Download Principles of Economic Growth

Thorvaldur Gylfason
Joint Vienna Institute/IMF Institute
Course on Macroeconomic Management in
Natural Resource-Rich Countries
Vienna, 2-13 April 2012
1. Real vs. nominal exchange rates
2. Exchange rate policy, welfare,
and growth
3. Dutch disease, overvaluation,
and volatility
4. Exchange rate regimes
 To float or not to float
 How many currencies?
eP
Q
P*
Increase in Q
means real
appreciation
Q = real exchange rate
e = nominal exchange rate
P = price level at home
P* = price level abroad
eP
Q
P*
Q = real exchange rate
e = nominal exchange rate
P = price level at home
P* = price level abroad
1. Suppose e falls
eP
Q
P*
Then more rubles 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
Capture all three by supposing Q falls
Then X rises, Z falls
Remember:
eP
Q
P*
Devaluation needs to be
accompanied by fiscal and
monetary restraint to prevent
prices from rising and thus eating
up the benefits of devaluation
To work, nominal devaluation must
result in real devaluation
Real exchange rate
Imports
Exports
Foreign exchange
Equilibrium between demand and
supply in foreign exchange
market establishes
Equilibrium real exchange rate
Equilibrium in balance of payments
BOP = X + Fx – Z – Fz
=X–Z+F
= current account + capital account = 0
Real exchange rate
R
Deficit
Imports
Overvaluation
Exports
Foreign exchange
Price of foreign exchange
Overvaluation works
like a price ceiling
Supply (exports)
Overvaluation
Deficit
Demand (imports)
Foreign exchange
 Appreciation
of currency in real terms,
either through inflation or nominal
appreciation, leads to a loss of export
competitiveness
 In 1960s, Netherlands discovered natural
resources (gas deposits)


Currency (Dutch guilder) appreciated
Exports of manufactures and services suffered,
but not for long
 Not
unlike natural resource discoveries, aid
inflows could trigger the Dutch disease in
receiving countries
Review
basic theory of Dutch
disease in simple demand and
supply model
Analytical literature uses complex
two- or three sector models
 Tradable
manufactures
 Tradable resources
 Nontradable services
Real exchange rate
C
B
A
Imports
Exports with oil
Exports without oil
Foreign exchange
Real exchange rate
C
B
Imports
Imports with
immigration
D
A
Exports with oil
Exports without oil
Foreign exchange
 Spending


Increased income from booming natural resource
sector boosts private and public spending, raising
prices and output in non-tradables sector
In non-natural resource tradables sector
(“manufacturing”), prices are fixed at world
levels, profits are squeezed by rising wages, and
increased demand is met out of rising imports
 Resource


effect
movement effect
Natural resource boom attracts capital and labor
away from rest of economy
Output declines in non-resource economy, esp. in
tradables, where prices are fixed at world levels
 Both


effects result in
Decrease in output share of non-natural resource
tradables relative to non-tradables
Appreciation of real exchange rate
 So,
decline of manufacturing and appreciation
of currencies in real terms tend to go hand in
hand



Extensive theoretical literature behind this result
What do the data say?
Recent literature survey by Magud and Sosa (2010)

“When and Why Worry About Real Exchange Rate
Appreciation? The Missing Link between Dutch Disease
and Growth,” WP/10/271
Number of cases reported
45
40
35
Yes
No
35
30
25
30
25
20
20
15
15
Yes
No
10
10
5
5
0
0
Dutch disease shocks
Natural resources/capital inflows
Source: Magud and Sosa (2011)
Number of cases reported
4
8
Yes
7
3
Yes
6
No
5
No
4
3
2
2
1
1
0
0
Appreciation
Lower T/NT
output
Remittances
Lower growth
Foreign aid
Source: Magud and Sosa (2011)
Number of cases reported
14
12
10
Yes
No
30
25
Yes
No
20
8
15
6
10
4
2
5
0
0
Empirical studies
Theoretical studies
Source: Magud and Sosa (2011)
Number of cases reported
30
6
Ye
s
25
5
20
4
15
3
10
2
5
1
0
0
Real overvaluation
Real undervaluation
Currency misalignments
Yes
No
Real appreciation
Real depreciation
Exchange rate changes
Source: Magud and Sosa (2011)
 Dutch


Resource booms make currencies appreciate
When currency appreciates in real terms, factors
of production are reallocated and production
switches away from manufacturing


disease does exist
Exchange rate volatility hampers economic growth
(not shown here, will see later)
Misalignment of real exchange rate from its
fundamental value also lowers growth


Overvaluation is always bad for growth
Evidence on the effect of undervaluation on growth is
inconclusive
Foreign
exchange earnings are
converted into local currency and
used to buy domestic goods
Fixed exchange rate regime
 Reserve
inflow causes expansion of money
supply that leads to inflation and
appreciation of domestic currency in real
terms
Flexible
 Increase
exchange rate regime
in supply of foreign exchange
leads to nominal appreciation of currency,
so real exchange rate also appreciates
Real exchange rate
C
B
A
Imports
Exports with aid
Exports without aid
Foreign exchange
Real exchange rate
C
B
A
Imports
Exports with inflow
Exports without inflow
Foreign exchange
90
80
70
60
50
40
30
20
10
0
Netherlands
Iceland
Norway
 Volatility
of commodity prices leads to
volatility in exchange rates, export earnings,
output, and employment
 Volatility can be detrimental to investment
and growth
 Hence, natural-resource rich countries may
be prone to sluggish investment and slow
growth due to export price volatility
 Likewise, high and volatile exchange rates
tend to slow down investment and growth
Uneven income stream
Even income stream
Per capita growth adjusted for initial incomw (% per year)
Inverse cross-country
correlation between
per capita growth and
GDP volatility
 GDP volatility is
defined as the
standard deviation of
per capita growth
 163 countries,
1960-2000

6
r = -0.47
4
2
0
-2
-4
-6
-8
0
4
8
12
16
20
Volatility of GDP
Output volatility and economic growth
1960-2000
Large
inflows of foreign exchange
earnings from a natural resource
discovery can trigger a bout of Dutch
disease
Real appreciation hurts competitiveness
of exports and can thus undermine
economic growth
 Exports
have played a pivotal role in the
economic development of many countries
 An accumulation of “know-how” often takes
place in the manufacturing export sector,
which may confer positive external benefits
on the rest of the economy
 Resource
disease if

It leads to high demand for nontradables



Production of nontradables cannot be increased without
raising wages in that sector
Resource rent is not used to build up
infrastructure and relax supply constraints


Trade restrictions may produce this outcome
Recipient country uses aid to buy nontradables (including
social services) rather than imports
Production is at full capacity


boom is likely to lead to Dutch
Including free mobility of labor across countries
Price and wage increases in nontradables sector
lead to strong wage pressure in tradables sector
The
risk that resource boom might
have adverse impact on economy due
to, e.g., oil-induced Dutch disease
crucially depends on how resource
rent is used in recipient countries
 We
can identify four different cases
based on how the rent is spent, and in
which the macroeconomic implications
of rent flows differ
Spending
can take several forms, with
different macroeconomic implications:
 Case
1: Rent is saved by government
 Case 2: Rent is used to purchase imported
goods that would not have been purchased
otherwise
 Case 3: Rent is used to buy nontradables
with infinitely elastic supply
 Case 4: Rent is used to buy nontradables
for which there are supply constraints
Rent
is saved by government
 Rent
inflow leads to accumulation of
foreign exchange reserves in Central Bank

… and, unlike increased rent that is spent, is
not allowed to enter the spending stream
 No
effect on money supply
 No inflation
 No appreciation of currency

I.e., no increase in exchange rate
 No
risk of Dutch disease
Rent
is used to purchase imported
goods that would not have been
purchased otherwise
 Import
purchases lead to transfer of real
resources from abroad, but not to
increased spending at home
 No effect on money supply
 No inflation
 No appreciation of currency
 No risk of Dutch disease
Rent
is used to buy domestic
nontradables with infinitely elastic
supply due to underutilized resources
(labor and capital) in economy
 Increased demand for nontradables
 Because some factors are unemployed,
greater demand leads to increased supply
 This has a positive impact on production
without increasing nontradables prices
 No risk of Dutch disease
Rent
is used to buy nontradables for
which there are supply constraints,
with all available resources already
in use (e.g., social services)
 Increased
demand for nontradables
 Increased prices for nontradables
 Shift of inputs away from tradables
(exports and import-competing goods and
services) into nontradables
 Real appreciation of the currency
 Dutch disease!
 Monetary
policy response determines if real
appreciation of currency will take place
through inflation or nominal appreciation
If foreign currency is used to increase Central
Bank reserves, increased spending on
nontradables increases money supply and
inflation, so currency appreciates in real terms
 If Central Bank sterilizes impact on money
supply of increased spending on nontradables by
selling foreign exchange, currency appreciates
in nominal, and real, terms

To
recapitulate, the risk of Dutch
disease varies, and depends on
 How
rent is used (saved or spent) – CASE 1
 The presence of a rent absorption
constraint – CASE 2
 The impact of rent on productivity in the
nontradables sector – CASE 3
 The existence of externalities in
nontradables sector affecting the rest of
the economy – CASE 4
Rent
inflow can give rise to Dutch
disease when government uses the
rent to purchase nontradables rather
than imported goods and when there
are constraints on increasing
production in nontradables sector
The risk of Dutch disease is greater
when rent is used in social sectors
facing constraints on increasing their
production due to resource scarcity
(rent absorption constraint)
How
can resource-rich countries avoid
translating rent into Dutch disease?
 Save
the rent and increase central bank
reserves (gross, not net) by not allowing
the rent inflow to enter spending stream

Recall the Hartwick rule
 Use
rent to purchase imported goods
 Boost rent absorption capacity in
nontradables sector
 Policymakers
in resource-rich countries
need to pay attention to potential early
warning signals of, say, oil-induced
Dutch disease such as
Tendency for wages and prices in
nontradables sector to increase
 Decline in profitability and sales of export
and import-competing industries
 Rapid relative rise of per capita GDP in
dollars


Recall: Argument applies to sudden inflows of
foreign capital as well as natural resource booms
The real exchange rate always
floats
Through nominal exchange rate
adjustment or price change
Even so, it matters 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
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
 Currency union or dollarization
 Currency board
 Peg
FIXED
Fixed
Horizontal bands
 Crawling peg
Without bands
With bands
 Floating
FLEXIBLE
Managed
Independent
Dollarization

Use another country’s currency as sole legal tender
Currency union

Share same currency with other union members
Currency board

Legally commit to exchange domestic
currency for specified foreign currency at fixed
rate
Conventional (fixed) peg


Single currency peg
Currency basket peg
Flexible peg
Fixed but readily adjusted
Crawling peg
Complete
Compensate for past inflation
Allow for future inflation
Partial
Aimed at reducing inflation, but real appreciation
results because of the lagged adjustment
Fixed but adjustable
Managed floating
 Management

by sterilized intervention
I.e., by buying and selling foreign
exchange
 Management
by interest rate policy,
i.e., monetary policy

E.g., by using high interest rates to
attract capital inflows and thus lift the
exchange rate of the currency
Pure floating
Governments may try to keep the
national currency overvalued
To keep foreign exchange cheap
To have power to ration scarce
foreign exchange
To make GDP look larger than it is
Other examples of price ceilings
Negative real interest rates
Rent controls in cities
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
Real exchange rate
Suppose inflation
is 10% per year
110
105
100
Average
Time
Real exchange rate
Suppose inflation
rises to 20%
120
110
Average
100
Time
Under floating
Depreciation is automatic: e moves
But depreciation may take time
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
 If
overvaluation of currency hurts exports,
undervaluation must by similar logic help
exports

Yet, as we saw, empirical evidence is mixed
 Some
countries – e.g., China – have kept
their currencies undervalued to boost
exports and contain imports

Undervaluation as export promotion policy
 Undervaluation
leads to buildup of foreign
exchange reserves

Reserve buildup raises some of the same issues as
natural resources booms
In
view of the success of the EU and
the euro, economic and monetary
unions appeal to many other
countries with increasing force
Consider four categories
 Existing
monetary unions
 De facto monetary unions
 Planned monetary unions
 Previous – failed! – monetary unions
 CFA

franc
14 African countries
 CFP

3 Pacific island states
 East

franc
Caribbean dollar
8 Caribbean island states

Picture of Sir W. Arthur Lewis, the great Nobel-prize
winning development economist, adorns the $100 note
 Euro,

more recent
16 EU countries plus 6 or 7 others

Thus far, clearly, a major success in view of old
conflicts among European nation states, cultural
variety, many different languages, etc.

Australian dollar


Indian rupee


South Africa plus Lesotho, Namibia, Swaziland – and
now Zimbabwe
Swiss franc


New Zealand plus 4 Pacific island states
South African rand


India plus Bhutan (plus Nepal)
New Zealand dollar


Australia plus 3 Pacific island states
Switzerland plus Liechtenstein
US dollar

US plus Ecuador, El Salvador, Panama, and 6 others
 East

Burundi, Kenya, Rwanda, Tanzania, and Uganda
 Eco

African shilling (2009)
(2009)
Gambia, Ghana, Guinea, Nigeria, and Sierra
Leone (plus, perhaps, Liberia)
 Khaleeji

Bahrain, Kuwait, Qatar, Saudi-Arabia, and United
Arab Emirates
 Other,

(2010)
more distant plans
Caribbean, Southern Africa, South Asia, South
America, Eastern and Southern Africa, Africa

Danish krone 1886-1939
Denmark and Iceland 1886-1939: 1 IKR = 1 DKR
 2009: 2,500 IKR = 1 DKR (due to inflation in Iceland)


Scandinavian monetary union 1873-1914


East African shilling 1921-69


Mauritius and Seychelles 1870-1914
Southern African rand


Kenya, Tanzania, Uganda, and 3 others
Mauritius rupee


Denmark, Norway, and Sweden
South Africa and Botswana 1966-76
Many others
 Centripetal
tendency to join monetary
unions, thus reducing number of currencies

To benefit from stable exchange rates at the
expense of monetary independence
 Centrifugal
tendency to leave monetary
unions, thus increasing number of currencies

To benefit from monetary independence often,
but not always, at the expense of exchange rate
stability
 With
globalization, centripetal tendencies
appear stronger than centrifugal ones
FREE CAPITAL
MOVEMENTS
Monetary
Union (EU)
FIXED
EXCHANGE
RATE
MONETARY
INDEPENDENCE
FREE CAPITAL
MOVEMENTS
FIXED
EXCHANGE
RATE
Capital controls
(China)
MONETARY
INDEPENDENCE
FREE CAPITAL
MOVEMENTS
Flexible
exchange
rate (US, UK, Japan)
FIXED
EXCHANGE
RATE
MONETARY
INDEPENDENCE
FREE CAPITAL
MOVEMENTS
Flexible
exchange
rate (US, UK, Japan)
Monetary
Union (EU)
FIXED
EXCHANGE
RATE
Capital controls
(China)
MONETARY
INDEPENDENCE
 If
capital controls are ruled out in view of
the proven benefits of free trade in goods,
services, labor, and also capital (four
freedoms), …
 … then long-run choice boils down to one
between monetary independence (i.e.,
flexible exchange rates) vs. fixed rates

Cannot have both!
 Either
type of regime has advantages as well
as disadvantages
 Let’s quickly review main benefits and costs
Benefits
Fixed
exchange
rates
Floating
exchange
rates
Costs
Benefits
Fixed
exchange
rates
Floating
exchange
rates
Stability of trade
and investment
Low inflation
Costs
Benefits
Fixed
exchange
rates
Floating
exchange
rates
Costs
Stability of trade Inefficiency
and investment BOP deficits
Low inflation
Sacrifice of
monetary
independence
Benefits
Fixed
exchange
rates
Floating
exchange
rates
Costs
Stability of trade Inefficiency
and investment BOP deficits
Low inflation
Sacrifice of
monetary
independence
Efficiency
BOP equilibrium
Benefits
Fixed
exchange
rates
Floating
exchange
rates
Costs
Stability of trade Inefficiency
and investment BOP deficits
Low inflation
Sacrifice of
monetary
independence
Efficiency
Instability of
BOP equilibrium trade and
investment
Inflation
 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 due to currency
overvaluation are the main problem, floating
rates can help
 If high inflation is the main problem, fixed
exchange rates can help, at the risk of renewed
overvaluation
 Ones both problems are under control, time may
be ripe for monetary union
 There
is no evidence that countries with
abundant natural resources are more prone
to inflation than other countries

They tend to grow more slowly, yes, but their
inflation record is indistinguishable from others
 Therefore,
as far as inflation is concerned,
choice between fixed and floating rates is
essentially the same in natural-resource rich
countries and elsewhere

Volatility of export earnings in natural-resource
rich countries calls for flexibility – if not in
exchange rate, then, e.g., in migration
What countries actually do (Number of countries, April 2008)
(22)
(84)
(12)
(44)
(40)
(76)
(10)
(66)
(3)
(5)
(2)
Source: Annual Report on Exchange Arrangements and Exchange Restrictions database.
No national currency
Currency board
Conventional fixed rates
Intermediate pegs
Managed floating
Pure floating
6%
7%
36%
5%
24%
22%
100%
54%
46%
There is a gradual tendency towards floating, from 10% of LDCs
in 1975 to almost 50% today, followed by increased interest
in fixed rates through economic and monetary unions