For teachers and students of macroeconomics
This is about how real exchange rates are determined in the medium term. So we abstract from the complications caused by sticky prices and monetary policy. However as anyone who understands uncovered interest parity knows, exchange rates in the short run depend crucially on expectations about medium term exchange rates, so the determination of medium term exchange rates is important whatever your time horizon.
The framework I use when teaching at masters level is the ‘new open economy’ (NOEM) approach, associated with Obstfeld and Rogoff in particular. A classic survey is by Philip Lane. If this framework could be summed up in one sentence, it would be this. In a world where most international trade takes place in goods sold in imperfectly competitive markets, the real exchange rate moves to equate the demand and supply for domestically produced output.  What follows is not about whether that framework is empirically useful, but why teaching it can avoid some confusions and pitfalls.
This concept was not of course invented by NOEM. John Williamson’s approach to determining equilibrium exchange rates, later taken up by the IMF and others, is based on the same idea. (See this earlier post for references. Williamson's work can in turn be seen as a development of the 'Swan diagram'.) Indeed I sometimes get annoyed that the NOEM literature typically ignores its antecedents. However one source for confusion is that the essentially empirical literature associated with Williamson focuses on the current account, rather than the supply and demand for domestic output. It does this because the current account is a readily available indicator of this supply and demand balance much of the time. But not always, as the following classic example shows.
Suppose an economy discovers a finite natural resource, like oil, which takes a negligible amount of labour to extract. It takes a few years before the discovery leads to the resource being extracted, but the extent of the resource is common knowledge. This is a standard exercise in consumption smoothing. Consumption rises the moment the resource is discovered, anticipating higher future income. This leads to a current account deficit until the resource is extracted. Once it starts being extracted, consumers are now consuming less than their income, first to pay off their borrowing, and then to save for the day the resource runs out. So while the resource is extracted we get a current account surplus.
What happens to the real exchange rate? If we focus on the current account, we might be tempted to say that it first depreciates, and then appreciates when we have a surplus. This would be wrong. We could start with a special and highly unrealistic case, where there are no non-traded goods, the economy is so small that only a negligible amount of the additional consumption is spent on home produced goods, and labour supply is fixed. In that case nothing would happen to the real exchange rate at any time. More realistically, transport costs will mean there is some ‘home bias’ in consumption, and also some of the consumption will go on domestically produced non-traded goods. Both imply a domestic real appreciation, which begins while the current account is in deficit, and which stays the same as the current account switches to surplus. In addition, if consumers want to match higher consumption with more leisure, labour supply will decrease, and we get an appreciation to choke off demand for domestically produced goods. Again this happens throughout, and not just when the resource is extracted.
The reason why looking at the current account is misleading is that we are ignoring the capital account. Before the resource is extracted, consumption rises through borrowing from abroad. If all the extra consumption is on overseas goods, those lending to consumers require no domestic currency (they can lend in dollars). But if some of the additional consumption is spent domestically, some of the lending must also be in domestic currency, so we get an appreciation. Once the resource begins to be sold (for dollars), it is as if all the extra income is used to buy overseas assets. So the size of the appreciation remains unchanged.
Thinking about both current and capital accounts in this situation is tricky, but thinking about the supply and demand for the domestically produced tradable goods gives us the same answer much more easily.
 In a simple model without capital, supply is just labour supply and productivity. For a small open economy where there are no non-traded goods or home bias, demand for domestically produced goods just depends on world output and competitiveness=real exchange rate. In this simple set-up a consumer price based real exchange rate is constant (PPP holds), but once we introduce realistic features like home bias or non-traded goods competitiveness influences a consumer price based real exchange rate, and PPP no longer holds.
 For simplicity ignore the capital required to extract the resource, and we assume all the income from the resource goes to domestic consumers.
 The two mechanisms work in different ways, however. The additional demand for non-traded goods takes labour away from traded goods production, so reduced traded goods supply leads to an appreciation. With home bias we get an appreciation because of the additional demand for domestically produced traded goods.
Are you thinking of the IMF crisis of 1976? I took these notes:ReplyDelete
Other than USA, other industrialised nations saw a similar rise in their public expenditure 1972-6 and continued to grow to 1978, whereas UK’s fell back 1976-8 to nearly half-way to 1972 level. The problem for the UK was 1972-6 rise of inflation of 79%. In 1976 Belgium, France, and Italy all had balance of payments comparable with the UK, but none of these nations were a reserve currency and so exposed to large-scale withdrawals and they also held large reserves of foreign exchange.
In January 1977 £1.2 billion of the IMF loan was used and £384 million in May and August 1977, thus less than half of the loan was used.
In 1974 the economy was fully employed. North sea oil in 1978 was contributing £2.5 billion more than 1974. As such, the 1976 IMF crisis was a problem of borrowing until international prices moderated and north sea oil came on stream. 1974-5 borrowing was short-term and unstable.
Interest rates in UK fell because of inflow of funds and the strength of sterling:
Oct 1976 = 15%
Feb 1977 = 12%
May 1977 = 8%
Oct 1977 = 5%
Real wages grew 1970-4 by the high rate of 19%, but 1974-9 only 8%. 1970s inflation caused slow growth, was hard on profits, and kind to wages.
North sea oil, especially up to 1986, gave a large surplus and freedom from balance of payment difficulties, unlike early and mid 1970s.
I have a slightly different approach.ReplyDelete
Let's start with the question: what is the division of labour between the real exchange rate and the real interest rate in equilibrating demand and supply in a small open economy relative to ROW?
Use the PIH to figure out how shocks (like discovering oil) will affect net demand (demand minus supply) in the SOE relative to ROW, for given real exchange rates and real interest rates.
Decompose all shocks to net demand (relative to ROW) into a permanent component and a transitory component. (A one period shock is mostly transitory but not totally transitory, just like finding a $100 note on the sidewalk raises permanent income by (say) $5).
1. The real exchange rate adjusts to handle the permanent component of shocks to net demand (relative to ROW).
2. The real interest rate differential adjusts to handle the transitory component of shocks to net demand (relative to ROW).
Now I have to figure out whether my answer is the same as yours, and if not, how to reconcile them.
BTW, I don't think it matters for this question whether goods markets are perfectly or imperfectly competitive. It does matter whether domestic-produced goods are perfect or imperfect substitutes for foreign-produced goods. Because if they were perfect substitutes PPP holds. The more perfect the degree of substitutability, the less the real exchange rate needs to adjust.
What happens if nominal exchange rate (NER) or nominal interest rate (NIR) is controlled by a central bank? Does the RER push into either the other or into inflation?Delete
Squeeky: I was (implicitly) assuming the central bank was doing what was needed to adjust the interest rate or the exchange rate to offset shocks to supply and demand to keep inflation on target. (I should have made that explicit.)Delete
Nick: Thanks for response. I admit I'm still lost in how all these factors work together.Delete
So here's a case: a (very)-small open economy as above, discovers oil leading to a rise in RER. Further assume this economy is currently has very low inflation (perhaps due to gentrification ala Japan?). There will be an increase in NER -- other nations buy the oil (or invest in oil extraction) -- and/or a decrease in inflation to create the rise in RER. Assuming the central bank wants to fight disinflation and targets exchange rates, the central bank will attempt to lower, or at least hold steady, the RER. So what happens? If the central bank can control monetary policy then RER shouldn't change. If so, your model doesn't explain the exchange rate (controlled by central bank), but tells the central bank what it must do to get its target outcome (fight increasing RER). Is that right??
(I assume an analogous argument applies to interest rate pressures)
Thanks, Lost wheel
Lots of good tips in the article to do a quick Google search for currency conversions. Please Visit:ReplyDelete
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