External Sector Policies
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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.

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External sector policies

External Sector Policies

Thorvaldur Gylfason


External sector policies

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


External sector policies

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


External sector policies

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


External sector policies

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


External sector policies

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


External sector policies

Exchange rate policy and welfare

R moves when e is fixed

R

Deficit

Imports

Overvaluation

Real exchange rate

Exports

Foreign exchange


External sector policies

Exchange rate policy and welfare

Overvaluation works like a price ceiling

Supply (exports)

Price of foreign exchange

Overvaluation

Demand (imports)

Deficit

Foreign exchange


External sector policies

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


External sector policies

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


External sector policies

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


External sector policies

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


External sector policies

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


External sector policies

Inflation and overvaluation

Real exchange rate

Suppose inflation is 10 percent per year

110

Average

105

100

Time


External sector policies

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


External sector policies

How to correct overvaluation

  • 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


External sector policies

The Marshall-Lerner condition: Theory

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


External sector policies

The Marshall-Lerner condition

+

-

Import

elasticity

Export elasticity

-a

b

1

1


External sector policies

The Marshall-Lerner condition

Assume X = Z/e initially

X

if


External sector policies

The 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 improves the current account


External sector policies

Empirical evidence from developing countries

Elasticity ofElasticity of

exportsimports

Argentina0.60.9

Brazil0.41.7

India0.52.2

Kenya1.00.8

Korea2.50.8

Morocco0.71.0

Pakistan1.80.8

Philippines0.92.7

Turkey1.42.7

Average1.11.5


External sector policies

Small countries:

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


External sector policies

The importance of appropriate side measures

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


External sector policies

4

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


External sector policies

From exchange rate policy to economic growth

  • 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


External sector policies

Why inflation is bad for growth

  • 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


External sector policies

How trade 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”


External sector policies

How trade increases efficiency and growth

  • Trade also encourages international exchange of

    • Ideas

    • Information

    • Know-how

    • Technology

  • Trade is education

    • Which is also good for growth!


External sector policies

Efficiency 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


External sector policies

Trade and 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


External sector policies

Openness to FDI 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


External sector policies

Openness to Trade 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


External sector policies

Tariffs 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


External sector policies

African countries:Exports 2001 (% of GDP)

Botswana

Average


External sector policies

AFRITAC countries:Exports 1960-2001 (% of GDP)

Botswana

Weighted averages.

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


External sector policies

5

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


External sector policies

Exchange rate regimes

  • 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


External sector policies

Benefits and costs


External sector policies

Benefits and costs


External sector policies

Benefits and costs


External sector policies

Benefits and costs


External sector policies

Benefits and costs


External sector policies

Exchange rate regimes

  • 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


External sector policies

What countries actually do (2001)

No national currency39

Currency board 8

Adjustable pegs50

Crawling pegs 9

Managed floating33

Pure floating47

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

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


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