The paper studies the ways an economy working under a currency board could adjust when capital inflows stop suddenly. Six alternative solutions to restore the economic equilibrium are available when the sudden stop comes: a recession could push the prices of non-tradable goods down, a devaluation of the exchange rate could drive the prices of traded goods up, an increase in the international terms of trade could work in the same way the devaluation does, an increase in domestic savings could replace external savings, a recession could reduce the rate at which the economy creates new jobs or an increase in total factor productivity could validate the set of relative prices that ruled before the stop. The first three alternatives are short-run solutions (they require variables to adapt to new values of the parameters) while the rest could be addressed as structural solutions (they require parameters to change to keep variables at their original equilibrium levels). Solow`s neoclassical growth model (Solow,R. 1956) is used to analyze and evaluate each one of the six alternative solutions suggested. The model can easily accommodate supply side effects including total factor productivity growth which play a key rôle in this problem. The analysis of the changes in the values of parameters required for an 'structural adjustment' is made using elasticities to compare different steady-states. The results stress how important is for a safe currency board operation to encourage 'structural reforms' to favor total factor productivity improvements.currency board; growth; productivity growth; fixed exchange rate; stabilization; inflation; hyperinflation

Alfredo Canavese

English

Research Papers in Economics

 
"Currency Boards and Productivity 
Growth" 
Alfredo Canavese 
Universidad Torcuato Di Tella and  CONICET 
 
 
 
 
 
 
 
 
 
May, 2004  
2 
 
"Currency Boards and Productivity Growth" 
Alfredo Canavese 
Universidad Torcuato Di Tella and CONICET 
 
On March 20
th, 1991, Argentina put its money supply under a dollar 
exchange standard. The Convertibility Law  passed by the government on that 
date adopted a fixed exchange  rate between the austral (the Argentine currency 
by that time) and the US dollar and restricted rigorously the issue of money by 
the Argentine Central Bank turning it into a currency board. 
The Convertibility Law was the cornerstone of a new and desperate 
stabilization program devised to put an end to a history of almost fifty years of 
rates of inflation well above  international standards which climaxed in two 
hyperinflation accelerations during April-July 1989 and December 1989- March 
1990’. The Convertibility Law was the more visible feature of a program devised 
to stop inflation and to introduce structural reforms to make stabilization a lasting 
achievement. 
The Law linked the value of the austral to the dollar in a free market in 
which the Central Bank committed itself to sell dollars against australes at a fixed 
rate of australes 10.000 per dollar (an exchange rate slightly higher than the one 
ruling in the free market at the time the law was passed) although this 
commitment might not hold for purchases. 
On January 1992 the currency denomination was changed back to peso 
and australes 10.000 were converted into one peso or one dollar. To guarantee 
the convertibility rate, the monetary base was backed 100 percent by liquid 
international reserves, including dollar denominated government bonds valued
 at 
market prices.
1 The backing requirement implied that the only source of 
expansion of the monetary base was the purchase of international reserves. 
The law had two main targets: to persuade economic agents that to hold 
domestic currency was equivalent to holding U.S. dollars and to restrict the 
                                                  
1 The Law allowed the Central Bank to include government bonds in the backing of the monetary 
base up to a 30 percent of total reserves.  
3 
Treasury to have no deficit unless it could be financed in domestic or 
international  capital markets.  
The first target intended to avoid the complete dollarization of transactions 
in order to allow government to collect some kind of seignorage. Since the only 
way to meet an increase in money demand was to enlarge the backing of the 
monetary base made of international reserves, government was able to collect 
interest earnings on those increased reserves deposited abroad. 
To achieve the second target, the government enforced some policy 
measures to strengthen its fiscal stance. 
The backing of the monetary base with foreign reserves and the strict 
control on Central Bank liabilities set a limit to monetary expansion which, 
together with an opening up of the economy, drove down the inflation rate to 
international levels as it is shown in Table 1. 
Table 1 
Inflation Rates 
(Percentage annual changes in consumer`s prices) 
 
Year  1988  1989  1990  1991  1992  1993  1994 
Inflation 
Rates 
343.0  3079.5  2314.0  171.7  24.9  10.6  3.9 
 
Source: INDEC 
 
   
A set of structural reforms made to promote greater efficiency in the 
allocation of resources and to introduce more flexibility in the economy included  
the deregulation of markets, the privatization of public  enterprises, the 
elimination of distorting taxes  and a change from a pay-as-you-go to a 
capitalization retirement system. 
Stabilization plus reforms produced a reduction in country risk rates and 
an important increase in capital inflows as it is shown in Table 2.  
4 
 
          Table 2 
Capital Inflows 
         (Millons of US dolars) 
 
Year  1991  1992  1993  1994 
Private 
Sector 
2812  14078  12579  9292 
Public 
Sector 
972  -1896  3568  2176 
Total  3784  12182  16147  11468 
 
Source: Carta Económica, Estudio M.A.M. Broda 
 
  Credit that had disappeared during the inflation years, came back and 
consumption, investment and GDP grew as shown in Table 3. 
 
      Table 3 
Macroeconomic Performance 
           (Percentage annual changes) 
 
Year  GDP  Consumption  Inverstment  Exports  Imports 
1990  0.1  - 0.4  -  9.9  18.9  0.6 
1991  8.9  12.6  25.1  -  8.3  64.9 
1992  8.7  11.4  30.9  -  1.3  66.0 
1993  6.0  5.1  13.7  5.0  11.0 
1994  6.0  4.0  18.1  12.2  17.0 
1991/94  33.0  37.1  120.0  6.6  255.5 
 
Source: Carta Económica, Estudio M.A.M. Broda 
 
 
The growth in aggregate demand produced increases in the prices of non-
tradable goods and in  imports of tradable goods. The new set of relative prices 
encouraged new investments made to produce non-tradable goods (mainly 
services) and only in 1993 and 1994 a part of investment went to tradable goods 
production making exports to grow. 
Although domestic savings recovered the level they had before the 
hyperinflation episodes (17,2 % of GDP), economic growth remained dependent 
of external savings (3,0 % to 4,0 % of GDP). A sudden stop of capital inflows 
would induce a strong change in relative prices. Such a stop came by the end of 
1994 during the “Tequila effect”. Six alternative solutions to restore the economic 
equilibrium are available when the sudden stop comes: a recession could push 
the prices of non-tradable goods down, a devaluation of the exchange rate could 
drive the prices of traded goods up, an increase in the international terms of 
trade could work in the same way the devaluation does, an increase in domestic 
savings could replace external savings, a recession could reduce the rate at 
which the economy creates new jobs or an increase in total factor productivity  
5 
could validate the set of relative prices that ruled before the stop. The first three 
alternatives are short-run solutions (they require variables to adapt to new values 
of the parameters) while the rest could be addressed as structural solutions (they 
require parameters to change to keep variables at their original equilibrium 
levels). 
Solow`s neoclassical growth model (Solow,R. 1956) can be used to 
analyze and evaluate each one of the six alternative solutions suggested. The 
model can easily accommodate supply side effects including total factor 
productivity growth which play a key rôle in this problem. 
There are two markets in the model: the market for goods and the labor 
market. Both markets are linked through a production function that fulfills all 
Inada conditions (Inada,K. 1963) and presents GDP (Y) depending on capital 
(K) and labor (L) 
 
 
( ) L K F Y , =               (1) 
 
In the market for goods, savings ( S ) are proportional (through the 
average propensity to save s) to GDP 
 
  sY S =              1 Æ Æ 0 s                                          (2) 
 
Those savings become investment (I ) to increase capital 
 
  I S =                 (3) 
 
  In the labor market, supply for each instant t  is  
s
t L    
 
         
nt s
t e L L 0 =               (4) 
 
where L0  is the number of workers willing to work at   0 = t  and n is the 
exogenous and constant labor rate of growth. Equilibrium in the labor market 
requires 
 
d
t
s
t L L =                                                                          (5) 
 
where 
d
t L
 is labor used in the production function. 
In this simple model there are two prices: the wage rate  (w)  and the rate 
of profit on capital  (n ).  Under perfect competition and with firms maximizing 
benefits each price equals the respective marginal productivity. For given levels 
of K and L,  equations (1), (2), (3), (4), and (5) allow to get equilibrium levels of 
GDP and prices. A convenient way to get equilibrium paths for the variables is to  
6 
work with per capita values. Inada`s conditions require a constant returns to 
scale production function and so (1) can be written as 
( ) k f y =                              (6) 
where    
L
K
k =       and   
L
Y
y =  
 
The relative change of k through time is  
L
L
K
K
k
k
• • •
- =                                                                                    (7)                                  
 
where a dot on a variable denotes its time derivative. Since   
S I K = =
•
        and       n
L
L =
•
         
 
 
 
n
K
S
k
k
- =
•
                                            (8) 
 
 
From (2) and (6) it follows that (8) can be written as 
 
( ) nk k sf k - =
•
                        (9) 
 
Differential equation (9) describes the equilibrium path for capital  per 
capita. Inada`s conditions guarantee that capital  per capita converges to a 
steady-state path where 
0 =
•
k ,    
* = k k ,   
* = y y ,     ) ( '
* * = k f r               and  
 
) ( ' ) (
* * * * - = k f k k f w . 
 
  Even in such a simple model there are two goods: tradables and non-
tradables. The only good produced within the model is GDP which is also used in 
stock form as capital.  It is a tradable good. Labor is the non-tradable good. The 
domestic price of GDP in this small open economy is  q p p =  where  p  is the   
7 
exogenously given international price of the tradable good and q is the exchange 
rate (defined as q pesos for one dollar). The real wage is 
q p
w
' w =  where  w is 
the nominal wage rate. It must be remarked that the real wage is the relative 
price between non-tradable and tradable goods.  
The model can be solved for a Cobb-Douglas production function  
 
 
a Ak y =                        (10) 
 
where  
* = k k   is determined by domestic parameters. In this case 
 
  nk sAk k - =
•
a
                    (11) 
so that   0 =
•
k   when 
 
  ￿
ł
￿
￿
Ł
￿
- 1
1
=
*
n
sA
k
a
                     (12) 
 
and it implies that 
 
  ( )
a a
q
Ak
p
w
' w - = = 1                            (13) 
 
  Capital inflows will increase domestic capital whenever the marginal 
productivity of capital for 
* k  is greater than the international interest rate. Capital 
inflows will drive the capital  per capita to 
* * * æk k   So GDP  per capita, 
consumption per capita 
2  and investment per capita will grow and new relative 
prices implying an increase in the real wage will appear inducing imports to grow 
quicker than exports. The real wage increases because the nominal wage in 
pesos goes up with no changes in international prices or in the exchange rate. 
These effects are consistent with the data shown in Table 1 on macroeconomic 
performance in Argentina. 
  The change in relative prices can be measured as an elasticity applying 
logs to (13) so that 
         
 
                                                  
2 Consumption per capita will grow if in the original steady-state k
* was less than the level of k 
for which n=r  
8 
  a =
k d
w d
ln
' ln
                    (14) 
 
 
The new set of relative prices will remain unchanged if capital continues 
inflowing. If  capital inflows stop the economy should come back to the original 
steady-state associated with  
* k .  Without changes in other parameters, relative 
prices should come back to 
 
( ) ( )
a
a
q
* - = k A
p
w
1                               (15) 
 
While 
 
  ( ) ( )
a
a
q
** - = k A
p
w
1                                           (16) 
 
could remain unchanged only if parameters s, A and n change to validate 
* * k   
with no capital inflows. 
  There are three ways by which  
q p
w
 can be reduced when  
* * k   drops to  
* k : decreasing the nominal wage in pesos (i.e. decreasing the prices of non-
tradable goods) or increasing the exchange rate (i.e. devaluing the domestic 
currency) or through an improvement of the terms of trade (i.e. increasing the 
prices of tradable goods). These adjustments of the values of variables could be 
called “short-run” adjustments. 
  There are also three ways by which parameters in the model could change 
to validate the set of relative prices associated with 
* * k  : increasing the domestic 
propensity to save or increasing total factor productivity or decreasing the rate at 
which the  economy creates new jobs,. These adjustments of the values of 
parameters could be called “structural adjustments”. 
  “Short run” adjustments imply a drop in the transition growth rate and 
reduced permanent levels for real wages, income per capita and consumption 
per capita. These adverse effects do not appear if “structural adjustments” are 
promoted. 
  A reduction of real wages comes through a recession (a drop of the rate of 
growth of GDP below the rate of growth of labor supply) which is brought about 
by the stop in capital inflows. This solution endangers the fiscal equilibrium which 
is a key requirement for a smooth performance of a currency board. To devalue 
is equivalent to break the commitment the currency board adopted and it may 
drive agents behavior  towards a flight from domestic currency triggering a 
hyperinflation. On top of that both “short run” adjustments could put under stress 
the whole banking system because investment projects financed by credit that  
9 
were profitable with the former set of relative prices are unsustainable with the 
new set of relative prices. 
  The analysis of the changes in the values of parameters required for an 
“structural adjustment” can be made comparing steady-states. Elasticities will be 
used. So  
 
 
k d
k d
w d
w d ln
ln
ln
ln =                 (17) 
 
 
and 
 
 
*
* *
*
* * + = k ln d
k
k
k ln d
k
k
k ln d 0
0
                        (18) 
 
where   0 k dln  is the rate of change of k driven by capital inflows and    
* k d ln  
is the rate of change of k induced by changes in parameters s, A and n . From 
(12), (14), (15)  and  (18)  it follows that 
 
( )
￿
￿
￿
￿
￿
￿
- +
-
+ = - -
* *
*
* * * n ˆ A ˆ s ˆ
k
k
k ˆ
k
k
p ˆ ˆ w ˆ
a
a q
1
1 0
            (19) 
 
where a circumflex accent over a variable denotes its rate of change. And so 
 
 
a a
a
a
a
a
a
q
= -
+
-
-
-
- - -
* *
* *
*
* *
*
* *
*
k ˆ
k
k
n ˆ
k
k
A ˆ
k
k
s ˆ
k
k
p ˆ ˆ w ˆ
0
1 1 1
           (20) 
Equation (20) shows that each one per cent reduction in capital inflows will 
entail either a reduction of   ** k
k0 a  per cent in the prices of non-tradable goods 
( ) w ˆ  or an improvement of  ** k
k0 a   per cent in the terms of trade  ( ) p ˆ  or a 
devaluation of   ** k
k0 a   per cent  ( ) q ˆ  . The change in relative prices can be 
avoided either by increases of   ( ) a - * 1
0
k
k
per cent in the domestic propensity to  
10 
save  ( ) s ˆ  or in total factor productivity ( ) A ˆ  or by a reduction of   ( ) a - * 1
0
k
k
 per 
cent in the rate at which the economy creates new  jobs ( ) n ˆ . 
Table 4 reports the evolution of total factor productivity in the Argentine 
economy for the period 1990-1994 
 
 
                                Table 4 
    Total Factor Productivity Evolution 
 
        a  1-a       Â anual  Â   (1990/94) 
0.60  0.40  0.040  0.177 
0.62  0.38  0.040  0.174 
0.64  0.36  0.039  0.171 
0.66  0.34  0.038  0.168 
0.68  0.32  0.038  0.165 
0.70  0.30  0.037  0.161 
 
 
  The change in total factor productivity together with the observed values 
for  a  (the share of capital in GDP) help to estimate the level of capital outflows 
that the economy could accommodate avoiding recessions and devaluations. For 
example, for  Â = 0.04 per year and   a =0.65 , equation (20) with 
0 = = = = = n s p w ˆ ˆ ˆ ˆ ˆ q          yields 
 
a
a
a
=
- - 1
k
A
ˆ
ˆ
       if            
* @ k k0     
 
 
or          65 0 =
04 0 86 1 -
.
ˆ
) . )( . (
k
 
This implies that those values for Â and a made the economy strong enough to 
bear an external capital flow reversal equal to   ( )( )
11 0
65 0
04 0 86 1
.
.
. .
k ˆ - = - =  without  
going either through devaluations or recessions. On the other hand, equation 
(20) shows that for  
0 = = = = = p ˆ w ˆ n ˆ s ˆ A ˆ
 
  
11 
  a q = -
0 k ˆ
ˆ
          if        
** @ k k0  
 
or that the required devaluation for an 11% drop in capital inflows is  
 
 
07 0 = 11 0 65 0 = . ) . )( . ( ˆ q
 
  These illustrations show that an increase in total factor productivity of four 
per cent yearly allows the economy to accommodate a drop in capital inflows that 
would require a seven per cent devaluation per year.  
  These results stress how important is for a safe currency board operation 
to encourage “structural reforms” to favor total factor productivity improvements. 
 
 
REFERENCES 
 
CANAVESE,A. (1992): "Hyperinflation and Convertibility Based Stabilization in  
Argentina", en A.A.Zini Jr. (ed): The Market and the State in Economic 
 Development in the 1990's, North-Holland, Amsterdam. 
CALVO,G., LEIDERMAN,L. y REINHART,C. (1993): "Capital Inflows and Real  
Exchange Rate Appreciation in Latin America. The Role of External Factors",  
IMF Staff Papers, vol. 40, Nº 1. 
CEPAL (1994): "Nota sobre la evolución de la economía argentina en 1994", 
 Documento de Trabajo, Nº 64, Buenos Aires. 
CORBO,V. y HERNÁNDEZ, L. (1994): "Ajustes macroeconómicos ante la afluencia  
de capitales en cartera. Su lógica y algunas experiencias recientes". Estudios 
 Públicos, Nº 56. 
GERCHUNOFF,P. y KACEF, O. (1995): "Macroeconomía y mercado de trabajo  
durante el plan de convertibilidad", Instituto Torcuato Di Tella (mimeo), Buenos 
Aires. 
GERCHUNOFF,P. y MACHINEA,J.L. (1995): "Un ensayo sobre la política  
económica después de la estabilización", Instituto Torcuato Di Tella (mimeo), 
Buenos Aires. 
INADA, K-I. (1963): "On a Two Sector Model of Economic Growth: Comments and  
Generalization", Review of Economic Studies, junio. 
SOLOW, R. (1956): "A Contribution to the Theory of Economic Growth", Quarterly  
Journal of Economics, febrero. 
 
 
 
 

A Contribution to the Theory of Economic Growth&quot;,

Ajustes macroeconómicos ante la afluencia de capitales en cartera. Su lógica y algunas experiencias recientes&quot;. Estudios Públicos,

Capital Inflows and Real Exchange Rate Appreciation in Latin America. The Role of External Factors&quot;,

Hyperinflation and Convertibility Based Stabilization in Argentina&quot;,

Macroeconomía y mercado de trabajo durante el plan de convertibilidad&quot;, Instituto Torcuato Di Tella (mimeo), Buenos Aires.

On a Two Sector Model of Economic Growth: Comments and Generalization&quot;, Review of Economic Studies,

Un ensayo sobre la política económica después de la estabilización&quot;, Instituto Torcuato Di Tella (mimeo), Buenos Aires.

Currency Boards and Productivity Growth

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Currency Boards and Productivity Growth

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Research Papers in Economics