Exchange Rate Economics

1. Exchange Rate Economics John Williamson Senior Fellow, Peterson Institute for International Economics Paper prepared for World Bank’s Growth Commission, presumably concerned with whether “Asian model” should be applied more generally

2. Exchange Rate Economics revolutionized since era of flow models in 1960s Now seen as forward-looking asset price Current account’s influence comes only in pinning down long-run value of RER (either uniquely by PPP or by PPP plus real factors), with transition modeled by assuming the representative agent is rational and enjoys perfect foresight • Exposition of conventional models • Problems with these models and the most promising alternative • Dutch disease • Policy implications • Questions for additional research

3. The Standard Model Long-run equilibrium characterized by current account imbalance such as to keep NIIP/GDP constant Level of equilibrium NIIP/GDP determined by factors considered in intertemporal theory of c/a Steady-state is independent of price level • i.e. PPP prevails between equilibria • either shocks are entirely monetary • or real shocks are of second order of importance • empirical evidence: something close to PPP holds in L-R, but estimates of LRERs have significant coefficients also on NFAs, tot, G/Y, productivity.

4. But should s-s be required as equilibrium condition? Doesn’t this require that development be complete? Alternative: allow NIIP/GDP, but nothing else, to vary Theory of debt cycle In the short-run: • UIP • Overshooting • Portfolio models • Meese and Rogoff showed Dornbusch and Portfolio Models were outperformed by random walk in S-R (for industrial countries) Purists reject the L-R/S-R distinction and extend the S-R to L-R but impose a transversality condition with similar effect.

5. Problems Empirical implications of the standard model: -- Exchange rates respond systematically to changes in the fundamentals (money supplies, income levels, interest rates, expected inflation rates, tot, productivity—at least insofar as current values influence perceptions of permanent values), but do not change without “news” -- Money is made by having a good notion of the implications of the fundamentals, and will be lost by following chartist rules (Friedman) -- Exchange rate changes are normally distributed, no scope for “bubble-and-crash” dynamics

6. All these implications are strongly counter to empirical evidence: • Meese/Rogoff study (still dominant conclusion, though Gourinchas and Rey argue that adding the exchange-rate induced change in wealth to the c/a permits a degree of S-R forecastability, and in Rio Carneiro and Wu cast similar doubt on the result for EMs); and what explains the DM/euro rollercoaster in 1993-2003? • Chartist rules are used and profitable • DM/$ over 1986-95 had standard deviation of 0.0029 per day but 3 days with changes greater than 0.015 (probability once every 7,000 years). Frequent apparent bubble-and-crash dynamics Standard model is a hopeless empirical failure But models are replaced only by a superior theory

7. Candidate of de Grauwe and Grimaldi: “behavioral theory” • Same structure as that originally developed by Frankel and Froot in 1986, but more careful relationship to behavioral finance literature • FX market populated by agents who use fundamentalist and chartist strategies • Agent may act as either, and may change tactics in response to other rule proving more profitable (“bounded rationality”)

8. No analytical solution, but several thousand simulations suggest: • That exchange rate changes are disconnected from fundamentals, though level is cointegrated with its fundamental value • That chartist rule tends to be more profitable than fundamentalist one, though better is to switch • That exchange rate changes have fat tails • That the exchange rate is sometimes, but unpredictably, disconnected from its fundamental value and instead involved in bubble-and-crash dynamics That is, the model appears consistent with stylized facts.

9. Dutch Disease Is it a dangerous condition to be avoided by policy measures or welcomed as an improvement in a country’s situation? • Dangerous condition: • Parable of export-led growth in E. Asia • Possibility of interruption by Dutch disease • Developed country has more chance of giving good living standard to all citizens (exceptions) • Prudent act of investment (like Indonesia in 1978)

10. Welcome condition: • Dominant view among economists • Enlarges opportunities of domestic residents • May involve painful S-R adjustment, e.g. in size of export sector • Natural, efficient way to achieve this is by appreciation of RER.

11. What does econometric evidence say? • Evidence of a negative relationship between misalignment and growth (Razin and Collins) • Evidence of such a relationship in developing but not developed economies (Prasad, Rajan, and Subramanian) • Using a cross-country growth regression, Aguirre and Calderon get the usual results plus significant negative relationship between growth and misalignment driven largely by big misalignments (but the g-maximizing policy appears to be mild undervaluation)

12. An interesting result is that given change in RER may have differential effect on growth if it is an equilibrium phenomenon or a misalignment. Why? Perhaps because of different judgments of the private sector on the permanence of change. RER decrease increases profitability of investing in non-tradables to offset reduced profitability of investing in tradables (sold on world market). No reason to anticipate a crisis. Misalignment is quite different in both respects.

13. If one concludes that Dutch disease is bad for growth, what can policy do about it? Conventional view: little; e not a policy weapon because it floats; even if it doesn’t, offset by induced inflation. But is this right? Intervention is effective under the behavioral theory of e (because it increases the rewards of the fundamentalists). A potent instrument for avoiding large misalignments by chartists jumping on bandwagons. Aguirre-Calderon say no need to worry about a real appreciation caused by a permanent change.

14. Difficult case is one of uncertainty as to whether a strengthening is temporary or permanent. Costly to make error. • Is there another policy instrument? • Variation in prudential regulations: no, not cyclical variation. • Capital controls • Stabilization or Endowment Fund held outside country • Taxes; on entry of foreign capital as alternative to encaje, or on foreign interest income.

15. Policy Implications Assume that exchange rates are determined by behavioral finance model rather than standard model. Fixed e requires same 4 conditions: • Opt currency area • Bulk of trade with partner country • Macro policy consistency • Institutional arrangements to ensure credibility.

16. Implication re floating: should it be freeish or managed? Standard model suggests free floating: rate normally close to fundamental value, and there isn’t much the authorities can do anyway. Behavioral model challenges both propositions. But does not endorse “stable but adjustable”; still crisis-prone. I.e. choice is BBC, managed floating, unmanaged float. Band: main argument for adopting is to gain help of speculators in stabilizing the rate. Requires credible margins. Authorities have squandered credibility, so no BBC. Unmanaged float: laissez-faire would be ideal if e’s behaved as portrayed in standard model. But they don’t.

17. Two possible principles for more systematic management: • Leaning against the wind; but why if the wind is blowing the right way? Possible answer: because this will help fundamentalists make money. • Reference rates. Need to secure agreement on ref rates. Political issue: will countries agree to central rates despite traditional objection that all they can hope to identify are disequilibrium rates? (Perhaps: limited obligation.) Also technical issue: do the IMF’s Macro Balance/External Sustainability approaches yield similar outcomes to ERER approach?

18. Because of nature of obligation (not to push the rate away from ref rate), no conflict with IT Benefits: • Private market has sense of what official world believes equilibrium to be • Basis for public debate about e • International endorsement would aid in resisting cyclical appreciation caused by export boom or inflow surge. Most important for EMs/developing countries.

19. Additional Research • Not really research, but importance of IMF publication of its figures on Macro Balance v. ERER Approaches. • And understanding of whether Dutch disease is dangerous, and why. • And?

20. Concluding Remarks Big step forward in 1970s when flow models were replaced by models that regard e as forward-looking asset price But next step has not followed; it is overdue. Alternative model has important implications. Doesn’t idealize laissez-faire. Or recommend fixing e, or reverting to adjustable peg, or abandoning floating or IT But it does require the IMF to accept the duty of negotiating reference rates and enforcing the obligations they would impose Which would at least help countries avoid misalignments that the official sector can see rest on temporary factors.