Journal Issue
Working Paper Summaries (WP/94/1 - WP/94/76)

Working Paper Summaries 94/22: Targeting the Real Exchange Rate: Theory and Evidence

International Monetary Fund
Published Date:
August 1994
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Many developing countries adopt a real exchange rate target, most often to avoid losses in competitiveness. Such policies are usually referred to as “purchasing power parity (PPP) rules,” and episodes of PPP rules can be documented for Brazil, Chile, and Colombia, among others. For all its practical and policy relevance, there is relatively little analytical work, and even less econometric work, on real exchange rate targeting. This paper focuses on two key questions in analyzing real exchange rate targeting. First, what are the inflationary consequences of giving up a nominal anchor? Second, can money provide the needed nominal anchor if capital is less than perfectly mobile?

The paper analyzes the two questions in the context of a simple, neoclassical, optimizing model. It then tests the main implication of the model for Brazil, Chile, and Colombia and provides empirical evidence that supports the arguments in Lizondo (1991, 1993) and Montiel and Ostry (1991, 1992).

The analysis uses a representative-consumer, cash-in-advance model with flexible prices. It is shown that, in the absence of fiscal policy, the steady-state real exchange rate is independent of (permanent) changes in the rate of devaluation. Hence, policymakers can hope to target the real exchange rate for only a limited period of time.

Under perfect capital mobility, a more depreciated level of the real exchange rate can be achieved by generating higher inflation today than in the future. Numerical simulations of the model suggest that, since the intertemporal elasticity of substitution for most developing countries is low, the inflationary effects of real exchange rate targeting might be substantial.

Under no capital mobility, the paper shows that a temporary depreciation of the real exchange rate can be achieved without inflation. However, the domestic real interest rate will rise and keep increasing as long as the real exchange rate remains at its depreciated level. Again, simulations of the model indicate that the rise in the domestic real interest rate may be substantial. In sum, the model suggests that real exchange rate targeting will lead to some combination of higher inflation and high domestic real interest rates.

The empirical section of the paper assesses the relative importance of temporary shocks to the real exchange rate for Brazil, Chile, and Colombia. In all three countries considered, it is found that temporary shocks account for a sizable share of the variance of real exchange rate (between 43 and 62 percent). The paper also finds that in all three cases the correlation has the expected sign and is statistically different from zero, with values ranging from 0.26 to 0.42. Finally, the paper provides evidence on the long-run relationship between revenues from the inflation tax and the real exchange rate. The results suggest an indirect link between the two via wealth effects.

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