The Impact of Remittances on Exchange Rate and Money Supply: Does “Openness” Matter in Developing Countries?

ABSTRACT

Using a perfect-foresight general equilibrium monetary model, this article explores the impact of migrants’ remittances on exchange rate and money supply in developing countries and the effect of their “openness” on the impact. The findings indicate that the inflow of remittances leads to appreciation of the nominal exchange rate and increase of money supply under the fixed exchange rate regime. Moreover, a greater degree of openness helps mitigate the appreciation. These findings suggest that remittances and the degree of openness play a significant role in complementing monetary and exchange rate policy, helping to boost economic development. Using a sample of 114 developing countries from 1970 to 2013, empirical tests with both Anderson-Hsiao with instrumental variables and system generalized method of moments’ estimations confirm the theoretical findings.

KEY WORDS:

• “openness”
• exchange rate
• migrants’ remittances
• money supply

Correction Statement

This article has been republished with minor changes. These changes do not impact the academic content of the article.

Notes

1. See also Acosta (2006), Fajnzylber and López (2008), and Funkhouser (1992).

2. See also Amuedo-Dorantes and Pozo (2004) and Rajan and Subramanian (2005).

3. The average of imports’ share to GDP of 114 sample countries with 2,973 observations (about 29%) turns out to be greater than exports’ share to GDP (about 22%).

4. Durdu and Sayan (2010) find that migrant remittances are countercyclical for Mexico and procyclical for Turkey, while Sayan (2006) finds mixed evidence of countercylicality, procyclicality, and acyclicality across countries for the association between migrant remittances and economic activity in the home countries. In terms of motivations for sending remittances, there are both altruistic and self-interested motivations. Remittances are countercyclical with an altruistic motivation (Chami, Fullenkamp, and Jahjah 2005; Lucas and Stark 1985) and procyclical with an investment motivation (Giuliano and Ruiz-Arranz 2009; Sayan 2004).

5. Singer (2010) argues that remittances offset the economic recession automatically in a similar way to countercyclical monetary policy and that remittances-recipient countries are likely to adopt the fixed exchange rate regime.

6. The real exchange rate is also found to be inversely related to migrants’ remittances. For further details, see footnote 17.

7. Rajan and Subramanian (2005) find that unlike the inflows of aid, remittances do not lead to appreciation of real exchange rate.

8. The term Dutch disease originally described the difficulties of the manufacturing sector due to the real appreciation of the exchange rate from a natural resources’ boom in the Netherlands.

9. For more details, refer to the Obstfeld and Rogoff textbook (1996, p. 690).

10. For more details about the assumption of exogenous remittances inflows, refer to Ball, Lopez, and Reyes (2013).

11. The derivation is available upon request.

12. In market clearing conditions for nontradable goods under the symmetric household production, $C_N^A=y_N\left(z\right)=C_N$ for all $z$. The derivation is presented in the Appendix.

13. Hau (2002) also uses this parameter as a measure of openness.

14. The derivation of Equation 16(16) $M^s=\frac{\chi \left(1+\varphi \right)y_T{\bar{P}}_T}{\gamma \left(1-\beta \right)}\left[1+\frac{1}{1-\beta }{\hat{P}}_{T,t}-\frac{\beta }{1-\beta }{\hat{P}}_{T,t+1}\right]$(16) is presented in the Appendix.

15. The derivation of Equation 17(17) ${\hat{P}}_{T,t}=-1+\left[\frac{\gamma {\left(1-\beta \right)}^2}{\chi \left(1+\varphi \right)y_T{\bar{P}}_T}\right]\sum _{i=0}^{\mathrm{\infty }}{\beta }^i{M}_{t+i}^s$(17) is presented in the Appendix.

16. This result is analogous to the one from Cagan money demand that the current price level depends on current and future money supply.

17. The real exchange rate ($e_t$) can also be derived from Equations 9(9) $\frac{\gamma }{C{}_{T,t}^j}=P_{T,t}{\lambda }_t$(9) and 10(10) $\frac{1-\gamma }{C{}_{N,t}^j}=P_{N,t}{\lambda }_t$(10) , along with the market equilibrium condition as follows: $e_t=\frac{P_{T,t}}{P_{N,t}}=\left(\frac{\gamma }{1-\gamma }\right)\frac{C_{N,t}}{C_{T,t}}=\left(\frac{\gamma }{1-\gamma }\right)\frac{y_N}{\left(1+\varphi \right)y_T}$ for all $t$. Refer to Ball, Lopez, and Reyes (2013). Differentiation with respect to $\varphi$ presents the inverse relationship between the real exchange rate and remittances as follows: $\frac{\mathrm{\partial }{e}_t}{\mathrm{\partial }\varphi }=-\left(\frac{\gamma }{1-\gamma }\right)\frac{y_N}{{\left(1+\varphi \right)}^2{y}_T}<0$.

18. The same result can be derived from Equation 15(15) $M_t=\frac{\chi P_{T,t}\left(1+\varphi \right)y_T}{\gamma \left(1-\beta \frac{P_{T,t}}{P_{T,t+1}}\right)}$(15) . Under the fixed exchange rate regime, $P_{T,t}=E_t=\bar{E}$, which means $P_{T,t}=P_{T,t+1}$. Then, we can derive the relationship between the fixed exchange rate and money supply as follows: $M_t^s=\frac{\chi P_{T,t}\left(1+\varphi \right)y_T}{\gamma \left(1-\beta \frac{P_{T,t}}{P_{T,t+1}}\right)}=\frac{\chi \left(1+\varphi \right)y_T}{\gamma \left(1-\beta \right)}\bar{E}$. This implies that money supply is constant under the fixed exchange rate.

19. Data are the sum of two items defined in the sixth edition of the IMF’s Balance of Payments Manual. Following Catrinescu et al. (2009)’s method, workers remittances and compensation of employees are used, while Chami, Fullenkamp, and Jahjah (2005) and Amuedo-Dorantes and Pozo (2004) use only workers’ remittances.

20. GDP is constant US dollars. Since net inflows of FDI contains a negative value, it is not in logarithmic form.

21. Among 114 countries in the sample, 84 countries are classified as the ones with the fixed exchange rate regime. The list of the countries with the “fixed” and “flexible” exchange rate regimes is presented in Table S1 in the Supplementary Material, available online (i.e., See Table S1, available online).

22. Davidson-MacKinnon test of exogeneity for the variables of remittances and money supply is rejected, so instrumental estimation is valid.

23. Lags 2 of remittances, exchange rate, and money supply are used as GMM-style instruments.

24. Data for crop production index and livestock production index are available only up to 2013, so a final sample is chosen from 1970 to 2013. Only four countries-Algeria, Dominican Republic, Kenya, and South Africa-have the longest time series data from 1970 to 2013, so the sample is unbalanced across the countries.

25. Refer to Chami, Hakura, and Montiel (2012), Nsiah and Fayissa (2013), and Lartey (2017).

26. Lartey (2017) also finds that remittances have a positive effect on GDP per capita growth rate while money supply has a negative effect. When the level of money supply is used in lieu of the growth rate of money supply, as in Lartey (2017), the estimated coefficient appears to be negative.

27. To determine the fixed effect or random effect models, a Hausman test is performed and it selects the fixed effect model.

28. A Hausman test selects the random effect model. Nonetheless, the result of the fixed effect model estimation is presented, since it is not statistically different from the result of the random effect model estimation and the Hausman test singles out the fixed effect model in other regressions.

29. Aggarwal, Demirgüç-Kunt, and Pería (2011) also obtain weaker significance from dynamic system GMM estimation of Arellano and Bover (1995). Catrinescu et al. (2009) notes that the Anderson and Hsiao (1981)'s method is superior to the Arellano and Bond (1991) GMM estimator.

30. Unlike the previous outcomes, in the second column, remittances appear to be marginally significant and unexpectedly positive, while similar to the previous outcomes, in the third column, remittances, the openness dummy, and the interaction term are all estimated to be not statistically significant.

31. The fixed exchange rate regime includes no separate legal tender, currency board, conventional peg, stabilized arrangement, crawling peg, crawl-like arrangement, pegged exchange rate within horizontal bands, other managed arrangement. The flexible exchange rate regime includes floating and free floating.

Additional information

Funding

This work was supported by research funds from Chosun University, 2013.