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  1. Exchange Rate Regimes ThorvaldurGylfason Joint Vienna Institute/IMF Institute August 24–September 4, 2009

  2. outline • Real vs. nominal exchange rates • Exchange rate policy and welfare • Exchange rate regimes • To float or not to float

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

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

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

  6. 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

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

  8. Exchange rate policy and welfare R moves when e is fixed R Deficit Imports Overvaluation Real exchange rate Exports Foreign exchange

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

  10. Market equilibrium and welfare DR = 0, so R is fixed when e floats Price Consumer surplus Supply A Total welfare gainassociated with market equilibrium equals producer surplus (= ABE) plus consumer surplus (= BCE) B E Producer surplus Demand C Quantity

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

  12. Market intervention and 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

  13. The importance of appropriate side measures Remember: Devaluation needs to be accompanied by fiscal and monetary restraint to prevent prices from rising and thus eating up the benefits of devaluation To work, nominal devaluation must result in realdevaluation

  14. 3 Exchange rate regimes • 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

  15. Exchange rate regimes • 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

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

  17. Basically fixed 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

  18. intermediate 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

  19. Basically floating Managed floating • Management by sterilized intervention • Management by interest rate policy, i.e., monetary policy Pure floating

  20. 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 in cities

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

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

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

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

  25. marshall-lerner condition: theory Suppose prices are fixed, so that e = Q B = eX – Z = eX(e) – Z(e) Not clear that a lower e helps Bbecause decrease in elowerseXif Xstays put Let’s do the arithmetic Bottom line is: Devaluation strengthens current account as long as Valuation effect arises from the ability to affect foreign prices a = elasticity of exports b = elasticity of imports

  26. marshall-lerner condition - + Import elasticity Export elasticity -a b 1 1

  27. marshall-lerner condition Assume X = Z/e initially X if Appreciation weakens current account

  28. 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 strengthens the current account

  29. 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

  30. The small country 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 strengthens the current account

  31. why we have Fewer currencies than countries • 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

  32. Existing monetary unions • 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.

  33. De facto monetary unions • 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

  34. Planned monetary unions • 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

  35. Previous monetary unions • 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

  36. Conflicting forces • Centripetal tendency to join monetary unions, thus reducing number of currencies • To benefit from stable exchange rates at the expense of monetary independence • Centrifugal tendency to leave monetary unions, thus increasing number of currencies • 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

  37. Impossible trinity Free to choose only two of three options; must sacrifice one FREE CAPITAL MOVEMENTS 2 Monetary Union (EU) 1 3 FIXED EXCHANGE RATE MONETARY INDEPENDENCE

  38. Impossible trinity Free to choose only two of three options; must sacrifice one FREE CAPITAL MOVEMENTS 2 1 3 FIXED EXCHANGE RATE MONETARY INDEPENDENCE Capital controls (China)

  39. Impossible trinity Free to choose only two of three options; must sacrifice one FREE CAPITAL MOVEMENTS 2 Flexible exchange rate (US, UK, Japan) 1 3 FIXED EXCHANGE RATE MONETARY INDEPENDENCE

  40. Impossible trinity Free to choose only two of three options; must sacrifice one FREE CAPITAL MOVEMENTS 2 Flexible exchange rate (US, UK, Japan) Monetary Union (EU) 1 3 FIXED EXCHANGE RATE MONETARY INDEPENDENCE Capital controls (China)

  41. Fix or flex? • If capital controls are ruled out in view of the proven benefits of free trade in goods, services, labor, and also capital (four freedoms), … • … 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

  42. Benefits and costs

  43. Benefits and costs

  44. Benefits and costs

  45. Benefits and costs

  46. Benefits and costs

  47. Benefits and costs • 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 inefficiencyand slow growth due to currency overvaluation are the main problem, floating rates can help • 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?

  48. What countries actually do (2004, 193 countries) No national currency 17% Other types of fixed rates 23 Dollarization 5 Currency board 4 Crawling pegs 3 Bilateral fixed rates 3 Managed floating 26 Pure floating 19 100 49% The End 51% Gradual tendency towards floating, from 10% of LDCs in 1975 to over 50% today, followed by increased interest in fixed rates through economic and monetary unions