In a world of significant exchange rate variability, the problem of evaluating the impact of exchange rate changes on a country’s trade balance carries immediate operational relevance. Even those countries that continue to peg the value of their currencies find that frequent changes in the exchange rates of floating currencies affect the outlook for a substantial segment of their own exports and imports. For example, in 1977, countries that pegged their currencies to the U. S. dollar, the pound sterling, the French franc, the SDR, or some other currency composite still conducted roughly 40 per cent of their export trade with countries that either allowed their currencies to vary independently or did not fix their currencies to the same peg. On a global basis, trade between countries that fixed the value of their currencies in relation to one another accounted for less than one fifth of world exports in 1977.
The primary purpose of this paper is to present a small simulation model that can be used to estimate the medium-run effects of exchange rate changes on the trade balance of a primary producing country (PPC). The model is intended to be sufficiently general in structure to be applicable to a variety of primary producing countries, but for the purposes of empirical illustration it is applied here to four copper producing countries, Chile, Peru, Zaïre, and Zambia. Since reliable empirical estimates are not yet available for all the parameters appearing in the model, the reported simulation results should be regarded more as indications of the types of questions that can be answered by the model than as firm estimates for these particular countries.
The model has four general features that were designed to accommodate some of the more important characteristics of primary producing economies and of the international environment in which they operate. First, the model is multilateral in that it is capable of estimating the effect of a number of simultaneous exchange rate changes on a given country’s trade balance. The tendency for many exchange rates to change, either simultaneously (as in a negotiated currency realignment) or at close intervals (as in the continual readjustment of floating exchange rates), makes the multilateral approach necessary.
Second, the model adopts a commodity-by-commodity approach to primary producing countries’ export earnings. This aspect reflects the facts that, relative to industrial countries, the exports of most primary producing countries are concentrated in a small number of commodities or products, 1 and that these export products are ones that are not distinguished by their place of origin; for example, copper exported by Zambia is a perfect substitute for copper exported by Chile. This latter feature means that the price an exporter receives for his product depends on conditions in the world market for that commodity. Hence, in our view, the interplay between individual primary producing countries’ export receipts and world supply and demand conditions for the products they export can best be analyzed by taking a commodity-by-commodity approach. In addition, disaggregation of exports by commodity allows one to break free of the restriction that each primary producer be regarded either as a price taker or as a price setter for all its exports. In other words, disaggregation of exports by commodity permits a given primary producing country to be a price setter for some of its exports and a price taker for others, with the distinction based on the country’s ability to affect the world supply and hence the world price for that commodity.
The third general feature of the model is the attention paid to the extremely high rates of inflation experienced in many primary producing countries in the past, 2 the effects of which have partially, or even completely, offset the competitive advantage normally gained by devaluation (as regards the country’s external or internal terms of trade). 3 In the model the domestic rate of inflation in each primary producing country is expressed as a function of its excess money balances. The rate of change of domestic prices can then be used to adjust all nominal exchange rate changes into real exchange rate changes, since it is the real exchange rate that is likely to affect the decisions of exporters and importers. The model can perhaps best be understood as providing estimates of the impact of exchange rate changes on a country’s trade balance given some assumed stance of monetary policy in that country that determines its inflation rate. In simulation exercises with the model, it is therefore possible to estimate the trade balance effects of exchange rate changes under alternative rates of domestic monetary expansion. 4
Finally, the model was deliberately kept small and its structure was designed to be relatively simple, so that the information needed to solve the model would be readily available for at least many (less developed) primary producing countries. Thus, the model focuses on only a few key behavioral relationships, such as the demand for money, the demand for imports, the determination of real expenditure, and the supply of exports.
The approach here is to specify simple models of world trade in each of several primary commodities that make up the bulk of a primary producer’s export earnings. Exchange rate changes, which are assumed to be exogenous, together with changes in domestic price levels that are assumed to result from excess money supplies, shift the import demand and export supply schedules for each commodity. These shifts lead to changes in the world price of each commodity. Translating the world price into real domestic currency terms, the change in producer countries’ export earnings for that commodity depends on the size of the domestic supply elasticity. Summing over all of a country’s commodity exports yields the change in total export earnings induced by exchange rate and money supply changes. This change in export earnings, as well as the change in relative prices again resulting from exchange rate and money supply changes, determines the change in the country’s total imports. All of these effects are assumed to take place over the medium run, defined as the length of time over which the country can control both its money supply and its exchange rate, and over which the exchange rate has real effects on trade flows via the exchange rate induced change in relative prices. 5 For the purposes of the simulation exercises, the medium run has been rather arbitrarily labeled as three years, although if a country has relatively high rates of inflation, open capital markets, limited means for sterilizing reserve inflows or outflows, and a small nontraded sector, the relevant medium run may be measured in months rather than years.
The rest of the paper is organized into four sections. Section I describes the structure of the model, while Section II identifies its limitations as well as some of the problems encountered in constructing the model. Section III presents the results of three simulation exercises based on the model and also points out some additional potential uses of the model, including the generation of indices of effective exchange rates for individual primary producing countries. Some concluding remarks are offered in Section IV.
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Mr. Feltenstein, economist in the Special Studies Division of the Research Department, received degrees from Harvard and Yale Universities. Before joining the Fund, he taught at the University of Massachusetts at Amherst.
Mr. Goldstein, Assistant Chief of the Special Studies Division of the Research Department, is a graduate of Rutgers University and of New York University. He was formerly a Research Fellow in Economics at the Brookings Institution. He is currently on a leave of absence from the Fund at the Office of International Monetary Research, U.S. Treasury.
Ms. Schadler, economist in the Special Studies Division of the Research Department, holds degrees from Mount Holyoke College and the London School of Economics and Political Science.
To mention specific figures, the five primary commodities (copper, cobalt, iron ore, fish meal, and zinc) considered in this paper accounted for 97 per cent of Zambia’s total export earnings in 1976. The corresponding figures for Chile, Peru, and Zaïre were 64 per cent, 47 per cent, and 70 per cent, respectively.
For example, the (geometric) mean rate of consumer price inflation over the four years 1973–77 was 246 per cent in Chile, 27 per cent in Peru, 33 per cent in Zaïre, and 15 per cent in Zambia. The corresponding (GNP-weighted) inflation figures for the 14 industrial countries was 10 per cent. The link between inflation rates and money supply changes is strongly suggested by the analogous figures for money supply changes over this period, namely, 225 per cent for Chile, 25 per cent for Peru, 33 per cent for Zaïre, 15 per cent for Zambia, and 8 per cent for the industrial countries. These figures are taken from International Monetary Fund, International Financial Statistics (various issues).
The external terms of trade means the ratio of a country’s export prices to its import prices. In contrast, the internal terms of trade refers to the relationship between the price of tradable goods and the price of nontradable goods. Since for many primary producing countries the external terms of trade are fixed in the world market, exchange rate changes can have a real impact in the economy only by (temporarily) altering the country’s internal terms of trade, i.e., by altering the profitability of exporting relative to other activities in the economy.
The industrial country multilateral exchange rate model (hereafter referred to as industrial country MERM) developed by Artus and Rhomberg (1973) estimated the impact of exchange rate changes under the assumption that the authorities in each country adjusted monetary and fiscal policy so as to hold real output constant. Our model is similar in spirit to the Artus-Rhomberg model in that the effect of exchange rate changes can be estimated only when the path of monetary policy is known. It is, however, more general than the Artus-Rhomberg model, since by not restricting the growth of the money supply to only one value it permits the calculation of exchange rate effects under alternative assumptions about money supply growth (with the Keynesian-neutral, constant real output case as only one of many possibilities).
This stipulation about the medium run is important because in the long run all relative prices in the economy will be determined by real factors, and rates of change of exchange rates and money supplies will be jointly determined. Thus, while in the short run a country can set its exchange rate at some desired level and eliminate unwanted changes in its money supply by sterilizing inflows or outflows of foreign exchange, abnormal inflation rates will in the long run lead to either a depletion of foreign exchange reserves or a money supply backed entirely by foreign reserves. Ultimately, trade or capital restrictions will have to be introduced or intensified, or the exchange rate will have to be changed. At the other end of the spectrum, if the time period is too short, there will not be enough time for most consumers and producers to react to the relative price changes induced by exchange rate changes.
In the notation, the world price of commodities in terms of primary producing countries’ currencies is always expressed in real terms. For example, the world copper price in terms of U. S. dollars is converted into domestic PPC currency units (by the appropriate PPC currency/dollar exchange rate) and then deflated by the domestic PPC price level.
As noted earlier, another quite different argument for using the overall domestic price level as the deflator in the export supply function is that it permits exchange rate changes to affect at least one relative price in the economy even if the primary producing country’s external terms of trade are fixed in the world market. Specifically, because domestic prices include nontraded goods, an exchange rate change can affect trade flows by altering the relative price of traded to nontraded goods (i.e., the internal terms of trade).
In the case of Zambia, we did have access to an index of mining company costs for copper, albeit only for the period 1971–76. It was found that the simple correlation between this index and the consumer price index was about 0.9 (using annual observations for both series).
See, for example, Goldstein and Khan (1978) where trend real income, as well as relative export price, is included in the export supply equation.
Many models of import demand in developing countries ignore relative price effects since technological and institutional constraints are said to limit their importance. To make the model applicable to as wide a variety of countries as possible, however, a relative price argument has been included. Estimates of aggregate import demand functions for a number of less developed countries by Khan (1974) indicate a significant role for relative prices in many cases.
Import expenditure can, of course, vary positively with the increase in import prices if the elasticity of import demand with respect to relative import prices is inelastic (less than unity).
In simulation exercises it is unfortunately not possible to handle inflation determination symmetrically between primary producing countries and industrial countries. In the first place, the industrial country MERM employs far more restrictive assumptions about monetary policy than those applied here for primary producers (see footnote 4). Second, even if this was not the case, the estimation of money-demand equations for each of the industrial countries would be beyond the practical scope of this paper. In view of this constraint, the actual rate of inflation in industrial countries was used for the real exchange rate simulations that are reported in Section III. The reasoning was that it was less harmful to have a theoretical asymmetry in the explanation of inflation (i.e., exogenous and actual for industrial countries versus endogenous and estimated for the four primary producing countries) than to impose a restrictive set of assumptions about monetary policy in the four subject countries.
Following Hirsch and Higgins (1970, p. 454), one can think of the effective exchange rate in general terms as the “total relationship between the given currency and all others.”
In addition to these problems, it should also be mentioned that the model (like its predecessors) is unable to distinguish expected from unexpected exchange rate changes, nor does it account for the possibility that the structural coefficients may change over time as producers and consumers alter their behavior in response to past policy actions of the authorities. Suffice it to say that both these problems are very difficult to deal with.
Different methods of measuring foreign exchange receipts, as well as their role in the import demand function, are discussed in Hemphill (1974). Teigeiro (1977) found, however, that export earnings did as well or better than net foreign assets in explaining the demand for imports in the majority of 22 Latin American and Caribbean countries.
For example, data for Zambia and Zaïre are generally available only for 1965–75, and then usually only on an annual basis.
The estimated demand-for-money equations that were used to generate estimates of the domestic rate of inflation are available upon request from the authors, whose address is Research Department, International Monetary Fund, Washington, D.C. 20431. For Peru, we used an equation developed by the Bank of Peru. For Zambia, we used the estimates developed by Paljarvi and Russo (1977). Since good equations did not seem to be available for Chile and Zaïre, we produced our own estimates based on the model described in equations (14)–(16).
The commodity studies used to select values for the parameters in Tables 1 and 2 included Askari and Cummings (1977), Banks (1974), Bélanger (1976), Charles River Associates (1969), Fisher, Cootner, and Baily (1972), Labys (1975), Richard (1978), and Segura (1973). The studies by Aghevli and Khan (1976), Behrman (1975), Bélanger (1976), Hemphill (1974), Khan (1974), and Teigeiro (1977) proved useful in selecting values for the behavioral parameters in Table 3.
If the value of imports is low relative to the value of exports in a given year, then a smaller change in the value of imports than of exports could still be consistent with a larger percentage change in import value.
Bélanger (1976) came to the same conclusion about the dominance of export receipts in the cases of Zaïre and Zambia.
See Artus and Rhomberg (1973) and Artus and McGuirk (1978) for an explanation of the effective exchange rates calculated from the industrial country MERM. See Lipschitz (1979) for an evaluation of alternative bilateral and multilateral weighting schemes.
These indices of effective exchange rates in Tables 15 and 16 are obviously subject to margins of error as wide as those associated with the estimated trade balance changes. For example, there is a specific source of error introduced into the real effective rate indices by the fact that the model uses estimated as opposed to actual inflation rates in the four copper producing countries.
Although a review of the literature is not included, the model can be viewed as a descendent of earlier work done at the Fund by Armington (1969), Artus and Rhomberg (1973), Bélanger (1976), and Ridler and Yandle (1972). It is also related to recent work done outside the Fund on the effect of exchange rate changes on trade flows by Branson (1972), Black (1976), Bautista (1977), Clark (1977), and Isard (1977).
The feedback effect of the balance of payments on the money supply is, of course, widely recognized in the literature; see, for example, Frenkel and Johnson (1976) and International Monetary Fund (1977). For good treatments of the tradable/nontradable distinction within the context of a monetary model of inflation and the balance of payments, see Aghevli and Rodriguez (1979) and Blejer (1977).