f + TR

35. Y X - Z DefinitionGDP Trade balance Goods and nonfactor services

36. Y X - Z DefinitionGDP Trade balance Goods and nonfactor services GNP Current account excl. transfers Goods and services

37. Y X - Z DefinitionGDP Trade balance Goods and nonfactor services GNP Current account excl. transfers Goods and services GNDI Current account incl. transfers Goods and services plus transfers

38. Public  Public sector  G – T =  B +  D G +  D F Private  Private sector  I – S =  D P –  M –  B Now, add them up  G – T + I – S =   B +  D G +  D F +  D P –  M –  B =   D G +  D F +  D P –  M =   D –  M +  D F = -  R +  D F = Z - X External  External sector  X – Z =  R -  D F M = D + R D G + D P = D X – Z + F =  R F =  D F

39. Monetary survey  M = D + R From stocks to flows   M =  D +  R Solve for  R   R =  M –  D  Monetary approach  Monetary approach to balance of payments  Still holds that  R = X – Z + F

40. Foreign exchange Real exchange rate Imports Exports Earnings from exports of goods, services, and capital Payments for imports of goods, services, and capital Equilibrium Real exchange rate = eP/P*

41. 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 = X – Z + F = current account + capital account = 0

42. Foreign exchange Real exchange rate ImportsImports Exports Overvaluation Deficit R R moves when e is fixed

43. Foreign exchange Price of foreign exchange Supply (exports) Demand (imports) Overvaluation Deficit Overvaluation works like a price ceiling

44.  Ratio of export prices to import prices: P x /P z  Typically expressed in as an index  P x = Export price index  P Z = Import price index Expressed in the same currency as the prices included in the export price index  Indicator of the purchasing power of exports in terms of imports  Terms of trade improve when P x /P z rises  Terms of trade worsen when P x /P z falls Y = E + X – Z GNP = E N /P E + X N /P X – Z N /P Z (GNP) GNI = E N /P E + X N /P Z – Z N /P Z (GNI) Y = E + X – Z GNP = E N /P E + X N /P X – Z N /P Z (GNP) GNI = E N /P E + X N /P Z – Z N /P Z (GNI)

45.  Crucial indicator used to assess the external position of a country  The current account balance is equal to the change in net foreign assets with respect to the rest of the world  Includes change in net foreign assets of Non-banking sector Banking sector (including monetary authorities)  CAB  – F +  R because X – Z + F =  R

46.  CAB  – F +  R because X – Z + F =  R  Hence, current account deficit can be financed by foreign direct investment  Attracting foreign direct investment net foreign liabilities  Accumulating net foreign liabilities I.e., borrowing abroad net foreign assets  Running down the net foreign assets of the monetary authorities

47.  When does a current account deficit become a source of concern?  When it is a lasting (structural) deficit rather than a temporary (cyclical) deficit  When it is financed by short-term external borrowing or by a protracted reduction in net foreign assets Giudotti-Greenspan Rule  When foreign exchange reserves are low in terms of months of imports or in terms of the Giudotti-Greenspan Rule  Other factors  Capacity to meet financial obligations  Availability of external financing

48.  When does a current account deficit become a source of concern?  When continued current account deficits, reflecting the behavior of the government and the private sector, require drastic adjustment of economic policies in order to avoid a crisis, e.g., Collapse of exchange rate Default on external debt payments

49. solvent  A country is solvent if the present value of future current account surpluses is at least equal to its current external debt  The concept is simple, but putting it into practice is complicated If the projections of future surpluses are sufficiently large, any current account deficit could be consistent with the notion of solvency

50.  Another crucial indicator used to assess the external position of a country deficit decreasenet foreign assets exceptional financing  A deficit in the overall balance means a decrease in the net foreign assets of the monetary authority except when exceptional financing becomes available  Foreign reserves are traditionally held by the monetary authorities in order to finance payments imbalances and to defend the currency

51.  Exceptional financing  Exceptional financing can be needed in an emergency where reserves have fallen to perilously low levels  Three main types  Rescheduling  Rescheduling of external debt obligations Scheduled payments postponed in agreement with creditors  Debt forgiveness Voluntary cancellation by creditors  Payments arrears  Payments arrears on external debt service without Scheduled payments postponed without agreement with creditors

52.  Indicators of an appropriate level of foreign reserves  Ratio of reserves to monthly imports of goods and services of more than 3  Guidotti-Greenspan Rule  Other considerations  Capital mobility  Exchange rate regime  Composition of external liabilities  Access to foreign borrowing  Seasonal nature of imports and exports

53. Q = real exchange rate e = nominal exchange rate P = price level at home P* = price level abroad Increase in Q means real appreciation e e refers to foreign currency content of domestic currency

54. Q = real exchange rate e = nominal exchange rate P = price level at home P* = price level abroad Devaluation or depreciation of e makes Q also depreciate unless P rises so as to leave Q unchanged

55. 1.e falls 1. Suppose e falls Then more rubles per dollar, X risesZ falls so X rises, Z falls 2.P falls 2. Suppose P falls X risesZ falls Then X rises, Z falls 3.P* rises 3. Suppose P* rises X risesZ falls Then X rises, Z falls Q falls Capture all three by supposing Q falls X risesZ falls Then X rises, Z falls

56. Remember: fiscal and monetary restraint Devaluation needs to be accompanied by fiscal and monetary restraint to prevent prices from rising and thus eating up the benefits of devaluation real To work, nominal devaluation must result in real devaluation

57. Foreign exchange Real exchange rate Imports Exports Earnings from exports of goods, services, and capital Payments for imports of goods, services, and capital Equilibrium

58. Equilibrium between demand and supply in foreign exchange market establishes Equilibrium real exchange rate Equilibrium in balance of payments BOP = X + F x – Z – F z = X – Z + F = X – Z + F = current account + capital account = 0 X – Z = current account F = capital and financial account X – Z = current account F = capital and financial account

59. Foreign exchange Real exchange rate Imports Exports Overvaluation Deficit R R moves when e is fixed

60. Foreign exchange Price of foreign exchange Supply (exports) Demand (imports) Overvaluation Deficit Overvaluation works like a price ceiling

61. Supply Demand E Producersurplus Consumersurplus Quantity Price A B C welfare gain Total welfare gain associated with market equilibrium equals producer surplus (= ABE) plus consumer surplus (= BCE) welfare gain Total welfare gain associated with market equilibrium equals producer surplus (= ABE) plus consumer surplus (= BCE)  R = 0, so R is fixed when e floats

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

63. Supply Demand Price ceiling E F G Quantity Price Welfareloss Price ceiling imposes a welfare loss welfare loss that results from shortage (e.g., deficit) Price ceiling imposes a welfare loss welfare loss that results from shortage (e.g., deficit) A B C H J Shortage Welfare triangles Harberger triangles Welfare triangles Harberger triangles K

64.  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 countries See my “Dutch Disease” in New Palgrave Dictionary of Economics OnlineDutch Disease See my “Dutch Disease” in New Palgrave Dictionary of Economics OnlineDutch Disease

65. Foreign exchange Real exchange rate Imports Exports without oil Exports with oil A CB Oil discovery leads to appreciation, and reduces nonoil exports Composition of exports matters

66. Foreign exchange Real exchange rate Imports aid Exports without aid aid Exports with aid A CB Foreign aid leads to appreciation, and reduces exports (e.g., Zambia) Trade vs. aid

67. 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 in cities

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

69. Time Real exchange rate 100 110 105 Average Suppose inflation is 10 percent per year

70. Time 100 120 Real exchange rate 110Average real Hence, increased inflation lifts the real exchange rate as long as the nominal exchange rate adjusts with a lag Suppose inflation rises to 20 percent per year

71. floating Under floating e Depreciation is automatic: e moves But depreciation may take time fixed exchange rate regime Under a fixed exchange rate regime Q Devaluation will lower e and thereby also Q – provided inflation is kept under control Does devaluation improve the current account? The Marshall-Lerner condition

72. e B = eX – Z = eX(e) – Z(e) eB elowerseXX Not clear that a lower e helps B because decrease in e lowers eX if X stays put Let’s do the arithmetic Bottom line is: Devaluation strengthens current account as long as Suppose prices are fixed, so that e = Q a a = elasticity of exports b b = elasticity of imports a a = elasticity of exports b b = elasticity of imports Valuation effect arises from the ability to affect foreign prices eX Lower e raises X eZ Lower e reduces Z eX Lower e raises X eZ Lower e reduces Z

73. 11 -+ Export elasticity ImportelasticityImportelasticity -ab eX Lower e raises X eZ Lower e reduces Z eX Lower e raises X eZ Lower e reduces Z

74. if X Assume X = Z/e initially Appreciation weakens current account -ab

75. 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 strengthens the current account

76. Elasticity ofElasticity of exportsimports Argentina0.60.9 Brazil0.41.7 India0.52.2 Kenya1.00.8 Korea2.50.8 Morocco0.71.0 Pakistan1.80.8 Philippines0.92.7 Turkey1.42.7 Average1.11.5

77. price takers Small countries are price takers abroad Devaluation has no effect on the foreign currency price of exports and imports not 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 strengthens the current account

78. 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 exporter Effect depends on class of exporter Oil, non-oil, manufactures Most of the effect is through imports and is felt within 3 to 5 years

79. always floats The real exchange rate always floats Through 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

80. There is a range of options Monetary union or dollarization Means giving up your national currency or sharing it with others (e.g., EMU, CFA, EAC) Currency board Legal commitment to exchange domestic for foreign currency at a fixed rate Fixed exchange rate (peg) Crawling peg Managed floating Pure floating

81.  Currency union or dollarization  Currency board  Peg Fixed Horizontal bands  Crawling peg Without bands With bands  Floating Managed Managed Independent FIXED FLEXIBLE

82. Dollarization  Use another country’s currency as sole legal tender Currency union  Share same currency with other union members Currency board  Legally commit to exchange domestic currency for specified foreign currency at fixed rate Conventional (fixed) peg  Single currency peg  Currency basket peg

83. Flexible peg  Fixed but readily adjusted Crawling peg  Complete  Compensate for past inflation  Allow for future inflation  Partial  Aimed at reducing inflation, but real appreciation results because of the lagged adjustment Fixed but adjustable

84. Managed floating  Management 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

85. FREE CAPITAL MOVEMENTS FREE CAPITAL MOVEMENTS FIXED EXCHANGE RATE FIXED EXCHANGE RATE MONETARY INDEPENDENCE MONETARY INDEPENDENCE Monetary Union (EU) Monetary Free to choose only two of three options; must sacrifice one of the three

86. FREE CAPITAL MOVEMENTS FREE CAPITAL MOVEMENTS FIXED EXCHANGE RATE FIXED EXCHANGE RATE MONETARY INDEPENDENCE MONETARY INDEPENDENCE Capital controls (China) Free to choose only two of three options; must sacrifice one of the three

87. FREE CAPITAL MOVEMENTS FREE CAPITAL MOVEMENTS FIXED EXCHANGE RATE FIXED EXCHANGE RATE MONETARY INDEPENDENCE MONETARY INDEPENDENCE Flexibleexchange rate (US, UK, Japan) Flexibleexchange Free to choose only two of three options; must sacrifice one of the three

88. FREE CAPITAL MOVEMENTS FREE CAPITAL MOVEMENTS FIXED EXCHANGE RATE FIXED EXCHANGE RATE MONETARY INDEPENDENCE MONETARY INDEPENDENCE Monetary Union (EU) Monetary Flexibleexchange rate (US, UK, Japan) Flexibleexchange Capital controls (China) Free to choose only two of three options; must sacrifice one of the three

89. free trade four freedoms  If capital controls are ruled out in view of the proven benefits of free trade in goods, services, labor, and also capital (four freedoms), … monetary independence flexible exchange rates) vs. fixed rates  … then long-run choice boils down to one between monetary independence (i.e., flexible exchange rates) vs. fixed rates  Cannot have both!  Either type of regime has advantages as well as disadvantages  Let’s quickly review main benefits and costs

90. BenefitsCosts Fixed exchange rates Floating exchange rates

91. BenefitsCosts Fixed exchange rates Stability of trade and investment Low inflation Floating exchange rates

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

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

94. 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

95.  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 inefficiency  If inefficiency and slow growth due to currency overvaluation are the main problem, floating rates can help inflation  If high inflation 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

96. 96 Source: Annual Report on Exchange Arrangements and Exchange Restrictions database. What countries actually do (Number of countries, April 2008) (3) (12) (22) (5)(2)(66) (44)(40) (76) (84) (10)

97. No national currency 6% Currency board 7% Conventional fixed rates 36% Intermediate pegs 5% Managed floating 24% Pure floating 22% 100% 46% 54% increased interest in fixed rates There is a gradual tendency towards floating, from 10% of LDCs in 1975 to almost 50% today, followed by increased interest in fixed rates through economic and monetary unions

98.  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 categories  Existing monetary unions  De facto monetary unions  Planned monetary unions  Previous – failed! – monetary unions

99.  CFA franc  14 African countries  CFP franc  3 Pacific island states  East Caribbean dollar  8 Caribbean island states Picture of Sir W. Arthur Lewis, the great Nobel-prize winning development economist, adorns the $100 note  Euro, more recent  16 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.

100.  Australian dollar  Australia plus 3 Pacific island states  Indian rupee  India plus Bhutan  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

101.  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

102.  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%

103.  Centripetaljoin  Centripetal tendency to join monetary unions, thus reducing number of currencies stable exchange rates  To benefit from stable exchange rates at the expense of monetary independence  Centrifugalleave  Centrifugal tendency to leave monetary unions, thus increasing number of currencies monetary independence  To benefit from monetary independence often, but not always, at the expense of exchange rate stability  With globalization, centripetal tendencies appear stronger than centrifugal ones The End These slides will be posted on my website: www.hi.is/~gylfason