Economic adjustment and exchange rates in developing countries


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Prudent Monetary and Fiscal Policies

Dow nload this expert co mment in PDF or continue reading online. In contrast, my argument in this paper is that in the short term, it is better to manage external shocks to the capital account and the current account through changes in foreign exchange reserves, either through full sterilisation — neutralising change in the money supply by selling or buying government bonds — or through fiscal sterilisation, i.

In this case there would be no shocks to the money supply, inflation, or the RER, so economic agents are not disoriented by additional volatility.

Imports, Exports, and Exchange Rates: Crash Course Economics #15

It is prudent, however, to avoid decreases in FOREX without sterilisation, which can not only result in a depreciation of the RER, but also in a reduction of output if prices are sticky. In the long term, it is better to under-price the level of the RER than to overvalue it. Firstly, many resource-rich countries suffer from the Dutch disease — an overvaluation of the RER due to high revenues from resource exports, so special efforts are needed to avoid overvaluation. Secondly, the undervaluation of the real exchange rate is a de facto industrial policy that promotes export-oriented development and growth.

Or imagine that the shock is negative: there is a deterioration in the current account and an outflow of capital. There are several options to cope with these shocks, which I discuss in detail below and summarise briefly in table 1. Private international capital flows are volatile and do not fully mitigate terms-of-trade fluctuations. Even more so, they seem to be pro-cyclical, rather than countercyclical: when terms of trade deteriorate, capital flees the country instead of coming in.

The empirical evidence suggests that this is true for most countries. So, in fact, private capital flows add insult to injury and reinforce terms-of-trade shocks. Table 1. It suffices to recall the role of international financial institutions in recent currency crises around the world: in East Asian countries in ; in Russia in ; in Brazil in ; and in Argentina in In all of these cases official capital flows were nowhere near enough to counter the effects of private capital flight. So long as the international financial architecture remains as it is, countries will basically be left to themselves to manage shocks that affect their current and capital accounts.

Capital controls may be efficient in preventing financial and non-financial companies from borrowing abroad, i. The system of capital flow management has to be designed, implemented, and tested, which takes time, so it is better to have it in place before the shock occurs. Usually, it takes time to impose new taxes, so a scheme that could work quickly is an automatic one. For example, in many oil-exporting countries export taxes on oil depend on the global oil price: the higher it is, the higher the export tax.

The disadvantage of these taxes is that they have an impact on the real economy, so the restoration of equilibrium to the balance of payments comes via changes in the real sector. It may well be that these real changes are desirable anyway, so the government could kill two birds with one stone, but in most cases it is good to choose instruments that do not have side effects. It is also important to specify how tax proceeds are to be used. If they are diverted to a stabilisation fund that is invested abroad, like with foreign exchange reserves, the money supply does not increase, so there is no increase in demand and there are no inflationary consequences.

Accumulation of reserves as a reaction to a positive shock to the balance of payments is, however, a self-defeating policy if it is accompanied by sterilisation: sales of government bonds on the open market lead to increase in interest rates, which attracts even more capital from abroad, which leads to even greater accumulation of reserves and the need to sterilise these increases via more open-market operations, etc. If the shock is negative, reserves in most countries are barely enough to withstand several months of deterioration in the terms of trade and several weeks of capital outflows.

Fear of floating - Wikipedia

Among major resource exporters only Norway — an oil exporter — and Botswana — a diamond exporter — may have enough money in FOREX and stabilisation funds, i. Putting aside a portion of GDP into FOREX and stabilisation funds is costly, especially when this money is invested in short-term, low-risk, and hence low-yield securities abroad. This is precisely the reason why the policy of building up FOREX and stabilisation funds faces heavy criticism at home in many countries.

Why not use this money for improvements healthcare and education, for helping the poor, or for investment in ailing infrastructure, etc. The counter-argument, however, is no less powerful: if no cushion exists in the form of FOREX and stabilisation funds, the only way to cope with a negative trade shock and the associated outflow of capital is to devalue the real exchange rate, either through a nominal devaluation or through so-called internal devaluation, a relative decrease in domestic prices and wages.

The breakdown of the covered interest rate parity condition

When resource prices fall and capital flees, the deteriorating balance of payments can only be remedied by a nominal exchange rate devaluation, in the case of a floating exchange rate, or, in case of a fixed rate, by a slowdown of growth in the money supply; due to reduction of FOREX that is not sterilised; if it was sterilised, the money supply would not contract and the balance of payments will not return to equilibrium, so FOREX would eventually be depleted Popov, b. The advantage of a stabilisation fund is that shocks to the balance of payments are absorbed partially or completely by fluctuations in the size of the fund without any impact on the real economy, as money is invested in abroad in foreign currency.

In many countries, however, stabilisation fund that were initially designed to cope with temporary shocks accumulated substantial resources of a permanent or at least very long-term nature. This meant that after the funds had absorbed fluctuations in foreign exchange revenues and expenditure and thus fulfilled their role in cushioning and eliminating external shocks, another problem emerged: how to use the resources for the purposes of national development.

Some countries, like Russia, have created two funds — for the longer term perspective and for the medium term perspective — that are invested in financial instruments with different risks and returns. Other countries, like Chile, established rules that required repayment of national debt after export prices and fund resources accumulated to a certain threshold.


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In any case, in coping with their primary goal — mitigation of external shocks to the balance of payments — stabilisation funds are fairly successful all over the world. But if there is no sterilisation of the change in FOREX under fixed exchange rates, there is an automatic mechanism at work to correct the disequilibrium in the balance of payments.

The reduction of foreign exchange reserves leads to the reduction in the money supply: this will drive domestic prices down and stimulate exports, raise interest rates, and stimulate the inflow of capital, which will finally correct the balance of payments. Because national prices are less flexible than exchange rates, this type of adjustment, when compared to a nominal exchange rate change, is associated with a greater reduction in output. The empirical evidence from Eastern European countries and other transition economies for the —99 period — an outflow of capital after the Asian crisis and the Russian currency crisis and a slowdown of output growth rates — suggests that the second type of policy response — devaluation — was associated with a smaller loss of output than the first type — monetary contraction.

The —09 developments provide additional evidence for this hypothesis Popov, a.


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In a sense, the downsides of this type of adjustment match all the disadvantages of fixed exchange rates. In the long term, it cannot maintain inflation rates that differ from its major trading partners. In the short term, it does not have appropriate instruments to react to asymmetric shocks. Like in the previous case, the result is a real devaluation of the national currency, i.

This mechanism implies that export and import volumes change in response to changes in the RER, hence the real sector of the economy also responds, as seen in output changes. Suppose oil prices fall and the national currency of the oil-exporting country is devalued to keep the balance of payments in equilibrium.


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For oil producers, the positive impact of devaluation neutralises the negative impact of falling oil prices, but for other producers of tradable goods — machinery, for instance — real devaluation means higher prices and profits, so there is a reallocation of resources — capital and labour — from oil to the machinery sector. The problem is that this reallocation is temporary because after a while, oil prices will rise and resources should flow in the opposite direction.

Inasmuch as oil prices fluctuate around the trend, it does not make sense to change the structure of the economy in response to their fluctuations; this is just too costly. To word it differently, the real exchange rate should be as stable as possible; if it fluctuates a lot, this is a definite sign of bad policy that misleads economic agents. The real exchange rate RER is the nominal exchange rate adjusted for the ratio of prices between two countries.

To give an example, the real exchange rate of the US Dollar in terms of the Chinese Yuan is the nominal rate 6 yuan per dollar multiplied by the ratio of US prices to Chinese prices. When the US price of a particular good is multiplied by the nominal rate of the Dollar in Yuan 6 yuan per dollar , we get the price of American good in Yuan.

When we divide this latter value by the price of the same good in the Chinese market, we get the ratio of prices between the two countries. Normally, the RER is computed for a basket of goods — with weights that coincide with the share of these goods in GDP — of one country or another, or the geometric average of weights in two countries.

Introduction to "Economic Adjustment and Exchange Rates in Developing Countries"

The ratio of US prices to Chinese prices is about 1. This is usually explained by the Balassa-Samuelson effect, which I discuss later. The RER is very important because it determines competitiveness: if prices in country A, expressed in US dollars, are lower or getting lower than prices in country B, then exports from A to B are likely to increase, whereas imports from B to A are likely to fall.

The decline in the RER and the rise in competitiveness may result from devaluation — i. In macroeconomic textbooks, the RER is usually seen as endogenous, i. For example, if the country devalues its national currency via the nominal exchange rate, there will be an increase in export revenues and a reduction in imports, an inflow of foreign investment and hence an improvement in the balance of payments. If the exchange rate is floating, it will rise back to its initial value before devaluation. If the exchange rate is fixed and there is no sterilisation, the increase in foreign exchange reserves will cause the money supply to expand, which in turn will contribute to higher prices of national goods, i.

If monetary authorities pursue a sterilisation policy — i.

Exchange Rates

A sterilisation policy is hence considered self-defeating under conditions of free movement of capital. However, capital mobility is never perfect; some countries exercise controls over capital movements, and the size of foreign exchange reserves varies greatly across countries, even after controlling for objective determinants such as the size and volatility of foreign trade and the size of foreign debt Polterovich and Popov, This means that many countries pursue policies that influence their RER.

An excess accumulation of FOREX creates additional demand for foreign currency and an additional supply of domestic currency, so that with a sterilisation policy, the RER depreciates, thus deviating from equilibrium value.

Economic adjustment and exchange rates in developing countries Economic adjustment and exchange rates in developing countries
Economic adjustment and exchange rates in developing countries Economic adjustment and exchange rates in developing countries
Economic adjustment and exchange rates in developing countries Economic adjustment and exchange rates in developing countries
Economic adjustment and exchange rates in developing countries Economic adjustment and exchange rates in developing countries
Economic adjustment and exchange rates in developing countries Economic adjustment and exchange rates in developing countries
Economic adjustment and exchange rates in developing countries Economic adjustment and exchange rates in developing countries
Economic adjustment and exchange rates in developing countries Economic adjustment and exchange rates in developing countries

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