External Sector Policies

External External Sector Sector PoliciesPolicies

Thorvaldur Gylfason

OutlineOutline1)1)Real versus nominal exchange Real versus nominal exchange

ratesrates2)2)Exchange rate policy and Exchange rate policy and

welfarewelfare3)3)The scourge of overvaluationThe scourge of overvaluation4)4)From exchange rate policy to From exchange rate policy to

economic growtheconomic growth5)5)Exchange rate regimesExchange rate regimes

To float or not to floatTo float or not to float

Real versus nominal Real versus nominal exchange ratesexchange rates1

*PePQ

Q = real exchange ratee = nominal exchange rateP = price level at homeP* = price level abroad

Increase in Q means real appreciation

ee refers to foreign currency content of domestic currency

RealReal versus nominal versus nominal exchange ratesexchange rates

*PePQ

Q = real exchange ratee = nominal exchange rateP = price level at homeP* = price level abroad

Devaluation or depreciation of e makes Q also depreciate unless P rises so as to leave Q unchanged

Foreign exchangeForeign exchange

Real

exc

hang

e ra

teRe

al e

xcha

nge

rate

Imports

Exports

Exchange rate policy Exchange rate policy and welfareand welfare2

Earnings from exports of goods, services, and capital

Payments for imports of goods, services, and capital

Equilibrium

Equilibrium between demand and supply in foreign exchange market establishesEquilibrium real exchange rateEquilibrium in the balance of

paymentsBOP = X + Fx – Z – Fz

= X – Z + F = current account + capital

account = 0

Exchange rate policy Exchange rate policy and welfareand welfare


Real

exc

hang

e ra

teRe

al e

xcha

nge

rate

Imports

Exports


OvervaluationDeficit

RR R moves when e is fixed


Price

of f

orei

gn e

xcha

nge

Price

of f

orei

gn e

xcha

nge

Supply (exports)

Demand (imports)


Overvaluation

Deficit

Overvaluation works like a price ceiling

Market equilibrium and economic welfare

SupplySupply

DemandDemand

EE

ProducerProducersurplussurplus

ConsumeConsumerrsurplussurplus

Quantity

Price

AA

BB

CC

Total Total welfare gainwelfare gain associated associatedwith market equilibrium equalswith market equilibrium equalsproducer surplus (= ABE) plusproducer surplus (= ABE) plusconsumer surplus (= BCE)consumer surplus (= BCE)

R = 0, so R is fixed when e floats

SupplySupply

DemandDemand

Price ceilingPrice ceilingEE

FF

GG

Quantity

Price WelfareWelfarelossloss

Price ceiling imposes aPrice ceiling imposes awelfare losswelfare loss equivalent to equivalent tothe triangle the triangle EFGEFG

AA

BB

CC

Consumer surplus = AFGHConsumer surplus = AFGH

HH

JJ

Market intervention and economic welfare Producer surplus = CGHProducer surplus = CGH

Total surplus = AFGC

SupplySupply

DemandDemand

Price ceilingPrice ceilingEE

FF

GG

Quantity

Price WelfareWelfarelossloss

Price ceiling imposes aPrice ceiling imposes awelfare losswelfare loss that results that results from shortage (e.g., deficit)from shortage (e.g., deficit)

AA

BB

CC

HH

JJ

Market intervention and economic welfare

Shortage

The scourge of overvaluationGovernments may try to keep the

national currency overvaluedTo keep foreign exchange cheapTo have power to ration scarce

foreign exchangeTo make GNP look larger than it is

Other examples of price ceilingsNegative real interest ratesRent controls

3

Inflation and overvaluationInflation can result in an

overvaluation of the national currencyRemember: Q = eP/P*

Suppose e adjusts to P with a lagThen Q is directly proportional to

inflationNumerical example

Inflation and overvaluation

Time

Real exchange rate

100

110105 Average

Suppose inflation is 10 percent per year

Inflation and overvaluation

Time

100

120

Real exchange rate

110 Average

Hence, increased inflation increases the real exchange rate as long as the nominal exchange rate adjusts with a lag

Suppose inflation rises to 20 percent per year

How to correct overvaluationUnder a floating exchange rate

regimeAdjustment is automatic: e moves

Under a fixed exchange rate regimeDevaluation will lower e and thereby

also Q – provided inflation is kept under control

Does devaluation improve the current account?The Marshall-Lerner condition

The Marshall-Lerner condition: TheoryT = eeX – Z = eX(e) – Z(e)Not obvious that a lower e helps TLet’s do the arithmeticBottom line is:Devaluation improves the current

account as long as

1ba

Suppose prices are fixed, so that e = Q

a = elasticity of exportsb = elasticity of imports

Valuation Valuation effecteffect arises arises from the from the ability to ability to affect affect foreign foreign pricesprices

The Marshall-Lerner condition

ZeXB )()( eZeeXB

dedZ

dedXeX

dedB

eZ

Ze

dedZ

eX

Xe

dedXeX

dedB

1 1

-a b

- +

Export elasticityExport elasticity ImportImportelasticityelasticity

The Marshall-Lerner condition

eZ

Ze

dedZ

eX

Xe

dedXeX

dedB

XbabXaXXdedB

1

0dedB 1baif

X

Assume X = Z/e initially

The Marshall-Lerner condition: EvidenceEconometric studies indicate that

the Marshall-Lerner condition is almost invariably satisfied

Industrial countries: a = 1, b = 1Developing countries: a = 1, b =

1.5Hence,

1ba Devaluation improves the current account

Empirical evidence from developing countries Elasticity of Elasticity of

exports importsArgentina 0.6 0.9Brazil 0.4 1.7India 0.5 2.2Kenya 1.0 0.8Korea 2.5 0.8Morocco 0.7 1.0Pakistan 1.8 0.8Philippines 0.9 2.7Turkey 1.4 2.7Average 1.1 1.5

Small countries: A special caseSmall countries are price takers

abroadDevaluation 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

The importance of appropriate side measuresRemember:

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

*PePQ

From exchange rate policy to economic growthGovernments may try to keep the

national currency overvaluedOr inflation may result in

overvaluationIn either case, overvaluation

creates inefficiency, and hurts growth

Therefore, exchange rate policy matters for growth

Need real exchange rates near equilibrium

4

From exchange rate policy to economic growthHow 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 floatsThrough nominal exchange rate

adjustment or price change, but this may take time

Why inflation is bad for growthWe saw before that inflation leads

to overvaluation which hurts exports

So, here is one reason why inflation hurts economic growthExports – and imports! – are good for

growthSeveral other reasons

Inflation distorts production and impedes financial development

How trade increases efficiency and growthTrade with other nations

increases efficiency by allowing1. Specialization through

comparative advantage2. Exploitation of economies of scale3. Promotion of free competition

Not only trade in goods and services, but also in capital and labor“Four freedoms”

How trade increases efficiency and growthTrade also encourages international

exchange of Ideas Information Know-how Technology

Trade is educationWhich is also good for growth!

Efficiency is crucial for economic growthNeed economic policies that

increase efficiencyProduce more output from given

inputs Takes fewer inputs to produce given

outputMore efficiency, better technology are

two ways of increasing output per unit of input

So is more and better educationTrade increases efficiency and

thereby also economic growth

Trade and growth in Africa in the 1990sAverage 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

Openness to Openness to FDIFDI and and growth 1965-98growth 1965-98

-8

-6

-4

-2

0

2

4

6

-4 -2 0 2 4 6 8

Actual less predicted FDI 1975-1998 (% of GDP, ppp)

Ann

ual g

row

th o

f GN

P pe

r cap

ita 1

965-

98,

adju

sted

for i

nitia

l inc

ome

(%)

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

r = 0.62

85 countries

Botswana

Openness to Trade and Growth 1965-98

-8

-6

-4

-2

0

2

4

6

-40 -20 0 20 40

Actual less predicted exports 1965-98 (% of GDP)

Ann

ual g

row

th o

f GN

P pe

r cap

ita 1

965-

98,

adju

sted

for i

nitia

l inc

ome

(%)

87 countries

An increase in openness by 14% of GDP is associated with an increase in per capita growth by 1% per year

r = 0.42

Guinea Bissau

KoreaMalaysia

Belgium

Tariffs and Growth 1965-9882

countries

-8

-6

-4

-2

0

2

4

6

0 10 20 30 40

Import duties (% of imports 1970-98)

Ann

ual g

row

th o

f GN

P pe

r cap

ita 1

965-

98,

adju

sted

for i

nitia

l inc

ome

(%)

An increase in tariffs by 10% of imports is associated with a decrease in per capita growth by 1% per year

r = -0.52

India

Cote d'Ivoire

Botswana

African countries:African countries: ExportsExports 2001 (% of 2001 (% of GDPGDP))

Botswana

0 20 40 60 80 100

BurundiRwanda

Burkina FasoUganda

Central Af rican RepublicSudanChad

BeninEthiopia

TanzaniaComoros

NigerSierra Leone

Congo, Dem. Rep.Eritrea

MozambiqueZimbabwe

Cape VerdeKenya

MalawiZambiaGuinea

South Af ricaMadagascar

SenegalMali

CameroonTogo

LesothoMauritania

Sao Tome and PrincipeCote d'Ivoire

Guinea-BissauNigeria

BotswanaGhana

NamibiaGambia, The

GabonMauritiusSwaziland

AngolaCongo, Rep.Seychelles

Average

AFRITAC countries:AFRITAC countries: ExportsExports 1960-2001 (% of 1960-2001 (% of GDPGDP))

Botswana

0

5

10

15

20

25

30

35

40

45

50

1960

1964

1968

1972

1976

1980

1984

1988

1992

1996

2000

Eritrea EthiopiaKenya Rw andaTanzania UgandaSub-Saharan Africa High income

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

Exchange rate regimesThe real exchange rate always

floatsThrough nominal exchange rate

adjustment or price changeEven 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

5

Exchange rate regimesThere is a range of options

Monetary union or dollarizationMeans giving up your national

currency or sharing it with othersCurrency board

Legal commitment to exchange domestic for foreign currency at a fixed rate

Fixed exchange rate (peg)Crawling pegManaged floatingPure floating

Benefits and costsBenefitsBenefits CostsCosts

Fixed Fixed exchange exchange ratesrates

Floating Floating exchange exchange ratesrates



Stability of Stability of trade and trade and investmentinvestmentLow inflationLow inflation





InefficiencyInefficiencyBOP deficitsBOP deficitsSacrifice of Sacrifice of monetary monetary independenceindependence







EfficiencyEfficiencyBOP BOP equilibriumequilibrium






EfficiencyEfficiencyBOP BOP equilibriumequilibrium

Instability of Instability of trade and trade and investmentinvestmentInflationInflation

Exchange rate regimesIn 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 circumstanceIf inefficiency and slow growth are

the main problem, floating rates can help

If high inflation is the main problem, fixed exchange rates can help

What countries actually do (2001)No national currency 39Currency board 8Adjustable pegs 50Crawling pegs 9Managed floating

33Pure floating 47 186

25%

25%

50%

There is a gradual tendency towards floating, from 10% of LDCs in 1975 to over 50% today

Bottom lineBottom line

The EndThe EndExchange rate policy is important Exchange rate policy is important

because trade is importantbecause trade is importantNeed to maintain real exchange rates at Need to maintain real exchange rates at

levels that are consistent with BOP levels that are consistent with BOP equilibrium, including sustainable debtequilibrium, including sustainable debt Avoid overvaluation!Avoid overvaluation!

Need to adopt exchange rate regime Need to adopt exchange rate regime that is conducive to low inflation and that is conducive to low inflation and rapid growthrapid growth

These slides will be posted on my website: www.hi.is/~gylfason

External Sector Policies

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