APPENDIX: A Model of the Real Equilibrium Exchange Rate between the Irish Pound and Sterling
This appendix presents a model for the real exchange rate between the Irish pound and sterling which builds on three major features of the Irish economy—namely, high openness to trade, close ties with a large trading partner (the United Kingdom), and a sizeable general government debt. The model aims to formalize the mechanisms—already discussed in the main text—through which changes in key economic fundamentals determine the equilibrium path of the real exchange rate in this context.
The proposed setting is a two-country general equilibrium model, where each economy produces one tradable good and is inhabited by a two-period living agent and a long living government. 1/ The model thus consists of three building blocks: a production side, consumer behavior equations, and a government budget constraint. Under simple behavioral rules of utility and profit maximization and associated resource constraints, the model can be solved for a level of real exchange rate which equilibrates both goods and capital markets in the two countries.
Prepared by Luis Cãto.
As spelled out in a recent statement by the Finance Minister (March 19, 1995), the objective of Ireland’s exchange rate policy is that the Irish pound trade vis-a-vis the deutsche mark at least as well as other former ERM narrow band currencies—even if that implied breaching parity with sterling.
According to 1992 figures (i.e. before the introduction of the new system of trade accounting in the EU—the INTRASTAT), exports and imports of goods accounted for 56 percent and 48.7 percent of Ireland’s GDP, respectively. Comparable figures for Belgium are 61.5 percent and 62.5 percent. For a wider comparison across OECD countries, see OECD Economic Surveys: Ireland, OECD, Paris, 1993.
From the point-of-view of aggregate employment, trade links with the United Kingdom are even more important than these figures suggest. This is because labor-intensive exports are chiefly directed to the British market, while capital-intensive manufacturing exports are much more diversified geographically. A recent study which accounts for labor-intensity effects as well as for distortions of transfer pricing on Irish trade statistics, indicates that the level of dependence of Irish exports on the U.K. market has declined little over the last few years and is currently about 4 percent higher than that recorded in official trade statistics (Conroy, 1994, Low Labour Content Sectors: Implications for the Interpretation of Macroeconomic Data, Draft Research Paper, ESRI).
It must be noted, however, that some of these episodes involved other currencies as well and were part of a broader realignment within the system.
This was particularly the case in 1986, when sterling weakened considerably in the wake of the collapse in oil prices. During that year, the Irish pound was devalued twice, leading to the sharpest fall of the currency since the EMS was put into operation.
4/ Following the July 1993 European currency turmoil, the ERM bands have been enlarged so as to accommodate fluctuations of any member currency of up to 15 percent (either side), measured relative to the strongest currency of the system.
See, e.g., MacDonald and Lipschitz (1991) and Edwards (1989). This issue is not dealt with by existing studies (e.g., Thom (1992), Bartolini (1993), Honohan and Conroy (1994)), which assume PPP to hold. This assumption, however, is not robust for the 1979-94 period as a whole. Unit root tests provided in Table 1 cannot reject the hypothesis that Ireland’s real exchange rate—both against sterling as well as in real effective terms—is non-stationary, at variance with PPP.
This is equivalent to saying that the real equilibrium exchange rate is the level of exchange rate consistent with a current account surplus (deficit) that finances (is financed by) sustainable levels of capital outflows (inflows).
The ensuing real exchange rate appreciation “corrects” for the initial positive impact of faster productivity growth on the current account balance, thus bringing it back to equilibrium. The impact of productivity differentials on the real exchange rate is widely known as the “Balassa-Samuelson effect.”
This effect is bound to be particularly relevant for countries with capital-intensive export industries.
On the other hand, expenditure-based fiscal adjustments tend to be more expansionary. This may attenuate (and even reverse) the extent of the equilibrium exchange rate depreciation. See, e.g., Edwards (1989) and Barry and Devereux (1995).
The two-country theoretical setting of the proposed model is a useful analytical simplification, in the light of the high correlation between Ireland’s real bilateral exchange rate with the United Kingdom and its real effective exchange rate (Chart 2) as well as the remarkable similarity between the yield curves in the two countries. For example, as of June 14, 1995, Ireland’s interest rate differentials with Germany on 3-month, 12-month and 10-year bonds are 2.09 percent, 2.44 percent and 1.48 percent, respectively. Corresponding figures for the United Kingdom are 2.06 percent, 2.50 percent and 1.47 percent. In addition, the proposed model does allow for influences outside the Irish-United Kingdom “world”, such as exogenous terms-of-trade shocks.
As spelled out in the appendix, the exchange rate is here defined as the foreign price level over the domestic price level. So, a rise in the RER index implies a real appreciation of the pound.
The superconsistency property of least squares estimation ensures that, in the presence of cointegration, the residuals will have bounded variance and the estimated parameters will represent the long-run response of the real exchange rate to changes in the explanatory variables.
The traditional Durbin-Watson statistics as well as other tests on short-run dynamic misspecification are not reported here since they are irrelevant for the issue of cointegration and the existence of a stable long-run relationship between the real exchange rate fundamentals. Also, the t-ratios reported underneath the parameters should not be given their usual interpretation in classic regression analysis. In the present context, they represent asymptotic t-ratios which indicate the degree of precision with which the respective parameter is estimated.
Throughout the analysis productivity is measured as real GDP (the Unite Kingdom) or real GNP (Ireland) per person employed.
In the long-run, however, this constraint is likely to be gradually attenuated, as Ireland continues to diversify its foreign trade and capital links away from the United Kingdom.
This formulation draws on the existing literature on intertemporal general equilibrium models of exchange rate determination, applying its analytical framework to a two-country setting. For a standard one-country overlapping generations model with tradable and non-tradable goods, see Greenwood (1984). A neo-Keynesian version of the same basic approach can be found in Barry and Devereux (1995). A more general one-country model with non-tradable as well as with exportable and importable goods, is developed in Edwards (1989).
This definition of real exchange rate is consistent with the standard CPI-based index. Since there are only two goods in each country (the traded good and labor), the price level can be considered a weighted geometric average of the two, i.e.,