Exchange Rate Variability and the Macro-economy: Evidence from Developing and Developed Countries

Abstract

Using annual data, the paper studies the time-series evidence regarding the allocation of fluctuations in the exchange rate between demand components, real growth, and price inflation in a sample of developing and advanced countries. The evidence reveals patterns of interaction between the macro-economy and exchange rate variability. Across developing countries, appreciation decreases the cost of imports and price inflation, while depreciation shrinks the output supply, indicating high dependency on imported goods. The reduction in output supply correlates with higher inflation and an increase in the import value. In contrast, the evidence of the negative effect of currency appreciation on output growth is more prevalent across advanced countries, while depreciation stimulates competitiveness, resulting in higher demand for exports, investment and consumption. Across developing countries, exchange rate variability decreases trend real growth and increases trend price inflation. Across advanced countries, exchange rate variability decreases trend real growth while increasing the variability of price inflation and import growth. Minimizing variability of the exchange rate would be beneficial to sustain higher growth and reduce cyclical variability in developing and advanced countries.

Keywords:

• Variability
• exchange rate
• developing and advanced countries

JEL CLASSIFICATION:

• F4
• F41
• F43
• F44

Notes

The views in the paper are those of the author and should not be interpreted as those of the IMF or IMF policy.

1. 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), Bahmani (1991), Gylfason and Radetzki (1991), Rogers and Wang (1995), Hoffmaister and Vegh (1996), and Kamin and Rogers (2000).

2. For evidence of the impact of exchange rate shocks on disaggregated data in the United States, see Kandil and Mirzaie (2002, 2003).

3. Shocks are assumed to fluctuate in response to domestic economic conditions or in response to external vulnerability, for example, capital mobility or fluctuations in the current account balance.

4. Other channels could be relevant to the impact of exchange rate movements on economic activity. Recently, a growing body of the literature has focused on the financial channel of exchange rate volatility, specifically the balance sheet effects (see, e.g. Cowan, 2002; Gertler et al., 2003; Crespedes et al., 2004; Galindo & Montero, 2007). When a significant portion of debt is dominated in foreign currency, depreciation can lead to a larger financial burden, posing two problems: (1) higher debt services and liquidity shortfall, and (2) a net worth reduction due to currency mismatch (see, e.g. Gertler et al., 2003).

5. Asymmetry is expected in the face of unanticipated exchange rate fluctuations that affect demand and supply. In contrast, theory predicts that anticipated exchange rate determines the supply side of the economy only.

6. The theoretical model does not determine the exchange rate or other policy variables endogenously. Instead, the model is solved for the reduced forms that measure the responses to exogenous shocks. In theory, shocks approximate unanticipated deviations from agents’ forecasts based on rational expectations.

7. For details, see Kwiatkowki et al. (1992). That is, real output follows a random-walk process.

8. Test results indicate the non-stationarity of nominal GDP, the oil price, and the exchange rate in the empirical models. Nonetheless, real output is not jointly co-integrated with right-hand side variables.

9. Asymmetry may be induced by institutional constraints that increase nominal flexibility, e.g. in response to positive demand shocks, compared to negative shocks. Alternatively, higher uncertainty and/or higher trend price inflation may increase agents’ incentives for upwards nominal flexibility compared to downward flexibility (see, e.g. Cover & Van Hoose 1993; Ball & Mankiw, 1994).

10. Countries in the advanced group are based on the IMF classification in the World Economic Outlook (WEO) database.

11. Estimates of the empirical models in (1) and (2), as well as the results of estimating the empirical models for various demand components are available upon request.