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Topics in Development and Transition 2005 Handout No 6

Topics in Development and Transition 2005 Handout No 6. Nominal and Real Exchange Rates This Handout Covers Standard Arguments against an Active ER Policy The Nominal Rate as an Inflation Anchor – and Alternatives (e.g Monetary Targeting) The Real Exchange Rate –Why Important

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Topics in Development and Transition 2005 Handout No 6

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  1. Topics in Development and Transition 2005 Handout No 6 Nominal and Real Exchange Rates This Handout Covers • Standard Arguments against an Active ER Policy • The Nominal Rate as an Inflation Anchor – and Alternatives (e.g Monetary Targeting) • The Real Exchange Rate –Why Important • Causes and Effects of Misalignments (please cross reference Seminar Topic and slides from Week 9) EC 938 2006-2007 Handout No. 6

  2. 1. Nominal Exchange Rate Issues Four Standard Arguments Against an Active Nominal Exchange Rate Policy • Price elasticity pessimism - Marshall-Lerner conditions not met • Loss of real income due to terms of trade effects of devaluation • Price raising effects of devaluation on (a) low income groups and (b) govt budget • Supply elasticity pessimism 4. EC 938 2006-2007 Handout No. 6

  3. Arguments To Counter These Points ·Regarding Point 3a. If ER is seriously over-valued then the scarcity of official foreign exchange will be acute and prices will be set increasingly by reference to parallel ER rather than official rate (e.g. Agenor and Pinto materials from earlier handouts) • Regarding Point 3b. In same situation many exports and imports will be smuggled resulting in a reduced ability to tax exports, imports and many incomes deriving from these. govt. budget is helped by a devaluation that can (a) reduce these revenue losses and (b) raise the local currency prices at which imports are subject to tax. (Agenor and Pinto papers) · EC 938 2006-2007 Handout No. 6

  4. …… Continued • Regarding Point 1.……this argument is undermined if pre-existing nominal exchange rate results in progressive decline in the incentives to export relative to the production of importables and non-traded goods. this results in both import and export compression (e.g. the Pinto analysis) • Regarding Point 4. Supply elasticity pessimism become self fulfilling if incentives against exports are progressively undermined by policies which lower the supply prices of exports relative to alternative production. • Regarding Point 2. Adverse terms of trade effects is a possible concern but one that needs to be set against the other income losses that will occur if devaluation is not undertaken EC 938 2006-2007 Handout No. 6

  5. Ghana in 1970s (stylised) EC 938 2006-2007 Handout No. 6

  6. …some consequences in the 1970s EC 938 2006-2007 Handout No. 6

  7. 2. The Exchange Rate As A Nominal Anchor Why is a Nominal Anchor needed? 1. If credible it can tie-down agents’ price expectations and so contribute indirectly to lowering actual inflation 2. It can avoid the time inconsistency problem (Barro and Gordon, JPE 1983). this is the incentive of the authorities to pursue expansionary short-term policies to stimulate growth and employment even though it may be evident that such expansion cannot succeed longer term. 3. Properly done it can remove politics from the discussion of the most appropriate monetary stance at any given point in time. EC 938 2006-2007 Handout No. 6

  8. Exchange Rate Targeting is still Quite Common Pegging or Targeting fixes the value of the domestic currency in terms of some external commodity such as gold or in terms of the currency of a (normally) larger and low inflation country (e.g. Estonia and the DM/euro; Hong Kong and the US dollar) Advantages include: ·fixes prices for traded goods (via PPP) and so provides ONE block of stability in the overall price index. ·if credible, the peg connects expected inflation to the inflation rate of the anchor currency (but beware non-credibility see Rodrigues paper and seminar Topic 1) ·it creates an automatic control on domestic monetary policy and so avoids the time inconsistency problem (i.e. monetary policy becomes endogenous) ·it is a simple rule which easily commands respect. i.e. a strong currency is a very effective rallying cry c.f. the French franc in the early 1990s EC 938 2006-2007 Handout No. 6

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  13. What Factors Determine Merits of Pegging? –Agenor Ch 4 • Size and degree of openness of the economy: the higher the share of trade in output, the higher the costs of exchange rate volatility, the more likely to follow a pegged exchange rate regime. • Level of inflation: a country maintaining a rate of inflation that is higher than that of its trading partners needs to maintain a flexible exchange rate. • Degree of price and wage flexibility: the more rigid real wages are, the greater the need for exchange rate flexibility to respond to external shocks. EC 938 2006-2007 Handout No. 6

  14. ……… Continued • Degree of financial development: if financial markets are poor and thin, a flexible exchange rate regime may lead to large fluctuations in the exchange rate. • Degree of credibility of policymakers: the weaker is the anti-inflation reputation of the central bank, the stronger the case for pegging the exchange rate in order to build confidence that inflation will be controlled. • Degree of capital mobility: • the more open the economy is to capital movements, the more difficult it is to defend and maintain a fixed exchange rate regime. EC 938 2006-2007 Handout No. 6

  15. …….. Continued Open-economy trilemma (Obstfeld, 1998): • a country cannot simultaneously maintain fixed exchange rates and an open capital market while pursuing a monetary policy geared toward domestic economic objectives. • The more important the exchange rate is as a policy goal, the more constrained monetary policy is in pursuing other policy objectives (see earlier handout on Interest Rates for some of the downside). EC 938 2006-2007 Handout No. 6

  16. To Fix or Float - Example 1: Foreign (real) Output Shock Lower foreign demand for our goods results in shift in IS curve. With FIXED ER there is also an induced reduction in Money Supply and LM –new equilibrium is at B With a flexible rate the new equilibrium is at C (i.e far more insulation from the shock) EC 938 2006-2007 Handout No. 6

  17. To Fix or Float - Example 2: Foreign Monetary Shock Lower interest rate abroad results in • New equilibrium at B in the case of a FIXER ER (i.e. no insulation from shock) and at • C in the case of a FLEXIBLE ER –i.e. no protection from the shock but the ability to avoid monetary expansion EC 938 2006-2007 Handout No. 6

  18. The Main Problems of Pegging? • Loss of independent monetary policy means - shocks originating in anchor country transmit without blockage directly to the targeting country (example - German re-unification in 1990 resulted in unreasonably tight money in France and UK) • Same point if economic cycles are out of phase in the two countries (e.g. Uk in 1999 when euro was established) • Peg opens up countries to speculative attack if the “adopted” monetary stance is clearly inappropriate in terms of immediate domestic priorities (e.g. UK in September 1992) . this conjuncture constitutes a one way bet for speculators –Krugman JPE 1979 • Costs if speculative attacks emerge are huge and of two types (reserve losses and losses to central banks in trying to defend the peg; and recession costs if attack is successfully combated as in France in 1992/1993) ·      EC 938 2006-2007 Handout No. 6

  19. Particular Problems For Developing Countries • Such economies often have very thin financial markets making local borrowing difficult for both government and enterprises • Borrowing via foreign currency loans is often easier and can seem quite attractive (e.g. the Mishkin, 1996 paper)-also multilateral lenders • ER targeting achieved over a short period of time can increase the attractiveness of such borrowing [by apparently eliminating the foreign currency risks] EC 938 2006-2007 Handout No. 6

  20. Digression on the Particular Case of a Currency Board • This is a Legally based peg • Where the monetary base is backed (fully or partly) with foreign reserves Advantages: • Gain of credibility • Access to foreign capital markets • Inflation reduction (time consistency problem) • Less chance of speculative attack • First stage toward a currency union (maybe) • Post chaos countries discipline • Simplicity and transparency EC 938 2006-2007 Handout No. 6

  21. The “ideal” environment These will include many of the same things needed for an optimal currency union (see Paul de Grauwe textbook on the European Monetary Union), namely- • Sound fiscal policy • Flexible labour and good markets • Sound financial sector • Small open economy • Peg is against the main (dominant?) trade partner’s currency • Some chance of regional policy compensation mechanism EC 938 2006-2007 Handout No. 6

  22. Weaknesses Real exchange appreciation easily occurs if there is: • Inflation and wage inertia • Large Capital inflows • Initial misalignment (overvaluation) • Consequences • Loss of competitiveness • Risk of attack in spite of the legal commitment • Trade off flexibility/credibility EC 938 2006-2007 Handout No. 6

  23. The inherent weaknesses arise from: Asymmetric shocks • That cannot be corrected via high capital and labour mobility Restrictions on Monetary Policy • Limits in sterilising capital flows • Constraints on lending of last resort Risk in backing • M0 covered, but not M1 orM2 Open capital account • Leads to high volatility of flows EC 938 2006-2007 Handout No. 6

  24. …….. Continued Experience more generally shows that abandonment of the peg (if it becomes necessary) is a large and non-linear shock that can do great harm to both output and inflation. Why? •   Previous FOREX borrowing implies an increased (local currency) burden on govt. and enterprises •    Lower enterprise profitability results in weaker portfolios (even collapse) of banks •   Lower profitability reduces the collateral for further lending •    Further lending faces increased problems of moral hazard •    DEFENCE of peg will create very high interest rates which intensifies adverse risk selection problems for lenders and recession generally • So central banks may be less keen to mount a defence of the peg thereby increasing the likelihood that the peg will fail EC 938 2006-2007 Handout No. 6

  25. …….. Continued Examples: • Mexico in 1988 had inflation in excess of 100% . Pegging to the $ through December 1994 brought inflation down to only 7-8%. But collapse of peg thereafter pushed inflation rapidly above 50% and necessitated a major output recession. • Argentina - 1990 Currency Board (Inflation 1000% In 1989 But Down To 5% By 1994). After 2002 collapse inflation rampant again • East Asian countries such as Indonesia have confronted a similar experience. EC 938 2006-2007 Handout No. 6

  26. Other Problems Stable ER for a while may stimulate large capital inflows and rapid (but risky) expansion of bank credit which intensifies danger of eventual financial crisis ER peg may weaken the accountability of the authorities. notional endogeneity of monetary policy may hide [ via poor quality accounts] a variety of damaging interventions ultimately likely to boost inflation Does a Currency Board [as in Argentina 1990 -2002 and Bulgaria since 1996 a better bet? However, this provides zero insulation against external shocks [e.g Argentina imported some of the recession experienced in Mexico after 1994]see Roubini web site EC 938 2006-2007 Handout No. 6

  27. Alternative Inflation Anchors-Targets Monetary Targeting It is hard for large countries/blocs to use an exchange rate peg [examples Euroland, USA, Japan] The advantages include: • Monetary targets can be set partly to respond to domestic objectives additional to price stability • Targets based on monetary aggregates are easily understood though a bit less visible than an ER target • Such targets can provide for strong accountability of the central bank [i.e. they help to avoid time inconsistency problems] EC 938 2006-2007 Handout No. 6

  28. How to Choose? Agénor and Montiel (1999): under imperfect capital mobility, disinflation through a reduction in the nominal devaluation rate or a fall in the rate of growth of domestic credit are not equivalent. The choice between the exchange rate and the money supply as a nominal anchor depends on three main considerations: • of controllability and the effectiveness of the instrument in bringing down inflation; • adjustment path of the economy an d the relative costs associated with each instrument; • degree of credibility that each instrument commands, and its relationship with fiscal policy. EC 938 2006-2007 Handout No. 6

  29. Controllability and Effectiveness • Policymakers cannot control directly the money supply, but fixing the exchange rate can be done relatively fast and without substantial costs • When money demand is subject to large random shocks and velocity is unstable, the effectiveness of the money supply as an anchor is reduced. (Kenya –example on previous handout) • But an exchange rate peg will anchor the price level through its direct impact on prices of tradables • So fixing the exchange rate rather than the money stock may appear preferable. EC 938 2006-2007 Handout No. 6

  30. Adjustment Paths and Relative Costs • Money -based and exchange-rate-based stabilization programs differ significantly. Calvo and Végh (1993): • Exchange-rate-based stabilization programs lead to an initial expansion and a recession later on. • Money-based programs cause initial contraction in output. • Former pattern: boom-recession cycle IF credibility of the stabilization program is low may be perceived as temporary. • Agents, to take advantage of temporarily low prices of tradable goods, increase spending. EC 938 2006-2007 Handout No. 6

  31. …….. Continued • Result: current account deficit and real exchange rate appreciation by forcing the authorities eventually to abandon the attempt to fix the exchange rate. • Weak evidence in favor of large intertemporal substitution effects. • Reinhart and Végh (1995): it can explain the behavior of consumption for some of the programs implemented in the 1980s, but not for the tablita experiments of the 1970s in Argentina, Chile, and Uruguay. • Nominal interest rates would have had to fall more than they did to account for a sizable fraction of the consumption boom recorded in the data. EC 938 2006-2007 Handout No. 6

  32. Credibility, Fiscal Commitment, and Flexibility Degree of credibility of the money supply and the exchange rate is important in choosing a nominal anchor. Credibility depends on: • policymakers' ability to convey clear signals about their policy preferences, • the degree of controllability of policy instruments and the dynamic adjustment path of the economy, as discussed earlier. EC 938 2006-2007 Handout No. 6

  33. ………. Continued • Public ability to see what is happening to the exchange rate as opposed to monetary and credit aggregates enhances the credibility of an exchange rate anchor. • Money-based stabilization by an immediate recession may lose credibility rapidly, if the short-term output and employment cost is high. • When the exchange rate is used as a nominal anchor, residual inflation in home goods prices may remain high combined with the expansion of aggregate demand, it may lead to a real appreciation. • This directly weakens credibility. EC 938 2006-2007 Handout No. 6

  34. ……… Continued • When lack of credibility is pervasive, the choice between money and the exchange rate may not matter; inflation will remain high regardless of the anchor. • An exchange-rate rule is, however, more successful in reducing inflation if there is some degree of credibility; initial expansion and the upward pressure on the real exchange rate will be dampened. • Exchange rate anchor may induce a higher commitment to undertake stabilization measures: fiscal adjustment. EC 938 2006-2007 Handout No. 6

  35. ……… Continued • If there are doubts about the government's commitment to fiscal restraint, an exchange rate peg would also lack credibility. • Végh (1992): ten exchange-rate-based programs aimed at stopping high chronic inflation. • Seven of them were failures: • In two cases: failure was due to real appreciation of the currency following slow convergence of inflation, in spite of achieving fiscal balance. • In the remaining five: failure to implement a lasting fiscal adjustment was the main factor. EC 938 2006-2007 Handout No. 6

  36. Experiences with Monetary Targeting in Richer Countries Generally not very successful in stabilising inflation (example. UK in the 1980s). Why? •      Not done properly (e.g. multiple money aggregates targeted) •      Declining stability of velocity function over time with financial sector de-regulation etc. Germany and Switzerland apparently successful BUT •  Substantial flexibility in practice in setting inflation and monetary targets and in adhering to them • Social consensus about objectives and much effort to explaining targets may reconcile the apparent success [generally low inflation achieved without major output crises] with the pragmatic deviations from strict monetary targeting Conclusion This approach far less likely to succeed in a country or bloc with less overall social cohesiveness; less of a track record with successful inflation management [ e.g. Euroland as a whole]. EC 938 2006-2007 Handout No. 6

  37. Finally: Inflation Targeting Examples. •       New Zealand Since 1990 •        UK Since 1992 •        SPAIN Since 1994 Advantages Include: •        The Flexibility To Respond To Domestic Considerations And To External Shocks •        Velocity Instability Matters Less - No Stable Money Demand Function Is Implied •        An Inflation Target Is Easily Understood And Easily Checked • Enhanced Central Bank Accountability Avoids The Time Inconsistency Problem •        Political Pressures Are Sidelined EC 938 2006-2007 Handout No. 6

  38. ……… Continued • Problems Include: A rigid inflation target will impose undoubtedly large falls on output if target is used to bring inflation down from rates in excess of 10-20% to low levels close to zero. Less of a problem if targeting starts when inflation is already in low single digits. (reason- the stickiness of price expectations when the past has been one of high inflation). But if too much flexibility is allowed when the past has been highly inflationary then the target will really not be credible - i.e.time inconsistency re-appears. One reconciliation of this problem is a gradual hardening of the targets as actual inflation is reduced [e.g. Chile after 1990] Useful Reference: Bernanke, Laubach, Mishkin And Posen, Inflation Targeting: Lessons From International Experience, 1998 EC 938 2006-2007 Handout No. 6

  39. The Usefulness of the Real Exchange Rate The discussion of issue One above indicates why a concept of the “real exchange rate” is necessary. Developing and Transition Country anxieties about nominal devaluation and widespread use of Nominal Pegging have resulted in numerous examples of REAL ERs getting seriously out-of-line with prices. We need a way to assess this and understand some of the consequences of misalignments. The RER concept • enables us to analyse the relative incentives being provided to different types of activity in an economy • provides us with a coherent method to integrate a broader set of macro, sectoral and structural policies into the discussion of export and import performance. EC 938 2006-2007 Handout No. 6

  40. The Current Situation Globally EC 938 2006-2007 Handout No. 6

  41. and Reserve Accumulation has Opportunity Costs • Monetary inflows(if un-sterilised) lead to higher inflation unless Money Demand rises to match additional supply (not possible in the long term) 2. IF sterilised, then important that interest on reserves > interest on the instruments used to achieve the sterilisation – UNLIKELY in practice in most developing economies (see also Hanoudt No. 5 and the Calvo model). EC 938 2006-2007 Handout No. 6

  42. Two Ways to get Real Appreciation • Loose Money and Inflation • Harmful for exporters • Inflation generally is a risky approach • Tighter Money and Nominal Exchange Rate Appreciation • Also harmful for exporters • But those importing raw materials and intermediate goods are less damaged by this Example: What should China do now? EC 938 2006-2007 Handout No. 6

  43. Definitions (see also Seminar presentation in Week 9) DEFINITIONS. One:  RER = S.Pd/Pf [1]  This is a simple measure of competitiveness reminding us that differential inflation needs a nominal exchange rate adjustment to preserve a constant RER (in this sense).  if PPP held constantly, this is also a theory of the nominal exchange rate. ie.  dPd/Pd - dPf/Pf = dS/S [2]  But if PPP applies only to tradable goods, then the theory of the nominal ER becomes EC 938 2006-2007 Handout No. 6

  44. See what this does to Real Income Comparisons EC 938 2006-2007 Handout No. 6

  45. ………. Continued Two RER = SPt/Pnt [4] with disaggregations as RERx = SPx/Pnt [5] RERm = SPm/Pnt [6] where both Px and Pm are assumed to be priced in dollars if we label the RER in [4] as “e” then the reconciliation of the two definitions is dE/E = 1/a.dSpp/Spp + b/a(dPft/Pft - dPfn/Pfn) [7] where Spp = the PPP real exchange rate; “a” and “b” are the weights of non-traded goods in the overall price indices of the domestic and the foreign countries respectively. Source: Sebastian Edwards, Exchange Rate Misalignment, Annex] EC 938 2006-2007 Handout No. 6

  46. The Equilibrium Real Exchange Rate (ERER) This is the level of the RER that for sustainable values of other key variables [capital flows, trade taxes, employment] results in: •   Internal balance [i.e. the absence of gaps between Snt and Dnt both now and expectationally in the future] • External balance [i.e sustainable current account balance] This RER can be changed from the ERER level by many factors any one of which can therefore necessitate a policy adjustment to restore the equilibrium [Note: a nominal exchange rate change is merely one of many factors than can create the divergence RER v. ERER or eliminate such a divergence] EC 938 2006-2007 Handout No. 6

  47. Determinants of ERER include International Factors ·       international prices (tot) ·       international transfers ·       world real interest rates Domestic Policies ·       import tariffs ·       import quotas ·       export taxes ·       capital controls ·       levels of govt expenditure ·       composition of government expenditure EC 938 2006-2007 Handout No. 6

  48. Examples of changes in Fundamentals • Import tariffs will appreciate the ERER • Removal of capital controls will likely appreciate the ERER • Terms of trade deterioration will (likely)depreciate the ERER (higher cost imports being offset by large negative income effects) • Increased foreign aid will appreciate the ERER • Increased fiscal deficits will appreciate the ERER if (as is likely) the higher expenditures have a high non-tradable element EC 938 2006-2007 Handout No. 6

  49. Example of ERER and Changes in ERER Non-tradables Relative prices unchanged C1 P1 N1 U o Tp Tc Tradables EC 938 2006-2007 Handout No. 6

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