Flexible Exchange Rate and Excess Capital Mobility

macroeconomics, exchange rates, excess capital

Two Notes on Exchange Rate Rules and on the Real Value of External Debt

This report presents two unrelated, short papers on exchange rate rules and on the real value of the external debt. The paper on exchange rate policy uses the Taylor model of overlapping, long term wage contracts to ask whether accommodating or PPP oriented exchange rate policies tend to stabilize output. In earlier work I had shown that exchange rate indexing, while destabilizing prices enhances the stability of output. The result is qualified hereby showing that the exchange rate not only affects aggregate demand directly but operates also, through the cost of imported intermediates, on the price level. It is shown that unless monetary policy is sufficiently accommodating this latter effect may dominate with the consequence that increased exchange rate indexation reduces output stability .The paper on the real value of external debt poses the question how to integrate external debt holdings in the traditional framework used to evaluate the effects on real income of changes in world prices. It is shown that integrating debt service liabilities in a comprehensive income measure makes real disposable income equal to the value of output less the real value of real interest payments on the external debt. Furthermore, with the CPI being the appropriate deflator for foreign debt, a rise in export prices raises income in proportion to exports while a rise in import prices lowers real income in proportion to Imports. The proper accounting of debt in a comprehensive income framework, noting the intertemporal budget constraints, thus restores the conventional treatment of the income effects of price changes.

Intergenerational and International Trade

The paper sets out an overlapping generations model in an open economy context. In the absence of productive capital a real consol is the vehicle for intertemporal consumption smoothing. The presence of a long term asset implies that the anticipated future path of the economy, through the term structure of interest, affects current generations. The model is applied to issues in the closed and open economy. These include the effects of debt issue on asset prices and welfare, the effect of present or anticipated future income growth, permanent or transitory. In the open economy context we investigate the welfare and current account effects of income changes on debt issue. The role of international differences in risk aversion is studied.

Notes on Credibility and Stabilization

Do existing theories of stabilization help understand the credibility issues involved in such programs? The experience with stabilization in a hyperinflation setting in Israel and Latin America makes it worthwhile to ask how much existing theories help understand the success and failure of these experiments. Theories typically focus on interaction between policy makers and the public, with imperfect information about the true nature of the government and resulting games. But this model often does not help greatly in explaining stabilization. These notes raise some of the questions left unanswered by the traditional modeling of credibility. The first sections deals with stabilization as a one shot problem. This approach is used to ask what "credibility might mean in a world where it is inconceivable that a program will succeed with probability 1. A model is spelled out where the equilibrium program has an ex ante probability of success. The model draws attention to the factors which raise or lower the probability of success of a stabilization program. The next section deals with the problem of waiting which is familiar from the option literature and recent international applications. It is shown here that in the immediate aftermath of stabilization there is a great difficulty in persuading the public to repatriate assets and engage in irreversible investment except at a large premium. But generating that premium is politically difficult.

Stopping Hyperinflation: Lessons from the German Inflation Experience of the 1920s

The special role of money in the hyper inflation process, and particularly in the stabilization phase, has now been reconsidered in a bestselling essay by Sargent. The message is that credible fiscal stabilizationis the sine qua non of stopping inflation. This is definitely not viewed as being in conflict with the monetary hypothesis, but it does represent a shift of emphasis. We draw attention to a third aspect of the hyperinflation process, and the stablization, namely exchange rate and interest rate policy. Even though a government may accomplish all the right measures in terms of budget stablization or control of money creation, there remains the problem of making these measures credible and hence being able to actually achieve them. We argue that exchange rate and interest rate policy in the transition have traditionally formed the vehicle for establishing that credibility by a de facto stablization. We make that point by discussing the events of the German hyperinflation. In that case the stablization was a much more diffuse, accidental matter than a reading of the classics reveals with exchange rate policy playing a key role. Immensely high interest rates in the face of a sharply appreciating free market exchange rate wiped out adverse speculation thus helping to establish stablization. The real exchange rate sharply appreciated in the final stage and persisted at an appreciated level well into the post-stabilization phase. It reflects the reverse of the coin of real depreciation in the capital flight phase.

External Balance Correction: Depreciation or Protection

macroeconomics, external balance, depreciation