1. Thorvaldur Gylfason IMF Institute/Center for Excellence in Finance, Slovenia Course on Macroeconomic Management and Financial Sector Issues Ljubljana, Slovenia September 21–29, 2011

2. 1.Real exchange rates versus nominal exchange rates 2.Exchange rate policy and welfare 3.Capital flows 4.Exchange rate regimes To float or not to float To float or not to float 5. Why we have fewer currencies than countries

3. 1 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

4. 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

5. 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

6. 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

7. Foreign exchange Real exchange rate Imports Exports 2 Earnings from exports of goods, services, and capital Payments for imports of goods, services, and capital Equilibrium

8. 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

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

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

11. 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

12. 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

13. 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

14.  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

15. 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

16. 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

17. 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

18. 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

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

20. 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

21. 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

22. 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

23. 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

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

25. 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

26. 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

27. 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

28. 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 Most of the effect is through imports and is felt within 3 to 5 years

29. Source: Obstfeld & Taylor (2002), “Globalization and Capital Markets,” NBER WP 8846. A stylized view of capital mobility 1860-2000 Capital mobility First era of international financial integration Capital controls Return toward financial integration 3

30. Emerging countries save a little Saving Investment Real interest rate Loanable funds

31. Industrial countries save a lot Saving Investment Real interest rate Loanable funds

32. Emerging countriesIndustrial countries Saving Investment Real interest rate Borrowing Lending Loanable funds Financial globalization encourages investment in emerging countries and saving in industrial countries

33. Source: IMF WEO

34.  External factors “pushed” capital from industrial countries to LDCs  Cyclical conditions in industrial countries  Recessions in the early 1990s  Decline in world interest rates  Structural changes in industrial countries  Financial structure developments  Demographic changes

35.  Internal factors “pulled” capital into LDCs from industrial countries  Macroeconomic fundamentals  Reduction in barriers to capital flows  Private risk-return characteristics  Creditworthiness  Productivity

36.  Improved allocation of global savings  Allows capital to seek highest returns  Greater efficiency of investment  More rapid economic growth  Reduced macroeconomic volatility through risk diversification (which dampens business cycles)  Income smoothing  Consumption smoothing

37.  Open capital accounts may make receiving countries vulnerable to foreign shocks  Magnify domestic shocks and lead to contagion  Limit effectiveness of domestic macro policy instruments  Countries with open capital accounts are vulnerable to  Shifts in market sentiment  Reversals of capital inflows  May lead to macroeconomic crisis  Sudden reserve loss, exchange rate pressure  Excessive BOP and macro adjustment  Financial crisis

38.  Overheating of the economy  Excessive expansion of aggregate demand with inflationary pressures, real exchange rate appreciation, widening current account deficit  Increase in consumption and investment relative to GDP Quality of investment suffers Construction booms  Monetary consequences of capital inflows and accumulation of foreign exchange reserves depend crucially on exchange regime

39. Real stock prices during inflow periods, selected countries Year with respect to start of Inflow period Note: The Index for Finland, Mexico, and Sweden is shown on the left; the index for Chile during the 1980s and 1990s and for Venezuela is shown on the right. Source: World Bank (1997) Sweden Venezuela Chile 1978-81 Mexico Chile 1989-94 Finland

41.  Large deficits  Current account deficits  Government budget deficits  Poor bank regulation  Government guarantees (implicit or explicit), moral hazard Stock and composition of foreign debt  Ratio of short-term liabilities to foreign reserves  Mismatches  Maturity mismatches (borrowing short, lending long)  Currency mismatches (borrowing in foreign currency, lending in domestic currency)

44.  External or financial crisis followed capital account liberalization  E.g., Mexico, Sweden, Turkey, Korea, Paraguay  Response  Rekindled support for capital controls  Focus on sequencing of reforms  Sequencing makes a difference  Strengthen financial sector and prudential framework before removing capital account restrictions  Remove restrictions on FDI inflows early  Liberalize outflows after macroeconomic imbalances have been addressed

45. Transitory High degree of risk sharing Permanent No risk sharing Foreign direct investment Long term debt (bonds) Portfolio equity Short term debt

46.  Pre-conditions for liberalization  Sound macroeconomic policies  Strong domestic financial system  Strong and autonomous central bank  Timely, accurate, and comprehensive data disclosure

47. 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 4

48. 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

49. Currency Union/ DollarizationCurrency Board Peg Fixed Horizontal Bands Crawling Peg Without Bands With Bands Floating Managed Independent FixedFlexible Independent Monetary Policy No Independent Monetary Policy

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

51. 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

52. 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

53. 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

54.  “Pure” float  X - Z + F = ΔR = 0, so X – Z = -F  Independent float  Exchange rate is market-determined  Market intervention is limited to moderating the rate of change and preventing undue fluctuations  Managed float  Central bank influences exchange rate by active intervention without specifying, or committing to, an exchange rate path

55. 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

56. 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

57. 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

58. 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

59.  Monetary authorities face a tradeoff between the degree of exchange rate stability and the extent to which they can act to stabilize economic activity and the domestic price level  International capital mobility exacerbates the tradeoff

60. Outside Europe  Floating exchange rates  Monetary policy used to pursue domestic stabilization objectives  Removal of capital controls Within much of Europe  Fixed exchange rates  Common currency floating against outside world  Monetary policies highly coordinated and pooled in the European Central Bank  Removal of capital controls

61. 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

62. BenefitsCosts Fixed exchange rates Floating exchange rates

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

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

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

66. 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

67.  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

68. 68 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)

69. 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

70.  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 5

71.  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.

72.  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

73.  East African shilling (2009, delayed)  Burundi, Kenya, Rwanda, Tanzania, and Uganda  Eco (2009, delayed)  Gambia, Ghana, Guinea, Nigeria, and Sierra Leone (plus, perhaps, Liberia)  Khaleeji (2010, delayed)  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

74.  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%

75.  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

76. External sector policies are important because external trade is important for growth Need to maintain real exchange rates at levels that are consistent with BOP equilibrium, including sustainable debt Must avoid overvaluation! Must avoid overvaluation! Need to adopt monetary and exchange rate regimes that are conducive to moderate inflation and rapid growth

77.  Monetary policy and exchange rate regimes have changed over time  Over the past decade,  Many countries have moved to more flexible exchange rate arrangements, with more independent monetary policy  Others aim to form monetary unions sound fiscal, monetary, and financial policies  Choice of exchange rate regime may be viewed as a means to sound fiscal, monetary, and financial policies These slides will be posted on my website: www.hi.is/~gylfason These slides will be posted on my website: www.hi.is/~gylfason The End