External Sector Policies
Download
1 / 45

External Sector Policies - PowerPoint PPT Presentation


  • 101 Views
  • Uploaded on

External Sector Policies. Thorvaldur Gylfason. 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. 1. Real versus nominal exchange rates.

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 ' External Sector Policies' - temima


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

External Sector Policies

Thorvaldur Gylfason


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


1

Real versus 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


Real versus 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


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


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


Exchange rate policy and welfare

R moves when e is fixed

R

Deficit

Imports

Overvaluation

Real exchange rate

Exports

Foreign exchange


Exchange rate policy and welfare

Overvaluation works like a price ceiling

Supply (exports)

Price of foreign exchange

Overvaluation

Demand (imports)

Deficit

Foreign exchange


Market equilibrium and economic welfare

DR = 0, so R is fixed when e floats

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


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


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


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


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


Inflation and overvaluation

Real exchange rate

Suppose inflation is 10 percent per year

110

Average

105

100

Time


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


How to correct overvaluation as long as the nominal exchange rate adjusts with a lag

  • Under a floating exchange rate regime

    • Adjustment is automatic: e moves

  • 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


The Marshall-Lerner condition: Theory as long as the nominal exchange rate adjusts with a lag

Suppose prices are fixed, so that e = Q

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


The as long as the nominal exchange rate adjusts with a lagMarshall-Lerner condition

+

-

Import

elasticity

Export elasticity

-a

b

1

1


The as long as the nominal exchange rate adjusts with a lagMarshall-Lerner condition

Assume X = Z/e initially

X

if


The Marshall-Lerner condition: as long as the nominal exchange rate adjusts with a lagEvidence

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


Empirical evidence from developing countries as long as the nominal exchange rate adjusts with a lag

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


Small countries: as long as the nominal exchange rate adjusts with a lag

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


The importance of appropriate side measures as long as the nominal exchange rate adjusts with a lag

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


4 as long as the nominal exchange rate adjusts with a lag

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


From exchange rate policy to economic growth as long as the nominal exchange rate adjusts with a lag

  • 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


Why inflation is bad for growth as long as the nominal exchange rate adjusts with a lag

  • 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


How as long as the nominal exchange rate adjusts with a lagtrade 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”


How trade increases efficiency and growth as long as the nominal exchange rate adjusts with a lag

  • Trade also encourages international exchange of

    • Ideas

    • Information

    • Know-how

    • Technology

  • Trade is education

    • Which is also good for growth!


Efficiency as long as the nominal exchange rate adjusts with a lag 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


Trade and as long as the nominal exchange rate adjusts with a lag 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


Openness to as long as the nominal exchange rate adjusts with a lagFDI 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


Openness to as long as the nominal exchange rate adjusts with a lagTrade and Growth 1965-98

87 countries

r = 0.42

Korea

Malaysia

Belgium

An increase in openness by 14% of GDP is associated with an increase in per capita growth by 1% per year

Guinea

Bissau


Tariffs as long as the nominal exchange rate adjusts with a lag and Growth

1965-98

82 countries

An increase in tariffs by 10% of imports is associated with a decrease in per capita growth by 1% per year

Botswana

India

Cote d'Ivoire

r = -0.52


African countries: as long as the nominal exchange rate adjusts with a lagExports 2001 (% of GDP)

Botswana

Average


AFRITAC countries: as long as the nominal exchange rate adjusts with a lagExports 1960-2001 (% of GDP)

Botswana

Weighted averages.

Unweighted averages are higher: 33% for Africa and 42% for world as a whole.


5 as long as the nominal exchange rate adjusts with a lag

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


Exchange rate regimes as long as the nominal exchange rate adjusts with a lag

  • 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


Benefits and costs as long as the nominal exchange rate adjusts with a lag


Benefits and costs as long as the nominal exchange rate adjusts with a lag


Benefits and costs as long as the nominal exchange rate adjusts with a lag


Benefits and costs as long as the nominal exchange rate adjusts with a lag


Benefits and costs as long as the nominal exchange rate adjusts with a lag


Exchange rate regimes as long as the nominal exchange rate adjusts with a lag

  • 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


What countries actually do (2001) as long as the nominal exchange rate adjusts with a lag

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


Bottom line
Bottom line as long as the nominal exchange rate adjusts with a lag

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


ad