## Abstract

The macroeconomic effects of a variety of exogenous and policy-induced real disturbances are examined under the assumption that the authorities target the level of the real exchange rate. We first discuss the implications—particularly for inflation and the current account—of targeting the rate at an “overdepreciated” level, and then examine the dynamic response of both output and inflation to a number of shocks. Further applications of the model to fiscal explanations of inflation, high-inflation plateaus, and money-based stabilization programs are also considered,

**I**t is by now well accepted that the real exchange rate is an important endogenous variable that responds to both exogenous and policy-induced real disturbances. Not infrequently, however, it is also a variable that is implicitly or explicitly targeted by policymakers. For example, the acceleration of inflation in many developing countries has led to an increased use of nominal exchange rate depreciation as a means of preventing losses in international competitiveness. In many such cases, the nominal exchange rate is explicitly linked to inflation differentials in order to keep the real exchange rate from deviating too far from its targeted level. In this context, policymakers undertake to make frequent adjustments to the nominal exchange rate (in some cases on a daily basis) in order to keep the real exchange rate close to its “equilibrium” level, typically taken to be the level in some base period.^{1}

Previous analytical work has explored the relationship between the real exchange rate and its fundamental exogenous determinants under the assumption that the value of the equilibrium real exchange rate is determined by the requirement that the domestic market for nontradable goods be in continuous equilibrium (internal balance), and that the current account deficit be equal to the value of sustainable capital inflows (external balance).^{2} An important result that emerges from this line of research is that, depending on the values of a variety of elasticities and the type of exogenous disturbance under consideration, movements in the equilibrium real exchange rate may be substantial.^{3} A direct implication of this result is that policies to keep the real exchange rate constant in the face of exogenous real disturbances may prevent the establishment of macroeconomic equilibrium and, hence, may be destabilizing.

Given the prevalence of real exchange rate targeting in developing countries, it is perhaps surprising that there has not been much analytical work on the macroeconomic effects of real exchange rate rules.^{4} Further, there has apparently not been any systematic analysis of the effects of exogenous and policy-induced shocks (such as fluctuations in world interest rates and the international terms of trade and changes in government spending levels and commercial policies) in economies in which the real exchange rate is targeted by the authorities. This is all the more surprising given the frequency with which the developing countries are subjected to such disturbances, as well as the prevalence of real exchange rate targeting in these countries.

This paper addresses some of these issues in the context of a familiar dynamic model in which the authorities pursue an explicit target for the real exchange rate. Its structure is as follows. Section I describes the basic model under a real exchange rate rule. The model is then used in Section II to study the effects of the types of shocks described above on the main endogenous variables of the system. Section III considers further applications of the analysis having to do with fiscal explanations of inflation, high-inflation plateaus, and money-based stabilization programs. The main conclusions of the paper are presented in Section IV.

### I. The Analytical Framework

In this section, we develop a simple dynamic, dependent-economy model, in which the authorities are assumed to follow a PPP-type real exchange rate rule. The main equations of the model are presented first, followed by a description of its equilibrium and solution.

#### The Model

We consider a small open economy in which competitive firms combine labor (available in fixed supply) and a sector-specific factor to produce home goods and exportables, using a standard concave technology.^{5} All prices are flexible, ensuring that full employment is continuously maintained.

The income generated from production of the two goods is received by consumers who use it to buy home goods and importables. Consumers have Cobb-Douglas utility, which implies that they allocate a constant fraction of their total expenditures to each of the two goods in every time period. The real value of aggregate consumption expenditures is assumed to depend on the real value of factor income net of taxes, the real interest rate, and real financial wealth. Real factor income, which we denote by *y*, is the value of output of exportables and home goods, deflated by the consumer price index. As shown in Khan and Montiel (1987), under the assumption that the external trade surplus is zero in the initial steady-state equilibrium, real factor income depends only on the terms of trade (the price of exports relative to imports), denoted by p, with *y*′(*p*) > 0.

Denoting by *c* the real value of aggregate consumption, we have

where *t*_{p} denotes the real value of taxes; *r* is the real interest rate; *e* is the real exchange rate defined as the price of importables relative to nontrad-ables; θ is the weight of nontradables in the price index (and the utility function); and *a*_{p} is private wealth in terms of importables, so that *e*θ*a*_{p} is real private wealth in terms of the consumption basket.^{6}

Real household financial wealth consists of real money balances, *m* = *M /P*, where *M* is the nominal money stock, and *P* is the consumer price index, plus the real value of foreign securities, *f*_{p} = *sF*_{p}/*P*, where *s* is the nominal exchange rate, and *F*_{p} is the nominal value of foreign securities, minus the real value of the private sector's liabilities, *d*_{p} = *D*_{p}/*P*, which are taken to consist of the real value of loans extended by the banking system. Thus

It is assumed that money pays no interest, that the nominal return on foreign assets is *i**, and that the domestic cost of borrowing is *i*. Under the assumptions that domestic and foreign securities are perfect substitutes and that expectations are characterized by perfect foresight, uncovered interest parity implies

where a circumflex above a variable denotes a proportional rate of change, so that *E*(ŝ) is the expected (equal to actual) rate of depreciation of the domestic currency.

The real exchange rate rule followed by the authorities consists of a continuous adjustment in the nominal exchange rate, *s*, that keeps the real exchange rate, *e*, constant at the level that prevailed at the time the authorities began following the rule.^{7} Using the definition of the real exchange rate, *e*, as the price of importables relative to nontradables and the assumption that the law of one price holds for tradable goods, the real exchange rate rule takes the form^{8}

where π_{n} is the rate of inflation of home goods, and π* is the rate of inflation of the world price of the importable good. Because the domestic price index is a weighted average of the price of imports and home goods,^{9} the domestic rate of inflation, π, will be equal to the rate of inflation of home goods, π_{n}, under the real exchange rate rule. Therefore, the rule could equally be written as

which involves only the domestic rate of inflation and the rate of inflation of world prices.

Substituting equation (5) into equation (3) yields a relationship between the domestic interest rate, the foreign interest rate, and the inflation differential under a real exchange rate rule:

Assuming that the demand for real money balances, *L*. depends in conventional fashion on the nominal interest rate and real income, we have, using equation (6)

where *L*_{1} and *L*_{2} are the partial derivatives of real money demand with respect to *i* and *y*, respectively. Finally, defining the domestic real interest rate, *r*, as the difference between the nominal interest rate, *i*, and the rate of domestic inflation, π; and the foreign real interest rate, *r**, as the difference between *i** and π*; and applying equation (6), it is clear that domestic and foreign real interest rates will be equalized; that is, *r* = *r**. Private sector saving is the difference between disposable income and expenditure. Disposable income, in turn, is equal to the sum of factor income and income from asset holdings less tax payments to the government. If all variables are expressed in terms of units of the numeraire, after some manipulation, the real value of private saving, denoted *S*_{p}, may be written as

Using equation (8), the change in the real value of private asset holdings, ȧ_{p}, will be given by

The government in this model consumes the same two goods as the private sector. The reai value of its consumption (in terms of the consumption basket) is denoted by *g*. It finances its expenditures by levying taxes, *t*_{p}, through the receipt of transfers from the central bank. *t*_{b}, and by borrowing, *D*_{g}. Like the private sector, the government also holds foreign securities, *F*_{g}, which provide it with interest income.^{10} Its net worth at any instant (in terms of the numeraire) is denoted by *a*_{g} = (*sF*_{g} — *D*_{g})/*P*_{z}. At any point in time, the government's real budget surplus, *s*_{g}, will be given by

where *f*_{g} = *sF*_{g}/*P* denotes the real value of foreign securities, and *g*_{n} and *g*_{z} denote government consumption of nontradable and importable goods, respectively.

In addition to its instantaneous budget constraint (equation (10)), the government's actions must satisfy the standard intertemporal constraint, which rules out Ponzi-type schemes.^{11} It is straightforward to show that the joint satisfaction of this intertemporal constraint and the analogous constraint for the rest of the world requires that ȧ_{g} must converge to zero. Since

this means that

and, therefore, that one of the variables on the right-hand side of equation (10)—*t*_{p},*g*_{n}, or *g*_{z}— must eventually move into a residual role. Unless otherwise indicated, we will take this variable to be *g*_{z}, so that in the limit, the government's spending and taxation plans must satisfy

where the condition *s*_{g} = π*a*_{g} — *e*^{-θ}(π — π*)*f*_{g} has been imposed on (10).

Turning now to the central bank, its balance sheet is given by

where *a*_{b} represents the central bank's real net worth; and *f*_{b}, *d*_{p} *d*_{g}, and *m* represent, respectively, the real value of foreign securities, *F*_{b} held by the central bank, *sF*_{b}/*P*; the real value of credit extended to the private sector, *D*_{p}/*P*, and to the government, *D*_{g}/*P*; and the real money supply, *M* /*P*, The central bank's operating profits, *s*_{b}, in turn, are given by

Operating profits thus represent the difference between the real value of interest receipts, on the one hand, and transfers to the government, on the other. Finally, from the central bank's budget constraint:

We complete the model by specifying the behavior of the current and capital accounts of the balance of payments. The former, denoted *ca*, is by definition equal to the rate of accumulation of net claims on the rest of the world. If we let these claims be denoted by *F* = *F*_{p} + *F*_{g} + *F*_{b}, and use the definitions of the net worth of each of the three sectors, it is straightforward to show that

Thus, the current account is equal to national saving (recall that there is no investment in the model).

Turning to the capital account (denoted *ka*), using the balance of payments identity *ca* + *ka* = *e*^{-θ}*sḞ*_{b},/*P*, and substituting from the time-differentiated version of equation (14), we have

The first term on the right-hand side of equation (16) simply restates the balance of payments as the excess of the (flow) demand for money, ṁ, over the change in the net domestic assets of the banking system (ḋ_{p} + ḋ_{g} − ḋ_{b}), as in the monetary approach to the balance of payments.

#### Equilibrium and Solution of the Model

The first condition that must be satisfied in any equilibrium is that of internal balance, which requires that the domestic markets for labor and nontradable goods clear continuously:

Equation (17) states that the supply of nontraded goods (given on the left-hand side) must equal the sum of demands from the private and public sectors (on the right-hand side).^{12}

In the fixed nominal exchange rate version of the model, equation (17) determines the real exchange rate, *e*, at each instant, conditional on the predetermined variable, *a*_{p}. In the steady state, *a*_{p} must reach a constant value. Therefore, private wealth accumulation, ȧ_{p}, must be equal to zero:

Equations (17) and (18) together thus determine the steady-state values of *e* and *a*_{p} in the fixed exchange rate version of the model. Notice that, with *e* fixed in the steady state, equation (4) with ŝ = 0 implies that domestic inflation must be equal to world inflation. Assuming that the latter is zero, the steady-state domestic price level is stable (π = 0).

Suppose, for concreteness, that all operating profits of the central bank are transferred to the government in the fixed exchange rate steady state—that is, *t*_{b} = *r**(*f*_{b} + *d*_{p} + *d*_{g}). From equation (13), we then have *s*_{b} = 0. Since equation (11) must also hold, it will be true that *s*_{g} = 0. With steady-state national saving therefore equal to zero, the current account must necessarily be in balance in the fixed exchange rate steady state.

In order to analyze the determination of the equilibrium under a real exchange rate rule, we assume that the target level of the real exchange rate is initially set at the level corresponding to this fixed exchange rate steady state, given the values of the exogenous and policy variables, including the values of *t*_{b} and *g*_{z} described above. In particular, then, the current account of the balance of payments is equal to zero, and the domestic rate of inflation is also zero. The real exchange rate rule holds *e* Constant at its original steady-state value, but the nominal exchange rate. *s*, becomes an endogenous variable, as does the domestic price of importables, *P*_{z}. This means, in particular, that private real wealth, *a*_{p}, is no longer predetermined. Instead, it is an endogenous variable inversely related to the domestic price level, which itself must be proportional to *P*_{z} by the real exchange rate rule. Thus, equation (17) now determines *a*_{p} (through movements in the price level) for given values of *e* and the other exogenous variables. With *a*_{p} determined in this way, the condition ȧ_{p} = 0 must hold continuously, not just in the steady state, in order to ensure continuous equilibrium in the market for nontraded goods. In response to any change in the exogenous variables, equation (17) requires that the level of *a*_{p} jump discretely to its new steady-state value through an adjustment in the domestic price level. In contrast to the model with a fixed nominal exchange rate (and, therefore, an endoge-nously determined real exchange rate), there can be no dynamic adjustment of *a*_{p} during which the economy converges toward the new steady state. Since equation (18) must therefore hold continuously, changes in *a*_{p} induced by shocks must be offset by adjustments in the domestic inflation rate, π, which is the only other endogenous variable appearing in this equation.

The economics of the situation is straightforward. Shocks that give rise to changes in the domestic price level (and thus in *a*_{p}) will tend to alter measured private saving, *s*_{p}. This increase in saving in response to the initial discrete adjustment in *a*_{p} generates an incipient increase in real private wealth. This, in turn, would cause private consumption to increase over time, leading to excess demand for nontraded goods. In order to maintain equilibrium in the home goods market in the face of this incipient demand pressure, domestic prices must rise sufficiently rapidly to maintain *a*_{p} continuously at its new equilibrium level. As in Lizondo (1989), the inflation tax must be sufficiently high as to render the private sector willing to hold the stock of real wealth necessary to clear the market for nontraded goods, given the real exchange rate target and the values of the exogenous and policy variables.

The determination of equilibrium is illustrated in Figure 1. The level of the real exchange rate in the base period satisfies equations (17) and (18), at an initial domestic inflation rate of zero. On the vertical axis, we plot the domestic rate of inflation, π, while on the horizontal axis we plot the level of real domestic assets, *a*_{p}. Equation (17) is represented by the *NN* locus, which shows that, given the real exchange rate target, there is only one level of real assets that will clear the market for home goods. The condition for zero real private wealth accumulation (equation(18)) is labeled *SS*. Its slope is equal to

The numerator of this expression is negative as long as the marginal propensity to consume out of wealth exceeds the world real interest rate, which we assume to be the case.^{14} The sign of the denominator depends on whether the interest elasticity of money demand is greater or less than unity. In what follows, we make the conventional assumption (which would be valid, for example, in any semilog specification) that money demand is interest inelastic at low levels of inflation, but as inflation rises the elasticity eventually rises above unity. This implies that the 55 locus has the “C” shape portrayed in Figure 1, As is usual with this sort of money demand function, there are two possible equilibria, corresponding to the two intersection points of the *SS* curve with the *NN* line. We assume that the government, upon announcing the real exchange rate target. remains at the low-inflation equilibrium, denoted by point *A* in Figure 1, which corresponds to a position of long-run equilibrium for the fixed exchange rate version of the model.

The question of interest, of course, is how the economy will respond to shocks under the new policy regime. To begin with, we can ask how the equilibrium will be affected if the authorities decide on a real exchange rate target that is overdepreciated relative to the initial long-run level, which we denote *e** that is, what are the effects of choosing the target ē> *e**? It is straightforward to verify, from equation (18), that an increase in *e*, at a given value of π (in this case, π = 0), leads to an incipient tendency to dissave on the part of the private sector. To restore saving to its initial level, *a*_{p} has to fall. Thus, the *SS* curve shifts to the left in Figure 2 according to

The new equilibrium value of *a*_{p}, however, will be that which clears the nontraded goods market. Since a real exchange rate depreciation creates an excess demand for nontraded goods, the domestic price level must rise, and*a*_{p}must consequently fall. The locus *NN* thus shifts to the left in Figure 2, The change in the equilibrium value of*a*_{p,}and thus the magnitude of the shift, is given by

Although both curves shift to the left, it is straightforward to verify that the *NN* line shifts by more than the 55 curve and, therefore, that at the original (zero) rate of inflation, real private wealth would be increasing (ȧ_{p} > 0).^{15} This puts upward pressure on domestic prices, implying that the new point of equilibrium (*B* in Figure 2) must involve a higher inflation rate. Thus, the choice of a real exchange rate target that is higher than the one dictated by the long-run equilibrium of the fixed exchange rate version of the model leads to an increase in the domestic rate of inflation. This increase is permanent and is sustained by a permanent inflow of reserves, the counterpart of which is a surplus in the external current account. Given our assumption of perfect capital mobility, it is not possible for the authorities to prevent inflation from rising by sterilizing the increase in foreign exchange reserves.

**Effect of Choosing an Overdepreciated Real Exchange Rate Target**

Citation: IMF Staff Papers 1991, 003; 10.5089/9781451930801.024.A008

**Effect of Choosing an Overdepreciated Real Exchange Rate Target**

Citation: IMF Staff Papers 1991, 003; 10.5089/9781451930801.024.A008

**Effect of Choosing an Overdepreciated Real Exchange Rate Target**

Citation: IMF Staff Papers 1991, 003; 10.5089/9781451930801.024.A008

It should be noted also that choosing a real exchange rate target that avoids an increase in domestic inflation relative to the fixed exchange rate case (that is, setting ē at the level *e**) is no easy matter. In particular, detailed knowledge of the entire economic structure (that is, the values of all the parameters and exogenous variables in the model) is required. It follows that if such knowledge is unavailable and if, in setting a target level for the real exchange rate, one wishes to err on the side of an overdepreciated rather than an insufficiently depreciated target (say, because of external balance considerations), then real exchange rate targeting will be inherently inflationary.

**Effect on Equilibrium of Excessively Depreciated Real Exchange Rate Target**

Citation: IMF Staff Papers 1991, 003; 10.5089/9781451930801.024.A008

**Effect on Equilibrium of Excessively Depreciated Real Exchange Rate Target**

Citation: IMF Staff Papers 1991, 003; 10.5089/9781451930801.024.A008

**Effect on Equilibrium of Excessively Depreciated Real Exchange Rate Target**

Citation: IMF Staff Papers 1991, 003; 10.5089/9781451930801.024.A008

A final point to be made before turning to the comparative statics exercises is illustrated in Figure 3. There, it is seen that some targets for the real exchange rate are not feasible, in the sense that no equilibrium exists for choices of ē that are sufficiently above *e**. In terms of Figure 3, since the *NN* schedule shifts by more than the *SS* schedule as the real exchange rate target is raised, it follows that for a sufficiently depreciated target, the two curves will no longer intersect and no equilibrium will exist.^{16} The intuition for this type of situation is clear. While successively higher levels of ē require successively lower levels of*a*_{p}to eliminate excess demand for nontradables, substitution away from domestic money and into foreign currency-denominated assets at high rates of inflation implies that there is no level of inflation that is sufficiently high to generate a large enough inflation tax such that equation (18) can be satisfied. In such a situation, some other policy will need to be altered if such a depreciated real exchange rate target is to be maintained and the economy is to achieve a steady-state equilibrium.

### II. Effects of Shocks in the Presence of Real Exchange Rate Rules

In this section we consider the effects on the two endogenous variables of the system—the level of inflation and the level of private real wealth— of a variety of real shocks frequently experienced by developing countries. The shocks to be considered are a change in the terms of trade; changes in fiscal policies; changes in commercial policies; and fluctuations in the level of world real interest rates.

#### Fluctuations in the Terms of Trade

Consider first the effects of a rise in ρ—that is, an improvement in the terms of trade.^{17} From equation (8), we know that, for a given rate of inflation π, an increase in p raises saving because it leads to a rise in real factor income, not all of which is consumed. The stabilization of real private wealth therefore requires a rise in*a*_{p,} which reduces saving by increasing consumption. This is shown by the rightward shift of the *SS* curve in Figure 4, whose magnitude is given by

**An improvement in the Terms of Trade**

Citation: IMF Staff Papers 1991, 003; 10.5089/9781451930801.024.A008

**An improvement in the Terms of Trade**

Citation: IMF Staff Papers 1991, 003; 10.5089/9781451930801.024.A008

**An improvement in the Terms of Trade**

Citation: IMF Staff Papers 1991, 003; 10.5089/9781451930801.024.A008

In order to determine the new equilibrium value of*a*_{p,}we turn to the condition for equilibrium in the market for nontraded goods. An increase in p raises the real product wage in the home goods sector, and thereby causes a reduction in the supply of nontradable goods. In addition, the rise in p raises real factor income, *y*, which increases the demand for home goods. Thus, both the supply and the demand effects lead to an incipient excess demand in the home goods market, which requires (given that *e* is fixed by equation (4)) a reduction in *a*_{p} to restore market clearing.^{19} The magnitude of the reduction in *a*_{p} and, hence, the extent of the leftward shift of the AW schedule in Figure 4, is given by

It is clear from Figure 4 that, at the original level of inflation, real private wealth would be increasing. The fact that ȧ_{p} is incipiently positive generates excess demand pressures in the home goods market, thereby putting upward pressure on domestic prices. Equilibrium is therefore only re-established once inflation, and, hence, the inflation tax, has increased to a level that is sufficient to induce the private sector to hold the new equilibrium value of *a*_{p} (which is determined in the home goods market, given the new value of p).

The new equilibrium is given by point *B* in Figure 4, where*a*_{p}is lower and π higher than at point *A*. Totally differentiating equations (18) and (17) yields the magnitude of the increase in inflation as given by

This equation shows that inflation rises for two reasons. First, as previously indicated, the rise in p directly contributes to an increase in saving, which, from equation (18), requires π to rise in order to stabilize real wealth. The magnitude of this direct effect is given by the first term in equation (24), y′[1 − *c*_{1} − (*r** + π)*L*_{2}]. In addition, the fall in*a*_{p}that is necessary to clear the home goods market also increases saving, and, hence, requires an increase in inflation to keep *a*_{p} from rising above zero. The magnitude of this indirect effect is given by the second term in equation (24), namely, -[(*c*_{3} − *r**)(∂*y*_{n}/∂ρ − *y*′θ*c*_{1})/θ*c*_{3}].

Finally, as mentioned earlier, the effects of an improvement in the terms of trade under real exchange rate targeting depend on which definition of the real exchange rate is chosen as the target. Formally, if the authorities decide to target the exportables real exchange rate, *e*_{x} = *e*ρ, the effects of a rise in ρ will be a combination of those that have been analyzed so far in this subsection, together with a reduction in the real exchange rate, *e*. From Figure 2, we know that the qualitative effects of a reduction in *e* are to lower inflation and raise the level of real wealth and, hence, are opposite to the effects of a rise in p (which tends to raise π and lower *a*_{p}). In fact, the apparent ambiguity can be established analytically, so that in the presence of a target for the exportables real exchange rate, it is not possible to determine in advance whether a change in the terms of trade will be inflationary or deflationary, and whether it will lead to a rise or a fall in real private sector wealth. This underscores the potential importance of specifying which definition of the real exchange rate is actually to be targeted when an economy is subject to shocks that affect its terms of trade.

#### A Change in the Composition of Government Spending

Consider now the effects of an increase in government spending on nontradable goods that is financed by a reduction in spending on importables—that is, a shift in the composition of government spending. Because the government's budget constraint is satisfied without any change in taxes, the compositional shift does not directly affect private sector saving decisions, and, hence, the *SS* curve does not shift in response to the policy change.

Clearly, however, the rise in *g*_{n} creates an incipient excess demand for nontraded goods, the elimination of which requires a fall in *a*_{p} The magnitude of this fall, and, hence, the shift of the AW schedule (see Figure 5), is given by

**A Shift in the Composition of Government Spending Toward Home Goods**

Citation: IMF Staff Papers 1991, 003; 10.5089/9781451930801.024.A008

**A Shift in the Composition of Government Spending Toward Home Goods**

Citation: IMF Staff Papers 1991, 003; 10.5089/9781451930801.024.A008

**A Shift in the Composition of Government Spending Toward Home Goods**

Citation: IMF Staff Papers 1991, 003; 10.5089/9781451930801.024.A008

At a constant inflation rate, this fall in*a*_{p}would increase private sector saving. In order to stabilize real wealth, inflation must therefore rise. The magnitude of the rise (which is indicated by the move along the *SS* schedule from point *A* to point *B* in Figure 5) is given by

#### Changes in Tariff on Imports

Changes in trade taxes are a frequent component of economic policy-making in developing countries. As is well known, the effects of changes in import tariffs or export taxes may be decomposed into an income effect and a substitution effect. When both are present, the effects of trade taxes are very similar to those of shocks to the international terms of trade. Since these were investigated in an earlier subsection, we will concentrate here on the pure substitution effects associated with trade taxes. This is done by assuming that the government redistributes the proceeds from the trade tax in a lump-sum fashion, and also that there are no initial distortions. Under these circumstances, changes in the tariff, or equivalently in the tax on exports, do not alter the level of real disposable income received by the private sector. Finally, in terms of the notation we have presented thus far, it is necessary to reinterpret the variables ρ and *e* as the *internal* terms of trade and real exchange rate—that is, relative prices that are inclusive of the ad valorem tax rates on imports or exports.^{20}

Since the level of real disposable income received by the private sector, *y*(ρ) — *t*_{p}, is unaffected by the tariff change, it is clear from equation (18) that for a given level of inflation, private sector saving is unchanged. Thus, the *SS* curve does not shift in Figure 6. However, the imposition of the tariff reduces the real product wage in the nontradables sector, and thereby leads to an expansion of output in that sector. In order to maintain market clearing, the level of real private wealth must jump upwards. The magnitude of this increase, and, hence, the extent of the rightward shift of the *NN* schedule in Figure 6, is given by

Given the rise in*a*_{p}that is necessary to clear the home goods market, it is clear that at the initial inflation rate associated with point A in Figure 6, there is a decrease in private sector saving. In order to stabilize private sector wealth, the new equilibrium (given by point *B*) requires a lower level of inflation, where the magnitude of the change is given by

**An Increase in Tariffs on Imports**

Citation: IMF Staff Papers 1991, 003; 10.5089/9781451930801.024.A008

**An Increase in Tariffs on Imports**

Citation: IMF Staff Papers 1991, 003; 10.5089/9781451930801.024.A008

**An Increase in Tariffs on Imports**

Citation: IMF Staff Papers 1991, 003; 10.5089/9781451930801.024.A008

In this subsection, as in the one dealing with terms of trade shocks, we have assumed that the measure of the real exchange rate targeted by the authorities, *e*, is the consumption or importables measure. However, one could either think of the government targeting *e* = *e**(1 + *t*), where *t* is the ad valorem tariff rate, and *e** is the exchange rate-adjusted world price of importables relative to the domestic price of nontraded goods, or *e** itself.^{21} As in the terms of trade case, when the government targets *e**, it follows that the effects are a combination of the ones identified here, together with a change in the real exchange rate target—that is, a rise in *e*. Recall that a rise in *e* raises π and lowers *a*_{p}; that is, it has opposite effects on the model's endogenous variables to those of the tariff change. In fact, however, these indirect effects coming from the change in the real exchange rate target will actually outweigh the direct effects of the tariff change. Therefore, when the authorities target the real exchange rate, *e**, rather than *e*, the new equilibrium following the imposition of a tariff will involve higher inflation and a lower steady-state level of real private sector wealth. Since this is opposite to the results obtained when the authorities targeted *e*, it is clear once again that the choice of which measure of the real exchange rate is to be targeted is of considerable importance when the economy is faced with shocks that affect the internal terms of trade.

#### Changes in World Real Interest Rates

The final exercise to be considered concerns the effects of fluctuations in world real interest rates. As previously mentioned, under a real exchange rate rule such as that given in equation (5), the interest parity condition (equation (6)) implies that domestic and world real interest rates will continuously be equalized; that is, at every instant, *r* — *r**. Thus, fluctuations in *r** will be immediately transmitted to the domestic economy.

At a given inflation rate, an increase in the world real interest rate exerts three distinct effects on domestic saving. First, given the form of the consumption function, a rise in *r** depresses the real value of current consumption, which tends to raise saving. The magnitude of this effect is given by the partial derivative, *c*_{2}, of the consumption function. Second, there is an increase in real interest income in proportion to the existing holdings of interest-bearing assets,*a*_{p}− *L* (which we assume to be positive). This rise in real income also tends to raise saving. Finally, real money balances, which constitute the base for the inflation tax, will fall, The reduction in this tax base (for a given level of the rate) raises the private sectors available resources and thereby contributes to an increase in saving, with the magnitude of this effect being proportional to the change in real balances with respect to the interest rate, *L*_{1}. Thus, these three effects on saving at a given level of π cause the private sector's wealth accumulation to become incipiently positive and therefore require a rise in*a*_{p}in order to return ȧ_{p} to zero. Thus, the magnitude of the shift in the 55 curve in Figure 7 is given by

where the three effects on saving described above correspond to the three terms in the numerator of equation (29).

As before, the change in*a*_{p}resulting from the shock to world interest rates is determined by the equilibrium condition in the market for home goods. Clearly, changes in *r** only affect the demand side of the non-traded goods sector, there being no investment effects on the supply side, With the rise in *r** depressing aggregate consumption, part of which falls on nontraded goods, it is clear that a rise in*a*_{p}(and therefore a fall in the domestic price level) is required to return consumption of home goods to its previous level, to match the fixed supply. The magnitude of the rise in private sector wealth, and, hence, the magnitude of the shift of the AW schedule in Figure 7, is given by

From equations (29) and (30), it is clear that, at a given inflation rate, the overall effect on the level of saving resulting from a rise in *r** depends on two conflicting forces. On the one hand, the direct effect of the rise in *r** is to raise saving (equation (29)). According to this direct effect, therefore, the stabilization of private sector wealth requires an increase in the inflation tax and, hence, in the rate of inflation. On the other hand, the indirect effect arises because the rise in *r** requires an increase in*a*_{p}to clear the home goods market. This rise in*a*_{p}tends to depress saving, and calls for a decline in inflation to ensure that ȧ_{p} is zero (equation (30)). However, inspection of the two equations reveals that the direct effect must always dominate (under the maintained assumption of an inelastic demand for money), so that a rise in *r** must always induce an increase in inflation as long as the economy is operating in the inelastic portion of its money demand schedule:

This is illustrated in Figure 7 where, at the new equilibrium (point *B*), both*a*_{p}and π are higher than initially (point *A*)—that is, prior to the rise in world interest rates.

**A Rise in World Real Interest Rates**

Citation: IMF Staff Papers 1991, 003; 10.5089/9781451930801.024.A008

**A Rise in World Real Interest Rates**

Citation: IMF Staff Papers 1991, 003; 10.5089/9781451930801.024.A008

**A Rise in World Real Interest Rates**

Citation: IMF Staff Papers 1991, 003; 10.5089/9781451930801.024.A008

### III. Some Applications

In this section, we apply the results derived above to three important macroeconomic issues: the fiscal view of inflation; the “plateau” character of high-inflation experience; and money-based stabilization.

#### Fiscal Explanation of Inflation

The view that sustained high levels of inflation in many developing countries has been the result of excessive budget deficits is a venerable one, and developments in macroeconomic analysis since Sargent and Wallace (1981) have strengthened this view. The current state of thinking is summarized in Fischer and Easterly (1990):

Milton Friedman's famous statement that inflation is always and everywhere a monetary phenomenon is correct. However, governments do not print money at a rapid rate out of a clear blue sky. They generally print money to cover their budget deficit. Rapid money growth is conceivable without an underlying fiscal imbalance, but it is unlikely. Thus, rapid inflation is almost always a fiscal phenomenon (pp. 138–39).

The analysis in the previous sections purported to explain equilibrium inflation rates, but it did so without explicit mention of the fiscal deficit. What, then, does this analysis have to say about the fiscal view of inflation? The answer to this question has three parts.

High levels of inflation can be sustained without large budget deficits, or even with a balanced budget.

Even where high levels of inflation are accompanied by large budget deficits, the budget deficits may result from high inflation, rather than vice versa.

Nevertheless, expansionary fiscal policy would indeed increase the sustainable level of inflation in this model.

It is easy to see how high inflation can occur without large budget deficits in this model. Suppose the target real exchange rate is one at which the current account is initially balanced, and suppose the economy experiences a favorable terms of trade shock. As shown in Section II, the resulting incipient excess demand for nontraded goods will cause the domestic price level to jump, causing a fall in real household wealth,*a*_{p,}which induces households to save, and thus gives rise to a current account surplus. This reserve inflow must be monetized by the central bank, since perfect capital mobility rules out the possibility of sterilization. As the money supply increases, sustaining equilibrium in the market for non-traded goods requires that prices continue to rise, keeping the real value of private wealth,*a*_{p,}at its new equilibrium level. With the real exchange rate unchanged, the price increase is sustainable, since the money supply continues to be fueled by a permanent increase in the current account surplus.

Notice that all of this occurs with unchanged fiscal policy. Thus, the government budget remains in balance—inflation, at a possibly high level, coexists with no budget deficit. Nonetheless, there is an increase in the inflation tax, which is the counterpart of the household “saving” required to keep the real money supply constant. With *t*_{b} unchanged, equation (14) shows that ȧ_{b} = π*L*, so this inflation tax accrues to the central bank (not the government). The bank receives this tax in the course of its foreign exchange operations, and devotes it to the accumulation of foreign exchange reserves.

While this general policy stance is sustainable indefinitely, it is not necessarily rational. If it persisted with its original fiscal policy permanently. the public sector in this economy (in the form of the central bank) would acquire claims on the rest of the world that would not ultimately be repaid.^{22} One way to avoid this would be for the central bank to transfer the inflation tax to the government, which would then spend it on imports, *g*_{z}. Then, the fiscal deficit would increase by the amount of the inflation tax, and the current account surplus would disappear.

The rate of inflation, however, is unaffected by this policy. If this transfer were done at the moment the terms of trade shock materialized, an observer would see an increase in the fiscal deficit financed by an expansion of central bank credit to the government, together with an increase in the rate of inflation. In this case, though, inflation is not caused by an increase in the fiscal deficit. Rather, the deficit and the increase in inflation are both caused by a terms of trade shock in the context of real exchange rate targeting. Moreover, the inflation rate may not be reduced by a fiscal adjustment. It would not be. for example, if that adjustment took the form of returning *g*_{z} to its initial level. The only effect of such a measure would be to alter the disposition of the inflation tax—instead of being used by the government to purchase goods abroad, it would be used to amass claims on foreigners,

Finally, none of this suggests that expansionary fiscal policy does not cause inflation. An increase in government spending on nontraded goods, *g*_{n}, would be consistent with the fiscal explanation of inflation. As shown in Section II, with an increase in *g*_{n}, the domestic price level would jump on impact,*a*_{p}would fall, and an increase in the desire to save on the part of households would give rise to an incipient current account surplus. Whether the surplus materializes or not depends on the response of *g*_{z}, but in any event the result is a higher rate of inflation accompanying an expansionary fiscal policy that also results in an increased fiscal deficit.

#### The Plateau Character of High Inflation

A number of developing countries have suffered through prolonged periods of high, but fairly stable, inflation. A common feature of such episodes is that the inflation rate tends to remain at a high and stable level for some time and then move rather quickly to a new (usually higher), but again stable, level. This plateau character of high-inflation episodes has been noted by several observers (see, for example, Liviatan and Piterman (1986)).

Competing explanations have been proposed for this phenomenon. Most familiar is the “fiscal view,” which essentially maintains that, for a variety of exogenous reasons, the government is confronted with the need to raise additional revenue, which it chooses to collect in the form of an inflation tax. An alternative “balance of payments” view suggests that changes in the underlying inflation rate arise from balance of payments crises, which induce exchange rate depreciations. These, in turn, raise the rate of inflation through increasing expectations of inflation, which are then accommodated by the monetary authorities, or through the wage indexation mechanism. The latter arises if the frequency of indexation increases due to inflationary expectations associated with a devaluation. With more frequent wage adjustments, a higher rate of inflation is required to maintain an equilibrium real wage (Liviatan (1986)).

The analysis of real exchange rate targeting presented in Section II sheds light on several aspects of this issue. First, it demonstrates that changes in a stable, but high, inflation rate can arise from either fiscal or external shocks, so the issue is an empirical, not an analytical one. Second, the model demonstrates that external shocks can move the economy to a higher inflation rate without the need to posit what seems to be a tenuous direct link between devaluation and expectations of permanently higher inflation.^{23} Third, external shocks can move the economy to a higher inflation plateau, even in the absence of periodic backward wage indexation or of accommodative credit policy. This can happen in two ways. First, some adverse external shocks, such as increases in world real interest rates, can directly move the economy to a higher inflation equilibrium in the absence of a change in the target real exchange rate. Even a favorable external shock, such as a positive movement in the terms of trade, can have this effect. Second, external shocks can produce an equilibrium with a higher stable rate of inflation, if, in response to such shocks, the authorities alter the real exchange rate target in a way that leads to overdepreciation. Thus, for example, while an adverse terms of trade shock would tend to *lower* the equilibrium inflation rate, a response in the form of a depreciation of the target real exchange rate could easily overshoot, resulting in a new, higher-inflation plateau. There is evidence, in fact, that the upward ratcheting of the inflation rate immediately preceding the “heterodox” stabilization programs adopted by Argentina, Brazil, and Israel in the mid-80s was prompted by exchange rate adjustments in response to adverse external shocks, followed by a period of real exchange rate targeting (see Montiel (1989)).

#### Money-Based Stabilization Programs

As a final application of the model, we examine the likely outcome of money-based stabilizations—that is, stabilization programs based on using a financial aggregate as a nominal anchor, while relying on a real exchange rate target to maintain competitiveness. Suppose, in particular, that the economy to be stabilized finds itself in one of the high-inflation, steady-state equilibria described in previous sections, and suppose that the proceeds of the inflation tax are transferred to the government by the central bank, which also maintains the real supply of credit constant to both the private and public sectors (̂*d*_{p}= ̂*d*_{g} = 0). Thus, high inflation is accompanied by rapid credit expansion and a substantial fiscal deficit.

Consider now the effects of a stabilization program along the following lines. The fiscal deficit is removed by curtailing government spending (we shall assume that this takes the form of reduced public sector imports), thereby removing the perceived fiscal roots of inflation. This is supplemented by the use of credit as a nominal anchor. To take an extreme case, suppose that a target of zero inflation is adopted, so that the stock of credit is frozen. To maintain external competitiveness, however, the nominal exchange rate is devalued initially, so as to achieve a substantial real exchange rate depreciation, and the authorities commit themselves to not allowing the real exchange rate to get out of line in the event of slippages in the rate of inflation—that is, a policy of active nominal exchange rate management is adopted designed to keep the real exchange rate at the target level.

What would be the outcome of such a program? The analysis in previous sections suggests that the rate of inflation will in fact *increase*, although the credit targets are strictly adhered to and the fiscal deficit is eliminated. The reason is that the stock of credit cannot provide a nominal anchor to this economy. The price level is determined by the stock of nominal wealth, and credit policy can only alter the composition of private portfolios, without affecting household net worth. The credit freeze cannot provide a nominal anchor because domestic price increases are being driven by private wealth accumulation, a process over which changes in the rate of growth of domestic credit have no effect. In spite of the credit freeze, the domestic money supply grows continuously, financed by external inflows in the form of the current account surplus,

Inflation increases in this case because the depreciation in the target real exchange rate increases the current account surplus, which, as indicated in Section III, must be monetized. The rate of growth of the money supply increases, despite the credit freeze, through both the current and capital accounts of the balance of payments. From equation (14), it can be shown that the increase in the central bank's net worth, ȧ_{b}, will equal the inflation tax, π*L*, and from equation (16), it follows that the credit freeze (which implies that ḋ_{p} + ḋ_{g} = -π(*d*_{p} + *a*_{g})) simply gives rise to a capital inflow equal to π(*d*_{p} + *d*_{g}). If the rate of growth of credit had instead been positive, the capital inflow (and thus the overall balance of payments surplus) would have been commensurately smaller, with no effect on the inflation outcome.

### IV. Conclusions

This paper has analyzed the macroeconomic implications of real exchange rate targeting in developing countries in the context of a familiar dynamic model. The analysis has concentrated on the following issues: (1) How does the choice of a real exchange rate target affect the nature of macroeconomic equilibrium? (2) Are all real exchange rate targets sustainable, in the sense that, once adopted, the economy converges to a new steady state without having to change some other exogenous variable in the system? (3) How do economies in which the real exchange rate is a target of macroeconomic policy adjust to the types of external and internal disturbances to which developing countries are frequently subjected?

A main result of the paper was that choosing an overdepreciated exchange rate (with a view, say, to achieving some external balance objective) would lead to a rise in the economy's inflation rate. This rate would, moreover, be sustainable, in the sense that in the absence of other exogenous or policy-induced disturbances, the economy would remain at that rate indefinitely. It was shown, however, that the pursuit of successively higher (that is, more depreciated) real exchange rate targets would increase the likelihood that no steady-state equilibrium would exist. These results were thought to be of more than theoretical interest, because choosing a target for the real exchange rate that avoided increasing the rate of inflation would involve detailed knowledge of a variety of structural relationships in the economy, something most policymakers would find difficult to obtain.

It was also shown that, when the authorities pursued a real exchange rate target, a variety of real shocks would have inflationary implications, a result that is quite different from what would obtain in the absence of the real exchange rate rule. For example, in the fixed exchange rate version of the model with an endogenous real exchange rate, terms of trade shocks, a shift in the composition of government spending, or commercial policy changes would have no effect on the economy's steady-state inflation rate. This was shown not to be the case when the real exchange rate is itself a target of policy. In particular, an improvement in the terms of trade and a compositional shift in government spending toward home goods are inflationary under a real exchange rate rule, while the inflationary effects of increases in import tariffs may be positive or negative, depending on which definition of the real exchange rate is actually targeted by the authorities. These results underscore the very different responses to macroeconomic shocks in economies with real exchange rate targeting, relative to those in which the real exchange rate is left to adjust freely in the face of various disturbances.

The far-reaching macroeconomic implications of targeting the real exchange rate were illustrated through three more general policy applications. We showed that inflation need not be the result of excessive fiscal deficits, and that even where a high rate of inflation is accompanied by a large deficit, both phenomena may result from an overdepreciated real exchange rate target, either because the target was chosen inappropriately to begin with, or was chosen correctly initially but rendered inconsistent with stable prices by subsequent events. Also, it was shown that successive plateaus of high inflation, a puzzling and controversial phenomenon observed in several developing countries, may arise due to the incidence of external shocks in the presence of real exchange rate targeting. Finally, stabilization of high inflation using domestic credit as a nominal anchor while relying on a real exchange rate target to maintain external competitiveness may prove to be a precarious undertaking. Depending on how the target real exchange rate is set, the rate of inflation may not only fail to decline, but may actually increase as a consequence of the program.

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^{}*

Peter J. Montiel was Deputy Division Chief of the Developing Country Studies Division of the Research Department when this paper was written and is currently Danforth/Lewis Professor of Economics at Oberlin College. He is a graduate of Yale University and the Massachusetts Institute of Technology.

Jonathan D. Ostry, an Economist in the Research Department, holds a doctorate from the University of Chicago, as well as degrees from the London School of Economics and Political Science, Oxford University, and Queen's University.

The authors thank Patrick Conway, Mohsin S. Khan, Saúl Lizondo, Assaf Razin, Carmen Reinhart, Carlos Végh. and seminar participants at the “Trade and Development” session of the Sixth Annual Congress of the European Economic Association, held in Cambridge, for useful comments.

^{}1

Such rules are usually justified on the grounds that they help to keep the real effective exchange rate close to its purchasing power parity (PPP) level.

^{}2

Examples are Dombusch (1974), Edwards (1989), Khan and Montiel (1987), and Ostry (1988).

^{}3

For an attempt to quantify the magnitude of the response of the equilibrium real exchange rate to a variety of disturbances using representative parameter values for the developing countries, see Khan and Ostry (1991).

^{}4

Exceptions are Dombusch (1982), Adams and Gros (1986), and Lizondo (1989). The differences between these studies and the present one will become clear as we proceed.

^{}5

The main features of the model draw on the standard two-good dependent economy model popularized by Dornbusch (1974), Rodriguez (1978), and Liviatan (1979), The modeling of asset accumulation is similar to that found in Calvo and Rodriguez (1977) and Khan and Lizondo (1987). For a more extensive exposition of the model presented here, see Khan and Montiel (1987).

^{}6

See, for example, Frenkel and Razin (1987a, 1987b, Chap. 4) for previous use of a similar consumption function in the context of an analysis of the Mundell-Flemming model.

^{}7

Alternative forms of a real exchange rate rule are considered in Lizondo (1989).

^{}8

There is an alternative definition of the real exchange as the price of exportables relative to nontradables. Both definitions will, of course, behave identically as long as the terms of trade do not change. Complications arising when there are terms of trade changes will be analyzed where relevant.

^{}11

Technically, the requirement is that the government's net worth be nonnegative in the long run.

^{}12

Equation (17) already incorporates labor market equilibrium, since the sectoral supply functions depend on the real wage, which, in turn, depends on the terms of trade and real exchange rate (see Khan and Montiel (1987)). For notational simplicity, the equilibrium wage function has been suppressed from equation (17).

^{13}

Throughout the analysis, we choose units such that, in the initial steady state, all prices (including *e*) are equal to unity.

^{}14

This assumption would hold, for example, in a life cycle model in which households had finite horizons (see Flavin (1985)).

^{}15

That the *NN* schedule shifts by more than the *SS* schedule can be seen from the fact that the first terms in equations (20) and (21) are identical but the last two terms in equation (21) are each strictly negative.

^{}16

Because the extent of the horizontal shifts in the *NN* and *SS* loci do not depend on the initial level of inflation, the argument provided in the previous footnote is sufficient to establish that, for sufficiently depreciated real exchange rate targets, the two loci will not intersect, and hence, no equilibrium will exist.

^{}17

As mentioned previously, there is reason to believe that the effects of targeting the importables or the exportables real exchange rate will differ when there are shocks to the terms of trade. To begin with, we assume that the authorities target *e* (the importables real exchange rate). However, we then briefly consider the consequences of targeting the exportables real exchange rate, *e*ρ. Finally, it should be recalled that when p is constant (as in the remainder of this section. except for the subsection dealing with tariffs), it makes no difference which definition of the real exchange rate the authorities choose to target. Accordingly, except for the discussion on tariffs, we only consider the effects of targeting the importables real exchange rate, *e*.

^{18}

In signing equation (22), we assume that the marginal propensity to save remains positive even after allowing for the loss of interest income caused by the instantaneous portfolio shift into money that is induced by an increase in household income (see Khan and Montiel (1987. p. 690)).

^{}20

Since Lerner symmetry holds here, we will consider only the effects of changes in the tariff on imports. Also, since the shock in question affects the internal terms of trade, it will be necessary to consider its effects in the presence of alternative definitions of the real exchange rate. In the first part of this subsection, we consider the effects of the tariff in the presence of a target for the importables real exchange rate, while in the second part, we consider a target for the exportables real exchange rate.

^{}21

Notice that targeting *e** is equivalent to targeting the *exportables* real exchange rate, *e*ρ. where ρ is the *internal* terms of trade.