A discussion of the political economy of exchange rates can be guided by the following questions: Do politicians actually use it? Are the effects really there? Does it actually buy support?
For the first question, there is indeed evidence that politicians in Latin America have a bias toward appreciating their currencies. Dornbusch and Edwards (1990) refer to the ensemble of expansionary policies with distributive goals that have often generated real appreciation and periodic crisis in Latin America as “macroeconomic populism.” Frieden and Stein (2001) identify a conflict between external balance and domestic purchasing power in the decision to set the level of exchange rates. In a large cross-section of Latin American countries, they show that the currency tends to appreciate before and depreciate after elections.1 Bonomo and Terra (1999) base their discussion of the political economy of exchange rates in Brazil on the observation that real appreciations are politically popular.
Although the “popularity” of appreciated currencies in the region can be reasonably taken for granted, there has been a dearth of studies of the distributional effects of appreciations. This paper skips the discussion on the specific channels through which a policymaker can affect the real exchange rate.2 Instead, we focus on the second question: are the effects really there? The main contribution of this paper is analyzing whether distributional effects can amplify the scope for appreciation-prone policies. We use household-level data from Brazil and Mexico (which account for over half of Latin America’s output and population) to examine how the exchange rate affects households at different points in the income distribution and with different characteristics. The goal is to uncover a compelling, economically significant, distributional effect that might serve as a foundation for a political economy theory of exchange rate populism, and to motivate further research on the third question: do appreciation policies buy political support?3
In a simplified general equilibrium model, this paper identifies two channels through which exchange rate movements can affect household welfare. For a given level of income, changes in exchange rates that are passed through to domestic prices affect the purchasing power of households differentially, depending on how the prices of their consumption baskets respond to exchange rates. For instance, to the extent that poorer households spend a larger share of their consumption on tradable goods (food, a tradable good, tends to have a large weight on the poor’s budget) than richer households, the pass-through or consumption effect of an appreciation tends to be pro-poor. Exchange rate movements will also affect household welfare through a factor income channel. As exchange rate movements affect the relative profitability of different sectors of the economy (for example, manufacturing relative to services), it also shifts the relative demand for labor of different skills, locations, and sector of employment, among other characteristics.4. In addition to this labor market channel, an appreciation can also affect incomes through its impact on profits, and on public and private transfers. Once we have computed the effect of exchange rate movements through these different channels, we can compute its net effect at different points of the income distribution and for household with different characteristics. It is beyond the scope of this paper to estimate the effect of exchange rate movements on average income. Instead we will focus on its distributional effects on income (taking the average income as given) and will normalize the average effect on income to equal zero.
The focus on Brazil and Mexico is based on data availability, their large size, and the substantial differences in their export structures. Mexico has more opportunities for exporting labor intensive manufactures due to NAFTA and its proximity to the United States. As such, we should expect that a larger share of its population would be negatively affected by a real appreciation through the factor income channel.
Our results indicate that the short-term effect of currency appreciation through the consumption channel benefits poorer households more than proportionately as expected. For Brazil, the consumption or pass-through effect of a 10 percent appreciation is equivalent in welfare terms to an increase in income of 1½ percent for the poorest households and only 1 percent for the richest ones. In Mexico, where the exchange rate pass-through is higher, the average of that effect is 4½ percent, and the difference between poorer and richer households is more muted (only about ¼ percent), with the effects peaking at middle income levels (but varying by less than ½ percent across the distribution). The evidence on income effects, however, shows sizable differences that cut through regional and sectoral divides in both countries, but less so across the income distribution. Finally, when total effects are calculated through the sum of pass-through and income effects, the shape of the distribution of welfare effects is dominated by the factor income effects.
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Irineu de Carvalho Filho and Marcos Chamon are economists in the IMF Research Department. The authors are grateful to Rafael Oscório, Sergei Soares, and Sarah Tarsila for sharing the code mapping the Brazilian expenditure survey data to consumer price index items. They also thank Allan Drazen, participants at the 2007 IMF Annual Research Conference, and seminar participants at PUC-Rio for helpful comments.
More recently, Aisen (2007) argued that political opportunism causes exchange rate-based stabilizations to be more likely launched before elections, because they create an initial consumption boom, as the real exchange rate appreciates.
It seems reasonable to assume that there are a number of “levers” at the disposal of policymakers to affect exchange rates at least in the short term. One such option is through a tighter monetary policy. Other policy instruments include trade restrictions, fiscal policy (government spending tilted towards nontraded goods tend to appreciate the currency in the short run), financial sector regulation, capital controls, among others.
There is a related literature that explores individual survey data to inquire on determinants of individual attitudes towards trade policy. See Balistreri (1997); Beaulieu (2002); Scheve and Slaughter (2001); and Mayda and Rodrik (2005).
In the short run, it is plausible that the impact of exchange rate appreciations, which are usually transitory, is dominated by their effects on current income, causing the political cleavages to be drawn on industry, instead of factor, lines.
de Carvalho Filho and Chamon (2007) provide evidence that the apparent income stagnation in Brazil and Mexico is partly the result of measurement problems.
This simplifying assumption ignores the impact of exchange rate movements on savings.
Our results are robust to restricting the Brazilian sample only to the post-Plano Real period (1995–2006) and to the choice of NEER or REER to both Brazil and Mexico.
Ideally we would like to have information on sector of employment or activity at the POF, but that is not available.
ENIGHs are also available for 1984 and 1989, but we chose not to use these surveys because they did not provide this information on the size of localidades.
”Protection through higher-than-average tariffs is provided to activities such as beverages, transport equipment, clothing and footwear.” See World Trade Organization (2004).
For those currently not employed, the survey inquires about their sector of activity, if any, in the last 12 months before the week of reference.
We only interact one dimension at a time with the exchange rate and income in our estimates for Mexico, since the ENIGH sample is much smaller than the one in the PNAD, and we could not meaningfully estimate the interaction exchange rate and average income with each of the 150 combinations of age × education × region × sector.