Download Lecture 2

Thorvaldur Gylfason
IMF Institute/Joint Vienna Institute
Course on Macroeconomic Management and
Natural Resource Management
Vienna, 31 January - 11 February 2011
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
Price
A
B
C
Consumer
surplus
E
Producer
surplus
Supply
Total welfare gain associated
with market equilibrium equals
producer surplus (= ABE) plus
consumer surplus (= BCE)
Demand
Quantity
Consumer surplus = AFGH
Price
A
J
Welfare
loss
F
B
H
C
E
G
Producer surplus = CGH
Total surplus = AFGC
Supply
Price ceiling imposes a
welfare loss equivalent
to the triangle EFG
Price ceiling
Demand
Quantity
Price
A
J
Welfare
loss
F
B
H
C
Price ceiling imposes a
welfare loss that results
from shortage (e.g., deficit)
E
G
Shortage
Supply
Price ceiling
K
Demand
Quantity
 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
Real exchange rate
C
B
A
Imports
Exports with oil
Exports without oil
Foreign exchange
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
aid has
sometimes been
compared to natural
resource discoveries
 Aid and growth are
inversely related
across countries
 Cause or effect?
 156 countries,
1960-2000
Per capita growth adjusted for initial income (%)
 Foreign
r = rank correlation
r = -0.36
6
4
2
0
-2
-4
-6
-8
-20
0
20
40
60
Foreign aid (% of GDP)
80
Real exchange rate
C
B
A
Imports
Exports with inflow
Exports without inflow
Foreign exchange
 Term
refers to fears of de-industrialization that
gripped the Netherlands following the
appreciation of Dutch guilder after the discovery
of natural gas deposits in North Sea around 1960
 Is it Dutch? Is it a disease?
Some say No, viewing it simply as matter of one
sector’s benefiting at the expense of others, without
seeing any macroeconomic or social damage done
 Others say Yes, viewing the Dutch disease as an
ailment, pointing to the potentially harmful
consequences of the resulting reallocation of
resources – from high-tech, high-skill intensive service
industries to low-tech, low-skill intensive primary
production, for example – for economic growth and
diversification

90
80
70
60
50
40
30
20
10
0
Iceland
Netherlands
Norway
 Overvaluation
of currency hurts other exports
and import-competing industries


Norway’s total exports were long stagnant in
proportion to GDP following oil discoveries
Oil exports crowded out nonoil exports


Nokia is Finnish, LM Ericsson is Swedish, B&O is Danish
Norway’s almost unique unwillingness to join EU
 Composition

High-skill vs. low-skill intensive exports have
different spillover effects on other industries
 High

of exports matters
exchange rate hurts efficiency and growth
Just as China’s undervalued renmimbi boosts growth
 Rent

seeking …
Especially in conjunction with ill-defined
property rights, imperfect or missing markets,
and lax legal structures
…
tends to divert resources away from more
socially fruitful economic activity


“Other people’s money”
Social strife and conflict (e.g., “diamond wars”)
 False
sense of security
 Risk of rusting foundations of growth



Education (Human capital)
Investment (Physical capital)
Institutions (Social capital)
 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
Source: http://notendur.hi.is/gylfason/pic22.htm
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
boom is likely to lead to
Dutch disease if
 It
leads to high demand for nontradables
Trade restrictions may produce this outcome
 Recipient country uses aid to buy nontradables
(including social services) rather than imports

 Production

is at full capacity
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

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
Once
more, macroeconomic impact
of resource rents depends critically
on policy response to rents
 Interaction
between fiscal policy and
monetary policy is crucial
To
highlight this interaction, apply
two related but distinct concepts
 Absorption:
Monetary policy
 Spending: Fiscal policy
Absorption
(= expenditure)
 Extent
to which non-oil current account
deficit widens with increased rent

Captures amount of net imports financed by
increase in rents
 Given
fiscal policy, absorption is controlled
by Central Bank’s decision about how
much of rent-induced foreign exchange to
sell in markets

If Central Bank uses full increment of rentinduced foreign exchange to bolster reserves,
rent will not be absorbed
Spending
 Extent
to which non-oil fiscal deficit
widens with increased rent

Captures extent to which government uses rent
to finance increased expenditures
 Given
monetary policy, spending is
controlled by government’s decision
about how much of the rent to spend, on
either imports or non-traded goods

If government decides to save full increment in
rent, rent will not enter spending stream
 Different
combinations of absorption and
spending define policy response to a surge
in rent inflows
Absorption and spending are equivalent if rent
is stored abroad or spent on imports
 Absorption and spending differ when
government provides rent-related foreign
exchange to Central Bank and chooses how
much to spend on domestic goods while
Central Bank decides how much of the rentrelated foreign exchange to sell in markets

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
B = eX – Z in foreign currency
= eX(e) – Z(e)
Valuation
effect
arises
from the
ability to
affect
foreign
prices
Not clear that a lower e helps B because
decrease in e lowers eX if X stays put
Let’s do the arithmetic
Bottom line is:
Devaluation strengthens current
account as long as
a  b 1
-
+
B  eX  Z B  eX (e)  Z (e)
dB
 dX  dZ
 X  e

de
 de  de
-a
dB
 dX
 X  e
de
 de
b
 e  X   dZ   e  Z 
    
   
 X  e   de   Z  e 
1
1
-a
b
dB
 dX  e  X   dZ   e  Z 
 X  e
    
   
de
 de  X  e   de   Z  e 
dB
 X  aX  bX  1  a  b X
de
dB
0
de
if
a  b 1
X
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,
a  b 1
Argentina
Brazil
India
Kenya
Korea
Morocco
Pakistan
Philippines
Turkey
Average
Elasticity of Elasticity of
exports
imports
0.6
0.9
0.4
1.7
0.5
2.2
1.0
0.8
2.5
0.8
0.7
1.0
1.8
0.8
0.9
2.7
1.4
2.7
1.1
1.5
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
strengthens the current account
For an emerging country with …
Initial trade balance
Export-to-GDP ratio of 40%
… nominal depreciation by 10%
permanently improves trade balance
by 1½% to 2% of GDP in medium term
Effect depends on class of exporter
Oil, non-oil, manufactures
 Most of the effect is through imports
and is felt within 3 to 5 years
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
Costs
Fixed
exchange
rates
Stability of trade Inefficiency
and investment BOP deficits
Low inflation
Sacrifice of
monetary
independence
Floating
exchange
rates
Efficiency
BOP equilibrium
Benefits
Costs
Fixed
exchange
rates
Stability of trade Inefficiency
and investment BOP deficits
Low inflation
Sacrifice of
monetary
independence
Floating
exchange
rates
Efficiency
BOP equilibrium
Instability of
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
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