Topic 4:

Exchange Rate
Regimes & Policies
Outline
1. Real versus nominal exchange rates
2. Exchange rate policy and welfare
3. The scourge of overvaluation
4. From exchange rate policy to
economic growth
5. Exchange rate regimes
To float or not to float

Real versus nominal
exchange rates
* P
eP
R =
R = real exchange rate
e = nominal exchange rate (direct)
P = price level at home country
P* = price level abroad
Increase in R
means real
appreciation
Real versus nominal
exchange rates
* P
eP
R =
R = real exchange rate
e = nominal exchange rate
P = price level at home
P* = price level abroad
Devaluation or
depreciation of e
makes R also
depreciate unless P
rises so as to leave
R unchanged
Year Export-based Weights Trade-based Weights
REER NEER REER NEER
1 2 3 4 5
(Base: 1993-94 = 100)
1993-94 100 100 100 100
1994-95 104.88 98.18 104.32 98.91
1995-96 100.1 90.94 98.19 91.54
1996-97 98.95 89.03 96.83 89.27
1997-98 103.07 91.97 100.77 92.04
1998-99 94.34 90.34 93.04 89.05
1999-00 95.28 90.42 95.99 91.02
2000-01 98.67 90.12 100.09 92.12
2001-02 98.59 89.08 100.86 91.58
2002-03 95.99 87.01 98.18 89.12
2003-04 99.07 87.89 99.56 87.14
2004-05 98.3 88.41 100.09 87.31
(Base: 2004-05 = 100)
2005-06 102.74 102.2 103.1 102.24
2006-07 101.05 98 101.29 97.63
2007-08 108.57 105.62 108.52 104.75
2008-09 97.77 94 97.8 93.34
2009-10 95.28 91.42 94.74 90.94
2010-11 103.27 94.75 102.04 93.56
Year Export-based
Weights
Trade-based
Weights
1 REER NEER REER NEER
1993-94 113.1 101.7 99.9 114.5
1994-95 111.1 106.7 104.2 113.3
1995-96 102.9 101.8 98.1 104.8
1996-97 100.7 100.7 96.7 102.2
1997-98 104.0 104.9 100.7 105.4
1998-99 102.2 96.0 93.0 102.0
1999-00 102.3 96.9 95.9 104.2
2000-01 101.9 100.4 100.0 105.5
2001-02 100.8 100.3 100.8 104.9
2002-03 98.4 97.7 98.1 102.1
2003-04 99.4 100.8 99.5 99.8
2004-05 100 100 100 100
2005-06 102.74 102.2 103.1 102.24
2006-07 101.05 98 101.29 97.63
2007-08 108.57 105.62 108.52 104.75
2008-09 97.77 94 97.8 93.34
2009-10 95.28 91.42 94.74 90.94
2010-11 103.27 94.75 102.04 93.56
0.0
20.0
40.0
60.0
80.0
100.0
120.0
R
E
E
R

&

N
E
E
R

INDIA REER & NEER (2004-5=100)
REER
NEER
60
70
80
90
100
110
120
130
1
9
9
0
1
9
9
1
1
9
9
2
1
9
9
3
1
9
9
4
1
9
9
5
1
9
9
6
1
9
9
7
1
9
9
8
1
9
9
9
Australia China
Japan New Zealand
Philippines Af rica
Real effective exchange rates 1990-1999
(1995 = 100)
Foreign exchange
R
e
a
l

e
x
c
h
a
n
g
e

r
a
t
e

Imports
Exports
Exchange rate policy and
welfare
Earnings from exports of
goods, services, and
capital
Payments for imports of
goods, services, and
capital
Equilibrium between demand and supply in
foreign exchange market establishes
Equilibrium real exchange rate
Equilibrium in the balance of payments
BOP = X + F
x
Z F
z
= X Z + F
= current account + capital account
= 0
Exchange rate policy and
welfare
Where X = Exports, Z = Imports, F = Fin Flows
Foreign exchange
R
e
a
l

e
x
c
h
a
n
g
e

r
a
t
e

Imports
Exports
Exchange rate policy and
welfare
Overvaluation
Deficit
Foreign exchange
P
r
i
c
e

o
f

f
o
r
e
i
g
n

e
x
c
h
a
n
g
e

Supply (exports)
Demand (imports)
Exchange rate policy and
welfare
Overvaluation
Deficit
Overvaluation works
like a price ceiling
Market equilibrium and
economic welfare
Supply
Demand
E
Producer
surplus
Consumer
surplus
Quantity
Price
A
B
C
Total welfare gain associated
with market equilibrium equals
producer surplus (= ABE) plus
consumer surplus (= BCE)
Supply
Demand
Price ceiling
E
F
G
Quantity
Price
Welfare
loss
Price ceiling imposes a
welfare loss equivalent to
the triangle EFG
A
B
C
Consumer surplus = AFGH
H
J
Market intervention and
economic welfare
Producer surplus = CGH
Total surplus = AFGC
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
Common till 1980s across developing countries
Supply
Demand
Price ceiling
E
F
G
Quantity
Price
Welfare
loss
Price ceiling imposes a
welfare loss equivalent to
the triangle EFG
A
B
C
H
J
Market intervention
and economic welfare
Shortage
Inflation and overvaluation
Inflation can result in an overvaluation of the
national currency

Remember: R = eP/P*

Suppose e adjusts to P with a lag
Then R is directly proportional to inflation
Numerical example

Inflation and overvaluation
Time
Real exchange rate
100
110
105 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 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 R
provided inflation is kept under control

Does devaluation improve the current account?

The Marshall-Lerner condition
Net export function


NX = net exports
X = exports
e = nominal exchange rate
M = imports
Y* = income level in the foreign country
Y = income level at home

3 sources of changes in net exports:
1. Exports 2. Imports and 3. Exchange rate

Net Export & M L conditions
|
.
|

\
|
|
|
.
|

\
|
= e Y eM e Y X NX , ,
*
Time
J-Curve Hypothesis: Impact of
Devaluation on Net Exports
N
e
t

E
x
p
o
r
t
s

o
Export creation and Import substitution
or demand switching takes time
Marshall-Lerner condition

Devaluation is effective if
1 > +
m x
e e

Devaluation is ineffective if
1 < +
m x
e e

Devaluation has no effect in trade balance
1 = +
m x
e e

x
e
is elasticity of export
m
e
is the elasticity of imports
Change in net exports is zero if the sum of
exchange rate elasticity of exports and imports
equals 1.

Net export increases if this sum is greater than
one.

Net export decreases if this sum is less than one.

Example: There is a devaluation

Export elasticity is 0.9
import elasticity if 0.8
Net export rises because 0.9-(-0.8) =1.7%.
Numerical Example:
Marshall-Lerner Condition

Derivation
Marshall-Lerner condition

M X
e 1
=
e
X
M
1
=
e M M e X NX A A A = A
X
e
M
X
M
e
X
X
X
NX A

A
=
A

and
Change in net export

Divide both sides by X

0 =
A

A
=
A
e
e
M
M
X
X
X
NX
1 =
A A

A A
e
e
M
M
e
e
X
X

Marshall-Lerner Condition

Derivation
Marshall-Lerner condition

The Marshall-Lerner
condition: Theory
T = eX Z
= eX(e) Z(e)

Not obvious that a lower e helps T
Lets do the arithmetic
Bottom line is:
Devaluation improves the current
account as long as

1 > +b a
Historical examples
Italy 1992-93
Mexico 1994-95
Korea 1997-98
Poland 2009
The J-curve
Econometric estimation of elasticities
Table: Estimated Price Elasticities for
International Trade in Manufactured Goods
ERM crisis
& devaluation
Through a combination of devaluation and expenditure-reduction,
Mexico in 1995 and Korea in 1998 managed to convert
large trade deficits quickly to large trade surpluses.
The Polish real exchange rate depreciated by 35% when GFC hit.
Depreciation boosted net exports; contribution to GDP growth > 100%.
3,2
3,5
3,7
4,0
4,2
4,5
4,7
I III V VII IX XI I III V VII IX XI I III V VII IX
2008 2009 2010
8,0
13,0
18,0
23,0
28,0
Contribution of Net X to GDP:
2009: 2,5 3,4 3,2 3,4
GDP growth rate: 1,7
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,

1 > +b a
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
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
For M L conditions to work, nominal
devaluation must result in real devaluation
* P
eP
R =
From exchange rate policy
to economic 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

From exchange rate policy
to economic 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
Why inflation is bad for
growth
We saw before that inflation leads to
overvaluation which hurts exports
So, here is one more reason why high
inflation hurts economic growth
Exports and imports! are good for
growth
Several other reasons
High inflation distorts production and
impedes financial development
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
Exchange rate regimes
Case Study
Jeffrey Frankel 2002
Exchange rate regimes
There is a range of options to choose from
Monetary union or dollarization
Means giving up your national currency or sharing it
with others
Currency board
Legal commitment to exchange domestic for foreign
currency at a fixed rate
Fixed exchange rate (peg)
Crawling peg
Managed floating
Pure floating
Benefits and costs
Benefits Costs
Fixed
exchange
rates
Floating
exchange
rates
Benefits and costs
Benefits Costs
Fixed
exchange
rates
Stability of
trade and
investment
Low inflation
Floating
exchange
rates
Benefits and costs
Benefits Costs
Fixed
exchange
rates
Stability of
trade and
investment
Low inflation
Inefficiency
BOP deficits
Sacrifice of
monetary
independence
Floating
exchange
rates
Benefits and costs
Benefits Costs
Fixed
exchange
rates
Stability of
trade and
investment
Low inflation
Inefficiency
BOP deficits
Sacrifice of
monetary
independence
Floating
exchange
rates
Efficiency
BOP equilibrium
Benefits and costs
Benefits Costs
Fixed
exchange
rates
Stability of
trade and
investment
Low inflation
Inefficiency
BOP deficits
Sacrifice of
monetary
independence
Floating
exchange
rates
Efficiency
BOP equilibrium
Instability of
trade and
investment
Inflation
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
What countries actually do
(2005)
No national currency 39
Currency board 8
Adjustable pegs 50
Crawling pegs 9
Managed floating 33
Pure floating 47
186
25%
25%
50%
There is a gradual tendency towards floating,
from 10% of LDCs in 1975 to over 50% in 2005
Bottom line
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/Undervaluation
over LR
Need to adopt exchange rate
regime that is conducive to low
inflation and rapid growth