Transcript Principles of Economic Growth

Thorvaldur Gylfason
Singapore, February 2008
Outline
1) Real vs. nominal exchange rates
2) Exchange rate policy and welfare
3) The scourge of overvaluation
4) From exchange and trade policies to
economic growth
5) Capital flows
6) Exchange rate regimes
 To float or not to float
Real vs. nominal
exchange rates
Q 
eP
P*
Increase in Q
means real
appreciation
Q = real exchange rate
e = nominal exchange rate
P = price level at home
P* = price level abroad
Real vs. nominal
exchange rates
Q 
eP
P*
Devaluation or
depreciation of e
makes Q also
depreciate unless P
rises so as to leave
Q unchanged
Q = real exchange rate
e = nominal exchange rate
P = price level at home
P* = price level abroad
Three thought
experiments
Q 
eP
P*
1. Suppose e falls
Then more baht per dollar,
so X rises, Z falls
2. Suppose P falls
Then X rises, Z falls
3. Suppose P* rises
Then X rises, Z falls
Summarize all three by supposing Q falls
Then X rises, Z falls
Exchange rate policy and
welfare
Payments for imports of
Real exchange rate
goods, services, and
capital
Imports
Earnings from exports of
goods, services, and
capital
Exports
Foreign exchange
Exchange rate policy and
welfare
Equilibrium between demand and
supply in foreign exchange market
establishes
• Equilibrium real exchange rate
• Equilibrium in the balance of payments
BOP = X + Fx – Z – Fz
=X–Z+F
= current account + capital account
=0
Real exchange rate
Exchange rate policy and
welfare
R
Deficit
Imports
Overvaluation
Exports
Foreign exchange
Price of foreign exchange
Exchange rate policy and
welfare
Overvaluation works
like a price ceiling
Supply (exports)
Overvaluation
Deficit
Demand (imports)
Foreign exchange
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
Inflation and
overvaluation
Inflation can result in an overvaluation
of the national currency
• Remember: Q = eP/P*
Suppose e adjusts to P with a lag
Then Q is directly proportional to
inflation
Numerical example
Inflation and
overvaluation
Real exchange rate
Suppose inflation is
10 percent per year
110
105
100
Average
Time
Inflation and
overvaluation
Real exchange rate
Suppose inflation rises
to 20 percent per year
Hence, increased
inflation increases
the real exchange
rate as long as
the nominal
exchange rate
adjusts with a lag
120
110
Average
100
Time
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
Q – provided inflation is kept under
control
Does devaluation improve the current
account?
The Marshall-Lerner condition
The Marshall-Lerner
condition: Theory
Valuation
effect
arises
from the
ability to
affect
foreign
prices
B = eX – Z
= eX(e) – Z(e)
Not obvious that a lower e helps T
Let’s do the arithmetic
Bottom line is:
Devaluation strengthens the current
account as long as
ab 1
a = elasticity of exports
b = elasticity of imports
The Marshall-Lerner
condition
-
+
B  eX ( e )  Z ( e )
B  eX  Z
 dX  dZ
 X  e

de
 de  de
dB
-a
b
 dX    e   X    dZ    e   Z  
 X  e
 

  
    
de
 de    X   e    de    Z   e  
dB
1
1
The Marshall-Lerner
condition
 dX    e   X    dZ    e   Z  
 X  e
 

  
    
de
 de    X   e    de    Z   e  
dB
dB
de
 X  aX  bX  1  a  b  X
dB
de
0
if
a b 1
X
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,
ab 1
Empirical evidence from
developing countries
Argentina
Brazil
India
Kenya
Korea
Morocco
Pakistan
Philippines
Turkey
Average
Elasticity of Elasticity of
exports
imports
0.6
0.9
0.4
1.7
0.5
2.2
1.0
0.8
2.5
0.8
0.7
1.0
1.8
0.8
0.9
2.7
1.4
2.7
1.1
1.5
The small country case
Small countries are price takers abroad
• Devaluation has no effect on the foreign
currency price of exports and imports
So, the valuation effect does not arise
Devaluation will, at worst, if exports and
imports are insensitive to exchange
rates (a = b = 0), leave the current
account unchanged
Hence, if a > 0 or b > 0, devaluation
strengthens the current account
The importance of
appropriate side measures
Remember: Q  eP
P*
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
To work, nominal devaluation must
result in real devaluation
From exchange and trade
policies to 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 and trade
policies to 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
detrimental to growth
We saw before that inflation leads to
overvaluation which hurts exports
So, here is one additional reason why
inflation hurts economic growth
Exports and imports are good for growth
Several other reasons
Inflation distorts production and impedes
financial development, and scares
foreign investors away
How trade increases
efficiency and growth
Trade with other nations increases
efficiency by allowing
1. Specialization through comparative
advantage
2. Exploitation of economies of scale
3. Promotion of free competition
Not only trade in goods and services,
but also in capital and labor
“Four freedoms”
How trade increases
efficiency and growth
Trade also encourages international
exchange of
•
•
•
•
Ideas
Information
Know-how
Technology
Trade is education
Which is also good for growth!
Efficiency is crucial for
economic growth
Need economic policies that help
increase efficiency
• Produce more output from given inputs
• Takes fewer inputs to produce given
output
• More efficiency, better technology are two
ways of increasing output per unit of input
• So is more and better education
Trade increases efficiency and thereby
also economic growth
Per capita growth adjusted for initial income (%)
Exports and economic
growth 1960-2000
6
4
2
0
-2
-4
-6
-8
0
40
80
120
160
Exports (% of GDP)
200
163 countries
r = 0.26
Asia: Exports
(% of GDP)
Papua New Guinea
Myanmar
Japan
Singapore
Hong Kong
Malaysia
Mongolia
Thailand
Vietnam
Cambodia
Maldives
Philippines
Korea, Rep.
China
Sri Lanka
Indonesia
Bhutan
Lao PDR
India
Bangladesh
Nepal
Pakistan
Afghanistan
2005
1965
0
50
100
150
200
250
Per capita growth adjusted for initial income (%)
FDI and economic
growth 1960-2000
8
6
4
2
0
-2
-4
-6
-8
0
2
4
6
8
10
12
14
Foreign direct investment (% of GDP)
152 countries
r = 0.21
Asia: FDI net inflows
(% of GDP)
Hong Kong, China
Singapore
Mongolia
Cambodia
Vietnam
China
Malaysia
Thailand
Pakistan
Indonesia
Bangladesh
Sri Lanka
Maldives
Philippines
Lao PDR
India
Papua New Guinea
Korea, Rep.
Bhutan
Japan
Nepal
2005
1970
0
5
10
15
20
25
Evolution of capital flows
Capital mobility
A stylized view of capital mobility 1860-2000
First era of
international
financial
integration
Return toward
financial
integration
Capital
controls
Source: Obstfeld & Taylor (2002), “Globalization and Capital Markets,” NBER WP 8846.
Asia: Net capital flows and external debt
indicators, 1980-2006
170
150
130
110
Billions of USD ($)
90
70
50
30
10
-10
-30
-50
-70
-90
1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
Direct investment, net (left axis)
Source: WEO
Other private, net (left axis)
Official capital flows, net (left axis)
Push vs. pull factors
External factors “pushed” capital from
industrial countries to LDCs
 Cyclical conditions in industrial countries
 Recessions in the early 1990s
 Decline in world interest rates

Structural changes in industrial countries
 Financial structure developments
 Demographic changes
Push vs. pull factors
Internal factors “pulled” capital into LDCs
from industrial countries
 Macroeconomic fundamentals
 Reduction in barriers to capital flows
 Private risk-return characteristics
 Creditworthiness
 Productivity
Large capital flows to Asia have
resumed in recent years
Potential benefits
of capital flows
Improved allocation of global savings
(allows capital to seek highest returns)
Greater efficiency of investment
More rapid economic growth
Reduced macroeconomic volatility
through risk diversification (which
dampens business cycles)


Income smoothing
Consumption smoothing
Potential risks
of capital flows
Open capital accounts may make receiving
countries vulnerable to foreign shocks
 Magnify domestic shocks and lead to contagion
 Limit effectiveness of domestic macro policy
instruments
Countries with open capital accounts are
vulnerable to
 Shifts in market sentiment
 Reversals of capital inflows
May lead to macroeconomic crisis
 Sudden reserve loss, exchange rate pressure
 Excessive BOP and macro adjustment
 Financial crisis
Potential risks
of capital flows
Overheating of the economy
Excessive expansion of aggregate demand with
inflationary pressures, real exchange rate
appreciation, widening current account deficit
Increase in consumption and investment relative to
GDP
 Quality of investment suffers
 Construction booms
Monetary consequences of capital inflows and
accumulation of foreign exchange reserves
depend crucially on exchange regime
Real stock prices during inflow periods,
selected countries
6
0
0
1
,
6
0
0
Chile 1978-81
1
,
4
0
0
5
0
0
1
,
2
0
0
Mexico
4
0
0
1
,
0
0
0
Venezuela
Chile 1989-94
8
0
0
3
0
0
6
0
0
2
0
0
4
0
0
Sweden
Finland
2
0
0
1
0
0
0
0
3
2
0
0
2
1
0
1
2
3
4
5
6
7
Year with respect to start of Inflow period
Note: The Index for Finland, Mexico, and Sweden is shown on the left; the index for Chile during the
1980s and 1990s and for Venezuela is shown on the right.
Source: World Bank (1997)
Stock prices in Thailand 1987-2000
Early warning signs
Large deficits
 Current account deficits
 Government budget deficits
Poor bank regulation
 Government guarantees (implicit or explicit), moral
hazard
Stock and composition of foreign debt
 Ratio of short-term liabilities to foreign reserves
Mismatches
 Maturity mismatches (borrowing short, lending long)
 Currency mismatches (borrowing in foreign currency,
lending in domestic currency)
Asia: Ratio of short-term liabilities
to foreign reserves in 1997
Large reversals
M e x ic o , '9 3 -9 5
12% of G D P
K o re a , '9 6 -9 7
9% of G D P
M e x ic o , '8 1 -8 3
18% of G D P
T h a ila n d , '9 6 -9 7
15% of G D P
V e n e z u e la , '8 7 -9 0
11% of G D P
T u rk e y , '9 3 -9 4
6% of G D P
V e n e z u e la , '9 2 -9 4
10% of G D P
A rg e n tin a , '8 8 -8 9
7% of G D P
M a la y s ia , '8 6 -8 9
10% of G D P
In d o n e s ia , '8 4 -8 5
5% of G D P
A rg e n tin a , '8 2 -8 3
4% of G D P
0
10
20
30
40
B illio n d o lla rs
S o u rc e : F in a n c e a n d D e v e lo p m e n t, S e p te m b e r 1 9 9 9 .
50
60
Country experiences with capital
account liberalization

External or financial crisis followed capital
account liberalization


Response



E.g., Mexico, Sweden, Turkey, Korea, Paraguay
Rekindled support for capital controls
Focus on sequencing of reforms
Sequencing makes a difference



Strengthen financial sector and prudential framework
before removing capital account restrictions
Remove restrictions on FDI inflows early
Liberalize outflows after macroeconomic imbalances
have been addressed
Some types of capital flows are riskier
than others
High
degree
of risk
sharing
Portfolio
equity
Foreign
direct
investment
Short
term
debt
Long term
debt
(bonds)
No risk
sharing
Transitory
Permanent
Sequencing Capital
Account Liberalization
Pre-conditions for liberalization
 Sound macroeconomic policies
 Strong domestic financial system
 Strong and autonomous central bank
 Timely, accurate, and comprehensive data
disclosure
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
There is a range of options
Monetary union or dollarization
Means giving up your national currency or
sharing it with others (e.g., EMU, CFA, EAC)
Currency board
Legal commitment to exchange domestic for
foreign currency at a fixed rate
Fixed exchange rate (peg)
Crawling peg
Managed floating
Pure floating
Exchange rate regimes
 Currency union or dollarization
 Currency board
 Peg
FIXED
Fixed
Horizontal bands
 Crawling peg
Without bands
With bands
 Floating
FLEXIBLE
Managed
Independent
Basically fixed
Dollarization

Use another country’s currency as sole legal tender
Currency union

Share same currency with other union members
Currency board


Legally commit to exchange domestic
currency for specified
Foreign currency at fixed rate
Conventional (fixed) peg


Single currency peg
Currency basket peg
Intermediate
Flexible peg
Fixed but readily adjusted
Crawling peg
 Complete
Compensate for past inflation
Allow for future inflation
Partial
Aimed at reducing inflation, but real appreciation
results because of the lagged adjustment
Fixed but adjustable
Basically floating
Managed floating


Management by sterilized intervention
Management by interest rate policy, i.e.,
monetary policy
Pure floating
Benefits and costs
Benefits
Fixed
exchange
rates
Floating
exchange
rates
Costs
Benefits and costs
Benefits
Fixed
exchange
rates
Floating
exchange
rates
Stability of trade
and investment
Low inflation
Costs
Benefits and costs
Benefits
Fixed
exchange
rates
Floating
exchange
rates
Costs
Stability of trade Inefficiency
and investment BOP deficits
Low inflation
Sacrifice of
monetary
independence
Benefits and costs
Benefits
Costs
Fixed
exchange
rates
Stability of trade Inefficiency
and investment BOP deficits
Low inflation
Sacrifice of
monetary
independence
Floating
exchange
rates
Efficiency
BOP equilibrium
Benefits and costs
Benefits
Costs
Fixed
exchange
rates
Stability of trade Inefficiency
and investment BOP deficits
Low inflation
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 (2004, 193 countries)
No national currency
Other types of fixed rates
Dollarization
Currency board
Crawling pegs
Bilateral fixed rates
Managed floating
Pure floating
17%
23
5
4
3
3
26
19
100
There is a gradual tendency towards floating, from
10% of LDCs in 1975 to over 50% today
49%
51%
These slides will be posted on my website:
www.hi.is/~gylfason
Bottom line
 External sector policies are important
because external trade is important
 Need to maintain real exchange rates at
levels that are consistent with BOP
equilibrium, including sustainable debt
Must avoid overvaluation!
 Need to adopt exchange rate regime that is
conducive to moderate inflation and rapid
economic growth