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Exchange Rate Fluctuations and the Macro-Economy: Channels of Interaction in Developing and Developed Countries

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Abstract

The paper analyzes interactions between exchange rate fluctuations and the macro-economy in a sample of developing and developed countries. The effect of currency depreciation is particularly pervasive in decreasing consumption and investment across developing countries. Given the high dependency on imported goods in developing countries, currency appreciation decreases competitiveness and, therefore, export growth without a significant negative effect on imports. The trade balance generally improves as currency depreciation boosts export competitiveness in many developing countries. In contrast, the reduction (increase) in exports with respect to currency appreciation (depreciation) may be matched by a reduction (increase) in the domestic value of imports in many industrial countries.

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Notes

  1. Empirical support of this proposition for Group of 7 countries over the 1960–89 period is provided in Mendoza [1992].

  2. Meade [1951] discusses this theoretical possibility. The Marshall–Lerner condition states that devaluation will improve the trade balance if the devaluing nation's demand elasticity for imports plus the foreign demand elasticity for the nation's exports exceed 1. If the Marshall–Lerner condition is not satisfied, currency depreciation from an initial trade deficit reduces real national income and may lead to a fall in aggregate demand. Cooper [1971] confirms the point in a general-equilibrium model. Edwards [1986] finds that in developing countries, devaluations reduce output in a pooled time-series/cross-section sample.

  3. Gylfason and Schmid [1983] provide evidence that the final effect depends on the magnitude by which demand and supply curves shift because of devaluation. Hanson [1983] provides theoretical evidence that the effect of currency depreciation on output depends on the assumptions regarding the labor market. Solimano [1986] studies the effect of devaluation by focusing on the structure of the trade sector. Agenor [1991] introduces a theoretical model for a small, open economy and distinguishes between anticipated and unanticipated movements in the exchange rate. Based on Turkish data for the 1960–1990 period, Domac [1997] shows that unanticipated devaluations have a positive effect on output but anticipated devaluations do not. Kamin and Rogers [2000] finds that the response of output to depreciation is negative and permanent. Berument and Pasaogullari [2003] find that real depreciations are contractionary and inflationary in Turkey. Other examples of empirical investigations include Edwards [1986], Gylfason and Radetzki [1991], Rogers and Wang [1995], Hoffmaister and Vegh [1995], Bahmani [1998], Kandil [2000], and Kandil and Mirzaie [2002, 2003].

  4. For an analytical overview, see Lizondo and Montiel [1989].

  5. As Knetter [1989] indicated, unexpected currency depreciation and appreciation may affect the economy differently because the exit–entry decisions and price-setting behaviors of export-oriented firms may vary with the currency movements in different directions so as to avoid a reduction in their profits. Froot and Klemperer [1989] and Knetter [1989] point out that the asymmetric response of stock prices to currency movements may occur owing to asymmetric pricing-to-market behavior. On the one hand, when the domestic currency appreciates, exporting firms with a market-share objective do not permit local currency prices to increase because of the risk of losing their share, so they decrease their profit margins. On the other hand, under currency depreciation, exporting firms with a market-share objective maintain rather than increase their profit margins as a result of their focus on sales volume. Other studies that support the same arguments are Marston [1990] and Goldberg [1995]. Another explanation of the asymmetric effect of exchange rate fluctuations is proposed by Baldwin and Krugman [1989] and Dixit [1989]. They argue that new export competitors enter the market during depreciation periods. However, these competitors remain in the market when the currency appreciates (hysteretic behavior).

  6. For similar theoretical models, see Agenor [1991]. For other relevant references, see Buiter [1990].

  7. More recently, currency crises have illustrated the balance sheet effects of currency depreciation. Depreciation increases outstanding liability of foreign currency relative to domestic assets, resulting in credit crunch and further exacerbating the contractionary effects on the supply side of the economy.

  8. Further, depreciation may raise the windfall profits in export and import-competing industries. If money wages lag the price increase and if the marginal propensity to save from profits is higher than from wages, national savings will go up and consumption will decrease. See, for example, Diaz-Alejandro [1963]. Krugman and Taylor [1987] and Barbone and Rivera-Batiz [1987] have formalized these views.

  9. The group of industrial countries follows UN classification. The group of developing countries is selected based on data availability, combining a diverse sample of countries in many respects. The sample period starts in 1971. Given lags involved in estimation, the effective sample period avoids structural breaks due to the surge in oil price and the collapse of the Bretton Woods’ fixed exchange rate system in early seventies. The truncation of the sample period in 2000 is based on data availability across countries.

  10. Appendix A describes how the estimation technique accounts for possible endogeneity of exchange rate movements with respect to underlying fundamentals. Shocks are exogenous, by construction, to movements in fundamentals.

  11. The effects of government spending and the money supply isolate the direct effects of domestic policies from indirect effects attributed to changes in the exchange rate with domestic policies.

  12. Except for structural break dummies, the empirical model is uniform across countries to maintain consistency and capture the effect of major shocks determining economic conditions in theory.

  13. For details, see Kwiatkowski et al. [1992]. Non-stationarity indicates that the series follows a random walk process. Upon first-differencing, the resulting series are stationary, providing the domain for demand and supply shocks as specified in theory. Following tests of non-stationarity of the energy price, the money supply, government spending and the exchange rate, there is no evidence of cointegration between the non-stationary dependent variables and non-stationary independent variables. Hence, the empirical models are estimated without an error correction term.

  14. Given non-stationarity of the estimated dependent variables, the empirical models are estimated in first-difference form. Hence, the anticipated component measures anticipated change in the policy variable. Shocks approximate unanticipated change in the policy variable.

  15. Demand components are measured in nominal domestic currency. Real data are not available over a long span across countries. Moreover, fluctuations in components underlying aggregate spending determine channels of transmitting exchange rate fluctuations to the product market in the form of real growth and price inflation. Except for the trade balance, all values are scaled down using logarithmic transformation. The trade balance is measured by the difference between exports and imports, including goods and services and excluding income for labor and investment. As the balance may take positive or negative values, it enters without logarithmic transformation in estimation.

  16. The degree of capital mobility may reinforce or moderate the effects of exchange rate fluctuations on the macroeconomy. By accounting for the change in the money supply, the model controls for the effects of capital mobility and isolates movements in the exchange rate from variation in the degree of capital mobility in various countries. Moreover, variation in the money supply controls for the difference in the exchange rate system across countries. The more flexible the exchange rate, the more independent the monetary policy. In contrast, fluctuations in the money supply are highly dependent on the exchange rate target under a fixed exchange rate system.

  17. The empirical procedure (see Appendix A) accounts for possible endogeneity in demand shifts. In the real world, institutional rigidity may interfere with agents’ ability to adjust fully to anticipated demand shifts. Institutional rigidity may be attributed to wage and/or price rigidity. For a discussion of the implications of sticky-wage and sticky-price models, see Kandil [1996].

  18. The growth of the money supply is a proxy for monetary policy. While the central bank maybe targeting the interest rate, the end result will be reflected in monetary growth. The latter captures the combined effect of discretionary monetary policy, adjustment in money demand, accompanying domestic fluctuations, and/or external shocks.

  19. Nominal GDP or GNP is likely to vary with a variety of shocks that underlie aggregate demand: the money supply, government spending, velocity, consumption, investment, and external shocks attributed to fluctuations in the current and financial accounts.

  20. In addition to dummy variables in the forecast equations (see Appendix A for details), dummy variables are introduced in the empirical Models (1) and (2), where necessary.

  21. The model specification is the same for all countries to establish comparability across countries. The estimation technique accounts for country-specific variation in forming agents’ forecasts of endogenous variables and the selection of instruments (see Appendix A for details).

  22. Detailed results are available upon request.

  23. Across developing countries where depreciation decreases consumption growth significantly, the correlation between consumption growth and import growth ranges from a low of 0.35 in Egypt to a high of 0.92 in Mexico, and 0.97 in Argentina and Chile.

  24. Across industrial countries where depreciation decreases consumption growth significantly, the correlation between import growth and consumption growth ranges from a low of 0.37 in Denmark to a high of 0.90 in Iceland.

  25. For details, see Kandil [1991]. Developing countries import a large share to keep up with the surge in consumption demand that cannot be satisfied domestically. Absent resources to finance the increase in imports, financing external debt maybe unsustainable over time without a deliberate effort to stimulate investment spending and real growth.

  26. Where imports increase despite currency depreciation in developing countries, the average share of imports to GDP ranges from a low of 8.5 percent in Argentina to a high of 140 percent in Brazil.

  27. Where imports increase despite currency depreciation in industrial countries, the average share of imports to GDP ranges from a low of 14 percent in Japan to a high of 39 percent in Australia.

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Acknowledgements

I thank four anonymous referees and the Editor, Joyce Jacobsen, for helpful comments on earlier drafts. The views expressed in this paper are those of the author and should not be interpreted as those of the International Monetary Fund.

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  1. Western Hemisphere Department, International Monetary Fund, 700 nineteenth Street, Washington, 20431, DC, USA

    Magda Kandil

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Appendices

Appendix A

ECONOMETRIC METHODOLOGY

The surprise terms that enter Models (1) and (2) are unobservable, necessitating the construction of empirical proxies before estimation takes place. Thus, the empirical models include equations that describe agents’ forecast of aggregate (nominal GDP) or specific demand growth (monetary growth and growth of government spending), the change in energy price, and the change in the real effective exchange rate. All variables are first-differenced to render the series stationary.

To decide on variables in the forecast equations, a formal causality test is followed. Each variable is regressed on two of its lags as well as two lags of all variables that enter the model: the change in the log value of the energy price, nominal GNP or GDP, the real exchange rate, government spending, and the money supply. Moreover, dummy variables are introduced to account for structural break where necessary.

The joint significance of the lags is tested for each variable. Accordingly, the forecast equations account for the lags of variables proven to be statistically significant. In countries where monetary policy accommodates fiscal spending, lagged values of government spending are likely to be significant in the money equation. If inflation is a priority for the conduct of monetary policy the growth of money supply would vary significantly with determinants of inflation, the energy price, government spending, and/or aggregate demand.

Similarly, significant variables in the forecast equation of the exchange rate vary across countries. Under a fixed exchange rate, monetary growth varies significantly to target the exchange rate. This variation determines priorities of conducting monetary policy. Similarly, significant variation in other variables would determine sources of pressure on the exchange rate, regardless of the prevailing system.

Subtracting the above forecasts from the actual change in the variable results in surprises that enter the empirical model. The positive and negative components of exchange rate shocks are defined for joint estimation, following the suggestions of Cover [1992], as follows:

where abs(.) is the absolute value operator and Dss t is the shock to the change in the log value of the exchange rate. The terms negs t and poss t are the negative and positive components of the shock such that negs t indicates unexpected depreciation of the real effective exchange rate and poss t indicates unexpected appreciation. Shocks are distributed symmetrically around the steady-state stochastic trend that varies with agents’ forecast such that positive and negative shocks cancel out, on average, over time.

In order to obtain efficient estimates and ensure correct inferences (i.e., to obtain consistent variance estimates), the empirical models are estimated jointly with a forecast equation for each anticipated regressor, following the suggestions of Pagan [1984;, 1986]. To account for endogenous variables, instrumental variables are used in the estimation of the empirical models. The instrument list includes two lags of output, two lags of price, three lags of nominal GNP or GDP, five lags of the energy price, five lags of the real exchange rate, five lags of the money supply, and five lags of government spending. The paper's evidence remains robust with respect to modifications that alter variables or the lag length in the forecast equations and/or the instruments list.

Following the suggestions of Engle [1982], the results of the test for serial correlation in simultaneous equation models are consistent with the presence of first-order autoregressive errors for some countries. To maintain comparability, it is assumed in all models that the error term follows an AR(1) process. The estimated models are transformed, therefore, to eliminate any possibility of serial correlation. The estimated residuals from the transformed models have zero means and are serially independent.

Appendix B

DATA SOURCES

The sample period for investigation is 1971–2000. Annual data for the above countries are described as follows:

  1. 1

    Real output: Real output of GDP or GNP measured in terms of 1982 dollars.

  2. 2

    The price level: The deflator for GDP or GNP.

  3. 3

    The energy price: The price of Saudi Arabia oil.

  4. 4

    Government spending: Nominal values of all payments by the central government.

  5. 5

    Money supply: The sum of currency plus demand and time deposits.

  6. 6

    Real exchange rate: The real price of the domestic currency in terms of currency of major trading partners, a weighted average of the real bilateral exchange rates with weights representing the size of the major trading partners in total trade (exports+imports).

  7. 7

    Aggregate demand: The nominal value of GNP or GDP.

  8. 8

    Consumption, investment, exports, and imports: Nominal values of expenditure components in the national income account.

Sources: 1–8 are taken from the World Economic Outlook database available from the International Monetary Fund, Washington, DC.

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Kandil, M. Exchange Rate Fluctuations and the Macro-Economy: Channels of Interaction in Developing and Developed Countries. Eastern Econ J 34, 190–212 (2008). https://doi.org/10.1057/palgrave.eej.9050026

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