Economic Policy in the European Union Prof. Edwin G. Dolan University of Economics, Prague, 2006

1. Economic Policy in the European UnionProf. Edwin G. DolanUniversity of Economics, Prague, 2006 Lecture 6:Using Exchange Rates to Stop Inflation

2. The euro and its future • 14 Nov: Before the euro: Using exchange rates to stop inflation • 15 Nov: Is the euro right for the Czech Republic? • 21 Nov: Fiscal policy in the euro area • 22 Nov: Argentina and Italy: Two cautionary tales • 28 Nov: The European Central Bank: In search of stability and prosperity ◊ ◊ ◊ ◊ ◊ • 29 Nov. Helping Africa: Is Aid Oil?

3. Part 1 Needed: A Nominal Anchor

4. From the mid-1970s to the mid-1990s, chronic inflation was a world-wide problem In the past 10 years, inflation has become a rarity Transition economies have been one of the success stories in the fight against inflation World Inflation Trends

5. Stylized post-transition inflation cycle • All transition economies underwent a cycle of inflation during the post-transition recession • At first inflation increased as output fell • Later, as inflation fell, the transition economies began to grow again

6. Examples • In Russia, Ukraine, and some others, inflation was severe and return to positive growth was slow • In Central Europe, inflation was more moderate and recovery more rapid

7. Exchange-rate Based Stabilization • To resist inflation, the economy needs a nominal anchor • In a healthy economy, money is the nominal anchor (MV=PQ) • Ending inflation requires finding a new anchor • Exchange-rate based stabilization (ERB stabilization) uses a fixed exchange rate tied to a stable foreign currency as the needed anchor • During the 1990s, 18 of 25 transition economies used this approach

8. How to maintain the anchor (1) • Assume the Hungarian central bank sets a fixed exchange rate of 250 forints (HUF) per euro (EUR) • If there is an increase in demand for foreign currency, other things being equal, the forint will begin to depreciate

9. How to maintain the anchor (2) • To prevent the depreciation of the forint, the central bank can sell euros from its foreign exchange reserves • The sale will shift the supply curve to the right until S1 and D1 intersect at the desired exchange rate

10. When the central bank sells euros, private parties that buy them pay with forints that they have on deposit in commercial banks As a result, the monetary base decreases Tighter monetary policy slows inflation and economic growth in Hungary Slowing inflation and growth help to stabilize the forint at its desired level How to maintain the anchor (3)

11. Part 2 Real and Nominal Exchange Rates

12. Nominal Exchange Rates • Direct quotations: Units of domestic currency per unit of foreign currency • Example: 28 CZK/EUR • Indirect quotations: Units of domestic currency per unit of foreign currency • Example: .035 EUR/CZK

13. Appreciation and depreciation • If a currency strengthens, it is said to appreciate • Using direct quotations, appreciation is shown by a decrease • Example: a change from 30 CZK/EUR to 25 CZK/EUR is an appreciation of the koruna • If a currency weakens, it is said to depreciate • Using direct quotations, depreciation is shown by an increase • Example: A change from 25 CZK/EUR to 30 CZK/EUR is an appreciation of the koruna

14. The real exchange rate is the nominal rate adjusted for price levels in both the domestic and foreign economies Let H = nominal exchange rate h = real exchange rate Pd = domestic price level Pf = foreign price level then h = H (Pf/Pd) The Real Exchange Rate

15. Real appreciation • A currency will appreciate in real terms if • There is a nominal appreciation with no inflation at home or abroad • The nominal rate is unchanged while domestic inflation is faster than foreign inflation • The nominal rate depreciates but at a rate less than the domestic rate of inflation (foreign prices unchanged) • Results of real appreciation: • It is harder for domestic producers to compete with imports • Exports become harder to sell on world markets • The economy becomes less competitive

16. Examples: Russia 1991-2000 • In 1992-1995, Russian inflation exceeded the rate of nominal depreciation so the ruble appreciated in real terms • In 1995-1998, nominal depreciation matched the rate of inflation so that the real rate was constant • After the 1998 crisis, the ruble depreciated about 400% in nominal terms vs. inflation of about 200% so the ruble depreciated in real terms • From 1999 to 2000, inflation continued while the nominal exchange rate stabilized so the ruble again appreciated in real terms

17. Let H = nominal exchange rate h = real exchange rate Pd = domestic price level Pf = foreign price level then h = H (Pf/Pd) Often expressed as an index with base 100 in a selected year May be based on indirect quotations so that appreciation is shown as an increase May be based on a weighted average of exchange rates of trading partners—the Real Effective Exchange Rate (REER) May be deflated by unit labor costs instead of prices to better show competitiveness Variations on the Real Exchange Rate

18. Part 3 Case Study in ERB Stabilization: Bulgaria’s Currency Board

19. Bulgaria, like other transition economies, experienced inflation and falling GDP in the early 1990s After a partial recovery, there was a new crisis in 1996-1997 Adopted currency board as urgent need to fight inflation in July 1997 Currency board led to successful control of inflation and return to positive growth Post-transition Inflation in Bulgaria

20. Background: Dominance of State Banks In the early 1990s, Bulgaria was slow to reform and restructure its economy. Dominance of state banks was one sign of this.

21. State banks loaned mainly to government and state firms Loans made without regard to borrower’s ability to repay Much private lending to firms having common ownership with banks (connected lending) Nonperforming loans 60-70 percent of total Poor lending practices led to a banking crisis Loans from: Loans to:

22. at the end of 1995 . . . All but one state bank was insolvent Half of large private banks were insolvent Remaining state and private banks, as well as foreign banks, did not meet international CAR standards Insolvency and inadequate capital

23. January 1996: Bank runs Jan-April: Central bank make large loans to banks in attempt to stabilize system April-September: Runs continue, several banks close Oct.-Dec: Central bank lending to government forces up money supply, inflation accelerates December: Government falls February 1997: Inflation reaches hyperinflationary rate of 250% per month Development of the Crisis

24. 1997: Reform and resolution Mar. 97: New government announces that the central bank will follow a currency board policy • Mar-June: Technical work in preparation for currency board • July 1, 1997: Currency board introduced

25. Duties of the central bank under a currency board arrangement: Must hold foreign currency reserves at least equal to the monetary base Must buy or sell domestic currency at a fixed rate without any restriction Must not use any other form of monetary policy Countries with currency boards Bulgaria Estonia Lithuania Bosnia Hong-Kong Argentina (1990-2001) What is a Currency Board?

26. Inflation falls in anticipation of currency board Once the currency board was announced, expectations stabilized and inflation ended before the policy was in fact implemented

27. Behavior of velocity The drop in inflation following announcement of the currency board was caused by a sharp drop in velocity

28. The Danger of Real Appreciation • If inflation slows but does not stop after exchange rate is fixed, real exchange rate will appreciate*: h=H(Pf/Pd) • Economy becomes less competitive, growth slows • Chart shows average experience and range of 8 ERB stabilizations in the 1990s *Formula shows real exchange rate based on direct quotations, so that real appreciation means a decrease in h; chart is based on indirect quotations so that real appreciation is an increase

29. Real and nominal exchange rates Unlike many countries, Bulgaria experienced little real exchange rate appreciation following ERB stabilization

30. Since the introduction of the currency board, Bulgaria’s macroeconomic performance has been good Inflation remains under control and economic growth is steady The reward: Bulgaria will join the EU in 2007 Good performance since 1998

31. Part 4: Soft Pegs and Exchange Rate Corridors

32. In what sense soft? Exchange rate may vary in a range + or – from a target value Target value may be adjusted as needed No automatic linkage to domestic money supply Objective: to combine some of the stability of a fixed exchange rate with some of the flexibility of floating rates Provide a stable framework for trade Allow some flexibility of response to unexpected shocks Provide a nominal anchor that will gradually end inflation What is a Soft Peg?

33. Rules for a horizontal corridor Select a target rate (e.g., 10 pesos per dollar) Select a trading range (e.g. + or – 2%) Allow rate to move freely within the band Sell currency reserves to resist depreciation if rate hits top of band Buy reserves to resist appreciation if rate hits bottom of corridor A fixed rate with a horizontal corridor Sell reserves to resist depreciation Buy reserves to resist appreciation

34. When it works best A horizontal corridor works best if the target rate is close to the long-run equilibrium, the need for intervention is not frequent, sales of reserves balance purchases over a period of time, and confidence in the corridor is strong

35. When it works less well A horizontal corridor does not work well when limits are out of line with long-term fundamentals, the need for intervention is frequent, sales of reserves tend to exceed purchases, and confidence in the corridor is low

36. Possible ways to fix the problem • Make a one-time adjustment of the target rate to reflect a one-time change in fundamental conditions that is expected to last • Adjust the money supply to realign long-term equilibrium with the existing target rate • Allow continuous adjustment of the target rate—a “crawling peg”

37. Fundamentals of a crawling peg To implement a crawling peg, adjust the exchange rate automatically each month to reflect inflation. Target may be an exact exchange rate or a corridor around a central target rate

38. Passive variant Adjusted ex-post to reflect actual inflation in the previous period Does not provide a nominal anchor Avoids any tendency toward appreciation of real exchange rate Active variant Adjusted ex-ante to reflect target rate of inflation in the coming period Provides a moderate nominal anchor if the inflation target is credible Can lead to appreciation of real exchange rate over a period of time if the inflation target is not met Active vs. passive crawling peg

39. Part 5: Poland’s Crawling Peg Disinflation

40. Inflation and Real Output in Poland • Post-transition inflation in Poland was the most severe in Central Europe • Although Poland returned to growth by 1992, inflation slowed only gradually

41. Phase 1: Fixed Exchange Rate • January 1990 • Monthly inflation approaches annual rate of 1,000% • Central bank fixes zloty at 1 USD = .95 PLN • May 1991 • Inflation continues, real exchange rate appreciates • Current account moves from 1% surplus to 2.6% deficit • Central bank reserves fall rapidly • Zloty depreciated to 1 USD = 1.1 PLN and tied to 5-currency basket

42. Performance in Phase 1 As the Polish central bank sold reserves to maintain the fixed exchange rate, the growth rate of the money stock and inflation fell, but not as rapidly as hoped. Falling reserves and a rising current account deficit forced a devaluation in May 1991.

43. In October 1991, the fixed rate was changed to a crawling peg The planned rate of depreciation was gradually slowed to bring down the inflation rate Planned depreciation was not enough. A rising current account deficit forced two unplanned devaluations 26 Feb, 1992: 12% 27 Aug, 1993: 8% Phase 2: Crawling Peg—No Corridor

44. Crawling peg was not flexible enough to deal with external shocks and variable financial flows After May 1995, a corridor of was established around the target rate The corridor was broadened as the rate of crawl slowed In April 2000, Poland moved to a floating exchange rate Phase 3: Crawling Peg with Corridor

45. Performance in Phase 2 and 3 Under the crawling peg, the rate of money growth and inflation continued to slow. In 2000, the central bank switched to a floating exchange rate and formally adopted an inflation targeting strategy

46. Current account during the disinflation • In the early phases of the disinflation, devaluations were made to deal with growing current-account deficits • After introduction of the corridor in 1993, the current account swung to surplus

47. Real Exchange Rate Trends During the period of the corridor, the real exchange rate deflated by the consumer price index appreciated, but because of rising productivity, the real exchange rate deflated by unit labor costs remained relatively stable

48. Remaining Problems • Successful disinflation and a floating exchange rate have not solved all of Poland’s problems • Economic growth has been uneven • The unemployment rate remains the highest in the EU and far above the EU15 average

49. What am I going to do about unemployment? How am I going to get us into the euro?

50. Required and Suggested Readings Required Reading: Michael Mussa et al, “Exchange Rate Regimes in an Increasingly Integrated World,” IMF Occasional Paper 193, Appendix III, “Recent Experience with Exchange-Rate Based Stabilization,” pp. 44-47 Suggested Reading: Vladimir Klyuev, “A Model of Exchange Rate Regime Choice in the Transitional Economies,” IMF Working Paper WP/01/140 (2001)