Economic policy in the european union prof edwin g dolan university of economics prague 2006
Download
1 / 50

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


  • 72 Views
  • Uploaded on

Economic Policy in the European Union Prof. Edwin G. Dolan University of Economics, Prague, 2006. Lecture 6: Using Exchange Rates to Stop Inflation. 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?

loader
I am the owner, or an agent authorized to act on behalf of the owner, of the copyrighted work described.
capcha
Download Presentation

PowerPoint Slideshow about ' Economic Policy in the European Union Prof. Edwin G. Dolan University of Economics, Prague, 2006' - rigel-burris


An Image/Link below is provided (as is) to download presentation

Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author.While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server.


- - - - - - - - - - - - - - - - - - - - - - - - - - E N D - - - - - - - - - - - - - - - - - - - - - - - - - -
Presentation Transcript
Economic policy in the european union prof edwin g dolan university of economics prague 2006

Economic Policy in the European UnionProf. Edwin G. DolanUniversity of Economics, Prague, 2006

Lecture 6:Using Exchange Rates to Stop Inflation


The euro and its future
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?


Part 1 needed a nominal anchor

Part 1

Needed: A Nominal Anchor


World inflation trends

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


Stylized post transition inflation cycle
Stylized post-transition inflation cycle world-wide problem

  • 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


Examples
Examples world-wide problem

  • 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


Exchange rate based stabilization
Exchange-rate Based Stabilization world-wide problem

  • 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


How to maintain the anchor 1
How to maintain the anchor (1) world-wide problem

  • 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


How to maintain the anchor 2
How to maintain the anchor (2) world-wide problem

  • 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


How to maintain the anchor 3

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)


Part 2 real and nominal exchange rates

Part 2 them pay with forints that they have on deposit in commercial banks

Real and Nominal Exchange Rates


Nominal exchange rates
Nominal Exchange Rates them pay with forints that they have on deposit in commercial banks

  • 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


Appreciation and depreciation
Appreciation and depreciation them pay with forints that they have on deposit in commercial banks

  • 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


The real exchange rate

The them pay with forints that they have on deposit in commercial banksreal 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


Real appreciation
Real appreciation them pay with forints that they have on deposit in commercial banks

  • 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


Examples russia 1991 2000
Examples: Russia 1991-2000 them pay with forints that they have on deposit in commercial banks

  • 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


Variations on the real exchange rate

Let them pay with forints that they have on deposit in commercial banks

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


Part 3 case study in erb stabilization bulgaria s currency board

Part 3 them pay with forints that they have on deposit in commercial banks

Case Study in ERB Stabilization:

Bulgaria’s Currency Board


Post transition inflation in bulgaria

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


Background dominance of state banks
Background: Dominance of State Banks inflation and falling GDP in the early 1990s

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


Poor lending practices led to a banking crisis

State banks loaned mainly to government and state firms inflation and falling GDP in the early 1990s

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:


Insolvency and inadequate capital

at the end of 1995 . . . inflation and falling GDP in the early 1990s

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


Development of the crisis

January 1996: Bank runs inflation and falling GDP in the early 1990s

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


1997 reform and resolution
1997: Reform and resolution inflation and falling GDP in the early 1990s

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


What is a currency board

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?


Inflation falls in anticipation of currency board
Inflation falls in anticipation of currency board arrangement:

Once the currency board was announced, expectations stabilized and inflation ended before the policy was in fact implemented


Behavior of velocity
Behavior of velocity arrangement:

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


The danger of real appreciation
The Danger of Real Appreciation arrangement:

  • 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


Real and nominal exchange rates
Real and nominal exchange rates arrangement:

Unlike many countries, Bulgaria experienced little real exchange rate appreciation following ERB stabilization


Good performance since 1998

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


Part 4 soft pegs and exchange rate corridors

Part 4: macroeconomic performance has been good

Soft Pegs and

Exchange Rate Corridors


What is a soft peg

In what sense soft? macroeconomic performance has been good

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?


A fixed rate with a horizontal corridor

Rules for a horizontal corridor macroeconomic performance has been good

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


When it works best
When it works best macroeconomic performance has been good

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


When it works less well
When it works less well macroeconomic performance has been good

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


Possible ways to fix the problem
Possible ways to fix the problem macroeconomic performance has been good

  • 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”


Fundamentals of a crawling peg
Fundamentals of a crawling peg macroeconomic performance has been good

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


Active vs passive crawling peg

Passive variant macroeconomic performance has been good

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


Part 5 poland s crawling peg disinflation

Part 5: macroeconomic performance has been good

Poland’s Crawling Peg Disinflation


Inflation and real output in poland
Inflation and Real Output in Poland macroeconomic performance has been good

  • Post-transition inflation in Poland was the most severe in Central Europe

  • Although Poland returned to growth by 1992, inflation slowed only gradually


Phase 1 fixed exchange rate
Phase 1: Fixed Exchange Rate macroeconomic performance has been good

  • 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


Performance in phase 1
Performance in Phase 1 macroeconomic performance has been good

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.


Phase 2 crawling peg no corridor

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


Phase 3 crawling peg with corridor

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


Performance in phase 2 and 3
Performance in Phase 2 and 3 shocks and variable financial flows

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


Current account during the disinflation
Current account during the disinflation shocks and variable financial flows

  • 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


Real exchange rate trends
Real Exchange Rate Trends shocks and variable financial flows

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


Remaining problems
Remaining Problems shocks and variable financial flows

  • 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


What am I going to do about unemployment? shocks and variable financial flows

How am I going to get us into the euro?


Required and suggested readings
Required and Suggested Readings shocks and variable financial flows

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)


ad