Policymakers in a small developing country that seeks to fix its exchange rate in a world of generalized floating are faced with two principal questions: (a) Against what standard should the country fix the value of its currency, keeping in mind that to fix to any other single currency is to float jointly with that currency against the rest of the world? and (b) under what conditions should there be discretionary changes of the value of the currency vis-à-vis the chosen standard? This paper provides a framework for the discussion of these two questions.
The hypothetical country under consideration is “small” insofar as it exerts neither monopoly power over its exports nor monopsony power over its imports; it is a “developing” country insofar as it lacks a well-developed financial system. The question of the optimal exchange rate system for such a country—that is, whether it should adopt a fixed, managed floating, or free floating exchange rate system—is not addressed in this paper.1 In general, the literature on this question tends to favor the adoption of a fixed exchange rate regime for a developing country: first, because exchange fluctuations will probably be exacerbated if the market for the currency in question is thin and, second, because the effects of transitory supply shocks—crop failures, for example—are cushioned by the use of reserves under a fixed exchange rate system.2 The framework in this paper is relevant, therefore, only after the authorities have decided to peg the exchange rate.
A discussion of exchange rate policy and, in particular, of the appropriateness of changes in the exchange rate must define some long-run equilibrium exchange rate against which to assess the actual exchange rate. This paper makes use of the purchasing-power-parity condition (PPP) to determine a long-run equilibrium toward which prices tend.3 PPP is based on two fundamental assumptions: (a) the law of one price, and (b) the long-run neutrality of money.4 If identical goods originating in two countries are priced identically by the market, and all relative prices are fixed (by the neutral money assumption) in the long run, then overall price indices must obey the PPP condition. However, money is not neutral in the short run, and there is some recent evidence5 that the law of one price does not hold, even over a number of years. Moreover, there is great difficulty in establishing the appropriate base period for a PPP calculation and even greater difficulty in allowing for real (for example, relative productivity) effects on relative prices over time. Various alternative methods of assessing the long-run equilibrium exchange rate have been suggested, all of which provide rather rough-and-ready rules of thumb; those more sophisticated than PPP require either a substantial investment in econometric modeling or a clear idea about how exchange rate expectations are formed.6 For these reasons, and because it is simple and widely understood, we have relied on the use of PPP in this paper.
The sections that follow introduce, in turn, questions that are important to the selection of an exchange rate standard and to the determination of appropriate adjustments against that standard. Where it is considered helpful, the discussion is illustrated by a case study of India. Although India is not a small country by most conventional measures, it is undoubtedly “small” in terms of the operational definition given above. The final section provides a summary of the material covered.
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 Rudolf R. Rhomberg, “A Multilateral Exchange Rate Model,” Staff Papers, Vol. 20 (November 1973), pp. 591–611.
Bélanger, Gérard, “An Indicator of Effective Exchange Rates for Primary Producing Countries,” Staff Papers, Vol. 23 (March 1976), pp. 113–36.
Black, Stanley W., Exchange Policies for Less Developed Countries in a World of Floating Rates, Essays in International Finance, No. 119 (Princeton University, Department of Economics, 1976).
Brillembourg, Arturo (1977), “Purchasing Power Parity and the Balance of Payments: Some Empirical Evidence,” Staff Papers, Vol. 24 (March 1977), pp. 77–99.
Brillembourg, Arturo (1978), “Exchange Rate Policies for Developing Countries: An Alternative View” (unpublished, International Monetary Fund, 1978).
Bruno, Michael, “The Two-Sector Open Economy and the Real Exchange Rate,” American Economic Review, Vol. 66 (September 1976), pp. 566–77.
Feltenstein, Andrew, Morris Goldstein, and Susan M. Schadler, “Multilateral Exchange Rate Model for Primary Producing Countries,” Staff Papers, Vol. 26 (September 1979), pp. 543–82.
Fischer, Stanley, “Stability and Exchange Rate Systems in a Monetarist Model of the Balance of Payments,” in The Political Economy of Monetary Reform, ed. by Robert Z. Aliber (New York, 1977), pp. 59–73.
Heller, H. Robert, “Determinants of Exchange Rate Practices,” Journal of Money, Credit and Banking, Vol. 10 (August 1978), pp. 308–21.
Knight, Malcolm, “Output, Prices and the Floating Exchange Rate in Canada: A Monetary Approach” (unpublished, International Monetary Fund, December 30, 1976).
Kravis, Irving B., and Robert E. Lipsey, “Price Behavior in the Light of Balance of Payments Theories,” Journal of International Economics, Vol. 8 (May 1978), pp. 193–246.
Laffer, Arthur B., “Two Arguments for Fixed Exchange Rates,” in The Economics of Common Currencies, ed. by Harry G. Johnson and Alexander K. Swoboda (London, 1973), pp. 25–34.
Lipschitz, Leslie, “Exchange Rate Policies for Developing Countries: Some Simple Arguments for Intervention,” Staff Papers, Vol. 25 (December 1978), pp. 650–75.
Lucas, Robert E., Jr., “Some International Evidence on Output-Inflation Tradeoffs,” American Economic Review, Vol. 63 (June 1973), pp. 326–34.
Mundell, Robert A., “Uncommon Arguments for Common Currencies,” in The Economics of Common Currencies, ed. by Harry G. Johnson and Alexander K. Swoboda (London, 1973), pp. 114–32.
Officer, Lawrence H., “The Purchasing-Power-Parity Theory of Exchange Rates: A Review Article,” Staff Papers, Vol. 23 (March 1976), pp. 1–60.
Schadler, Susan, “Sources of Exchange Rate Variability: Theory and Empirical Evidence,” Staff Papers, Vol. 24 (July 1977), pp. 253–96.
Sundararajan, V., “Purchasing Power Parity Computations: Some Extensions to Less Developed Countries” (unpublished, International Monetary Fund, November 19, 1976).
Mr. Lipschitz, economist in the Asian Department, is a graduate of the London School of Economics and Political Science.
In addition to colleagues in the Fund, the author is indebted to Carlos Rodriguez and John Williamson for comments on earlier drafts of this paper.
The weight of various factors in the actual, historical choice of an exchange rate regime by a number of countries is discussed in Heller (1978). There is a vast literature on factors that ought to be taken into account in such a choice. Recent articles are Black (1976), Fischer (1977), and Lipschitz (1978).
See Artus (1977).
This is simply the extreme case of a country for which an export-weighted basket and an import-weighted basket are quite different. The example can be easily generalized.
The basket used here is a geometrically weighted average of the yen and the U.S. dollar.
In countries with rapidly adjusting expectations in an inflationary environment, confusion between relative price changes and changes in the overall price index can generate expectations that undermine incomes policies and sustain inflationary pressures. Lucas (1973) provides an interesting discussion of this point.
The MERM is developed in Artus and Rhomberg (1973). Bélanger (1976) describes a similar analysis for primary producing countries; Feltenstein, Goldstein, and Schadler (1979) provide a more complete approach to this problem.
Long-term capital that is used to finance consumption, or investment in nontraded goods with prices that are above equilibrium, provides the exception to this generalization.
Unless the global supply of reserves is infinitely elastic, so that reserves are demand-determined. This, however, implies that only the aggregate of countries besides the reserve currency countries could run a surplus while the aggregate of reserve currency countries would have to run a deficit.
Where these two sets of weights differ, the weights of the Japanese and U.S. inflation rates in the domestic rate are more complicated combinations of the two sets of weights.
Ideally, this should be
An index of nontraded goods prices is not usually available but, assuming relative prices within partner countries are fixed, so that P* is a good proxy for
John Williamson has pointed out that this mechanism assumes that price adjustments precede quantity adjustments. Of course, insofar as there are no price adjustments—owing, for example, to perfect commodity arbitrage—there is no distinction between fixing the real or the nominal exchange rate after a transitory real shock.