1. The document discusses different exchange rate regimes and their impact on economic welfare and growth. 2. Overvaluation of a currency can occur under fixed exchange rates or due to inflation, and leads to inefficiencies and current account deficits that hurt growth. Devaluation can improve the current account if export and import elasticities satisfy the Marshall-Lerner condition. 3. No single exchange rate regime is optimal for all countries at all times. The choice depends on a country's specific challenges - floating rates may help address inefficient overvaluation while fixed rates can help control inflation. Most countries now utilize adjustable pegs or managed floating.

1. Exchange
Rate
Regimes
and Policies
Thorvaldur Gylfason

2. Outline
1. Real versus nominal exchange rates
2. Exchange rate policy and welfare
3. The scourge of overvaluation
4. From exchange rate policy to
economic growth
5. Exchange rate regimes
 To float or not to float

3. Real versus nominal
exchange rates
*P
eP
R 
R = real exchange rate
e = nominal exchange rate
P = price level at home
P* = price level abroad
Increase in R
means real
appreciation

4. Real versus nominal
exchange rates
*P
eP
R 
R = real exchange rate
e = nominal exchange rate
P = price level at home
P* = price level abroad
Devaluation or
depreciation of e
makes R also
depreciate unless P
rises so as to leave
R unchanged

5. Foreign exchange
Realexchangerate
Imports
Exports
Exchange rate policy and
welfare
Earnings from exports of
goods, services, and
capital
Payments for imports of
goods, services, and
capital

6. 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
Exchange rate policy and
welfare

7. Foreign exchange
Realexchangerate
Imports
Exports
Exchange rate policy and
welfare
Overvaluation
Deficit

8. Foreign exchange
Priceofforeignexchange
Supply (exports)
Demand (imports)
Exchange rate policy and
welfare
Overvaluation
Deficit
Overvaluation works
like a price ceiling

9. Market equilibrium and
economic welfare
Supply
Demand
E
Producer
surplus
Consumer
surplus
Quantity
Price
A
B
C
Total welfare gain associated
with market equilibrium equals
producer surplus (= ABE) plus
consumer surplus (= BCE)

10. Supply
Demand
Price ceiling
E
F
G
Quantity
Price
Welfare
loss
Price ceiling imposes a
welfare loss equivalent to
the triangle EFG
A
B
C
Consumer surplus = AFGH
H
J
Market intervention and
economic welfare
Producer surplus = CGH
Total surplus = AFGC

11. 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

12. Supply
Demand
Price ceiling
E
F
G
Quantity
Price
Welfare
loss
Price ceiling imposes a
welfare loss equivalent to
the triangle EFG
A
B
C
H
J
Market intervention
and economic welfare
Shortage

13. Inflation and
overvaluation
Inflation can result in an overvaluation
of the national currency
Remember: R = eP/P*
Suppose e adjusts to P with a lag
Then R is directly proportional to
inflation
Numerical example

14. Inflation and
overvaluation
Time
Real exchange rate
100
110
105 Average
Suppose inflation is
10 percent per year

15. Inflation and
overvaluation
Time
100
120
Real exchange rate
110 Average
Hence, increased
inflation increases
the real exchange
rate as long as
the nominal
exchange rate
adjusts with a lag
Suppose inflation rises
to 20 percent per year

16. 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
R – provided inflation is kept under
control
Does devaluation improve the current
account?
The Marshall-Lerner condition

17. The Marshall-Lerner
condition: Theory
T = eX –Z
= eX(e) –Z(e)
Not obvious that a lower e helps T
Let’s do the arithmetic
Bottom line is:
Devaluation improves the current
account as long as
1ba

18. 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,
1ba

19. Empirical evidence from
developing countries
Elasticity of Elasticity of
exports imports
Argentina 0.6 0.9
Brazil 0.4 1.7
India 0.5 2.2
Kenya 1.0 0.8
Korea 2.5 0.8
Morocco 0.7 1.0
Pakistan 1.8 0.8
Philippines 0.9 2.7
Turkey 1.4 2.7
Average 1.1 1.5

20. The importance of
appropriate side measures
Remember:
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
*P
eP
R 

21. From exchange rate policy
to economic 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

22. From exchange rate policy
to economic 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

23. Why inflation is bad for
growth
We saw before that inflation leads to
overvaluation which hurts exports
So, here is one reason why inflation
hurts economic growth
Exports – and imports! – are good for
growth
Several other reasons
Inflation distorts production and impedes
financial development

24. 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”

25. 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!

26. Efficiency is crucial for
economic growth
Need economic policies that 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

27. Trade and growth in
Africa in the 1990s
Average ratio of exports to GDP in Africa
was 30% against 40% outside Africa
Current account deficit in Africa was 7%
of GDP against 4% outside Africa
Real effective currency depreciation in 15
African countries was 16%
Per capita growth in Africa was 0.2% per
year against 1.3% elsewhere

28. Openness and growth
1965-98: Evidence
-8
-6
-4
-2
0
2
4
6
-40 -30 -20 -10 0 10 20 30 40
Actual less predicted exports 1965-98 (% of GDP)
AnnualgrowthofGNPpercapita1965-98,adjustedfor
initialincome(%)
Malaysia
Belgium
Korea
Guinea Bissau
An increase in openness by
14% of GDP is associated
with an increase in per capita
growth by 1% per year.

29. 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

30. Exchange rate regimes
There is a range of options
Monetary union or dollarization
Means giving up your national currency or
sharing it with others
Currency board
Legal commitment to exchange domestic for
foreign currency at a fixed rate
Fixed exchange rate (peg)
Crawling peg
Managed floating
Pure floating

31. Benefits and costs
Benefits Costs
Fixed
exchange
rates
Floating
exchange
rates

32. Benefits and costs
Benefits Costs
Fixed
exchange
rates
Stability of trade
and investment
Low inflation
Floating
exchange
rates

33. Benefits and costs
Benefits Costs
Fixed
exchange
rates
Stability of trade
and investment
Low inflation
Inefficiency
BOP deficits
Sacrifice of
monetary
independence
Floating
exchange
rates

34. Benefits and costs
Benefits Costs
Fixed
exchange
rates
Stability of trade
and investment
Low inflation
Inefficiency
BOP deficits
Sacrifice of
monetary
independence
Floating
exchange
rates
Efficiency
BOP equilibrium

35. Benefits and costs
Benefits Costs
Fixed
exchange
rates
Stability of trade
and investment
Low inflation
Inefficiency
BOP deficits
Sacrifice of
monetary
independence
Floating
exchange
rates
Efficiency
BOP equilibrium
Instability of
trade and
investment
Inflation

36. 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

37. What countries actually
do (2001)
No national currency 39
Currency board 8
Adjustable pegs 50
Crawling pegs 9
Managed floating 33
Pure floating 47
186
25%
25%
50%
There is a gradual tendency towards floating,
from 10% of LDCs in 1975 to over 50% today

38. Bottom line
• Exchange rate policy is important
because trade is important
• Need to maintain real exchange rates
at levels that are consistent with BOP
equilibrium, including sustainable debt
 Avoid overvaluation!
• Need to adopt exchange rate regime
that is conducive to low inflation and
rapid growth
The End