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External Sector Policies

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  1. External Sector Policies Thorvaldur Gylfason

  2. Outline • Real versus nominal exchange rates • Exchange rate policy and welfare • The scourge of overvaluation • From exchange rate policy to economic growth • Exchange rate regimes • To float or not to float

  3. 1 Real versus nominal exchange rates Increase in R means real appreciation e refers to foreign currency content of domestic currency R = real exchange rate e = nominal exchange rate P = price level at home P* = price level abroad

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

  5. 2 Exchange rate policy and welfare Payments for imports of goods, services, and capital Imports Real exchange rate Equilibrium Earnings from exports of goods, services, and capital Exports Foreign exchange

  6. Exchange rate policy and welfare • Equilibrium between demand and supply in foreign exchange market establishes • Equilibrium real exchange rate • Equilibrium in the balance of payments • BOP = X + Fx – Z – Fz • = X – Z + F • = current account + capital account • = 0

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

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

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

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

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

  12. 3 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

  13. 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

  14. Inflation and overvaluation Real exchange rate Suppose inflation is 10 percent per year 110 Average 105 100 Time

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

  16. 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

  17. The Marshall-Lerner condition: Theory Suppose prices are fixed, so that e = R 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 Valuation effect arises from the ability to affect foreign prices a = elasticity of exports b = elasticity of imports

  18. 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

  19. Empirical evidence from developing countries Elasticity of Elasticity of exports imports Argentina 0.6 0.9 Brazil 0.4 1.7 India 0.5 2.2 Kenya 1.0 0.8 Korea 2.5 0.8 Morocco 0.7 1.0 Pakistan 1.8 0.8 Philippines 0.9 2.7 Turkey 1.4 2.7 Average 1.1 1.5

  20. 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

  21. 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

  22. 4 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

  23. 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

  24. 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

  25. How trade increases efficiency and growth • Trade with other nations increases efficiency by allowing • Specialization through comparative advantage • Exploitation of economies of scale • Promotion of free competition • Not only trade in goods and services, but also in capital and labor • “Four freedoms”

  26. 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!

  27. 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

  28. 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

  29. Openness to trade and growth 1965-98: Evidence 87 countries r = 0.40 An increase in openness by 14% of GDP is associated with an increase in per capita growth by 1% per year.

  30. Openness to FDI and growth 1965-98 85 countries r = 0.62 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.

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

  32. AFRITAC countries:Exports 1960-2001 (% of GDP) Botswana Weighted averages. Unweighted averages are higher: 33% for Africa and 42% for world as a whole.

  33. 5 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

  34. 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

  35. Benefits and costs

  36. Benefits and costs

  37. Benefits and costs

  38. Benefits and costs

  39. Benefits and costs

  40. 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

  41. What countries actually do (2001) No national currency 39 Currency board 8 Adjustable pegs 50 Crawling pegs 9 Managed floating 33 Pure floating 47 186 25% 50% 25% There is a gradual tendency towards floating, from 10% of LDCs in 1975 to over 50% today

  42. Bottom line These slides will be posted on my website: www.hi.is/~gylfason • 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 The End