Real Exchange Rate Depreciation Research Articles

The Exchange Rate in a Dynamic-Optimizing Business Cycle Model
 with Nominal Rigidities: A Quantitative Investigation

This paper studies a quantitative dynamic-optimizing business cycle model of a small open economy with staggered price and wage setting. The model exhibits exchange rate overshooting in response to money supply shocks. Predicted standard deviations of the nominal and, particularly of the real exchange rate are noticeably higher - and closer to the data - than in standard RBC models with flexible prices and wages. The nominal rigidities structure captures 40% to 50% of the historical standard deviations of nominal and real exchange rates of Japan, Germany and the UK vis-a-vis the U.S. during the post-BW era. It also generates improved predictions for other business cycle statistics: the predicted correlation between the nominal and the real exchange rate is markedly higher (and closer to the data) than when flexible prices and wages are assumed. In addition, the structure captures more closely the historical variability of GDP, consumption, and the nominal interest rate. The model predicts that a positive domestic money supply shock lowers the domestic interest rate, raises GDP, and triggers a depreciation of both the nominal and real exchange rate. Increases in domestic productivity and in the world interest rate are also predicted to induce a nominal and real exchange rate depreciation.

Current Account Adjustment in Industrialized Countries

This paper examines the dynamics of current account adjustment among industrialized countries. We identify twenty-five episodes in which a large sustained improvement in the current account occurred between 1980 and 1997. We find that a typical current account reversal begins when the current account deficit is about 5 percent of GDP, that it is associated with slowing income growth and a 10-20 percent real exchange rate depreciation. Real export growth, declining investment, and an eventual leveling off in both the net international investment position and the budget deficit-GDP ratio are also likely to be part of the adjustment. These results suggest that current account reversals in industrialized countries are largely a function of the business cycle.

Indonesia's Non-Oil Export Performance During the Economic Crisis: Distinguishing Price Trends from Quantity Trends

Despite an enormous currency depreciation, the growth rate of Indonesia's non-oil exports, measured in dollars, did not accelerate during the first two years of the Asian crisis. In fact, during the second year of the crisis non-oil export value dropped sharply. This paper demonstrates that the main reason for the decline in the dollar value of non-oil exports was a collapse of export prices. Non-oil export dollar prices fell 26% between the second quarter of 1997 and the second quarter of 1999. Measured at constant prices, non-oil exports grew 24% and manufactured exports 31% during this period. Non-oil import prices fell by roughly the same amount as non-oil export prices during the crisis, with little change in the non-oil terms of trade. The decline in the price of traded goods significantly reduced the magnitude of the real exchange rate depreciation experienced by Indonesia.

Fulfilment of purchasing power parity conditions in Africa: the differential role of CFA and non-CFA membership

The paper reports empirical evidence on the fulfilment or otherwise of purchasing power parity (PPP) conditions in African countries, based on the popular augmented Dickey-Fuller test methodology that is used to identify whether the nominal exchange rate and price levels are co-integrated. The empirical analysis is based on quarterly data for the 1980(I)-1991(IV) period for 35 African countries and our finding is that the PPP conditions are met in 17 countries that are almost exclusively non-CFA zone members but are not met in the remaining 18 countries comprising nine non-CFA and nine CFA zone members. Given this lopsidedness in the distribution of countries where the conditions are met or not met between the two zones, it is inferred that certain macroeconomic features common to the CFA zone members but which are generally less pronounced in other countries might have been responsible for this finding. A number of such features relating to the extent of monetary growth, inflation rates, rate of depreciation of real and nominal exchange rates, domestic price variability, nominal exchange rate variability and the type of exchange rate system being operated were related to the tendency for PPP to be fulfilled across countries. But, while the direction of their observed effects are generally as expected, the effects do not exhibit statistical significance.

Capital flows and real exchange rate fluctuations following Spain's entry into the European Community

Spain's 1986 entry into the European Community was followed by a dismantling of restrictions on international capital flows. Initial trade deficits and real exchange rate appreciation were followed by trade surpluses and real exchange rate depreciation. This paper analyzes Spain's financial liberalization using a dynamic general equilibrium model with a traded and nontraded good where a capital poor country opens itself to its capital rich neighbors. A carefully calibrated model has trouble accounting for the large changes in relative prices observed given the small changes in quantities. Variants of the model with frictions in factor mobility between sectors fare better.

Liquidity Crises in Emerging Markets: Theory and Policy

We build a model of financial sector illiquidity in an open economy. Illiquidity defined as a situation in which a country's consolidated financial system has potential short-term obligations in foreign currency that exceed the amount of foreign currency it can have access to on short notice can be associated with self fulfilling bank and/or currency crises. We focus on the policy implications of the model, and study the role of capital inflows and the maturity of external debt, the way in which real exchange rate depreciation can transmit and magnify the effects of bank illiquidity, options for financial regulation, the role of debt and deficits, and the implications of adopting different exchange rate regimes.

The effects of real exchange rate depreciation on stochastic producer prices in low‐income agriculture

AbstractThis paper considers the effects of real exchange rate depreciation on stochastic agricultural producer prices in low‐income agriculture. Conventional wisdom, that real depreciation achieved through nominal currency devaluation stimulates tradables production, does not universally hold in the presence of stochastic prices. In fact, real depreciation is only stimulative in two cases–importables that remain importable and nontradables that become exportable. GARCH estimation of time‐series price data on several commodities from Madagascar support the hypotheses generated by the analytical model.

The effects of real exchange rate depreciation on stochastic producer prices in low-income agriculture

Abstract This paper considers the effects of real exchange rate depreciation on stochastic agricultural producer prices in low-income agriculture. Conventional wisdom, that real depreciation achieved through nominal currency devaluation stimulates tradables production, does not universally hold in the presence of stochastic prices. In fact, real depreciation is only stimulative in two cases – importables that remain importable and nontradables that become exportable. GARCH estimation of time-series price data on several commodities from Madagascar support the hypotheses generated by the analytical model.

Economic openness, trade restrictions and external shocks: modelling short run effects in Sub-Saharan Africa

The trade restrictions imposed by most sub-Saharan Africa countries have clearly reduced the openness of their economies. However, it is not clear that this protectionism has reduced the impact of external shocks. Instead, the type of restrictions chosen, import rationing, has introduced new transmission channels for external shocks. A dependent-economy model is developed to compare export price shocks with and without import rationing, and the type of trade regime is shown to have quantitative importance in a CGE-model of Zimbabwe. The economies are shown to be more vulnerable to external shocks under import rationing than with trade liberalization, and real exchange rate depreciation can go hand in hand with a positive external shock contrary to the `Dutch disease' story. The outcome is a result of a resource-expansion effect: a higher export price stimulates growth by improving the import capacity in a situation of rationing and unemployment.

The Exchange Rate in a Dynamic-Optimizing Current Account Model with Nominal Rigidities: A Quantitative Investigation

This paper studies dynamic-optimizing model of a semi-small open economy with sticky nominal prices and wages. The model exhibits exchange rate overshooting in response to money supply shocks. The predicted variability of nominal and real exchange rates is roughly consistent with that of G-7 effective exchange rates during the post-Bretton Woods era. The model predicts that a positive domestic money supply shock lowers the domestic nominal interest rate, that it raises output and that it leads to a nominal and real depreciation of the country’s currency. Increases in domestic labor productivity and in the world interest rate too are predicted to induce a nominal and real exchange rate depreciation.

The Exchange Rate in a Dynamic-Optimizing Current Account Model with Nominal Rigidities: A Quantitative Investigation

This paper studies dynamic-optimizing model of a semi-small open economy with sticky nominal prices and wages. The model exhibits exchange rate overshooting in response to money supply shocks. The predicted variability of nominal and real exchange rates is roughly consistent with that of G-7 effective exchange rates during the post-Bretton Woods era. The model predicts that a positive domestic money supply shock lowers the domestic nominal interest rate, that it raises output and that it leads to a nominal and real depreciation of the country’s currency. Increases in domestic labor productivity and in the world interest rate too are predicted to induce a nominal and real exchange rate depreciation.

The cointegrating relationship between productivity, real exchange rates and purchasing power parity

Johansen cointegration and hypotheses tests indicate that a statistically significant cointegrating relationship exists between domestic and foreign productivity differentials and the real exchange rate. Increases in the domestic productivity of traded goods (relative to the domestic productivity of nontraded goods) appreciates the real exchange rate in all six economies. Conversely, increases in the foreign productivity of traded goods causes a real exchange rate depreciation in four of the six economics.

On Credible Disinflation

We study the effects of a credible, gradual exchange rate based disinflation program in a two sector economy. After an initial real exchange rate depreciation, the reductions in the rate of devaluation reduce the monetary wedge generated by a cash in advance constraint, leading to a gradual increase in absorption that yields progressive real exchange rate appreciations and current account deficits. An initial boom in economic activity is not followed by a later contraction, as labor supply expands during the whole length of the program.

Openness and Inflation: Theory and Evidence

Because unanticipated monetary expansion leads to real exchange rate depreciation, and because the harms of real depreciation are greater in more open economies, the benefits of unanticipated expansion are decreasing in the degree of openness. Models in which the absence of precommitment in monetary policy leads to excessive inflation therefore predict lower average inflation in more open economies. This paper tests this prediction using cross-country data. The data show a strong and robust negative link between openness and inflation.

Real and Monetary Causes of Real Exchange Rate Movements in the Pacific Rim

Modem models of exchange rate determination suggest that real shocks can induce changes in the real exchange rate; a real shock which is permanent can induce a permanent deviation from Purchasing Power Parity (PPP). Nominal shocks, on the other hand, can induce temporary but not permanent deviations from PPP. Even if money is not neutral in the short-run, long-run money neutrality guarantees that monetary shocks of any variety have no permanent effects on the long-run value of the real exchange rate. For example, in the well-known Dornbusch [4] overshooting-model, an increase in the money supply initially causes real and nominal exchange rate depreciation. Over time, the real rate converges to its original level and the proportional change in the nominal rate approaches the percentage change in the money supply. To date, the vast majority of tests concerning PPP have been conducted for the U.S., European, and Japanese economies; most of these tests are not supportive of the hypothesis. For example, Corbae and Ouliaris [1] and Enders [5] use unit-root and co-integration tests to reject PPP for this group of nations. However, as shown by Mussa [9] and Enders [6], PPP works quite well for nations experiencing very different rates of inflation. These findings are consistent with the theoretical models of the exchange rate if the industrialized nations experience permanent real shocks while the high inflation nations experience substantial monetary growth. In this light, it is interesting to consider behavior of the real exchange rate for the Pacific Rim nations. These nations-particularly Japan and Korea-represent rapidly growing nations with strong trading ties to the United States and Europe. Comparing of the behavior of the real exchange rate between Japan and Korea (two rapidly growing nations) might provide an interesting contrast to that of Korea versus other Pacific Rim nations and Korea versus the United States.

Adjustment, Investment and the Real Exchange Rate in Developing Countries

LDC adjustment packages Riccardo Faini and Jaime de Melo Developing countries have been hit by a fall in their terms of trade, high real interest rates on their external debt, and a drought in commercial lending from abroad. Their subsequent adjustment packages, often supported by loans from the IMF and World Bank, focused on a sharp real exchange rate depreciation to restore external balance and a host of microeconomic reforms to secure a simultaneous supply-side improvement. This paper examines the success of these ‘adjustment with growth’ packages in a large sample of developing countries. We find these packages have been much more successful in LDCs which export manufactures than they have in those concentrating on primary exports (primarily low-income African countries); the latter have not resumed sustainable growth, and most of their external adjustment has arisen from expenditure reduction, not an increase in supply. The longer-term prospects for manufacturing exporters are also brighter: there we detect signs of increased efficiency and a smaller decline in investment than in primary exporters. But we also find that a high external debt burden and an unstable macroeconomic environment impede investment in all LDCs. In the longer term, adjustment with growth packages will succeed only if they are accompanied by a more stable macroeconomic environment and appropriate debt relief.

The real exchange rate, the capital stock, and fiscal policy

This paper studies the joint determination of aggregate supply, the real exchange rate and the current account in response to changes in government spending, in a model where there is no uncertainty in the aggregate, but where individuals are uncertain about their lives' duration. International capital mobility fixes the steady-state capital stock and aggregate supply in a small country, whereas in a large country the steady-state capital stock is endogenous. An increase in government spending is more likely to generate a real exchange-rate depreciation in a small country, since the loss of wealth associated with cumulated current account deficits does not increase rest-of-the-world spending. In the case of a large country current account deficits are wealth transfers to the rest of the world, and increase foreign spending: thus the normal long-run response is an increase in the relative price of domestic output.

Adjustment with a Fixed Exchange Rate: Cameroon, Côte d'Ivoire, and Senegal

As members of the CFA Franc Zone, Cameroom, Cote d'Ivoire, and Senegal cannot use the nominal exchange rate as a tool of macroeconomic adjustment. This article considers these countries' responses to the commodity and oil price shocks of the 1970s in light of this and other institutional constraints. Using a two sector model, it shows that there exist instruments that, in principle, permit the real exchange rate depreciation necessary for adjusting to macroeconomic imbalances. The authors interpret the very different adjustment experiences of the three countries (despite their common economic structure and institutional setting) in terms of different uses of these instruments. Alternative assumptions about the labour market leave the qualitative nature of the results unaltered. Statistical analysis of data from the three countries confirms the model's linking of the current account and real exchange rate with the instruments of adjustment.

Wage Indexation, Flexible Exchange Rates, and Macro-Economic Policy

After five years of floating exchange rates, the implications of flexible rates for countercyclical macroeconomic policies remain in doubt. Most neoclassical models exchange rate dynamics speak only indirectly to the issue the countercyclical policies, for the models are characterized by downward flexible prices and full employment equilbria. The prescriptions of standard Keynesian models, on the other hand, warrant scepticism. The Mundell-Fleming models, for example, suffects that expansionary monetary policy, by inducing a real exchange-rate depreciation, is effective in raising output in small, underemployed economy. The facts seem otherwise. In Italy, Great Britain, and other OECD countries expansionary monetary policies do not seem to have provided much real economic stimulus. In these countries, nominal money growth and depreciations have been followed by compensating increases in domestic wages and prices. Shifts in the real terms of trade between competitors have been blocked. Thus, the IMF notes "As a consequence of offsetting price and exchange rate developments, the parttern of competitiveness among most of the major industrial countries is not very similar to what it was early in 1973."