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Comments on real and monetary determinants of real exchange rate behavior: Theory and evidence from developing countries by Sebastian Edwards
Journal
of Development
Economics
29 (1988) 343-345.
North-Holland
COMMENTS ON Real and Monetary Determinants of Real Exchange Rate Behavior: Theory and Evidence from Developing Countries by Sebastian Edwards Ignacio
TRIGUEROS
Institute Tecnologico Autonomo de Mexico, Tizapan-San Angel, OlooO Mexico,
D.F., Mexico
Edward’s paper constitutes a remarkable contribution at dealing in a systematic and rigorous way with an issue that for a long and arduous time has bothered both academics and policy-makers: the fluctuations and trends in real exchange rate behavior in developing countries. The paper is quite successful in conveying the idea as to how, from a theoretical point of view, fundamentgl and macroeconomic disequilibrium factors affect the dynamics of the real exchange rate and, more importantly, in disentangling empirically how each of those factors has affected the behavior of the real exchange rate for a group of developing countries. This paper in which skillful theoretical work is combined with painstaking empirical estimates is indeed very welcome as it provides a solid and meaningful foundation on which our understanding of developing countries’ economies can build. Thus, my comments are directed basically to some aspects of the paper that in my opinion need further clarification. Some ideas about further work on this topic are also mentioned. I will organize my comments into four parts: the theoretical model, the relation between the theoretical model and the empirical evidence presented in one of the paper’s sections, the results of the empirical estimates and the policy prescriptions derived from them. The theoretical model captures in a simple, yet convincing way how the interplay between fundamentals, like terms of trade or commerical policy shocks, and macroeconomic disequilibria, determines the dynamics of the real exchange rate. However, I would argue that the assumption of capital controls used in the theoretical part of the paper is not quite convincing, since, it seems to me, capital flows have been crucial in explaining real exchange rate behavior of at least some developing countries. Two examples may be mentioned in this respect: The real depreciation observed during the last few years can reference to the debt problem. 0304-3878/88/%3.50
0
in many Latin American countries hardly be explained without explicit
1988, Elsevier Science Publishers
B.V. (North-Holland)
344
I. Trigueros,
Comments
There are many developing countries in which capital controls are absent or simply ineffective. For those countries macro disequilibrium will show up partially as capital outflows, a feature that obscures the relation between macropolicies and the real exchange rate. Regarding the relation between the theoretical model and the empirical evidence presented in section 4, there are three aspects that deserve comment. The first one has to do with the way macroeconomic disequilibrium variables are measured in the empirical part of the paper. For instance, it is not clear to me why in a country in which the difference between the rate of growth of domestic credit and the rate of growth in real output, defined as EXCRE in the paper, can have an influence of its own on the real exchange rate if it is fully matched by nominal depreciation or by world inflation. It is clear from the theoretical part of the paper that monetary variables influence the real exchange rate only when they become misaligned with respect to the domestic price of traded goods. Thus, estimating separate coefficients for macropolicy variables and for the rate of depreciation of the nominal exchange rate seems to be inappropriate, as is the exclusion of some measure of world inflation in the estimated equations. Secondly, the inclusion of the financial exchange rate premium in some of the estimated equations is altogether puzzling. As is recognized by the author, estimation problems are introduced right from the start because the financial exchange rate premium is endogenous and a lagged endogenous variable is included in the estimated equation. In any case the theoretical model suggests that once the effects of the fundamentals and of macropolicies are taken into account, there is no additional influence on the real exchange rate derived from the financial exchange rate premium. Particularly interesting in this respect is the fact that the estimated coefficients of macropolicy variables fall whenever the financial exchange rate premium is included in the estimated equations. It seems to me that this relation is the result of the effect of those policies on the financial exchange rate, and in this sense the financial exchange rate is not capturing any additional feature (related with exchange controls) as is suggested by the author. Finally, while in the theoretical model it is assumed that expectations are rational, that assumption is almost completely ignored in the econometric estimation. I am aware of the fact that the explicit incorporation of the rational expectation assumption into the empirical part of the paper will considerably, and perhaps unnecessarily (given our current understanding of real exchange rate behavior) complicate the estimation procedure. Nevertheless, one of the basic lessons of the rational expectations hypothesis should be kept in mind when interpreting the results of econometric work based on more conventional methods: the parameters estimated using those methods include not only the structural parameters of the model but also parameters
I. Triperos,
Comments
345
pertaining to the stochastic processes of the exogenous variables. This aspect could be added to the list of limitations derived from the use of pooled data mentioned by the author, i.e., it is reasonable to assume that the stochastic processes of the terms of trade differ across countries, and make questionable the policy prescription presented in the paper regarding the amount of nominal depreciation required to correct a given real exchange rate misalignment. Concerning the empirical results, it is not clear to me exactly how the proposition that long-run equilibrium real exchange rate movements depend on real variables only is tested in the empirical part of the paper. From my point of view, nominal variables enter in exactly the same way as real variables in the estimated equation and therefore their long-term effect should also be the same. It may be argued that because in principle only the non-sustainable part of monetary variables enter the regression equations, those variables are bound to vanish in the long run and therefore they will cease to affect the real exchange rate. Nevertheless, this type of reasoning is somewhat circular to the extent that the long-term influence of monetary variables is assumed away from the beginning. This issue could perhaps be assessed by testing some restriction on the estimated parameters of different nominal variables, or on the parameters of a combination of nominal and real variables entered, only for this purpose, separately, that in some sense define the sustainability of the behavior of the former in the long run. I would like to make a final remark regarding the policy prescriptions advanced in the paper, and in particular the one related to the assertion that ‘when there is real exchange rate misalignment, nominal devaluation, if properly implemented, can be a very powerful tool to help reestablish equilibrium’. As is pointed out in the theoretical part of the paper, when economic agents anticipate a nominal devaluation as the normal reaction of the authorities to certain types of events, the sole possibility that those events may occur induces, through the interaction between goods and assets markets, real exchange rate misalignment. Thus there seems to be a nontrivial trade-off arising from the use of nominal devaluations. In my opinion the central issue regarding the problem of under- or overvaluation lies more in designing mechanisms that prevent or limit the occurrence of an exchange rate misalignment than in the way a specific policy instrument has to be used when the misalignment occurs. The regulation of capital inflows, as well as the abandonment of exchange rate management in the presence of either a strong and expansionist fiscal authority (e.g., Argentina in the late 70s or Mexico in the early 80s) or a wage indexation scheme (e.g., the Chilean experience), are examples that come to mind with respect to those mechanisms.
of Development
Economics
29 (1988) 343-345.
North-Holland
COMMENTS ON Real and Monetary Determinants of Real Exchange Rate Behavior: Theory and Evidence from Developing Countries by Sebastian Edwards Ignacio
TRIGUEROS
Institute Tecnologico Autonomo de Mexico, Tizapan-San Angel, OlooO Mexico,
D.F., Mexico
Edward’s paper constitutes a remarkable contribution at dealing in a systematic and rigorous way with an issue that for a long and arduous time has bothered both academics and policy-makers: the fluctuations and trends in real exchange rate behavior in developing countries. The paper is quite successful in conveying the idea as to how, from a theoretical point of view, fundamentgl and macroeconomic disequilibrium factors affect the dynamics of the real exchange rate and, more importantly, in disentangling empirically how each of those factors has affected the behavior of the real exchange rate for a group of developing countries. This paper in which skillful theoretical work is combined with painstaking empirical estimates is indeed very welcome as it provides a solid and meaningful foundation on which our understanding of developing countries’ economies can build. Thus, my comments are directed basically to some aspects of the paper that in my opinion need further clarification. Some ideas about further work on this topic are also mentioned. I will organize my comments into four parts: the theoretical model, the relation between the theoretical model and the empirical evidence presented in one of the paper’s sections, the results of the empirical estimates and the policy prescriptions derived from them. The theoretical model captures in a simple, yet convincing way how the interplay between fundamentals, like terms of trade or commerical policy shocks, and macroeconomic disequilibria, determines the dynamics of the real exchange rate. However, I would argue that the assumption of capital controls used in the theoretical part of the paper is not quite convincing, since, it seems to me, capital flows have been crucial in explaining real exchange rate behavior of at least some developing countries. Two examples may be mentioned in this respect: The real depreciation observed during the last few years can reference to the debt problem. 0304-3878/88/%3.50
0
in many Latin American countries hardly be explained without explicit
1988, Elsevier Science Publishers
B.V. (North-Holland)
344
I. Trigueros,
Comments
There are many developing countries in which capital controls are absent or simply ineffective. For those countries macro disequilibrium will show up partially as capital outflows, a feature that obscures the relation between macropolicies and the real exchange rate. Regarding the relation between the theoretical model and the empirical evidence presented in section 4, there are three aspects that deserve comment. The first one has to do with the way macroeconomic disequilibrium variables are measured in the empirical part of the paper. For instance, it is not clear to me why in a country in which the difference between the rate of growth of domestic credit and the rate of growth in real output, defined as EXCRE in the paper, can have an influence of its own on the real exchange rate if it is fully matched by nominal depreciation or by world inflation. It is clear from the theoretical part of the paper that monetary variables influence the real exchange rate only when they become misaligned with respect to the domestic price of traded goods. Thus, estimating separate coefficients for macropolicy variables and for the rate of depreciation of the nominal exchange rate seems to be inappropriate, as is the exclusion of some measure of world inflation in the estimated equations. Secondly, the inclusion of the financial exchange rate premium in some of the estimated equations is altogether puzzling. As is recognized by the author, estimation problems are introduced right from the start because the financial exchange rate premium is endogenous and a lagged endogenous variable is included in the estimated equation. In any case the theoretical model suggests that once the effects of the fundamentals and of macropolicies are taken into account, there is no additional influence on the real exchange rate derived from the financial exchange rate premium. Particularly interesting in this respect is the fact that the estimated coefficients of macropolicy variables fall whenever the financial exchange rate premium is included in the estimated equations. It seems to me that this relation is the result of the effect of those policies on the financial exchange rate, and in this sense the financial exchange rate is not capturing any additional feature (related with exchange controls) as is suggested by the author. Finally, while in the theoretical model it is assumed that expectations are rational, that assumption is almost completely ignored in the econometric estimation. I am aware of the fact that the explicit incorporation of the rational expectation assumption into the empirical part of the paper will considerably, and perhaps unnecessarily (given our current understanding of real exchange rate behavior) complicate the estimation procedure. Nevertheless, one of the basic lessons of the rational expectations hypothesis should be kept in mind when interpreting the results of econometric work based on more conventional methods: the parameters estimated using those methods include not only the structural parameters of the model but also parameters
I. Triperos,
Comments
345
pertaining to the stochastic processes of the exogenous variables. This aspect could be added to the list of limitations derived from the use of pooled data mentioned by the author, i.e., it is reasonable to assume that the stochastic processes of the terms of trade differ across countries, and make questionable the policy prescription presented in the paper regarding the amount of nominal depreciation required to correct a given real exchange rate misalignment. Concerning the empirical results, it is not clear to me exactly how the proposition that long-run equilibrium real exchange rate movements depend on real variables only is tested in the empirical part of the paper. From my point of view, nominal variables enter in exactly the same way as real variables in the estimated equation and therefore their long-term effect should also be the same. It may be argued that because in principle only the non-sustainable part of monetary variables enter the regression equations, those variables are bound to vanish in the long run and therefore they will cease to affect the real exchange rate. Nevertheless, this type of reasoning is somewhat circular to the extent that the long-term influence of monetary variables is assumed away from the beginning. This issue could perhaps be assessed by testing some restriction on the estimated parameters of different nominal variables, or on the parameters of a combination of nominal and real variables entered, only for this purpose, separately, that in some sense define the sustainability of the behavior of the former in the long run. I would like to make a final remark regarding the policy prescriptions advanced in the paper, and in particular the one related to the assertion that ‘when there is real exchange rate misalignment, nominal devaluation, if properly implemented, can be a very powerful tool to help reestablish equilibrium’. As is pointed out in the theoretical part of the paper, when economic agents anticipate a nominal devaluation as the normal reaction of the authorities to certain types of events, the sole possibility that those events may occur induces, through the interaction between goods and assets markets, real exchange rate misalignment. Thus there seems to be a nontrivial trade-off arising from the use of nominal devaluations. In my opinion the central issue regarding the problem of under- or overvaluation lies more in designing mechanisms that prevent or limit the occurrence of an exchange rate misalignment than in the way a specific policy instrument has to be used when the misalignment occurs. The regulation of capital inflows, as well as the abandonment of exchange rate management in the presence of either a strong and expansionist fiscal authority (e.g., Argentina in the late 70s or Mexico in the early 80s) or a wage indexation scheme (e.g., the Chilean experience), are examples that come to mind with respect to those mechanisms.