Thorvaldur Gylfason
IMF-Middle East Center for Economics and Finance (CEF)
Course on Macroeconomic Management in Natural
Resource-Rich Countries
Kuwait City, Kuwait, 6-17 January 2013
1. Real vs. nominal exchange rates
2. Dutch disease, overvaluation,
and volatility
3. Exchange rate regimes
 To float or not to float
 How many currencies?
eP
Q
P*
Increase in Q
means real
appreciation
Q = real exchange rate
e = nominal exchange rate
P = price level at home
P* = price level abroad
eP
Q
P*
Q = real exchange rate
e = nominal exchange rate
P = price level at home
P* = price level abroad
1. Suppose e falls
eP
Q
P*
Then more dinars 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
Capture all three by supposing Q falls
Then X rises, Z falls
 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
Real exchange rate
C
B
A
Imports
Exports with oil
Exports without oil
Foreign exchange
Real exchange rate
C
B
Imports
Imports with
immigration
D
A
Exports with oil
Exports without oil
Foreign exchange
 Spending


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


effect
movement effect
Natural resource boom attracts capital and labor
away from rest of economy
Output declines in non-resource economy, esp. in
tradables, where prices are fixed at world levels
 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
hand



Extensive theoretical literature behind this result
What 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,” IMF WP/10/271
 Dutch


Resource booms make currencies appreciate
When currency appreciates in real terms, factors
of production are reallocated and production
switches away from manufacturing


disease does exist
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
Foreign
exchange earnings are
converted into local currency and
used to buy domestic goods
Fixed exchange rate regime
 Reserve
inflow causes expansion of money
supply that leads to inflation and
appreciation of domestic currency in real
terms
Flexible
 Increase
exchange rate regime
in supply of foreign exchange
leads to nominal appreciation of currency,
so real exchange rate also appreciates
Real exchange rate
C
B
A
Imports
Exports with aid
Exports without aid
Foreign exchange
Real exchange rate
C
B
A
Imports
Exports with inflow
Exports without inflow
Foreign exchange
90
80
70
60
50
40
30
20
10
0
Netherlands
Iceland
Norway
 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
Uneven income stream
Even income stream
Per capita growth adjusted for initial incomw (% per year)
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

6
r = -0.47
4
2
0
-2
-4
-6
-8
0
4
8
12
16
20
Volatility of GDP
Output volatility and economic growth
1960-2000
The real exchange rate always
floats
Through nominal exchange rate
adjustment or price change
Even 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
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
 Currency union or dollarization
 Currency board
 Peg
FIXED
Fixed
Horizontal bands
 Crawling peg
Without bands
With bands
 Floating
FLEXIBLE
Managed
Independent
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
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
Managed floating
 Management

by sterilized intervention
I.e., by buying and selling foreign
exchange
 Management
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
Governments may try to keep the
national currency overvalued
To keep foreign exchange cheap
To have power to ration scarce
foreign exchange
To make GDP look larger than it is
Other examples of price ceilings
Negative real interest rates
Rent controls in cities
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
Real exchange rate
Suppose inflation
is 10% per year
110
105
100
Average
Time
Real exchange rate
Suppose inflation
rises to 20%
120
110
Average
100
Time
 If
overvaluation of currency hurts exports,
undervaluation must by similar logic help
exports

Yet, as we saw, empirical evidence is mixed
 Some
countries – e.g., China – have kept
their currencies undervalued to boost
exports and contain imports

Undervaluation as export promotion policy
 Undervaluation
leads to buildup of foreign
exchange reserves

Reserve buildup raises some of the same issues as
natural resources booms
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 categories
 Existing
monetary unions
 De facto monetary unions
 Planned monetary unions
 Previous – failed! – monetary unions
 CFA

franc
14 African countries
 CFP

3 Pacific island states
 East

franc
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 recent
17 EU countries plus 6 others

Thus far, at least until recently (Greece), a success in
view of old conflicts among European nation states,
cultural variety, many different languages, etc.

Indian rupee


South African rand


Switzerland plus Liechtenstein (pop. 30,000)
Australian dollar


US plus Ecuador, El Salvador, Panama, and 6 others
Swiss franc


South Africa plus Lesotho, Namibia, Swaziland – and now
Zimbabwe
US dollar


India plus Bhutan
Australia plus 3 Pacific island states (small populations)
New Zealand dollar

New Zealand plus 4 Pacific island states (small pop.)
 East

African shilling
Burundi, Kenya, Rwanda, Tanzania, and Uganda
 Eco

Gambia, Ghana, Guinea, Nigeria, and Sierra
Leone (plus, perhaps, Liberia)
 Common

Bahrain, Kuwait, Qatar, and Saudi-Arabia
 Other,


currency for four GCC countries
more distant plans
Caribbean, Southern Africa, South Asia, South
America, Eastern and Southern Africa
African Union aims to launch the afro in 2029

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


East African shilling 1921-69


Mauritius and Seychelles 1870-1914
Southern African rand


Kenya, Tanzania, Uganda, and 3 others
Mauritius rupee


Denmark, Norway, and Sweden
South Africa and Botswana 1966-76
Many others
 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
FREE CAPITAL
MOVEMENTS
Monetary
Union (EU)
FIXED
EXCHANGE
RATE
MONETARY
INDEPENDENCE
FREE CAPITAL
MOVEMENTS
FIXED
EXCHANGE
RATE
Capital controls
(China)
MONETARY
INDEPENDENCE
FREE CAPITAL
MOVEMENTS
Flexible
exchange
rate (US, UK, Japan)
FIXED
EXCHANGE
RATE
MONETARY
INDEPENDENCE
FREE CAPITAL
MOVEMENTS
Flexible
exchange
rate (US, UK, Japan)
Monetary
Union (EU)
FIXED
EXCHANGE
RATE
Capital controls
(China)
MONETARY
INDEPENDENCE
 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
Fixed
exchange
rates
Floating
exchange
rates
Costs
Benefits
Fixed
exchange
rates
Floating
exchange
rates
Stability of trade
and investment
Low inflation
Costs
Benefits
Fixed
exchange
rates
Floating
exchange
rates
Costs
Stability of trade Inefficiency
and investment BOP deficits
Low inflation
Sacrifice of
monetary
independence
Benefits
Fixed
exchange
rates
Floating
exchange
rates
Costs
Stability of trade Inefficiency
and investment BOP deficits
Low inflation
Sacrifice of
monetary
independence
Efficiency
BOP equilibrium
Benefits
Fixed
exchange
rates
Floating
exchange
rates
Costs
Stability of trade Inefficiency
and investment BOP deficits
Low inflation
Sacrifice of
monetary
independence
Efficiency
Instability of
BOP equilibrium trade and
investment
Inflation
 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
 There
is no evidence that countries with
abundant natural resources are more prone
to inflation than other countries

They 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 elsewhere

Volatility of export earnings in natural-resource
rich countries calls for flexibility – if not in
exchange rate, then, e.g., in migration
190 countries
US dollar
(43)
Euro
(27)
Composite
(13)
Other
(8)
Monetary
aggregate
target
(29)
No separate legal
tender (13)
8
3
0
2
0
0
0
Currency board (12)
8
3
0
1
0
0
0
Conventional peg
(43)
14
19
5
5
0
0
0
Stabilized
arrangement (16)
7
1
1
0
2
1
4
Crawling peg (3)
1
0
1
0
0
0
1
Crawl-like
arrangement (12)
4
1
0
0
4
1
2
Pegged exchange
rate within
horizontal bands (1)
0
0
1
0
0
0
0
Other managed
Arrangement (24)
1
0
5
0
9
0
9
Floating (35)
0
0
0
0
14
19
2
Free floating (31)
0
0
0
0
0
11
20
Exchange rate anchor
Inflation
targeting
framework
(32)
Other
(38)
No national currency
Currency board
Conventional fixed rates
Intermediate pegs
Managed floating
Pure floating
7%
6%
31%
21%
19%
16%
100%
There is a gradual tendency towards floating, from 10% of LDCs
in 1975 to 35% of all countries today, followed by increased
interest in fixed rates in economic and monetary unions