MASTER 2: MACROECONOMIE MONETAIRE ET

BANCAIRE

COURSE: POLITIQUE DE CHANGE

SUBJECT : EXCHANGE RATE MISALIGNMENT

SUPERVISOR: Dr. DIEUDONNE MIGNAMISSI

PRESENTED BY MBUA PETER MBOLO

ACADEMIC YEAR: 2019-2020

Introduction

Over the years, the choice between a fixed and flexible exchange rate regime has
emerged as one of the central aspects within the larger debate concerning global
financial architecture and more precisely the real equilibrium exchange rate. As a
currency deviates from its equilibrium rate, we consider it as misalignment of
exchange rate. In this light, our objective shall be to examine the methods or
approaches of determination of equilibrium exchange rate, the effect of choice of
exchange rate regime influences the real exchange, then we shall discuss the effects
of exchange rate misalignment on economic growth, tourism and goods market and
finally the remedy for exchange rate misalignment.
I. Methods or approaches of calculation of the equilibrium exchange rate

There are several approaches used in calculating the equilibrium exchange rate but
the most durable is the Purchasing Power Parity(PPP).

A. The PPP

It is used by identifying a base period when the country was in external balance, then
the equilibrium value of the nominal exchange rate in the current period is the
base-period value adjusted for the inter-country difference in inflation rates between
the current and base period.

Three problems have limited the usefulness of the PPP approach. First, it is not easy
to find an equilibrium base period. For example Krugman (1985) regards 1980 as the
base period for the dollar because the measured United States of America (USA)
current account balance was near zero, Musa (1985) does not because the real value
of the dollar was then below the average level recorded in all but three of the past
40years. Second, when real balances that alter relative prices occur between the
base and the current period, it will be desirable to have a departure from the PPP, in
order to take these changes in real economic conditions in account. Third, PPP does
not seem to work, certainly not in the short run, and perhaps not in the long run
either.

B. The underlying balance approach

Here, the equilibrium exchange rate is defined as the rate that makes the “underlying”
current account equal to normal net capital flows over the next two to three years,
given anticipated real output and inflation paths, and the delayed effect of past
exchange rate changes.
II: Exchange misalignment and Regime

The question of whether the exchange rate arrangement matter in misalignment has
indeed, been a far-reaching issue over the years in the literature on international trade
and finance.

A. Floating exchange rates and Misalignment

Since the breakdown of the Bretton Woods system, nominal (and real) exchange
rates have been extremely volatile (Frenkel and Goldstein 1989). Currencies
experience wide swings in value from day to day and we observe a movement in
the exchange rate.

It is generally accepted that exchange rates behave in a manner more like asset
prices than as a reflection of economic fundamentals in the short run. They often
change in response to news, and are subject to contagion effects (Williamson
1985). Yagci notes that it could lead to short-term financial flows, which
themselves are influenced by speculations, manias, panics. Speculation could be
beneficial if it brought exchange rates back towards equilibrium, but as Krugman
points out, speculative efficiency is not is not consistent with the empirical
evidence (1993).

As models of exchange rate behavior under rational expectations and full

information have become increasingly unpopular due to serious shortcomings
explaining exchange rates empirically, incomplete information and irrationality
models have been introduced (Isard 1997). If the level of exchange rate is
governed in part by irrational behavior (or rational behavior based on limited
information), fundamentals cease to be an important determinant. This suggests
floating exchange rates may exhibit exhibit varying degrees of misalignment

Another possible explanation for the potential misalignment of floating rates

comes from increasing financial integration of developing countries. When capital
markets become more integrated with the rest of the world, exchange rate
determination is dominated by capital account transactions (Yagci, p. 10, 2001). If
this is the case, there may be a serious disconnect between the actual exchange
rate and the exchange rate needed for clearance in the goods sectors. In other
words, excessive capital flows to (away) from a country can bring about (among
other things) a currency appreciation (depreciation) that is not warranted or
sustained.

Floating exchange rates, then tend to create misalignment in open (or newly
opening) developing countries for a number of reasons. Emerging markets leave
openness leaves their currencies vulnerable due to thin foreign exchange
markets. When economic agents decide to invest in a particular country, it may
not be for any particular rational reason. Unanticipated announcements of news
may affect the level of the exchange rate.

B. Fixed exchange rates and Misalignment

exchange rates are certainly an option for developing countries. Depending on the
nature and severity of shocks a country faces, it may be in fact a reasonable
choice. However, when shocks cannot be accommodated Fixed through
conventional means, a country is left to defend a rate that is no longer in line with
the fundamentals upon which the peg is based.

In the last decade, there has been a string of crises in developing countries that
include Mexico (1994-1995), East Asia (1997), Brazil (1998). In each of these
cases, misalignment played a significant role bringing about the currency crash.

Mexico had been regarded as the poster child for neoliberal reforms during the
1980s and early 1990s. NAFTA (North African Free Trade Area) was becoming
more of a possibility and there was a lot of optimism regarding the prospects for
Mexican economic Growth (Edwards 1997). Mexico of course had embarked on a
course for stabilization, using the nominal exchange rate as an anchor (exchange
rate band with a sliding ceiling). At the same time, Mexican officials began to
liberalize capital account progressively, beginning in the late 1980s. The optimism
for investment opportunities coupled with the liberalization led to sizeable real
exchange rate appreciation over the next 5-10years. Some argued that
appreciation was justified for one reason or another, while others warned of the
dangers associated with worsening trade balances and appreciated real
exchange rates.

It became clear that the situation was untenable. Dornbush and Werner warned
that the real exchange rate was overvalued by at least 30 percent (1994). The
 exchange rate was at the ceiling of the band, and reserves were already at
precariously low levels relative to short-term debts obligations.

II. Effects or implications of misalignment of exchange rates

A: On economic growth

There is a negative relationship existing between exchange rate misalignment

and economic growth. The misalignment of exchange rate will steer overvaluation
which hurts growth more in developing countries than developed countries.

B: Goods market

There is a loss in the external competitiveness of export producing (and

import-competing) firms. As a currency becomes overvalued, it is increasingly
difficult to sell products in foreign markets in an open economy (Dornbush 1988,
Collins and Razin 1997). This is more dangerous when the export firm is a price taker,
and is constrained by world prices. This is predominant with developing countries
who heavily rely on primary products.

Furthermore, Dornbush points out that overvaluation ofthen affects the location
choice of firms (1988). With the prevalence of multinational firms that are able to
split production in different factory locations and different stages of production
throughout the world, this can become serious. If a country has costs that are too
high in terms of the home currency of the multinational, these firms may not be
competitive in the international arena by producing in a country with a misaligned
currency.

Additionally, the agricultural sector is often hampered by misalignment. In Africa

sustained periods of misalignment hampered the development of agriculture and
resulted in a drastically reduced food supply (World Bank). Cho, Sheldon and
McConstein find out that misalignment may hurt all sectors of an economy, but
agricultural sectors are often hit the hardest (2001).

Again, services that depend on the tourism sector are adversely affected by
overvaluation. When a developing country is able to market itself as a desirable place
to visit, tourism may become an important source of revenue (Dornbush 1998). When
the price of local currency is too high, and if there are perceived substitutes for a
particular country, tourism may take a major blow.

III. Remedies or proposals to remedy misalignment in exchange rate

Jacob Frenkel and Morris Goldstein, examine three proposals on improving the
functioning of the exchange rate system.

A. Target zones

The G-10 has characterized target zones as an exchange rate system where the
authorities “define wide margins around an adjustable set of exchange rates devised
to be consistent with a sustainable balance of payments.” Unlike an adjustable peg
system, there need not be a formal commitment to intervene to keep actual
exchange rates within the zone. On the other hand, unlike a pure floating system,
authorities are permitted to intervene and indeed, are typically encouraged “to take a
view” on the desirable level of the exchange rate. Two features that distinguish target
zones from managed floating in a broader sense are: the establishment of a target
zone for the exchange rate for some future period; and the greater influence of the
exchange rate on the conduct of monetary policy so as to keep the actual rate within
the zone.

Three questions about target zones merit particular attention. Will they help to
discipline errant fiscal policies? What policy instruments will be possible for internal
balance? Would wide and moving zones be capable of acting as a medium-term
anchor for exchange rate expectation?

One of the strongest claims made for target zones by their supporters is that they
will help to restore discipline and coordination to the conduct of macroeconomic
policies. In light of the experience in the first half of the 1980s, the area where
discipline and coordination are probably the most sorely needed in fiscal policy. Here,
advocates argue that: a threatened breach of the zone be it induced by errant fiscal
or monetary policy will initiate a multilateral review of all that country’s policies, with
strong peer pressure for adjustment and coordination.

As concerns the question on the extent monetary policy can be the primary
instrument for keeping actual exchange rates within target zones, the leading
response is fiscal policy. But fiscal policy in most industrial countries is hardly
flexible enough, rightly or wrongly to be used for stabilization policy. For Meade
(1984) the answer is the labor policy. Specifically, greater wage flexibility to stabilize
employment. The problem is that no one know how to bring it about without a
substantial reform of labor market institutions.

B. Restrictions and taxes on international capital flows

One of the recurring themes in an open economy macroeconomics is that

policymakers who seek to simultaneously achieve independent monetary policy,
fixed exchange rates, and free international capital markets will be frustrated. The
best they can do is to achieve any of the two.

Direct controls or a Tobin (1978) worldwide round-tripping tax on foreign exchange is

the case against the alternatives. The effect of capital control or taxes themselves
will depend on the following

 Whether speculation in the foreign exchange market is stabilizing or

destabilizing. Proposals that tax or regulate capital flows take as a point of
departure that there is too much speculation. But that is not universally
shared. Mckinon (1976), for example also decries the short-run volatility of
exchange rates but attribute it to the little stabilizing speculation.

 Secondly, there is an a priori distinction between “productive” and

“unproductive” capital flows. The Tobin tax for example, is designed to
penalize short-term flows more than long-term flows. Hence, more exchange
rate stability and capital flowing to its most productive use.

C. Stronger institutional condition of economic policies

According to Wallich (1984), international coordination is “ a significant modification

of national policies in recognition of international economic interdependence.”

Th basic rationae for coordination is that economic policy actions, especially those of
larger countries, create quantitatively significant spillover effects or externalities for
other countries, and that a global optimum requires that such externalities be taken
into account in the decision -making process.
CONCLUSION

Exchange rate misalignment is an issue that countries must keep in mind. So far, we
have examined the identification of the real exchange rate, the choice of the
exchange regime as well as the effects and remedies for misalignments of exchange
rates.

REFERENCES

Dornbush R (1988) “Overvaluation and Trade Balance”. In the open economy: Tools
for policy makers in developing countries, (eds. R Dornbush and F.L.Helmers),
pp80-107 washington D.C. oxford university press.

Frankel, J. and Goldstein, M. (1989). ‘ Exchange rate volatility and misalignment:

Evaluating some proposals for reforms,’ NBER Working paper series, 2894.

Reinhart, Carmen M., and Kenneth S. Rogoff, “ A modern Modern History of

Exchange Rate Arrangements: A reinterpretation,” National Bureau of Economic
Research working paper No. 8963, 2001.

Yagci, F. (2001). ‘Choice of Exchange Rate Regime for Developing Countries’, IMF
Africa Region Working Paper series, no. 16.