On the transmission of exchange rate fluctuations to the macroeconomy: Contrasting evidence for developing and developed countries

Abstract

The paper examines channels of interaction between exchange rate shifts and the macroeconomy. Exchange rate shifts are differentiated into anticipated and unanticipated components. Each component affects the demand and supply sides of the economy. Primarily, exchange rate shifts determine export competitiveness and the cost of imported inputs. The evidence reveals a relatively more important role for the cost channel in determining the real and inflationary effects in developing countries, compared with developed countries. Currency appreciation (depreciation), both anticipated and unanticipated, results in an increase (decrease) in output growth and a reduction (an increase) in price inflation in many developing countries. This evidence indicates the adverse effects of currency depreciation on macroeconomic performance in developing countries. Exchange rate policy should not be used to raise export competitiveness without considering the need for structural reforms in developing countries.

Keywords:

• Exchange rate
• anticipated vs. unanticipated shocks
• demand and supply channels
• developing vs. developed countries

Notes

¹ Bruno (1979) and van Wijnbergen (1989) postulate that in a typical semi-industrialized country where inputs for manufacturing are largely imported and cannot be easily produced domestically, firms' input costs will increase following a devaluation.

² As illustrated in Guitian (1976) and Dornbusch (1988), the success of currency depreciation in promoting trade balance largely depends on switching demand in proper direction and amount, as well as on the capacity of the home economy to meet the additional demand by supplying more goods. Empirical support of this proposition for the Group 7 of industrial countries is provided in Mendoza (1992).

³ For an analytical overview, see Lizondo & Montiel (1989). Gylfason & Schmid (1983) provide evidence that the final effects of exchange rate fluctuations depend on the magnitude by which demand and supply curves shift because of devaluation. Hanson (1983) provides theoretical evidence that the effect of currency depreciation on output depends on the assumptions regarding the labour market. Solimano (1986) studies the effect of devaluation by focusing on the structure of the trade sector. Agenor (1991) introduces a theoretical model for a small, open economy and distinguishes between anticipated and unanticipated movement in the exchange rate. Examples of empirical investigations include Edwards (1986), Gylfason & Radetzki (1991), Roger & Wang (1995), Hoffmaister & Vegh (1996), Bahmani (1998), Kamin & Rogers (2000), and Kandil & Mirzaie (2002 2003).

⁴ Several other channels may further indicate inconclusive effects of exchange rate fluctuations. Meade (1951) notes that if the Marshall – Lerner condition is not satisfied, currency depreciation could produce contraction. The Marshall – Lerner condition states that devaluation will improve the trade balance if the devaluing nation's demand elasticity for imports plus the foreign demand elasticity for the nation's exports exceed 1. Hirschman (1949) points out that currency depreciation from an initial trade deficit reduces real national income and may lead to a fall in aggregate demand. Currency depreciation gives with one hand, by lowering export prices, while taking away with the other hand, by raising import prices. If trade is in balance and the terms of trade are not changed, these price changes offset each other. But if imports exceed exports, the net result is a reduction in real income within the country. Cooper (1971) confirms this point in a general-equilibrium model. Diaz-Alejandro (1963) introduced another argument for contraction following devaluation. Depreciation may raise the windfall profits in export and import-competing industries. If money wages lag the price increase and if the marginal propensity to save from profits is higher than from wages, national savings will increase and real output will decrease. Krugman & Taylor (1978) and Barbone & Rivera-Batiz (1987) have formalized the same views.

⁵ For a similar definition, see Shone (1989).

⁶ The model assumes that exchange rate fluctuations affect the external sector through exports and imports. In the real world, currency fluctuations may affect financial flows. Appreciation increases the cost of inflows and decreases the cost of outflows. The net effect is consistent with a reduction in liquidity and, therefore, economic activity, further exacerbating the negative effect on aggregate demand (for details, see Kandil & Greene, 2002, and Clausen & Kandil, 2005).

⁷ The detailed solution of the model appears in Kandil & Mirzaie (2003).

⁸ With the exception of the energy price, shocks are assumed to fluctuate in response to domestic economic conditions or in response to external vulnerability, e.g. capital mobility or fluctuations in foreign reserves.

⁹ The price level may rise unexpectedly in response to energy price shocks, creating incentives to increase the output produced. This channel moderates the reduction in output and the increase in price in response to energy price shocks. For a detailed theoretical illustration, see Kandil & Woods (1997).

¹⁰ Other supply-side channels may reinforce the negative effect of currency depreciation on the output supplied. Recent crises in developing countries have illustrated the mismatch effect of currency depreciation on balance sheets. Many developing countries rely on foreign sources of financing. Currency depreciation increases the cost of borrowing by raising the burden of foreign currency-denominated liabilities. A higher cost of borrowing has an adverse effect on the supply side of the economy, further reinforcing the negative effect on output growth and the positive effect on price inflation in the theoretical model.

¹¹ In theory, shocks approximate unanticipated components of policy shifts based on rational expectations. For example, an overvalued exchange rate represents an unanticipated currency appreciation around agents' expectation of what the exchange rate should be. Econometrically, the anticipated component varies with agents' observations of macro-economic fundamentals, as described in Appendix A. Random shocks capture exogenous fluctuations around the moving trend over time.

¹² For details, see Kwiatkowski et al. (1992). Non-stationarity indicates that real output follows a random-walk process. Upon first-differencing, the resulting series is stationary, which is the domain of demand and supply shifts, as specified in theory.

¹³ Given the non-stationarity of the estimated dependent variables, the empirical models are estimated in first-difference form. Hence, the anticipated component measures anticipated change in the policy variable. Shocks approximate unanticipated change (growth) in the policy variable.

¹⁴ As unanticipated variables are stationary, by construction, cointegration is between the non-stationary dependent variable and non-stationary independent variables, i.e. the anticipated components of variables. As long as there exists at least one cointegrating vector, it is necessary to control for this long-run relationship in the empirical model using stationary data. The error correction term captures deviation around the long-run trend, i.e. the lagged value of the residual from regressing the non-stationary dependent variable on the non-stationary variables in the model. The list of non-stationary independent variables varies based on test results across countries. A negative and significant coefficient for the error correction term indicates that the non-stationary dependent and independent variables adjust together towards full-equilibrium.

¹⁵ In the real world, institutional rigidity may interfere with agents' ability to adjust fully to anticipated demand shifts. In the labour market, implicit or explicit contracts may be longer than one year, preventing wages at time t from adjusting fully to anticipated demand shifts at time t − 1. Accordingly, anticipated demand shifts are not absorbed fully in price. Alternatively, institutional rigidity may be attributed to price rigidity in the product market. To reduce menu costs, producers may resort to adjusting prices at specific intervals over time. Given price rigidity, anticipated demand shifts at time t − 1 may determine real output growth in the short-run.

¹⁶ The energy price is measured by the international energy price. For oil exporting countries, changes in the oil price are likely to contribute positively to output growth. Higher capacity, following a rise in the energy price, is likely to moderate price inflation.

¹⁷ This measure captures shifts attributed to the nominal exchange rate and the foreign price of imports.

¹⁸ Throughout the paper, appreciation will describe an increase in the foreign currency price of domestic currency attributed to either market forces or managed policy within a year. The estimation technique accounts for the endogeneity of the exchange rate with respect to domestic economic conditions. Exogenous shocks are attributed to domestic and/or external shocks.

¹⁹ This measure is likely to vary with a variety of shocks underlying aggregate demand: the money supply, government spending, velocity, consumption, investment, and external shocks attributed to fluctuations in the current and financial accounts.

²⁰ It is common in the macro-econometric literature to approximate aggregate demand using nominal GDP or GNP (see, for example, Kandil & Woods, 1997, and Kandil & Mirzaie, 2002 2003). This measure captures the effects of domestic policy, monetary and fiscal, as well as the effects of velocity and external shocks.

²¹ Anticipated shifts in the real exchange rate are a function of lagged values of variables that enter the forecast equation, including its own lags. Hence, lagged values of domestic price are captured in anticipated currency shifts.

²² Detailed results are available upon request.

²³ Where the contribution exceeds the variability of output, negative covariance exists among the various components of variability.

Additional information

Notes on contributors

Magda Kandil

The views in the paper are those of the author and should not be interpreted as those of the International Monetary Fund.