Exchange Rate Economics: Theories and Evidence


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There is a vast literature on the impact of exchange rate policies ERP on economic variables, including direct effects on some development policy objectives e. Several hypotheses have been presented on why the regime may be related to growth. Some channels have to do with global factors and others with domestic ones. From a global perspective, fixed exchange rates were viewed as one of the important drivers behind the development of international financial markets at the end of the 19th century Johnson [ ] provides an early defense.

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Later on, the Mundellian paradigm shifted the attention to domestic factors by focusing on the shock absorber role of exchange rates and the finding that fixed regimes tend to magnify real shocks. A somewhat related story is offered by Hausmann and Rigobon , who argue that the volatility of exchange rates may induce an under-specialization in tradables, which may hurt growth.

Empirically, while ERP is often found not to have significant growth effects in industrial countries, in developing economies results are mixed. Levy Yeyati and Sturzenegger , find that floating leads to higher growth, while Rogoff, Husain, and Mody report that this result applies only to advanced economies. To reconcile these results, one could think of the limitations of existing regime classification. For example, because ERP flexibility is usually proxied by the volatility of the exchange rate, peg failures, including currency crises, are often recorded as intermediates or floats despite the fact that, in those episodes, ERP is no longer a policy choice , whereas stable floats are often coded as intermediate or pegged regimes.

Empirically, Hausmann, Pritchett, and Rodrik find a depreciated real exchange rate to be an important component of growth accelerations; conversely, Johnson, Ostry, and Subramanian show that persistent overvaluations tend to be associated with poorer growth. Perhaps the most traditional and less controversial link to growth is given by the relation between exchange rate flexibility and output volatility, more specifically, to the role played by the exchange rate as shock absorber: Under floating exchange rates, the economy has a greater ability to adjust to real external shocks, a view that goes back to Meade and Friedman In contexts of high inflation, low credibility, and limited impacts of monetary policy announcements where inflation expectations and even current prices tend to adjust with an eye on changes in the exchange rate as a proxy nominal reference, the exchange rate is often used to anchor to inflation and coordinate expectations.

From an empirical perspective, there seems to be agreement on the fact that pegs are associated with lower inflation, even after controlling for money creation e. This suggests that countries with tighter dollar indexation would benefit the most from the immediate impact of an anchor on inflation expectations—and explains why they were its most active promoters.

It also indicates that the effect works through the anchoring of expectations rather than through the imposition of monetary discipline. Intuitively, in the long run, pegs help monetary policy not only by lowering expectations thereby reducing the growth sacrifice needed to contain prices , but also by disciplining monetary policy. There is a vast body of work on ERP and economic integration bilateral trade flows and cross-border capital flows, including foreign direct investment. This literature is largely based on the incidence of currency conversion which includes not only the bid—ask spreads but also currency risk due to potential losses from exchange rate variations on cross-border multicurrency transaction costs.

The exchange rate at the center of development economics

Underlying these analyses is the Optimal Currency Area OCA premise that a monetary treaty, by preventing competitive devaluations, fosters foreign direct investment and intraindustry trade. There is, in addition, a literature documenting the complementary link between trade and FDI Clausing, ; Svensson, ERP has been associated with financial development through three distinct channels. The first one, already mentioned, relates to the implications of exchange rate instability for cross-border flows.

A third channel points to how exchange rate rigidity most notably, a pegged regime favors financial dollarization, where the latter is defined as the use of a foreign currency to denominate financial assets and liabilities held by residents Levy Yeyati, Note that the links connecting ERP with development are further complicated by the fact that the workings of some of these channels change dramatically with specific country characteristics and global conditions. For example, de facto financial integration and capital mobility could foster exchange rate flexibility as they force the country to choose between a stable exchange rate and an autonomous monetary policy; however, if financial flows are denominated in the foreign currency, the concomitant increase in dollar liabilities may optimally inhibit exchange rate flexibility for fear of balance sheet losses in the event of a real depreciation.

Similarly, whereas flexible exchange rates help buffer the economy against adverse external shocks, the same channel would be contractionary in heavily dollarized countries, which would be better off with more rigid exchange rate arrangements. Tracing the policy debate in the post-Bretton Woods era sheds light on the different intervening factors identified in the literature as justification for alternative exchange rate policies ERP and provides a broader perspective to go from the analytical arguments and the empirical results to the actual policy choices.

The academic literature mirrored these concerns, assessing the merits of exchange rate-based stabilizations ERBS coupled with income policies relative to the more traditional money-based stabilizations. However, noncredible money-based stabilizations were expected to increase the demand for money, jacking up interest rates in the short run, appreciating the exchange rate, and causing a recession in the short term. As inflation concerns subsided and financial integration increased in the s, the ERP debate in developing economies shifted the focus to the interplay of two contrasting features of financial development.

The first feature was the fact that financial globalization led to a growing ineffectiveness of monetary policy or, more precisely, that capital controls were found to be decreasingly effective as economies became more sophisticated. Ultimately, to the extent that dollarization made depreciations contractionary Frankel, , it eliminated the benefits of flexible regimes, making hard pegs the only reasonable option for those countries. Additionally, the success in building central bank autonomy and monetary credibility, together with the resulting decline in inflation and exchange rate pass-through and an effort to reduce financial dollarization, led to the growing popularity of the float pole of the bipolar view, particularly inflation targeting arrangements that placed the inflation rate, rather than the exchange rate, as the key nominal anchor, an option that recovered autonomous monetary policy.

The declining degree of financial dollarization, combined with the improved quality of monetary institutions, explain the evolution of ERP in recent years. The recent changes in debt composition and policy quality in developing countries have led developing economies to use the inflation rate rather than the exchange rate as the main policy target, leading some observers to salute the combination of floating exchange rates and inflation targeting as a new, possibly more resilient ERP paradigm Rose, Inflation targeting IT comes in many varieties, from soft numerical inflation targets in the form of a wide inflation band to more sophisticated schemes that include: a a legal commitment to price stability as the primary goal of monetary policy; b a communication strategy that allows agents to anticipate policy decisions; and c direct accountability of the central bank management for attaining the targets Truman, From an operational point of view, an inflation targeting regime typically implies identifying an intervention variable, usually a reference interest rate for funds offered by the central bank.

This rate is defined and discussed in regular meetings, the proceeds of which are made available to the public, sometimes with a lag.

The early empirical literature on the consequences of floating plus inflation targeting FIT on development suffers from some important drawbacks: a FIT adopts a number of forms that are not always strictly comparable; b launched in by the Bank of New Zealand, it has been adopted in developing countries relatively recently Chile and Israel led the way in the mids, although they implemented a fully fledged IT framework only in the s and, as noted, in times of moderate two-digit inflation. In short, IT has been instrumental in bringing inflation rates to one-digit levels, but once there, its benefits are more difficult to identify.

Supply shocks unrelated to domestic demand are usually transitory and, for this reason, partially dismissed under the IT framework by targeting an adjusted core price index less sensitive to supply swings. However, IT is not prepared to address persistent shocks, such as the increase in international food and energy prices throughout the early s until mid, particularly in developing economies where, because of a lack of central bank credibility, the target was set against the more sensitive but transparent headline inflation, where central banks were forced into a tightening interest rate cycle, even in a context of a cooling economy.

Conversely, the deepening of the financial crisis in late and the ensuing collapse of commodity prices and downbeat growth outlook led central banks to switch back to monetary easing, even before inflation came within the target band, in many cases intervening heavily in the foreign exchange to contain the currency and attenuate the pass-through to prices. This, followed by another upward wave of commodity prices and concerns about spillovers from monetary easing in the advanced economies, has, in the late s, caused a partial reappraisal of FIT as a paradigm for the developing world and, in particular, a partial comeback of active ERP aimed at reducing excess exchange rate swings.

Prudential issues certainly play an indirect role in the mercantilist view of intervention: The decline of financial dollarization in the s relaxed the balance sheet concerns behind the fear of floating, recovering the expansionary benefits of a depreciated currency.

That notwithstanding, to the extent that currency wars in which countries attempt beggar-thy-neighbor competitive depreciations are hard to sustain in globally integrated markets, the mercantilist view seldom applies, typically so to less financially integrated economies.

The first candidate interpretation of the surge in international reserves in developing economies in the s pointed at prudential considerations; specifically, the fear of a dollar liquidity crunch similar to those crutches that caused the emerging market crises in the second half of the s. However, it was argued that in many cases the stock of reserves went beyond what would be justified by self-insurance Summers, ; Rodrik, b and that some additional motivations were missing. More recently, the empirical evidence has favored an alternative prudential motive, which explains foreign exchange intervention as an exchange rate rather than a reserve policy objective.

In that sense, intervention could be justified as a tool to smooth out excessive exchange rate volatility without having any specific target level, a view that transpires from the actual intervention narratives of central banks Bank of International Settlements, , Leaning-against-the-wind exchange rate policies ERP are commonly associated with intervention through purchases and sales of foreign exchange whereby the public sector the central bank or the treasury takes the opposite side of private investors willing to invest in local currency-denominated assets, to stabilize the clearing price.

But the central bank does not need to be alone in this effort, since a similar effect could be achieved through balance sheet operations by the treasury by issuing local currency debt to cancel or buy back dollar debt or by investing public external or fiscal surpluses as in the case of sovereign wealth funds in foreign assets. Quantifying this effect is not simple, as it entails not only a good account of other factors that may be pressing on both the exchange rate and the level of reserves, but also accurate measures of intervention and currency strength.

The marginal cost of carrying reserves is proportional to the marginal cost of the debt that implicitly funds them or, alternatively, that could be cancelled with the reserves , the net of the returns obtained on reserves. Depending on whether the debt issued is in foreign or local currency, this cost is either proportional to the sovereign debt risk premium the spread paid by a country on its dollar debt in excess of a U. These costs have been declining or were never that high to start with.

Relative Purchasing Power Parity (RPPP)

Sovereign risk premiums in developing economies have come down significantly in the s. In addition, reserve carrying costs need to be netted against the benign effect of holding reserves on credit ratings and sovereign spreads Levy Yeyati, and could be further reduced by investing reserves in liquid but higher-yielding long-run saving instruments. But, to the extent that intervention simply delays the transition to an appreciated exchange rate hence, the appreciation expectations , it may lead to a valuation loss i.

It follows that if intervention pursues a mercantilist objective, with appreciation pressures reflecting a more permanent fundamental change, reserve purchases may end up being costly once the exchange rate reaches its new, more appreciated equilibrium. By contrast, if appreciation pressures are a transitory phenomenon due, for example, to cyclical inflows or a transitory run on the currency, the reversion of the exchange rate to its earlier, more depreciated level may eliminate valuation losses and much of the leaning-against-the-wind intervention cost.

The fact that equilibrium exchange rates are in practice so difficult to assess—and, as a result, often assumed to be random walks—makes the evaluation of long-term intervention costs rather difficult to pin down ex ante. A number of lessons can be drawn from the discussion in this article. The first thing to note is that the exchange rate policies ERP debate is far from closed. This is a natural consequence of the fact that the pros and cons of alternative ERP and actual policy choices evolve both with country characteristics and the global context. Exchange rate anchors that were popular in the developing world in the context of high inertial inflation and partial dollar indexation lost their edge when central banks won the inflation battle and pass-through coefficients declined—coincidentally, at a time when financial integration rendered pegged regimes more vulnerable to self-inflicted crises or self-fulfilling attacks.

However, the recent process of external deleveraging and de-dollarization in the developing world, by reducing currency imbalances, increased the scope to use flexible exchange rates as shock absorbers and, by eliminating the need to defend a parity in times of distress, enhanced the scope for countercyclical monetary policy. The fact that most medium and large developing economies and virtually all industrial ones reveal a preference for exchange rate flexibility simply reflects this evolution. However, pegs still represent more than half of the IMF reporting countries—particularly, small ones—indicating that exchange rate anchors are still favored by small open economies that give priority to the trade dividend of stable exchange rates and find the conduct of an autonomous monetary policy too costly, due to lack of human capital, scale, or an important non-tradable sector.

Is the combination of inflation targeting IT and countercyclical exchange rate intervention a new IT 2. While it is still too early to judge, the historical perspective highlights a number of recent developments in the way advanced and emerging economies think of the impossible trinity, which, in a context of deepening financial integration, has become a dilemma between nominal and real stability, for which IT 2.

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    In the short period, both capital flows and payments on the current account play a role. In the long period, the capital account and the current account are individually in equilibrium. In the very long period, purchasing power parity holds. Cash-in-advance models are dealt with separately. Many models that purport to explain exchange rates do in fact not provide for the exchange of currencies.

    No model stands up satisfactorily to econometric testing. This aside, the fundamental assumption of rational expectations itself is suspect. Unable to display preview. Download preview PDF. Skip to main content. Advertisement Hide. Authors Authors and affiliations H. This process is experimental and the keywords may be updated as the learning algorithm improves. This is a preview of subscription content, log in to check access. Adler, M. Google Scholar. Aivazian, V. Callen, I.

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    Salin ed. Genberg, H. Gerlach, S. Grubel, H. Reprinted in: J. Dunning ed. Hallwood, P. Heitger, B.

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