External Sector Policies

1. External Sector Policies Thorvaldur Gylfason

2. Outline • Real versus nominal exchange rates • Exchange rate policy and welfare • The scourge of overvaluation • From exchange and trade policies to economic growth • Exchange rate regimes • To float or not to float

3. 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

4. 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

5. Three experiments 1. Suppose e falls Then more shillings per dollar, so X rises, Z falls 2. Suppose P falls Then X rises, Z falls 3. Suppose P* rises Then X rises, Z falls Summarize all three by supposingQ falls Then X rises, Z falls

6. 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

7. 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

8. Exchange rate policy and welfare R moves when e is fixed R Deficit Imports Overvaluation Real exchange rate Exports Foreign exchange

9. Exchange rate policy and welfare Overvaluation works like a price ceiling Supply (exports) Price of foreign exchange Overvaluation Demand (imports) Deficit Foreign exchange

10. 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

11. 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

12. Inflation and overvaluation Real exchange rate Suppose inflation is 10 percent per year 110 Average 105 100 Time

13. 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

14. 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

15. 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

16. The Marshall-Lerner condition + - Import elasticity Export elasticity -a b 1 1

17. The Marshall-Lerner condition Assume X = Z/e initially X if

18. 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

19. Empirical evidence from developing countries 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

20. 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

21. 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

22. 4 From exchange and trade policies to 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

23. From exchange and trade policies to 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

24. Why inflation is bad for growth • We saw before that inflation leads to overvaluation which hurts exports • So, here is one additional reason why inflation hurts economic growth • Exports and imports are good for growth • Several other reasons • Inflation distorts production and impedes financial development, and scares foreign investors away

25. 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”

26. How trade increases efficiency and growth • Trade also encourages international exchange of • Ideas • Information • Know-how • Technology Trade is tantamount to technological progress • Trade is education • Which is also good for growth!

27. Efficiency is crucial for economic growth • Need economic policies that help 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

28. 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

29. 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

30. Tariffs and Growth 1965-98 82 countries Average tariffs around the world have decreased from 40% to 5% since 1945 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

31. MEFMI countries:Exports 1960-2002 (% of GDP) Unweighted average Botswana Weighted average (unweighted average is higher because US and Japan then have lower weights)

32. MEFMI countries:Exports 2002 (% of GDP) Botswana Average

33. MEFMI countries:GDP per capita 1960-2002 (USD at 1995 prices) Botswana

34. 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

35. Exchange rate regimes • There is a range of options • Monetary union or dollarization • Means giving up your national currency or sharing it with others (e.g., EMU, CFA, EAC) • Currency board • Legal commitment to exchange domestic for foreign currency at a fixed rate • Fixed exchange rate (peg) • Crawling peg • Managed floating • Pure floating

36. Benefits and costs

37. Benefits and costs

38. Benefits and costs

39. Benefits and costs

40. Benefits and costs

41. 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

42. What countries actually do (2001) 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

43. 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