Real Exchange Rate Adjustment Research Articles

Foreign Capital Inflows and Macroeconomic indicators: Are Developing Economies in the Trap of the Dutch Disease Hypothesis?

The Dutch disease phenomenon has been related to foreign inflows into emerging economies in particular, including foreign aid, migrant’s remittances, and foreign direct investment. A surge in these inflows is expected to yield a rise in the real exchange rate. Recipient countries have seen a decline in industry as a result of the rise in the non-marketable sector and the slump in the marketable sector. This study empirically investigates the mechanisms of real exchange rate adjustments to migrant remittances, ODA, and FDI toward emerging economies. For the analysis covering the years 2001–2020, dynamic panel data approaches, difference GMM and system GMM, are used to investigate the incidence of Dutch Disease in 84 emerging economies. Numerous econometric studies have shown that Dutch Disease does exist in emerging economies. The Dutch Disease theory is supported by an expanded study that has included the empirical analysis of both industrial (marketable) and service (nonmarketable) sectors.

Monetary policy transparency and real exchange rate adjustment

AbstractWe study the effect of different attributes of monetary policy transparency on real exchange rate adjustment by estimating the half‐life of the real exchange rate. After controlling for sample‐selection bias, results from the panel error‐correction model suggest that the economic aspect of transparency facilitates real exchange rate adjustment in non‐industrial countries. The driving force behind this finding is that economic transparency enhances nominal exchange rate adjustment. However, none of the different attributes of monetary policy transparency significantly affect real exchange rate adjustment in industrial countries. Failure to control for sample‐selection bias over‐rejects the null hypothesis.

RETRACTED: Foreign inflows, commercial law, and dutch disease: Evidence from developing economies

It is commonly believed that developing markets require inflows of foreign capital to achieve their growth targets; however, recent research has shown that these inflows are either ineffective or even harmful to the economy. A surge in foreign inflows, such as foreign aid, remittances, and foreign direct investment, into developing markets, particularly, have been connected to the Dutch disease hypothesis. A sharp rise in such inflows will stimulate real exchange rate in receiving nations due to the uptick in the non-tradable sector and the downturn in the tradable sector. The purpose of this research is to investigate, using quantitative approaches, the variations of real exchange rate adjustments that occur in response to official development assistance, foreign direct investments, and international remittances flowing into developing markets. To investigate the onset of Dutch Disease over the period 2001–2020, this analysis makes use of panel data estimation techniques in the form of fixed and random effect models The findings of a substantial amount of econometric investigation revealed that Dutch Disease is present in developing countries. The scope of the study has been broadened to include an investigation of the expansion of both tradable and non-tradable industries. According to the findings of this study, larger inflows of foreign capital slow growth in the tradable sector (the industrial sector), while simultaneously boosting growth in the non-tradable sector (Service sector).

Exchange rate flexibility, the real exchange rate, and adjustment to terms‐of‐trade shocks

AbstractWe study the impact of exogenous terms‐of‐trade shocks in a large sample of small open economies. Using a panel vector autoregression, we estimate the response of domestic variables including the exchange rate, output, exports, imports, and domestic demand, allowing impulse responses to vary according to the de facto exchange rate regime. We find strong evidence that flexible exchange rate regimes play a shock‐absorbing role by reducing the response of output to terms‐of‐trade shocks. Results show that flexible regimes see a stronger response of the real exchange rate and faster external adjustment, suggestive of a mechanism that switches expenditure from imported to domestically‐produced goods.

A MARKOV SWITCHING VECM MODEL FOR RUSSIAN REAL GDP, REAL EXCHANGE RATE AND OIL PRICES

This paper considers an application of the Markov switching vector error correction model to the analysis of the long-run and the short-run dependence of Russian real GDP and real exchange on oil prices. An algorithm for estimation of the model with a priori information on a state of hidden Markov chain in some periods of time is provided. It is shown that for the period of 1999–2018 two different regimes are well defined: with a slow adjustment of real exchange rate and a sharp reaction of GDP in response to oil price shock and with a fast adjustment of real exchange rate and a slow adjustment of GDP in response to shock. We have concluded that floating ruble exchange rate is a natural stabilizer of the Russian economic activity.Keywords: Russian economy, GDP, real exchange rate, oil prices, error correction model, Markov switching model.JEL Classifications: С22, C51, E52, F31, F41DOI: https://doi.org/10.32479/ijeep.10667

TESTING PURCHASING POWER PARITY IN SOME EMERGING ECONOMIES IN THE LONG-RUN

ABSTRACT In this paper, we examine the long-run purchasing power parity (PPP) by testing for a unit root in real exchange rates between the US and 14 emerging economies from 1st January 1990 to 31st December 2018. The main objective of this paper is to investigate the real exchange rate adjustment for these emerging economies using both standards linear and nonlinear of exponential smooth transition autoregressive (ESTAR) model. Specifically, the objective is to estimate the PPP adjustment toward long-run equilibrium. The research also aims to model long-run validity of PPP hypothesis using bivariate vector error correction models which we can do with our data. The speed of adjustment is better captured that way as it a bivariate approach. The results seem to suggest that both linear and nonlinear unit root tests fail to reject the null hypothesis of the exchange rates for these emerging economies. One key policy implementation is that the validity of using PPP to decide the equilibrium exchange rate for these 8 countries. Moreover, our vector error correction model seems to suggest that most of the countries do not support PPP. Keywords unit root test; real exchange rates; panel data; non-stationary; Johansen cointegration test, vector error correction model

A nonlinear adjustment in real exchange rates under transaction costs hypothesis in developed and emerging countries

This paper tries to empirically examine the exchange rate deviations to its level under the purchasing power parity (PPP) and transaction costs hypotheses using a battery of newly developed nonlinear approaches. To explain the persistent differences in exchange rates,we use the half-life function analysis with quarterly data over the period 1988Q1–2018Q2 for a panel of 23 developed and emerging countries. Our results show that some deviations to PPP relation may be governed by non-linear dynamics. The adjustment toward the fundamental equilibrium seems to depend on the size and the sign of the gap from the PPP equilibrium. The foreign exchange rate adjustment can be modeled by symmetric process with the ESTAR model and asymmetric process with LSTAR model.

Real Effective Exchange Rate and Trade Balance Adjustment

There is an ongoing debate in the literature on whether global trade flows have become disconnected from the large real effective exchange rate movements in the wake of the global financial crisis. The question has important policy implications for the role of exchange rates in supporting growth and restoring external balance. In this paper, we use Turkey---a large and open emerging market economy that has experienced sizable swings of the real effective exchange rate---as a case study to test competing hypotheses. Our results lend support to the finding in existing cross-country studies that the real effective exchange rate remains an important determinant of trade flows. But, its effect is not symmetric in secular periods of appreciation and depreciation and is, oftentimes, dwarfed by the impact on trade flows of the income growth differential between trade partners.

International business cycles and financial frictions

In this study, I build a two-country DSGE model to investigate the impact of financial integration on business cycle co-movements with financial frictions. In this model, the investor can borrow but faces a collateral constraint that is tied to the value of her capital and real estate holdings. I show quantitatively that the degree of financial integration and real exchange rate adjustment are important for understanding business cycle synchronization under different types of shocks. With the technology shock, greater financial integration leads to lower cross-country correlations, while with the financial shock, greater financial integration leads to stronger cross-country correlations. These findings are consistent with the empirical evidence from the literature.

Real Effective Exchange Rate and Trade Balance Adjustment: The Case of Turkey

There is an ongoing debate in the literature on whether global trade flows have become disconnected from the large real effective exchange rate movements in the wake of the global financial crisis. The question has important policy implications for the role of exchange rates in supporting growth and restoring external balance. In this paper, we use Turkey---a large and open emerging market economy that has experienced sizable swings of the real effective exchange rate---as a case study to test competing hypotheses. Our results lend support to the finding in existing cross-country studies that the real effective exchange rate remains an important determinant of trade flows. But, its effect is not symmetric in secular periods of appreciation and depreciation and is, oftentimes, dwarfed by the impact on trade flows of the income growth differential between trade partners.

Global Commodity and Oil Price Movements, Macroeconomic Performance and Challenges for an Emerging Economy: The Indian Experience

Commodity and oil price fluctuations have significant bearing on domestic macroeconomic performance and macroeconomic policymaking of an emerging economy. The article explores the impact of non-energy commodity and oil price fluctuations on output, inflation and real exchange rate (RER) in India; and commodity and oil constituting sizeable imports. The empirical analysis carried out through vector error correction model (VECM) for the post-liberalization period 1991–2014 clearly points out that commodity and oil price shocks have a significant impact on the variation in output and prices accounting for RER adjustment and the role of a developed financial market (private credit). The RER adjusts to commodity and oil price shocks, accounting for foreign exchange reserves and financial markets (private credit). The impulse response functions indicate that one standard deviation shock in commodity and oil price persists for three to eight quarters over domestic prices and output. While these results point to lessening of commodity and oil imports through a series of medium and long-term structural-cum-policy reform measures, in the immediate, they also lend a role of intervention by monetary authority (central bank) in pursuit of inflation targeting. Conjointly, pursuance of countercyclical fiscal policy to stabilize domestic output and prices in short run are called for.

DOES THE LAUNCH OF THE EURO HINDER THE CURRENT ACCOUNT ADJUSTMENT OF THE EUROZONE?

This paper examines current account adjustments before and after the launch of the euro. Applying a dynamic panel model, we provide robust evidence to support that the adoption of the euro facilitates rather than hinders the adjustment of current accounts. This finding agrees with our results that the use of the euro assists real exchange rate and inflation rate adjustments. We also find that the independence of exchange rate regimes from current account, real exchange rate and inflation rate adjustments is observed when standard panel estimation methods are applied and when time‐varying smooth shifts in mean are not controlled. (JEL C33, F32, F41)

“Conditional PPP” and real exchange rate convergence in the euro area

While economic theory highlights the usefulness of flexible exchange rates in promoting adjustment in international relative prices, flexible exchange rates also can be a source of destabilizing shocks. We find that when countries joining the euro currency union abandoned their national exchange rates, the adjustment of real exchange rates toward their long-run equilibrium surprisingly became faster. To investigate, we distinguish between differing rates of purchasing power parity (PPP) convergence conditional on alternative shocks, which we refer to as “conditional PPP.” We find that the loss of the exchange rate as an adjustment mechanism after the introduction of the euro was more than compensated by the elimination of the exchange rate as a source of shocks, in combination with faster adjustment in national prices. These findings support claims that flexible exchange rates are not necessary to promote long-run international relative price adjustment.

Internal Devaluation in Currency Unions: The Role of Trade Costs and Taxes

This paper studies export adjustment to negative shocks in currency unions. I consider the hitherto ignored role of trade costs and taxes in internal devaluations, which have been brought to the fore of international policy during the recent euro periphery crisis. Trade costs can limit the pass-through of internal devaluation on export prices. Using data on export prices ”on the dock”, I document that higher trade costs are associated with a lower reduction of export prices relative to domestic prices in the euro periphery. Furthermore, VAT (in theory trade neutral, but in practice much higher on tradables) hikes prevent the required shift of resources towards tradables. I show that the real exchange rate (RER) adjustment was heavily affected by indirect tax hikes, by comparing headline RER and tax-adjusted RER. I then build a standard New Keynesian small open economy model with sticky wages and prices, incorporating trade costs and indirect taxes (allowing for VAT imperfections), and show that both these frictions, but especially trade costs, can be quantitatively crucial in affecting export growth, more so than either product markups or wage rigidity. I apply the model to data for Greece, the least successful of the euro periphery fiscal devaluation programs, and show that it can account for the most salient features of the data; trade costs explain the failure to substantially raise exports, and taxes the initial small fall in exports. JEL Classification: F32, F33, F41, F45

Internal Devaluation in Currency Unions: The Role of Trade Costs and Taxes

This paper studies export adjustment to negative shocks in currency unions. I consider the hitherto ignored role of trade costs and taxes in internal devaluations, which have been brought to the fore of international policy during the recent euro periphery crisis. Trade costs can limit the pass-through of internal devaluation export prices. Using data export prices on the dock, I document that higher trade costs are associated with a lower reduction of export prices relative to domestic prices in the euro periphery. Furthermore, VAT (in theory trade neutral, but in practice much higher tradables) hikes prevent the required shift of resources towards tradables. I show that the real exchange rate (RER) adjustment was heavily affected by indirect tax hikes, by comparing headline RER and tax-adjusted RER. I then build a standard New Keynesian small open economy model with sticky wages and prices, incorporating trade costs and indirect taxes (allowing for VAT imperfections), and show that both these frictions, but especially trade costs, can be quantitatively crucial in affecting export growth, more so than either product markups or wage rigidity. I apply the model to data for Greece, the least successful of the euro periphery fiscal devaluation programs, and show that it can account for the most salient features of the data; trade costs explain the failure to substantially raise exports, and taxes the initial small fall in exports.

TAYLOR RULE REACTION COEFFICIENTS AND REAL EXCHANGE RATE PERSISTENCE

ABSTRACTRecent literature has established a link between the persistence of real exchange rates and the degree of inertia in Taylor rule monetary policy reactions functions. This paper provides a different view on this link by investigating how the size of Taylor rule reaction coefficients impacts the adjustment dynamics of the real exchange rate. Within a stylized sticky‐price open‐economy macro model, it is demonstrated that a stronger interest rate reaction to inflation in the Taylor rule raises the convergence speed of the real exchange rate. Conversely, raising the coefficient on the output gap or attending to the exchange rate in an open‐economy version of the Taylor rule slows down real exchange rate adjustment. In all cases, more rapid convergence comes at the cost of stronger initial real exchange rate misalignments in the wake of monetary policy shocks.

“Conditional PPP” and Real Exchange Rate Convergence in the Euro Area

While economic theory highlights the usefulness of flexible exchange rates in promoting adjustment in international relative prices, flexible exchange rates also can be a source of destabilizing shocks. We find that when countries joining the euro currency union abandoned their national exchange rates, the adjustment of real exchange rates toward purchasing power parity (PPP) became faster. To disentangle the possible causes for this finding we develop a novel methodology for conducting counterfactual simulations of an estimated VECM that distinguishes between the roles of the nominal exchange rate as an adjustment mechanism and as a source of shocks. We find evidence that prior to joining the euro currency union, member countries relied upon exchange rate adjustments as a mechanism to correct for PPP deviations arising from divergent domestic inflation rates. But the loss of the exchange rate as an adjustment mechanism after the introduction of the euro was more than compensated by the elimination of the exchange rate as a source of shocks, in combination with faster adjustment in national price indices. These findings support claims that flexible exchange rates are not necessary to promote long-run international relative price adjustment.

Debt thresholds and real exchange rates: An emerging markets perspective

In this paper we empirically analyze nonlinearities in short-run real exchange rate dynamics. Our findings suggest that real exchange rate misalignments are considerably less persistent and more volatile during times of high debt. Assessing the variance of changes in misalignments, we retrieve evidence indicating that the nominal exchange rate and inflation differentials are more important determinants in states of high debt than in states of low debt. Overall, our results imply that nonlinearities have non-negligible implications for the mechanics of real exchange rate adjustment in emerging markets.

Is fiscal devaluation welfare enhancing?

Due to the experience of large external imbalances and misaligned real exchange rates within the euro area, the concept of fiscal devaluation has gained increasing attention, which mimics the effects of external devaluation in the absence of flexible nominal exchange rates and an independent monetary policy. This paper uses a small open economy model with nominal wage and price rigidities to analyse the welfare effects of fiscal devaluation, understood as budgetary-neutral tax shift from employers' social security contributions towards consumption tax. The paper finds that fiscal devaluation can support external rebalancing by accelerating real exchange rate adjustments and regaining price competitiveness. From a household welfare perspective, internal devaluation with its concomitant worsening of the terms of trade tends to induce welfare losses. The overall welfare effects are pro-cyclical in the sense that the stronger the tax shift, the higher the welfare losses for the average household. The losses increase with the openness of the economy and the relative size of the tradable sector. In the presence of supply shocks, however, fiscal devaluation can imply small welfare gains. A scenario with flexible nominal exchange rates and autonomous monetary policy performs better in terms of household welfare, but implies stronger external fluctuations in the short run.

Macroeconomic effects of terms of trade fluctuations in commodity exporting advanced economies

ABSTRACTThe paper examines the impact of world commodity prices on national output and trade balances in Australia, Canada, New Zealand, and Norway, OECD economies that, unlike other advanced economies, are heavily dependent on commodity exports. Contrary to Dutch disease theory based on real exchange rate adjustment, it highlights the relative price effects of terms of trade (ToT) changes on gross domestic product and net exports with reference to the experience of this unique set of OECD countries. The econometric analysis verifies key predictions of this alternative perspective that ToT fluctuations should (i) have no significant short-run impact on GDP and that (ii) due to relative price effects a strong positive relationship between the ToT and net exports is unlikely.