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Thorvaldur Gylfason
DUTCH DISEASE, VOLATILITY, AND EXCHANGE RATE REGIME IN RESOURCE-RICH COUNTRIES
Joint Vienna Institute/IMF InstituteCourse on Macroeconomic Management in
Natural Resource-Rich Countries Vienna, 2-13 April 2012
1. Real vs. nominal exchange rates
2. Exchange rate policy, welfare, and growth
3. Dutch disease, overvaluation, and volatility
4. Exchange rate regimes To float or not to float How many currencies?
OUTLINE
BACKGROUND: REAL VS. NOMINAL EXCHANGE RATES
1
*P
ePQ
Q = real exchange ratee = nominal exchange rateP = price level at homeP* = price level abroad
Increase in Q means real appreciation
e refers to
foreign currency
content of
domestic currency
Q = real exchange ratee = nominal exchange rateP = price level at homeP* = price level abroad
Devaluation or
depreciation of e
makes Q also
depreciate
unless P rises so
as to leave Q
unchanged
BACKGROUND: REAL VS. NOMINAL EXCHANGE RATES
*P
ePQ
THREE THOUGHT EXPERIMENTS
*P
ePQ
1. Suppose e fallsThen more rubles per dollar, so X rises, Z falls
2. Suppose P fallsThen X rises, Z falls
3. Suppose P* risesThen X rises, Z falls
Capture all three by supposing Q falls
Then X rises, Z falls
IMPORTANCE OF APPROPRIATE SIDE MEASURESRemember:
Devaluation needs to be accompanied by fiscal and monetary restraint to prevent prices from rising and thus eating up the benefits of devaluation
To work, nominal devaluation must result in real devaluation
*P
ePQ
Foreign exchange
Real exc
hang
e r
ate
Imports
Exports
2
Earnings from
exports of goods,
services, and capital
Payments for imports
of goods, services,
and capital
Equilibrium
EXCHANGE RATE POLICY AND WELFARE
Equilibrium between demand and supply in foreign exchange market establishesEquilibrium real exchange rateEquilibrium in balance of
paymentsBOP = X + Fx – Z – Fz
= X – Z + F = current account + capital
account = 0
EXCHANGE RATE POLICY AND WELFARE
X – Z = current account
F = capital and financial account
Foreign exchange
Real exc
hang
e r
ate
Imports
Exports
EXCHANGE RATE POLICY AND WELFARE
Overvaluation
Deficit
R R moves when e is fixed
Foreign exchange
Pri
ce o
f fo
reig
n e
xch
an
ge
Supply (exports)
Demand (imports)
EXCHANGE RATE POLICY AND WELFARE
Overvaluation
Deficit
Overvaluation works like a price ceiling
Appreciation of currency in real terms, either through inflation or nominal appreciation, leads to a loss of export competitiveness
In 1960s, Netherlands discovered natural resources (gas deposits)Currency (Dutch guilder) appreciated Exports of manufactures and services
suffered, but not for long Not unlike natural resource discoveries,
aid inflows could trigger the Dutch disease in receiving countries
3See my “Dutch Disease” in New Palgrave Dictionary of Economics Online
DUTCH DISEASE
IMPACT OF AID ON REAL EXCHANGE RATE Review basic theory of Dutch disease in simple demand and supply model
Analytical literature uses complex two- or three sector modelsTradable manufacturesTradable resourcesNontradable services
DUTCH DISEASE: HOW OIL EXPORTS CROWD OUT NONOIL EXPORTS
Foreign exchange
Real exc
han
ge r
ate
Imports
Exports without oil
Exports with oil
A
C BOil discovery
leads to appreciation
, and reduces nonoil exports
Compositi
on of exports
matters
MIGRATION MITIGATES INCREASE IN REAL EXCHANGE RATE
Foreign exchange
Real exc
han
ge r
ate
Imports
Exports without oil
Exports with oil
A
C B Imports with immigration
D Immigrations
means more
income and imports
as well as
remittances abroad
TWO MAIN CHANNELS Spending effect
Increased income from booming natural resource sector boosts private and public spending, raising prices and output in non-tradables sector
In non-natural resource tradables sector (“manufacturing”), prices are fixed at world levels, profits are squeezed by rising wages, and increased demand is met out of rising imports
Resource movement effect Natural resource boom attracts capital and
labor away from rest of economyOutput declines in non-resource economy,
esp. in tradables, where prices are fixed at world levels
DECLINING MANUFACTURES, RISING CURRENCIES Both effects result in
Decrease in output share of non-natural resource tradables relative to non-tradables
Appreciation of real exchange rate So, decline of manufacturing and
appreciation of currencies in real terms tend to go hand in handExtensive theoretical literature behind this
resultWhat do the data say?Recent literature survey by Magud and Sosa
(2010) “When and Why Worry About Real Exchange Rate
Appreciation? The Missing Link between Dutch Disease and Growth,” WP/10/271
Dutch disease shocks Natural resources/capital inflows
0
5
10
15
20
25
30
35
40
45YesNo
Source: Magud and Sosa (2011)
Num
ber
of
case
s re
port
ed
0
5
10
15
20
25
30
35Yes
No
EMPIRICAL EVIDENCE: LITERATURE REVIEW IN NUMBERS I
Remittances Foreign aid
Appreciation Lower T/NT output
Lower growth
0
1
2
3
4
Yes
No
0
1
2
3
4
5
6
7
8Yes
No
Num
ber
of
case
s re
port
ed
Source: Magud and Sosa (2011)
EMPIRICAL EVIDENCE: LITERATURE REVIEW IN NUMBERS II
Empirical studies Theoretical studies
0
2
4
6
8
10
12
14Yes
No
0
5
10
15
20
25
30Yes
No
Num
ber
of
case
s re
port
ed
Source: Magud and Sosa (2011)
EMPIRICAL EVIDENCE: LITERATURE REVIEW IN NUMBERS III
EMPIRICAL EVIDENCE: LITERATURE REVIEW IN NUMBERS IV
Currency misalignments Exchange rate changes
Num
ber
of
case
s re
port
ed
Source: Magud and Sosa (2011)
Real overvaluation Real undervaluation0
5
10
15
20
25
30
YesNo
Real appreciation Real depreciation0
1
2
3
4
5
6
Yes
No
Does overvaluation reduce growth? Does
undervaluation?
SUMMARY OF RESULTS Dutch disease does exist
Resource booms make currencies appreciate
When currency appreciates in real terms, factors of production are reallocated and production switches away from manufacturing Exchange rate volatility hampers economic
growth (not shown here, will see later)Misalignment of real exchange rate from its
fundamental value also lowers growth Overvaluation is always bad for growth Evidence on the effect of undervaluation on
growth is inconclusive
DUTCH DISEASE Foreign exchange earnings are
converted into local currency and used to buy domestic goods
Fixed exchange rate regimeReserve inflow causes expansion of
money supply that leads to inflation and appreciation of domestic currency in real terms
Flexible exchange rate regimeIncrease in supply of foreign exchange
leads to nominal appreciation of currency, so real exchange rate also appreciates
M = D + R
Q = eP/P*
M = Money
D = Domestic
creditR = Reserves
DUTCH DISEASE: HOW FOREIGN AID CROWDS OUT EXPORTS
Foreign exchange
Real exc
han
ge r
ate
Imports
Exports without aid
Exports with aid
A
C B
Foreign aid
leads to appreciation
, and reduces exports (e.g., Zambia)
Trade vs.
aid
DUTCH DISEASE: HOW CAPITAL INFLOW CROWDS OUT EXPORTS
Foreign exchange
Real exc
han
ge r
ate
Imports
Exports without inflow
Exports with inflow
A
C B
Capital account
liberalization
leads to appreciation,
and sometimes
instability when
inflow stops or
reverses itself
Crises
NETHERLANDS: EXPORTS 1960-2010 (% OF GDP)
1960
1963
1966
1969
1972
1975
1978
1981
1984
1987
1990
1993
1996
1999
2002
2005
2008
0
10
20
30
40
50
60
70
80
90
Nether-landsIcelandNorway
Volatility of commodity prices leads to volatility in exchange rates, export earnings, output, and employment
Volatility can be detrimental to investment and growth
Hence, natural-resource rich countries may be prone to sluggish investment and slow growth due to export price volatility
Likewise, high and volatile exchange rates tend to slow down investment and growth
DIFFERENT MANIFESTATIONS: VOLATILITY
Output volatility and economic growth 1960-2000
Inverse cross-country correlation between per capita growth and GDP volatility
GDP volatility is defined as the standard deviation of per capita growth
163 countries, 1960-2000
-8
-6
-4
-2
0
2
4
6
0 4 8 12 16 20
Volatility of GDP
Per
cap
ita g
row
th a
djus
ted
for
initi
al in
com
w (
% p
er y
ear)
VOLATILITY AND GROWTH
r = -0.47
Large inflows of foreign exchange earnings from a natural resource discovery can trigger a bout of Dutch disease
Real appreciation hurts competitiveness of exports and can thus undermine economic growthExports have played a pivotal role in
the economic development of many countries
An accumulation of “know-how” often takes place in the manufacturing export sector, which may confer positive external benefits on the rest of the economy
RISK OF DUTCH DISEASE
RISK OF DUTCH DISEASE Resource boom is likely to lead to
Dutch disease if It leads to high demand for nontradables
Trade restrictions may produce this outcome Recipient country uses aid to buy nontradables
(including social services) rather than importsProduction is at full capacity
Production of nontradables cannot be increased without raising wages in that sector
Resource rent is not used to build up infrastructure and relax supply constraints Including free mobility of labor across countries
Price and wage increases in nontradables sector lead to strong wage pressure in tradables sector
RISK OF DUTCH DISEASE The risk that resource boom
might have adverse impact on economy due to, e.g., oil-induced Dutch disease crucially depends on how resource rent is used in recipient countriesWe can identify four different cases based on how the rent is spent, and in which the macroeconomic implications of rent flows differArgument also applies to inflows of foreign aid
Spending can take several forms, with different macroeconomic implications:Case 1: Rent is saved by government Case 2: Rent is used to purchase
imported goods that would not have been purchased otherwise
Case 3: Rent is used to buy nontradables with infinitely elastic supply
Case 4: Rent is used to buy nontradables for which there are supply constraints
RISK OF DUTCH DISEASE
HOW RENT IS USED AND THE RISK OF DUTCH DISEASE: CASE 1 Rent is saved by government
Rent inflow leads to accumulation of foreign exchange reserves in Central Bank … and, unlike increased rent that is spent,
is not allowed to enter the spending streamNo effect on money supplyNo inflationNo appreciation of currency
I.e., no increase in exchange rateNo risk of Dutch disease
Rent is used to purchase imported goods that would not have been purchased otherwiseImport purchases lead to transfer of
real resources from abroad, but not to increased spending at home
No effect on money supplyNo inflationNo appreciation of currencyNo risk of Dutch disease
HOW RENT IS USED AND THE RISK OF DUTCH DISEASE: CASE 2
Rent is used to buy domestic nontradables with infinitely elastic supply due to underutilized resources (labor and capital) in economy Increased demand for nontradablesBecause some factors are unemployed,
greater demand leads to increased supply
This has a positive impact on production without increasing nontradables prices
No risk of Dutch disease
HOW RENT IS USED AND THE RISK OF DUTCH DISEASE: CASE 3
Rent is used to buy nontradables for which there are supply constraints, with all available resources already in use (e.g., social services)Increased demand for nontradablesIncreased prices for nontradablesShift of inputs away from tradables
(exports and import-competing goods and services) into nontradables
Real appreciation of the currencyDutch disease!
HOW RENT IS USED AND THE RISK OF DUTCH DISEASE: CASE 4
Monetary policy response determines if real appreciation of currency will take place through inflation or nominal appreciationIf foreign currency is used to increase
Central Bank reserves, increased spending on nontradables increases money supply and inflation, so currency appreciates in real terms
If Central Bank sterilizes impact on money supply of increased spending on nontradables by selling foreign exchange, currency appreciates in nominal, and real, terms
HOW RENT IS USED AND THE RISK OF DUTCH DISEASE: CASE 4
So, in either case,
currency appreciates in
real terms
To recapitulate, the risk of Dutch disease varies, and depends onHow rent is used (saved or spent) –
CASE 1The presence of a rent absorption
constraint – CASE 2The impact of rent on productivity in
the nontradables sector – CASE 3The existence of externalities in
nontradables sector affecting the rest of the economy – CASE 4
HOW RENT IS USED AND THE RISK OF DUTCH DISEASE: LESSONS
Rent inflow can give rise to Dutch disease when government uses the rent to purchase nontradables rather than imported goods and when there are constraints on increasing production in nontradables sector
The risk of Dutch disease is greater when rent is used in social sectors facing constraints on increasing their production due to resource scarcity (rent absorption constraint)
HOW RENT IS USED AND THE RISK OF DUTCH DISEASE: LESSONS
How can resource-rich countries avoid translating rent into Dutch disease? Save the rent and increase central
bank reserves (gross, not net) by not allowing the rent inflow to enter spending stream Recall the Hartwick rule
Use rent to purchase imported goodsBoost rent absorption capacity in
nontradables sector
HOW RENT IS USED AND THE RISK OF DUTCH DISEASE: LESSONS
Policymakers in resource-rich countries need to pay attention to potential early warning signals of, say, oil-induced Dutch disease such asTendency for wages and prices in
nontradables sector to increase Decline in profitability and sales of export
and import-competing industriesRapid relative rise of per capita GDP in
dollars Recall: Argument applies to sudden inflows of
foreign capital as well as natural resource booms
RISK OF DUTCH DISEASE: EARLY WARNING SIGNALS
The real exchange rate always floatsThrough nominal exchange rate
adjustment or price changeEven so, it matters 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
4EXCHANGE RATE REGIMES
EXCHANGE RATE REGIMESThere is a range of options
Monetary union or dollarizationMeans giving up your national
currency or sharing it with others (e.g., EMU, CFA, EAC)
Currency boardLegal commitment to exchange
domestic for foreign currency at a fixed rate
Fixed exchange rate (peg)Crawling pegManaged floatingPure floating
Currency union or dollarization Currency board
Peg Fixed Horizontal bands
Crawling peg Without bands With bands
Floating Managed
Independent
FIXED
FLEXIBLE
EXCHANGE RATE REGIMES
DollarizationUse another country’s currency as sole legal
tender
Currency unionShare same currency with other union
members
Currency boardLegally commit to exchange domestic
currency for specified foreign currency at fixed rate
Conventional (fixed) pegSingle currency pegCurrency basket peg
BASICALLY FIXED
Flexible pegFixed but readily adjusted
Crawling pegComplete
Compensate for past inflation
Allow for future inflation
PartialAimed at reducing inflation, but real appreciation results because of the lagged adjustment
Fixed but adjustable
INTERMEDIATE
Managed floatingManagement by sterilized
intervention I.e., by buying and selling foreign
exchangeManagement by interest rate
policy, i.e., monetary policy E.g., by using high interest rates to
attract capital inflows and thus lift the exchange rate of the currency
Pure floating
BASICALLY FLOATING
THE SCOURGE OF OVERVALUATION
Governments may try to keep the national currency overvaluedTo keep foreign exchange cheapTo have power to ration scarce
foreign exchangeTo make GDP look larger than it
isOther examples of price ceilings
Negative real interest ratesRent controls in cities
INFLATION AND OVERVALUATION
Inflation can result in an overvaluation of the national currencyRemember: Q = eP/P*
Suppose e adjusts to P with a lag
Then Q is directly proportional to inflation
Numerical example
INFLATION AND OVERVALUATION
Time
Real exchange rate
100
110
105 Average
Suppose inflation is 10% per year
INFLATION AND OVERVALUATION
Time
100
120
Real exchange rate
110 Average
Hence, increased
inflation lifts the
real exchange rate
as long as the
nominal exchange
rate adjusts with a
lag
Suppose inflation rises to 20%
HOW TO CORRECT OVERVALUATION
Under floatingDepreciation is automatic: e
movesBut depreciation may take time
Under a fixed exchange rate regimeDevaluation will lower e and
thereby also Q – provided inflation is kept under control
Does devaluation improve the current account?The Marshall-Lerner condition
FROM OVERVALUATION TO UNDERVALUATION If overvaluation of currency hurts
exports, undervaluation must by similar logic help exportsYet, as we saw, empirical evidence is mixed
Some countries – e.g., China – have kept their currencies undervalued to boost exports and contain importsUndervaluation as export promotion policy
Undervaluation leads to buildup of foreign exchange reservesReserve buildup raises some of the same
issues as natural resources booms
WHY WE HAVE FEWER CURRENCIES THAN COUNTRIES In view of the success of the EU
and the euro, economic and monetary unions appeal to many other countries with increasing force
Consider four categoriesExisting monetary unionsDe facto monetary unionsPlanned monetary unions Previous – failed! – monetary unions
EXISTING MONETARY UNIONS CFA franc
14 African countries CFP franc
3 Pacific island states East Caribbean dollar
8 Caribbean island states Picture of Sir W. Arthur Lewis, the great Nobel-prize
winning development economist, adorns the $100 note
Euro, more recent16 EU countries plus 6 or 7 others
Thus far, clearly, a major success in view of old conflicts among European nation states, cultural variety, many different languages, etc.
DE FACTO MONETARY UNIONS Australian dollar
Australia plus 3 Pacific island states Indian rupee
India plus Bhutan (plus Nepal) New Zealand dollar
New Zealand plus 4 Pacific island states South African rand
South Africa plus Lesotho, Namibia, Swaziland – and now Zimbabwe
Swiss franc Switzerland plus Liechtenstein
US dollar US plus Ecuador, El Salvador, Panama, and 6 others
PLANNED MONETARY UNIONS East African shilling (2009)
Burundi, Kenya, Rwanda, Tanzania, and Uganda
Eco (2009)Gambia, Ghana, Guinea, Nigeria, and Sierra
Leone (plus, perhaps, Liberia) Khaleeji (2010)
Bahrain, Kuwait, Qatar, Saudi-Arabia, and United Arab Emirates
Other, more distant plansCaribbean, Southern Africa, South Asia,
South America, Eastern and Southern Africa, Africa
PREVIOUS MONETARY UNIONS Danish krone 1886-1939
Denmark and Iceland 1886-1939: 1 IKR = 1 DKR 2009: 2,500 IKR = 1 DKR (due to inflation in
Iceland) Scandinavian monetary union 1873-1914
Denmark, Norway, and Sweden East African shilling 1921-69
Kenya, Tanzania, Uganda, and 3 others Mauritius rupee
Mauritius and Seychelles 1870-1914 Southern African rand
South Africa and Botswana 1966-76 Many others
No significant
divergence of
prices or currency
rates following
separation
99.95%
CONFLICTING FORCES Centripetal tendency to join monetary
unions, thus reducing number of currencies To benefit from stable exchange rates at the
expense of monetary independence Centrifugal tendency to leave monetary
unions, thus increasing number of currencies To benefit from monetary independence
often, but not always, at the expense of exchange rate stability
With globalization, centripetal tendencies appear stronger than centrifugal ones
IMPOSSIBLE TRINITY
FREE CAPITAL MOVEMENTS
FIXEDEXCHANGE
RATE
MONETARYINDEPENDENCE
MonetaryUnion (EU)
Free to choose
only two of three
options; must
sacrifice one of the
three
1
2
3
IMPOSSIBLE TRINITY
FREE CAPITAL MOVEMENTS
FIXEDEXCHANGE
RATE
MONETARYINDEPENDENCECapital controls
(China)
Free to choose
only two of three
options; must
sacrifice one of the
three
1
2
3
IMPOSSIBLE TRINITY
FREE CAPITAL MOVEMENTS
FIXEDEXCHANGE
RATE
MONETARYINDEPENDENCE
Flexible exchange rate (US, UK, Japan)
Free to choose
only two of three
options; must
sacrifice one of the
three
1
2
3
IMPOSSIBLE TRINITY
FREE CAPITAL MOVEMENTS
FIXEDEXCHANGE
RATE
MONETARYINDEPENDENCE
MonetaryUnion (EU)
Flexible exchange rate (US, UK, Japan)
Capital controls (China)
Free to choose
only two of three
options; must
sacrifice one of the
three
1
2
3
FIX OR FLEX? If capital controls are ruled out in view of
the proven benefits of free trade in goods, services, labor, and also capital (four freedoms), …
… then long-run choice boils down to one between monetary independence (i.e., flexible exchange rates) vs. fixed rates Cannot have both!
Either type of regime has advantages as well as disadvantages
Let’s quickly review main benefits and costs
Benefits Costs
Fixed exchange rates
Stability of trade and investmentLow inflation
Floating exchange rates
BENEFITS AND COSTS
Benefits Costs
Fixed exchange rates
Stability of trade and investmentLow inflation
InefficiencyBOP deficitsSacrifice of monetary independence
Floating exchange rates
BENEFITS AND COSTS
Benefits Costs
Fixed exchange rates
Stability of trade and investmentLow inflation
InefficiencyBOP deficitsSacrifice of monetary independence
Floating exchange rates
EfficiencyBOP equilibrium
BENEFITS AND COSTS
Benefits Costs
Fixed exchange rates
Stability of trade and investmentLow inflation
InefficiencyBOP deficitsSacrifice of monetary independence
Floating exchange rates
EfficiencyBOP equilibrium
Instability of trade and investmentInflation
BENEFITS AND COSTS
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 due to
currency overvaluation are the main problem, floating rates can help
If high inflation is the main problem, fixed exchange rates can help, at the risk of renewed overvaluation
Ones both problems are under control, time may be ripe for monetary union
BENEFITS AND COSTS
What do countries do?
To eliminate high
inflation, need fixed
exchange rate for a
time
NATURAL RESOURCES, INFLATION, AND EXCHANGE RATES There is no evidence that countries with
abundant natural resources are more prone to inflation than other countriesThey tend to grow more slowly, yes, but
their inflation record is indistinguishable from others
Therefore, as far as inflation is concerned, choice between fixed and floating rates is essentially the same in natural-resource rich countries and elsewhereVolatility of export earnings in natural-
resource rich countries calls for flexibility – if not in exchange rate, then, e.g., in migration
Source: Annual Report on Exchange Arrangements and Exchange Restrictions database.
What countries actually do (Number of countries, April 2008)
(3)
(12)
(22)
(5) (2)(66)
(44) (40)
(76)
(84)
(10)
No national currency 6%Currency board 7%Conventional fixed rates
36%Intermediate pegs 5%Managed floating 24%Pure floating 22% 100%
46%
54%
There is a gradual tendency towards floating, from 10% of LDCs in 1975 to almost 50% today, followed by increased interest in fixed rates through economic and monetary unions
WHAT COUNTRIES ACTUALLY DO (2008, 182 COUNTRIES)
The End
These slides will be posted on
my website:
www.hi.is/~gylfason