Download Exchange Rate Economics

Exchange Rate Economics
John Williamson
Senior Fellow, Peterson Institute for
International Economics
Paper prepared for World Bank’s Growth Commission,
presumably concerned with whether “Asian model”
should be applied more generally
Exchange Rate Economics revolutionized since era of flow models in
1960s
Now seen as forward-looking asset price
Current account’s influence comes only in pinning down longrun value of RER (either uniquely by PPP or by PPP plus real
factors), with transition modeled by assuming the
representative agent is rational and enjoys perfect foresight
1.
2.
3.
4.
5.
Exposition of conventional models
Problems with these models and the most promising alternative
Dutch disease
Policy implications
Questions for additional research
The Standard Model
Long-run equilibrium characterized by current account
imbalance such as to keep NIIP/GDP constant
Level of equilibrium NIIP/GDP determined by factors
considered in intertemporal theory of c/a
Steady-state is independent of price level
• i.e. PPP prevails between equilibria
• either shocks are entirely monetary
• or real shocks are of second order of importance
• empirical evidence: something close to PPP holds in LR, but estimates of LRERs have significant coefficients
also on NFAs, tot, G/Y, productivity.
But should s-s be required as equilibrium condition?
Doesn’t this require that development be complete?
Alternative: allow NIIP/GDP, but nothing else, to vary
Theory of debt cycle
In the short-run:
•
•
•
•
UIP
Overshooting
Portfolio models
Meese and Rogoff showed Dornbusch and Portfolio
Models were outperformed by random walk in S-R (for
industrial countries)
Purists reject the L-R/S-R distinction and extend the S-R to
L-R but impose a transversality condition with similar
effect.
Problems
Empirical implications of the standard model:
-- Exchange rates respond systematically to changes in the
fundamentals (money supplies, income levels, interest
rates, expected inflation rates, tot, productivity—at least
insofar as current values influence perceptions of
permanent values), but do not change without “news”
-- Money is made by having a good notion of the
implications of the fundamentals, and will be lost by
following chartist rules (Friedman)
-- Exchange rate changes are normally distributed, no
scope for “bubble-and-crash” dynamics
All these implications are strongly counter to empirical evidence:
• Meese/Rogoff study (still dominant conclusion, though
Gourinchas and Rey argue that adding the exchange-rate
induced change in wealth to the c/a permits a degree of S-R
forecastability, and in Rio Carneiro and Wu cast similar doubt
on the result for EMs); and what explains the DM/euro
rollercoaster in 1993-2003?
• Chartist rules are used and profitable
• DM/$ over 1986-95 had standard deviation of 0.0029 per day
but 3 days with changes greater than 0.015 (probability once
every 7,000 years). Frequent apparent bubble-and-crash
dynamics
Standard model is a hopeless empirical failure
But models are replaced only by a superior theory
Candidate of de Grauwe and Grimaldi:
“behavioral theory”
• Same structure as that originally
developed by Frankel and Froot in 1986,
but more careful relationship to behavioral
finance literature
• FX market populated by agents who use
fundamentalist and chartist strategies
• Agent may act as either, and may change
tactics in response to other rule proving
more profitable (“bounded rationality”)
No analytical solution, but several thousand simulations
suggest:
• That exchange rate changes are disconnected from
fundamentals, though level is cointegrated with its
fundamental value
• That chartist rule tends to be more profitable than
fundamentalist one, though better is to switch
• That exchange rate changes have fat tails
• That the exchange rate is sometimes, but
unpredictably, disconnected from its fundamental value
and instead involved in bubble-and-crash dynamics
That is, the model appears consistent with stylized facts.
Dutch Disease
Is it a dangerous condition to be avoided by policy
measures or welcomed as an improvement in a
country’s situation?
•
•
•
•
Dangerous condition:
Parable of export-led growth in E. Asia
Possibility of interruption by Dutch disease
Developed country has more chance of giving
good living standard to all citizens (exceptions)
• Prudent act of investment (like Indonesia in
1978)
Welcome condition:
• Dominant view among economists
• Enlarges opportunities of domestic
residents
• May involve painful S-R adjustment, e.g. in
size of export sector
• Natural, efficient way to achieve this is by
appreciation of RER.
What does econometric evidence say?
• Evidence of a negative relationship between
misalignment and growth (Razin and Collins)
• Evidence of such a relationship in developing
but not developed economies (Prasad, Rajan,
and Subramanian)
• Using a cross-country growth regression,
Aguirre and Calderon get the usual results plus
significant negative relationship between growth
and misalignment driven largely by big
misalignments (but the g-maximizing policy
appears to be mild undervaluation)
An interesting result is that given change in RER
may have differential effect on growth if it is an
equilibrium phenomenon or a misalignment. Why?
Perhaps because of different judgments of the
private sector on the permanence of change. RER
decrease increases profitability of investing in nontradables to offset reduced profitability of investing
in tradables (sold on world market). No reason to
anticipate a crisis. Misalignment is quite different in
both respects.
If one concludes that Dutch disease is bad for growth,
what can policy do about it?
Conventional view: little; e not a policy weapon because
it floats; even if it doesn’t, offset by induced inflation.
But is this right? Intervention is effective under the
behavioral theory of e (because it increases the rewards
of the fundamentalists). A potent instrument for avoiding
large misalignments by chartists jumping on
bandwagons.
Aguirre-Calderon say no need to worry about a real
appreciation caused by a permanent change.
Difficult case is one of uncertainty as to whether a
strengthening is temporary or permanent. Costly to
make error.
Is there another policy instrument?
•Variation in prudential regulations: no, not cyclical
variation.
•Capital controls
•Stabilization or Endowment Fund held outside
country
•Taxes; on entry of foreign capital as alternative to
encaje, or on foreign interest income.
Policy Implications
Assume that exchange rates are determined by
behavioral finance model rather than standard
model.
Fixed e requires same 4 conditions:
• Opt currency area
• Bulk of trade with partner country
• Macro policy consistency
• Institutional arrangements to ensure credibility.
Implication re floating: should it be freeish or managed?
Standard model suggests free floating: rate normally close to
fundamental value, and there isn’t much the authorities can do
anyway.
Behavioral model challenges both propositions.
But does not endorse “stable but adjustable”; still crisis-prone.
I.e. choice is BBC, managed floating, unmanaged float.
Band: main argument for adopting is to gain help of speculators in
stabilizing the rate. Requires credible margins. Authorities have
squandered credibility, so no BBC.
Unmanaged float: laissez-faire would be ideal if e’s behaved as
portrayed in standard model. But they don’t.
Two possible principles for more systematic
management:
• Leaning against the wind; but why if the wind is
blowing the right way? Possible answer:
because this will help fundamentalists make
money.
• Reference rates. Need to secure agreement on
ref rates. Political issue: will countries agree to
central rates despite traditional objection that all
they can hope to identify are disequilibrium
rates? (Perhaps: limited obligation.) Also
technical issue: do the IMF’s Macro
Balance/External Sustainability approaches yield
similar outcomes to ERER approach?
Because of nature of obligation (not to push the
rate away from ref rate), no conflict with IT
Benefits:
• Private market has sense of what official world
believes equilibrium to be
• Basis for public debate about e
• International endorsement would aid in resisting
cyclical appreciation caused by export boom or
inflow surge. Most important for EMs/developing
countries.
Additional Research
• Not really research, but importance of IMF
publication of its figures on Macro Balance
v. ERER Approaches.
• And understanding of whether Dutch
disease is dangerous, and why.
• And?
Concluding Remarks
Big step forward in 1970s when flow models were replaced
by models that regard e as forward-looking asset price
But next step has not followed; it is overdue.
Alternative model has important implications.
Doesn’t idealize laissez-faire.
Or recommend fixing e, or reverting to adjustable peg, or
abandoning floating or IT
But it does require the IMF to accept the duty of negotiating
reference rates and enforcing the obligations they would
impose
Which would at least help countries avoid misalignments
that the official sector can see rest on temporary factors.