Since the development of the simple IS-LM framework, short-run macroeconomic policy questions have usually been analyzed—implicitly or explicitly—in terms of demand-determined models. 1 Analysis of stabilization policy has generally been in the context of developed economies, and the elegance and appropriateness of more or less sophisticated versions of the IS-LM framework (frequently extended to incorporate openness of the economy) have led, over time, to its becoming the accepted and familiar model. The need for policy formulation in less developed primary producing countries, subject to fluctuating output, calls, however, for an emphasis on the distinction between supply-constrained and demand-constrained situations.
This paper develops some simple propositions about managing an economy under conditions of fluctuations in output, and contrasts them with the more usual case of fluctuations in demand. The focus is on short-run stabilization policy in a developing economy. Since output is exogenous, stabilization policy is defined to mean that policymakers aim to minimize fluctuations in domestic absorption. The economic authority does not ascribe any importance to the exchange rate, the price level, or the stock of foreign exchange in themselves—their only importance is in their effect on absorption. While the framework chosen is simple, it serves to bring together a number of points made in different contexts in a model sufficiently stark to reiterate them forcefully. The model is based on the absorption approach to the balance of payments. 2 There is no domestic bond market and no internationally traded financial asset. Stock disequilibria in the domestic money market are cleared over time and, in the interregnum, affect absorption. As may be expected, in a model where money is the only asset, although the balance of payments is explicitly characterized by an absorption equation, the results of the analysis are identical to those that would emerge from the monetary approach.
Recent agreement on the need for international surveillance over exchange rates has led to a discussion of the principles that should govern surveillance and the criteria by which the appropriateness of exchange rate policies should be judged. 3 A number of economists have argued that official intervention in foreign exchange markets is desirable where market forces lead, in the short run, to exchange rates substantially different from long-term equilibrium rates. The present analysis is aimed explicitly at the use of exchange rate policy, as one instrument of stabilization policy, for a developing country. This stylized developing economy is characterized principally by a lack of diversification and a consequent vulnerability to large and erratic fluctuations in its primary product sectors. The main argument in this paper is that the extent of official intervention in the foreign exchange market should depend upon the origin of short-term shocks to the economy, and that the confusion of various types of shock can lead to erroneous prescriptions that may be particularly serious for a developing country. This paper therefore makes a simple case for intervention in the exchange market under certain well-specified conditions.
It is frequently argued that insofar as flexible exchange rates insulate 4 an economy against shocks of foreign origin, an economy more volatile than the rest of the world should fix its exchange rate; one less volatile should allow its exchange rate to float freely. Such a prescription is, of course, globally inconsistent. In contrast, this analysis suggests that the origin of domestic shocks to the economy is of critical importance: shocks owing to fluctuations in output that are independent of demand are best contained by a more fixed exchange rate regime; shocks to demand that are independent of real output are best dealt with by a more flexible exchange rate regime. 5 Policy analysis is complicated by the difficulty of distinguishing demand shocks from supply shocks or indeed distinguishing “shocks”—which are defined here as transitory changes expected to be reversed in the near future—from more permanent changes in the economic environment.
The paper is set out as follows. Section I specifies a simple model of an open economy and examines the impact effects of two types of domestic shock to the system under different exchange rate regimes. Section II traces the time paths of the endogenous variables of the model after a shock and finds that even this very simple model leads to some interesting patterns of absorption and exchange rate overshooting. In general, however, the simple prescriptions that emerge from an examination of impact effects remain valid when the full disequilibrium dynamics are taken into consideration. Given the domestic component of base money, it is found that intervention in the exchange market can alter the time path of adjustment of absorption to a shock, but not the total amount of adjustment required. Section III introduces active monetary policy and finds that under any but a pure flexible exchange rate regime monetary policy can stabilize absorption. Successful monetary policy of this sort, however, requires that the authorities have perfect information about the time pattern of shocks and, where shocks originate in output, leads to greatly accentuated fluctuations in external reserves. Section IV presents an analysis, under extreme, simplifying assumptions, of exchange rate policy under external shocks—specifically, changes in import prices. Finally, Section V summarizes the conclusions of the analysis. The Appendix sets out some of the algebra of the exchange rate dynamics.
APPENDIX Dynamics of the Model
Suppose that the initial condition is one of full-stock equilibrium in period t-1, that is, Ft-1 = F0,
The final equation for F is as follows:
Defining δ = [1 γz(1 -θ)], the solution of the difference equation in F is
for j = 0, … ,∞
As long as the stability condition (-1 < δ < 1) is met,
Similarly, the final equation for A may be written
j = 1, … ∞,
For a money demand shock in period t,
The solution of the difference equation in F is
for j = 0, … , ∞
Similarly, the final equation for A may be written
j = 1, …,∞
Under both sorts of shock, the exchange rate changes to ensure financial flow equilibrium in each period.
For notational simplicity, in what follows we write
Artus, Jacques R., “Methods of Assessing the Long-Run Equilibrium Value of an Exchange Rate,” Journal of International Economics, Vol. 8 (May 1978), pp. 277–99.
Artus, Jacques R., and Andrew D. Crockett, Floating Exchange Rates and the Need for Surveillance, Essays in International Finance, No. 127, International Finance Section, Princeton University (May 1978).
Black, Stanley W., Exchange Policies for Less Developed Countries in a World of Floating Exchange Rates, Essays in International Finance, No. 119, International Finance Section, Princeton University (December 1976).
Day, William H. L., “Flexible Exchange Rates: A Case for Official Intervention,” Staff Papers, Vol. 24 (July 1977), pp. 330–43.
Fischer, Stanley, “Stability and Exchange Rate Systems in a Monetarist Model of the Balance of Payments,” Ch. 5 in The Political Economy of Monetary Reform, ed. by Robert Z. Aliber (Montclair, N.J., 1977), pp. 59–73.
Foley, Duncan K., “On Two Specifications of Asset Equilibrium in Macroeconomic Models,” Journal of Political Economy, Vol. 83 (April 1975), pp. 303–24.
Johnson, Harry G., “Toward a General Theory of the Balance of Payments,” Ch. 6 in his International Trade and Economic Growth: Studies in Pure Theory (London, 1958), pp. 153–68.
Laffer, Arthur B., “Two Arguments for Fixed Rates,” Ch. 1 in The Economics of Common Currencies: Proceedings of the Madrid Conference on Optimum Currency Areas, ed. by Harry G. Johnson and Alexander K. Swoboda (London, 1973), pp. 25–34.
Laursen, Svend, and Lloyd A. Metzler, “Flexible Exchange Rates and the Theory of Employment,” Review of Economics and Statistics, Vol. 32 (No. 4, 1950), pp. 281–99.
McKinnon, Ronald I., “Instability in Floating Foreign Exchange Rates: A Qualified Monetary Interpretation” (unpublished, 1976). (It is scheduled for publication in Money in International Exchange: The Convertible Currency System.)
Miller, Marcus H., “Can A Rise in Import Prices Be Inflationary and Deflationary? Economists and U. K. Inflation, 1973-74,” American Economic Review, Vol. 66 (September 1976), pp. 501–19.
Mundell, Robert A., “Uncommon Arguments for Common Currencies,” Ch. 7 in The Economics of Common Currencies: Proceedings of the Madrid Conference on Optimum Currency Areas, ed. by Harry G. Johnson, and Alexander K. Swoboda (London, 1973), pp. 114–32.
Mussa, Michael, “A Monetary Approach to Balance-of-Payments Analysis,” Journal of Money, Credit and Banking, Vol. 6 (August 1974), 333–51.
Nurkse, Ragnar, Conditions of International Monetary Equilibrium, Essays in International Finance, No. 4, International Finance Section, Princeton University (Spring 1945).
Poole, William, “Optional Choice of Monetary Policy Instruments in a Simple Stochastic Macro Model,” Quarterly Journal of Economics, Vol. 84 (May 1970), pp. 197–216.
Rodriguez, Carlos Alfredo, “The Terms of Trade and the Balance of Payments in the Short Run,” American Economic Review, Vol. 66 (September 1976), pp. 710–16.
Schadler, Susan, “Sources of Exchange Rate Variability: Theory and Empirical Evidence,” Staff Papers, Vol. 24 (July 1977), pp. 253–96.
Shinkai, Yoichi, “Stabilization Policies in an Open Economy: A Taxonomic Discussion,” International Economic Review, Vol. 16 (October 1975), pp. 662–81.
Thakur, Subhash M., “A Note on the Concept of Effective Exchange Rate” (unpublished, International Monetary Fund, July 18, 1975).
Mr. Lipschitz, economist in the Asian Department, is a graduate of the London School of Economics and Political Science.
The author is indebted to Carlos Rodriguez and to colleagues in the Fund for comments on earlier drafts of this paper. They are not, of course, responsible for remaining errors or for views expressed in this article.
Some papers in the discussion are the following. Artus (1978) discusses methods of identifying the long-run equilibrium exchange rate. The literature on excessive exchange rate variability is reviewed in Schadler (1977). McKinnon (1976) and Day (1977) discuss risk in the foreign exchange market in a framework that readily leads to a case for intervention. That case is, however, quite different from the one made in this paper. Artus and Crockett (1978) discuss the need for surveillance, and various criteria that might be employed in its conduct.
Black (1976) suggests a similar principle without formalizing or generalizing it. Fischer (1977) comes to conclusions similar to those in the present paper. Earlier drafts of the two papers were written independently at about the same time.
For simplicity of expression, it is assumed that capital gains and losses on reserve holdings are monetized. This assumption serves also to simplify the dynamics in the following section without detracting from the generality of the argument. It could be removed simply by substituting
See Shinkai (1975).
A fixed exchange rate regime, in a world of generalized floating, must necessarily define the standard to which it is fixed. To fix the exchange rate in terms of one other currency is to float against all the rest. In this note, a fixed exchange rate refers to a rate effectively fixed in terms of an appropriately weighted basket of trading partner currencies, such that the effects of bilateral changes with individual currencies in the basket sum to zero. See Thakur (1975); Rhomberg (1976).
This characterization of the intervention function is analogous to a rational expectations model insofar as the authorities are postulated to act as if they know the model.
Notably, this is only one sort of demand shock. The standard Hicks-Hansen model distinguishes between shocks that are due to changes in autonomous expenditure and those that are due to monetary instability. Our demand shock is a shock to money demand, but our analysis of demand shocks would not be altered qualitatively if we used a money supply shock or an autonomous expenditure shock.
If the model is to display plausible properties, the stability condition –1 < 1 –(1 – θ)γz < 1 must be met. Alternatively stated, stability requires that a change in base money alters absorption in the following period by a multiple of less than 2. The logic is easiest for the fixed exchange rate case. Suppose that the domestic component of the money base were to rise above equilibrium by 10 units. (i) If the multiplier with respect to absorption were less than 2—say, 1.5—absorption would rise by 15 and external reserves would fall by 15, leaving the money base below equilibrium by 5 but closer to equilibrium than the initial 10-unit discrepancy. Successive changes would oscillate back toward equilibrium. (ii) If the multiplier were greater than 2—say, 2.5—absorption would rise by 25 and external reserves would fall by 25, leaving the money base 15 units below equilibrium. Successive changes would increase the amplitude of oscillations, and the model would be explosive. (iii) If the multiplier were less than unity—say, 0.8—absorption would increase by 8 units and the money base would move to 2 units above equilibrium. The system would not oscillate but would move monotonically back toward equilibrium. In the discussion that follows, it is assumed in the text, for simplicity of exposition, that (1-θ)γz ≤ 1. If in fact (1 – θ)γz > 1, there would be some change in the description of the time paths to equilibrium, but, as long as the model was stable, no change in the basic conclusions.
See Foley (1975) for a discussion of stocks and flows as beginning-of-period and end-of-period models.
This states simply that any transitory changes in money demand are accommodated, and amounts to a repetition of the standard prescription that, insofar as disturbances arise from the monetary system, the money supply process should be accommodating. In the IS-LM framework, which includes a financial market, this argues that if the LM curve shifts about, the authorities should fix the interest rate. (See Poole (1970).) The “demand shock” in this model is a monetary shock, not an autonomous expenditure shock. While the accommodating-money-supply prescription would not hold for an autonomous expenditure shock, flexible exchange rates would stabilize absorption under any sort of demand shock.
In the absence of any monetary-stock disequilibrium, absorption equals the absorptive capacity of income. Changes in the terms of trade will therefore alter absorption both directly and via monetary effects. It is quite simple to construct instead a permanent income model, where absorption is not directly affected by short-term fluctuations in the terms of trade. This would lead to what has been termed a “vicious circle” situation, with domestic agents attempting to maintain real absorption in the face of a reduced real output in terms of their absorption commodity basket. In a richer model, with some goods produced only domestically and some produced only abroad, this system would precipitate an accelerating balance of payments (or exchange rate) crisis, or sharp substitutions out of foreign goods into domestic goods.
The changes in exchange rates are as follows:
Deviations from the initial equilibrium sum to zero. Changes in external reserves are as follows:
j = 1, …, ∞
Deviations from the initial equilibrium sum to
The most interesting problems in this example of an externally generated change in the terms of trade are unfortunately beyond the scope of this simple model. A model including nontraded goods and allowing for some substitution in expenditure could examine the effects of such a shock on the nontraded goods sector. While a substitution effect will reorient expenditure toward nontraded goods, an income effect will decrease demand over all. Here the effect in the nontraded goods sector—and hence employment, prices, and output—will depend on the price elasticity of demand for importables and the behavior of savings.
It has long been well understood that transitory, cyclical shocks require a different policy response than that required by more persistent exogenous changes. This formulation, of course, begs the question of how short must the cycle be for one to characterize a shock as cyclical. See Nurkse (1945).
Stein (1963) considers the optimum time path of absorption. Using his analysis in conjunction with that in the present paper, one should, in principle, be able to find the optimum extent of intervention.
The assumption that rates will be relatively stable seems to imply a harmonization of national economic policies, which, of course, dispenses with the need for flexibility. As noted in Schadler (1977), the evidence from the current period of floating refutes this assumption. There is no adequate measure of the costs of exchange rate fluctuations.