This paper considers elements of macroeconomic policy central to Ireland’s objective of being among the first countries to enter into European Economic and Monetary Union. The paper analyzes the main determinants of the Irish pound/sterling exchange rate, an issue brought to the fore by the currency turbulence of March 1995, which saw a sterling-inspired decline in the Irish pound against the deutsche mark. It also considers fiscal developments and prospects, highlighting tax reform measures undertaken to accelerate job creation, the growth of spending in recent years, and the medium-term fiscal outlook.

Abstract

This paper considers elements of macroeconomic policy central to Ireland’s objective of being among the first countries to enter into European Economic and Monetary Union. The paper analyzes the main determinants of the Irish pound/sterling exchange rate, an issue brought to the fore by the currency turbulence of March 1995, which saw a sterling-inspired decline in the Irish pound against the deutsche mark. It also considers fiscal developments and prospects, highlighting tax reform measures undertaken to accelerate job creation, the growth of spending in recent years, and the medium-term fiscal outlook.

I. The Irish Pound-Sterling Exchange Rate: Long-Term Trends and Main Determinants1/

1. Introduction

The recent turbulence in foreign exchange markets has brought exchange rate issues back to center stage in the policy debate in Ireland. After a year of relative stability within the exchange rate mechanism (ERM), in early 1995 the Irish pound experienced a sharp depreciation via-vis the deutsche mark and other former ERM narrow-band currencies. By mid-March the Irish pound reached historical lows vis-a-vis the deutsche mark—trading at over 9 percent below its central ERM rate—and remained for weeks at the bottom of the ERM grid. Reflecting some policy tightening, Irish short-term interest rates rose to 7.1 percent (from an average of 5.9 percent during 1994), opening up a differential of over 2 percentage points against Germany; and, notwithstanding some recovery in the last few weeks, as of June 14, 1995, the Irish pound’s bilateral exchange rate with the deutsche mark remained 5.1 percent below the ERM central parity of IR£1. = DM 2.411.

These events have clearly posed a challenge to the announced objective of exchange rate policy 2/ and thus call for a more detailed look into the issue. An influential explanation for the relative vulnerability of the Irish pound in the ERM emphasizes structural constraints posed by the high openness of the Irish economy and its close links with the United Kingdom. According to the share of exports and imports over GDP, Ireland stands out as the second most open OECD economy. 3/ On the one hand, this degree of openness implies that the low inflation objective of monetary policy dictates that the pound should be kept stable vis-a-vis strong currencies—such as the former ERM narrow band currencies. On the other hand, high openness to foreign trade makes employment crucially dependent on export performance. This constraint is particularly severe in the Irish case because trade with the United Kingdom still accounts for 30 percent of exports and 42 percent of imports. 1/ A depreciation of sterling against strong ERM currencies while the Irish pound keeps its relative position in the ERM, would thus impart a substantial loss of competitiveness for the Irish export sector; unless the strengthening of the Irish pound against sterling is offset by productivity gains or by changes in other “fundamentals” of the Irish economy, this is likely to generate depreciation expectations and thus drive the Irish pound down in the ERM grid.

This chapter examines possible explanations for the recent fluctuations of the Irish pound from a long-term perspective. It looks at a number of potentially important determinants of the exchange rate against sterling since Ireland joined the ERM in 1979, and investigates the extent to which fluctuations in the Irish exchange rate can be explained by changes in economic fundamentals, as opposed to other less systematic influences. To this end, a simple model of the interaction between the Irish and the U.K. economies is developed and estimated empirically, distinguishing between short- and long-run determinants of the Irish pound-sterling exchange rate.

The structure of the chapter is as follows. Section 2 briefly reviews the Irish experience in the ERM since its inception in 1979 and describes the main trends in the nominal and real exchange rates. This sets the stage for a more formal modelling and econometric estimation of the long-run determinants of the sterling-Irish pound exchange rate, which is provided in Section 3. Section 4 summarizes the main findings and points to some policy implications.

2. Trends in Ireland’s bilateral exchange rates

Ireland joined the European Monetary System (EMS) in early 1979, ending the monetary union with the United Kingdom that had prevailed since independence a half century earlier. The decision to participate fully in the EMS since its inception was a decisive turnaround in Ireland’s exchange rate policy, as it became clear at the time that sterling would not initially participate in the exchange rate mechanism of the EMS. Interestingly enough, neither authorities nor market participants appeared to expect, at that point, that the task of keeping the Irish pound stable vis-a-vis the deutsche mark and other ERM currencies would be strongly dependent on fluctuations in sterling. 1/

These initial expectations failed to materialize, however, soon after the Irish pound joined the ERM. After some respite brought about by a revaluation of the deutsche mark in late 1979, the period 1980-87 witnessed 10 realignment episodes 2/ which resulted in a cumulative depreciation of the Irish pound against the deutsche mark of about 29 percent. Chart 1 shows that the Irish pound’s slide was highly correlated with, and often preceded by, a depreciation of sterling relative to the deutsche mark. 3/

CHART 1
CHART 1

IRELAND REAL EXCHANGE RATES

(Indices: 1979Q1=100)

Citation: IMF Staff Country Reports 1995, 076; 10.5089/9781451818673.002.A001

Sources: IMF, Information Notice System; and staff calculations.

The period of frequent realignments came to an end in 1987, in the context of a broad shift toward tight fiscal and monetary policies. During 1987–92 the Irish pound was kept rather stable at around the central parity of IR£1 = 2.679. Realignment risks were gradually brushed aside and policy credibility enhanced, leading to a substantial narrowing of interest rate differentials with Germany. Also in contrast with the pre-1987 period, the Irish pound experienced a clear long-term appreciation vis-a-vis sterling. This contrasts with the experience of the early 1980s, during which the Irish pound remained well below with sterling, thus creating a widespread perception of parity with sterling as an insurmountable “market barrier.”

Despite its appreciation against sterling beginning in the late 1980s, the Irish pound remained vulnerable to sharp swings in the former currency. Chart 1 shows that the Irish pound breached parity with sterling and avoided a devaluation in the ERM when sterling left the system in September 1992, but this was short-lived; a 10 percent devaluation came a few months later. Following the January 1993 devaluation, the Irish pound traded below parity with sterling, but resumed an appreciating trend vis-a-vis the former currency. Parity with sterling was gradually approached and eventually breached as sterling experienced a sharp decline in early 1995. Yet, this could not prevent a substantial depreciation of the Irish pound within the wide-band ERM. 4/

A prominent explanation for the apparent difficulties of the Irish pound in breaching parity with sterling stresses competitiveness issues. Since wages and prices are relatively rigid in the short run, a nominal appreciation of the Irish pound against sterling would entail a loss of external competitiveness for Irish exports, at least in the short run. 1/ Substantial overvaluation of the Irish pound arising in these circumstances is thus likely to be unsustainable. Chart 2 presents prima-facie evidence in support of this view. One can observe that an appreciation against sterling has been historically associated with an appreciation in Ireland’s real effective exchange rate. In particular, episodes of major realignments of the Irish pound within the ERM, such as in mid-1986 and early 1993, were immediately preceded by sharp appreciations of the real effective exchange rate. 2/

CHART 2
CHART 2

IRELAND REAL EXCHANGE RATES

(Indices: 1979Q1=100)

Citation: IMF Staff Country Reports 1995, 076; 10.5089/9781451818673.002.A001

Sources: IMF, Information Notice System; and staff calculations.

A critical step in this analysis is to measure the degree of over- or under-valuation of the pound by simply looking at changes in the actual real exchange rate. The relationship between actual changes in real exchange rate indices and external competitiveness is far from straightforward.3/ Actual movements in real exchange rates may themselves be a response to shifts in relative competitiveness between national economies. For instance, if productivity in the domestic economy is growing much faster than abroad, the resulting real exchange rate appreciation is not incompatible with an equilibrium current account position. Likewise, a country which undergoes fiscal consolidation, leading to falling interest rates, may enjoy a real exchange rate appreciation, and this need not generate current account disequilibria. For these reasons, an analysis of the impact of competitiveness on the nominal exchange rate by simply looking at actual changes in the real exchange rate around devaluation episodes can be misleading. This is especially pertinent in the Irish case, given the far-reaching changes in productivity, fiscal performance, and in other economic fundamentals since the country joined the ERM. In light of these considerations, Section 3 looks at the impact of changes in economic fundamentals on the real exchange rate and external competitiveness of the Irish economy.

3. Determinants of Ireland’s equilibrium real exchange rate with sterling

The degree of over- or under-valuation of a currency should be judged in reference to its equilibrium real exchange rate. Actual and equilibrium real exchange rates can differ due to temporary misalignments brought about by monetary shocks, wage and price stickiness and other non-systematic factors. Once these dissipate, however, it is expected that the real exchange rate moves in line with its “fundamentals”, i.e., variables which determine the equilibrium position of a country’s basic balance. 1/ In this general framework, the hypothesis of Purchasing Power Parity or of a constant real equilibrium exchange rate appears as a particular case which may fail to hold in a number of instances.

Table 1.

Ireland: Unit Root Tests

(In percent)

article image
Source: Staff estimates.

Dickey-Fuller test (no time trend included among the regressors). Critical value at a 5 percent significance level: -2.91.

Augmented Dickey-Fuller test where “lag” stands for the number of lags of the autoregressive term. Critical value at a 5 percent significance level: -3.48.

Ireland’s real effective exchange rate based on relative consumer price indices.

Although there is much controversy about the way in which distinct macroeconomic variables determine the real equilibrium exchange rate, most studies agree on the potential importance of three key variables. One is relative productivity growth. As a number of studies have shown, faster productivity growth in a country’s tradable sector (relative to its non-tradable sector or to the tradable sector of its trading partners) exerts an upward pressure on domestic wages and the price of non-tradable goods. This tends to produce an equilibrium appreciation of the real exchange rate. 2/

The external terms-of-trade is another variable which usually has an important bearing on the real equilibrium exchange rate, particularly in small open economies. On the supply-side, an improvement in the terms-of-trade caused by, say, a fall in the price of imported inputs (e.g. oil) enhances the production potential of a country’s export sector and hence improves its current account; 3/ in equilibrium, this will call for an appreciation of the real exchange rate. On the demand side, an improvement in the terms-of-trade raises national income and hence the demand for domestic goods. This pushes both wages and non-tradable prices up, thus also leading to an equilibrium appreciation of the real exchange rate.

Fiscal consolidation is also bound to affect the equilibrium real exchange rate through distinct channels. Important distinctions in this connection are those between the effects on goods and capital markets and between expenditure-based and tax-based fiscal consolidation. In general, fiscal consolidation will have a positive effect on domestic capital markets, stemming pressure on domestic interest-rates and thus leading to an equilibrium depreciation in the real exchange rate. Yet, the effects of an expenditure-based fiscal consolidation tend to be stronger than those of tax-based fiscal consolidation due to its direct impact on goods markets. As government expenditure is usually more labor-intensive and biased towards non-tradables, an expenditure-based consolidation shifts demand away from wages and non-tradable goods to a greater extent and thus induces a larger equilibrium depreciation of the real exchange rate. 1/

The effect of these three variables on the equilibrium real exchange rate of the Irish pound should have been considerable. Since Ireland is a small (very) open economy, highly dependent on oil, and with a relatively large share of primary commodities in total exports, terms-of-trade changes have a major bearing on national income. On the other hand, Ireland has witnessed an impressive expansion of hi-tech sectors and a major shake-up of its traditional manufacturing sector since the early 1980s, with far-reaching effects on labor productivity. These favorable productivity developments have been reinforced by fiscal consolidation—the country moved from fiscal profligacy in the late-1970s/early-1980s to a regime of greater fiscal discipline from 1987, with emphasis on expenditure reduction.

The appendix provides a choice-theoretic general equilibrium model which spells out how these distinct transmission mechanisms operate in the context of a small open economy with close ties to a large trading partner. 2/ More specifically, the proposed model attempts to capture three basic features of the Irish economy—namely, its high openness to trade, its close links with the United Kingdom and the country’s sizeable public debt. The solution to the model allows us to write the equilibrium real exchange rate between the Irish pound and sterling as

RERIRUK=F(TOTIR+/TOTUK,ProdIR+/ProdUK,debt+IR,GNPIR,GIR/GNPIR)(1)

where TOT, Prod, debt and G, stand for the net barter terms-of-trade, aggregate productivity, the stock of general government debt and government consumption, respectively. The subscripts “IR” and “UK” indicate whether the respective variable refers to Ireland or to the United Kingdom, and f is a non-linear functional form. The positive signs underneath (1) stand for the signs of the respective partial derivatives. 1/

Due to its non-linear functional form, equation (1) is better estimated by non-linear least squares. Also, since (1) represents a long-run relationship, estimation should be carried out in levels rather than in first-differences of the variables. 2/ The existence of cointegration can then be tested on the basis of the time-series properties of the regression residuals. Table 2 presents the estimation results.

Table 2.

Ireland: Non-Linear Least Squares Estimation of the Equilibrium Real Exchange Rate between the Irish Pound and Sterling

article image

Based on the regression of squared residuals on squared fitted values.

These results suggest that all the variables have an important bearing on the equilibrium real bilateral exchange rate between the Irish pound and sterling. The signs of the values of the estimated parameters are in accordance with those of the theoretical model and their values suggest plausible long-run elasticities.

The diagnostic statistics for the estimated model are also satisfactory. 3/ The “reset” test indicates that the use of a log-linear functional form is not inappropriate, while Dickey-Fuller unit root tests (“DF” and “ADF”) reject the existence of a unit root in the residuals, thus supporting the hypothesis of a long-run, cointegrating relationship among the four variables. Finally, the resulting R2-statistic is very good for an equilibrium real exchange rate model, indicating that it can explain 71 percent of actual variations in the real exchange rate.

Chart 3 depicts both the actual and the equilibrium bilateral real exchange rate computed on the basis of equation (1). The difference between the two can be viewed as an estimate of the over- or under-valuation of the Irish pound relative to sterling and reveals a number of interesting features. First, previous episodes of devaluation of the Irish pound within the ERM were just preceded by a substantial overvaluation relative to sterling. This was clearly the case in 1986 as well as in late-1992. Second, during the relatively long period of stability of the Irish pound within ERM between 1987 and mid-1992, the Irish pound-sterling real exchange rate was never substantially overvalued. Rather, during most of the period, the computed real equilibrium exchange rate was slightly above the actual rate. This suggests that, if anything, the Irish pound was slightly undervalued during those years and hence could “afford” a nominal appreciation against sterling.

CHART 3
CHART 3

IRELAND REAL EXCHANGE RATE AGAINST THE UNITED KINGDOM

(Based on relative CPI, 1979Q1=100)

Citation: IMF Staff Country Reports 1995, 076; 10.5089/9781451818673.002.A001

Source: Staff calculations.

Finally, and somewhat surprisingly, Chart 3 indicates that during late-1993 and 1994, the Irish pound witnessed a real equilibrium depreciation against sterling. A careful look at the parameters of the model reveals the reason. This was a period during which the United Kingdom’s aggregate productivity 1/ rose sharply and the fiscal stance was tightened relative to Ireland, hence leading to a comparative improvement in the United Kingdom’s external competitiveness. As the Irish pound continued to appreciate during the period, this produced an apparent real exchange rate misalignment of about 10 percent in early-1994, which was then subsequently reduced to just over 3 percent by the fourth quarter of 1994. Notwithstanding this improvement, the competitive position of the Irish economy relative to the United Kingdom was not especially strong on the eve of the sharp decline in sterling in early-1995. And although the erosion in Ireland’s external competitiveness during early 1995 was not as large as just before previous devaluation episodes, such as in 1986 and in late-1992, this was probably not enough to sustain further substantial appreciation against sterling.

4. Summary and conclusions

This chapter has documented the main trends in Ireland’s exchange rate since the country joined the ERM in early 1979 and reexamined the reasons for the recent vulnerability of the pound within the ERM. The analysis presented here lends support to the view that links with the United Kingdom continue to play a prominent role in pushing the Irish currency down in the ERM grid during periods of weakness of sterling vis-a-vis the deutsche mark. This is not only due to the substantial dependence of Irish exports on the U.K. market but also due the comparative macroeconomic performance of the two countries which, in turn, defines a sustainable or “equilibrium” level of their real bilateral exchange rate.

This chapter has developed and empirically estimated a model which captures some basic features of the interaction between the Irish and the U.K. economies. In particular, the model shows that differentials in productivity performance, in the external terms-of-trade, and in the Irish fiscal position are major fundamentals which determine the path of the real equilibrium exchange rate between the Irish pound and sterling. A comparison between the predictions of the model and an analysis of past devaluation episodes as well as of the recent depreciation of the pound within the ERM, indicates that attempts to push the nominal and hence the real bilateral exchange rate above such sustainable levels led to speculative pressures on the currency. This suggests that, notwithstanding the increasing geographical diversification of Ireland’s foreign trade since the 1980s, “excessive” appreciation against sterling remains an important constraint on Irish currency policy. 1/

The analysis of this chapter also highlighted similarities as well as differences between the recent depreciation of the pound in the wider-band ERM and past devaluation episodes. A clear similarity is the fact that a real overvaluation against sterling has, once again, brought the pound down vis-a-vis the deutsche mark and other former narrow band currencies. In other words, the Irish currency could not “afford” to appreciate against sterling to the extent necessary to keep its relative position in the ERM grid.

On the other hand, the results also suggest that the gap between the real and the “sustainable” real exchange rate with sterling was small by early 1995, relative to the degree of misalignment observed just prior to the devaluations of 1986 and of January 1993. This seems to indicate that a substantial part of the sharp depreciation against the deutsche mark in early 1995 cannot be attributed to the economic fundamentals discussed above but appears to be responding to nominal shocks or other short-term factors. This suggests that, under a favorable fiscal performance and continuing low inflation prospects, a gradual nominal appreciation of the Irish pound against sterling would therefore be warranted by the relative fundamentals between the two economies.

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.

1. The production side

Both countries produce a tradable good on the basis of time-varying stocks of capital (K) and labor (L) according to a Cobb-Douglas production function:

Y1t=A1tK1tαL1t(1α)(1)
Y2t=A2tK2tβL2t(1β)(2)

where A stands for total factor productivity and the subscripts 1 and 2 for “home” and “foreign” country, respectively. Under perfect competition, the marginal conditions yield

w1t=A1t(1α)k1tα(3)
r1t=A1tαkα1(4)
w2t=A2t(1β)k2tβ(5)
r2t=A2tβk2tβ1(6)

where k is the capital-labor ratio and w and r are the wage and the profit rates, respectively.

2. Consumer behavior

The representative consumer in the home country seeks to maximize her utility from consuming an amount c of the tradable commodity (measured in terms of labor units). Consumption can differ between the first and the second part of her life, depending on the rate of time preferences. Her maximization effort is subject to a budget constraint given by the wage she earns (w) minus a marginal tax rate (t) and how much she saves in the form of private capital (k) and government bonds (b). Since she has a two-period life and no bequest motive, everything she saves in period 1 will be consumed in period 2. Thus, her behavior can be simply described by the maximization of her utility function subject to a sequence of intertemporal budget constraints:

Max.U1=logc1t+δlogc1t+1(7)
s.t.c1t=w1trtb1tk1t(8)
c1t+1=(1+i1t)b1t+(1+r1t)k1t(9)

where, r and i are real rates of return in private assets and government bonds, respectively. Assuming perfect arbitrage between government bonds and private stocks, (7) to (9) can be solved for the optimal savings ratio in country 1:

S1t=δ1+δ(w1tr1t)(10)

Similar behavior is assumed to hold for country 2, with the only difference that the agent only holds foreign bonds as his government does not run excessive deficits, as country 1, and so does not issue bonds. The optimal savings ratio for the foreign country is therefore

S2t=δ1+δ(w2td1t)(11)

3. The government budget constraint

As indicated above, the home government has run sizeable budget deficits over the years and so has a stock of domestic liabilities (b) as well as a stock of foreign liabilities (d). Domestic bonds yield a real rate of interest il; foreign bonds yield a real rate of interest i2, which is the same as the rate of return in private capital markets in country 2 (otherwise the home government would not be able to trade its bonds abroad). This allows us to write the home government budget constraint as:

g1t+b1t+i1t+dti2t=t1t+b1t+1b1t+dt+1d1t(12)

In contrast, the foreign government is assumed to run either a balanced budget or a relatively small deficit. Due the much larger size of the foreign government and its more developed financial relations with third countries, its small deficit could be easily financed by selling bonds outside this two-country world. Under these assumptions, the foreign government’s budget constraint does not have a bearing on the solution of the model and is thus omitted.

4. The resource constraint and solution to the model

In a general equilibrium setting, savings in the two countries have to equal domestic capital formation as well as the issuing of government bonds, i.e.,

s1+s2=b1t+1+d1t+1+k1t+k2t(13)

Substituting (10) and (11) into (13) and noting that k1t[r1t/A2tα]1/1α and k2t[r2t/A2tβ]1/β1 from the production marginal conditions, yields

δ{A2t(1β)[r2tA2tβ]ββ1d1t+A1t(1α)[r1tA1tα]αα1τ1t}=(1+δ){b1t+1+(r1tA1tα)1α1+(r2tA2tβ)1β1}(14)

The latter can be further simplified by taking the logarithm approximation ln (1+δ)= ln δ. Moreover, it has been observed in the Irish case that the size of domestic and external debt have been roughly similar, which enables us to assume that b=d. Since in steady state the tax variables t can be written as a function of current expenditure plus the service of existing debt and r1=γr2, we can write

A2t(1β)[γr1tA2tβ]ββ1+A1t(1α)[r1tA1tα]αα1(γr1tA2tβ)1β1(1γ)r1tb1t[r1tA1tα]1α1=bt+bt+1+Gt(15)

or, more succinctly, as

r1t=g(A1t,A2t,Gt,bt)(16)

where g is a non-linear function.

An expression for the real equilibrium exchange rate can be derived by combining the production side of the model—equations (3) and (5)—with (16). Defining the real bilateral exchange rate as the ratio between country 1 wage rate over the wage rate in country 2, 1/ and adjusting for relative terms-of-trade gains or losses with the “outside” world, we have

RERt=A1tA2t(1α)(1β)(r1tA1tα)αα1(r2tA2tβ)1β1tot1ttot2t(17)

Taking logs of (17) yields

LogRER=constant+(1+11α)logA1t(1+11β)logA2t+(1α1+γβ1)logr1t+log(tot1ttot2t)(18)

Substituting for r1 as defined in (18), enables one to write the real equilibrium exchange rate between the two countries as a function of the four fundamentals (A1/A2,tot1/tot2,b,G).

References

Chapter 1

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1/

Prepared by Luis Cãto.

2/

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.

3/

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.

1/

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).

2/

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.

3/

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/

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.

1/

This view underlines the studies by Bartolini (1993) and Honohan and Conroy (1994) on devaluation expectations and the interest-rate premium on the Irish pound.

2/

This holds for different real exchange rate indices, as shown in the bottom panel of Chart 2.

3/

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.

1/

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).

2/

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.”

3/

This effect is bound to be particularly relevant for countries with capital-intensive export industries.

1/

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).

2/

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.

1/

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.

2/

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.

3/

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.

1/

Throughout the analysis productivity is measured as real GDP (the Unite Kingdom) or real GNP (Ireland) per person employed.

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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.

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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).

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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., P1=Pmw1(1m) and P2=Pnw2(1n). If m=n, the two indices are identical; if not, they will move in tandem. A look at both indices, depicted in Chart 2, indicates that they are highly correlated.

Ireland: Background Papers
Author: International Monetary Fund