The role of the exchange rate in economic development Prof. Dr. Hansjörg Herr Berlin School of Economics and Law

Structure What determines the exchange rate? Exchange rate volatility and asset markets When do exchange rate adjustments not work? What do we learn?

Exchange rates and product and asset markets under flexible exchange rates Neoclassical paradigm  Exchange rate dominated by product market  Purchasing-Power-Parity model (PPP) Keynesian paradigm  Foreign exchange markets as asset market  Exchange rates dominated by asset markets  Exchanges rate as link between asset and product markets (similar to investment)

Exchange rates depends on interest rates and exchange rate expectation e = f (i F,i D,e*) e exchange rate in the spot market i F foreign interest rate, depends on monetary policy in the foreign country i D domestic interest rate, depends on monetary policy in the domestic country e* expected exchange rate/ exchange rate in future market

Key question: What determines e*? Neoclassical paradigm  Fundamentals For example the PPP model Real shocks Rational expectations (Dornbusch’s overshooting model)  Exchange rate system as part of the neutral monetary sphere

Keynesian paradigm  Expectations determine exchange rates in future markets  Expectations are given exogenously  Flexible exchange rate systems as chaos system driven by unstable expectations

”Direct evidence on the behaviour of real exchange rates strongly confirms that PPP is not a valid hypotheses about the relationship between nominal exchange rates and national price levels in the short run.” Isard 1995 „How well does PPP theory explain actual data on exchange rates and national price levels? A brief answer is that all versions of the PPP theory do badly in explaining the facts. In particular, changes in national price levels often tell us little or nothing about exchange rate movements.“ Krugman/Obstfied 2000 ”The clear conclusion is that exchange rates are moved largely by factors other than the obvious, observable, macroeconomic fundamentals. Econometrically, most of the ‚action‘ is in the error term.” Dornbusch/Frankel 1988

Exchange rate volatility and asset markets Volatile exchange rates destroy the coherence of international asset markets  Currency mismatch and twin crises  Changes in international value of domestic wealth Flexible exchange rates increase uncertainty and uncertainty the likelihood of expectation shocks ……. Exchange rate movements have in the end the same effects than inflation and deflation

When do depreciations not work? Debt relationships / currency mismatch / twin- crises Depreciation-wage price-spirals are triggered Marshall-Lerner condition does not hold The poverty effect of depreciations is strong

Fixed exchange rates and asset markets Fixed exchange rates serve asset markets Real convertibility implies fixed exchange rates Free capital flows and fixed exchange rates allow for non hegemonic countries no domestic oriented monetary policy Fixed exchange rates can make it difficult to adjust to  Shocks, for example waves of high nominal wage increases  Big current account deficits Fixed exchange rates can lead to stagnation

What do we learn? Global financial markets and flexible exchange rates contradict each other Fixed exchange rates are good for stabilising internationally deregulated asset markets Stable exchange rates and stable asset markets may not serve GDP growth and employment  may lead to extremely high domestic adjustment costs  may lead to the collapse of the fixed exchange rate system

To use exchange rates as an external adjustment mechanism implies a limited role of global financial markets There are other problems of flexible exchange rates, for example inflation and terms of trade effects Keynes in his proposals for the Bretton Woods System is in line with arguments presented here  Exchange rate adjustment only in case of fundamental external disequilibrium  Use of capital controls

Thanks

Exchange rate and growth - No capital flows ---- current account is balanced - Net capital imports ---- current account deficits - Net capital exports ---- current account surpluses In countries with own currency, flexible exchange rates and no interventions in foreign exchange market capital flows determine current account imbalances. In regions like the European Monetary Union capital flows follow trade flows at least until credit rationing takes place.