An evaluation of exchange rate policy and economic adjustment in Nicaragua, 1993--1995

Since the late 1970's, but particularly since the mid-1980s, the economy of Nicaragua has had persistent and large macroeconomic imbalances, while GDP per-capita has declined to 1950s' levels. By the second half of the 1990s, huge fiscal deficits and a reduction of foreign financing resulted in record hyperinflation. The Sandinista government's (1979–1990) harsh stabilization program in 1988–89 had only modest and short-lived success. It was doomed by their inability to lower the public sector deficit due to the war, plus diminishing financial support from abroad. Hyperinflation stopped only after their 1990 electoral defeat ended the war and massive aid began to flow in. Five years later, macroeconomic stability is still very fragile. A sluggish recovery of export agriculture plus import liberalization, have impeded a reduction of huge trade and current account deficits. Facing the prospects of diminished aid flows, the government's strategy has hinged on the achievement of a real devaluation through a crawling-peg adjustment of the nominal rate. However, at the end of 1995 the situation of the external accounts was still critical, and the modest progress achieved was attributable to cyclical terms-of-trade improvement and changes in the political outlook of agricultural producers. Using a Computable General Equilibrium Model and a Social Accounting Matrix constructed for this dissertation, the importance of structural rigidities in production and demand in explaining such outcome is shown. It is shown that under the plausible structural assumptions incorporated in the model, the role of devaluation in the adjustment process is restricted by structural rigidities. Moreover, contrary to the premise of the orthodox economic thinking behind the economic program, it is the contractionary effect of devaluation more than its expenditure-switching effects that provide the basis for is use in solving the external sector's problems. A fixed nominal exchange rate is found to lead to adverse results. The broader conclusion that emerges from the study is that a new social compact and a rapid increase in infrastructure spending plus fiscal support for the traditional agro-export activities is at the center of a successful adjustment towards external viability in Nicaragua. ^

The Real Exchange Rate in Small Open Developed Economies: Evidence from Cointegration Analysis

We examine the effects of the terms of trade and the expected real interest rate differential on the real exchange rate in a sample of small open developed economies. We employ cointegration analysis to search for possible long-term linkages. We find that while both the terms of trade and the expected real interest rate differentials affect the real exchange rate in the long run, the role of the terms of trade generally proves more consistent across countries. The speed of adjustment for the expected real interest rate differential in the error-correction model, however, is quantitatively larger than it is for the terms of trade.

Purchasing power parity and structural instability in the US/UK exchange rate

The aim of this study is to determine if nonlinearities have affected purchasing power parity (PPP) since 1885. Also using recent advances in the econometrics of structural change we segment the sample space according to the identified breaks and look at whether the PPP condition holds in each sub-sample and whether this involves linear or non-linear adjustment. Our results suggest that during some sub-periods, PPP holds, although whether it holds or not and whether the adjustment is linear or non-linear, depends primarily on the type of exchange rate regime in operation at any point in time.

Az árfolyamsávok empirikus modelljei és a devizaárfolyam sávon belüli előrejelezhetetlensége = Empirical models of exchange rate target zones

A sávosan rögzített devizaárfolyamok elméleti és gyakorlati vizsgálatai a nemzetközi közgazdaságtan egyik legnépszerűbb témaköre volt a kilencvenes évek elején. A gyakorlati módszerek közül az alkalmazások és hivatkozások száma tekintetében az úgynevezett eltolódással igazítás módszere emelkedett ki. A módszert alkalmazó szerzők szerint amíg a lebegő árfolyamú devizák előrejelzése céltalan feladatnak tűnik, addig sávos árfolyam esetén az árfolyam sávon belüli helyzetének előrejelzése sikeresen végezhető. E tanulmány bemutatja, hogy az Európai Monetáris Rendszer és az északeurópai államok sávos árfolyamrendszereinél e módszer alkalmazásával adódott eredmények például a lebegő árfolyamú amerikai dollárra és az egységgyökfolyamatok többségére is érvényesek. A tanulmány feltárja e látszólagos ellentmondás okait, és bemutat egy olyan, a sávos árfolyamrendszerek főbb megfigyelt jellemzőire épülő modellt, amelynek keretei között a sávon belüli árfolyam előrejelzése nem feltétlenül lehetséges, mert a leértékelés előtti időszakban a sávon belüli árfolyam alakulása kaotikus lehet. / === / Following the development of the first exchange rate target zone model at the end of the eighties dozens of papers analyzed theoretical and empirical topics of currency bands. This paper reviews different empirical methods to analyze the credibility of the band and lays special emphasis on the most widely used method, the so-called drift-adjustment method. Papers applying that method claim that while forecasting a freely floating currency is hopeless, predicting an exchange rate within the future band is successful. This paper shows that the results achieved by applications to EMS and Nordic currencies are not specific to data of target zone currencies. For example, application to US dollar and even to most unit root processes leads qualitatively to the same. This paper explores the solutions of this puzzle and shows a model of target zones in which the exchange rate within the band is not necessarily predictable since the process might follow chaotic dynamics before devaluation.

Exchange rate overvaluation under hyperinflation: The case of Peru

This dissertation examines the behavior of the exchange rate under two different scenarios. The first one is characterized by, relatively, low inflation or a situation where prices adjust sluggishly. The second is a high inflation economy where prices respond very rapidly even to unanticipated shocks. In the first one, following a monetary expansion, the exchange rate overshoots, i.e. the nominal exchange rate depreciates at a faster pace than the price level. Under high levels of inflation, prices change faster than the exchange rate so the exchange rate undershoots its long run equilibrium value.^ The standard work in this area, Dornbusch (1976), explains the overshooting process in the context of perfect capital mobility and sluggish adjustment in the goods market. A monetary expansion will make the exchange rate increase beyond its long run equilibrium value. This dissertation expands on Dornbusch's model and provides an analysis of the exchange rate under conditions of currency substitution and price flexibility, characteristics of the Peruvian economy during the hyper inflation process that took place at the end of the 1980's. The results of the modified Dornbusch model reveal that, given a monetary expansion, the change in the price level will be larger than the change in the exchange rate if prices react more than proportionally to the monetary shock.^ We will expect this over-reaction in circumstances of high inflation when the velocity of money is increasing very rapidly. Increasing velocity of money, gives rise to a higher relative price variability which in turn contributes to the appearance of new financial (and also non-financial) instruments that report a higher return than the exchange rate, causing people to switch their demand for foreign exchange to this new assets. In the context of currency substitution, economic agents hoard and use foreign exchange as a store of value. The big decline in output originated by hyper inflation induces people to sell this hoarded money to finance current expenses, increasing the supply of foreign exchange in the market. Both, the decrease in demand and the increase in supply reduce the price of foreign exchange i.e. the real exchange rate. The findings mentioned above are tested using Peruvian data for the period January 1985-July 1990, the results of the econometric estimation confirm our findings in the theoretical model. ^

The impacts of exchange rate volatility on vegetable trade flows

Trade flows of commodities are generally affected by the principles of comparative advantage in a free trade. However, trade flows might be enhanced or distorted not only by various government interventions, but also by exchange rate fluctuations among others. This study applies a commodity-specific gravity model to selected vegetable trade flows among Organization for Economic Co-operation and Development (OECD) countries to determine the effects of exchange rate uncertainty on the trade flows. Using the data from 1996 to 2002, the results show that, while the exchange rate uncertainty significantly reduces trade in the majority of commodity flows, there is evidence that both short- and long-term volatility have positive effect on trade flows of specific commodities. This study also tests the regional preferential trade agreements such as the North American Free Trade Agreement (NAFTA), the Asia-Pacific Economic Cooperation (APEC) and the EU, and their different effects on commodities.

The Macroeconomic Effects of Fiscal Policy in a Small Open Economy under a Flexible Exchange Rate Regime

This licentiate's thesis analyzes the macroeconomic effects of fiscal policy in a small open economy under a flexible exchange rate regime, assuming that the government spends exclusively on domestically produced goods. The motivation for this research comes from the observation that the literature on the new open economy macroeconomics (NOEM) has focused almost exclusively on two-country global models and the analyses of the effects of fiscal policy on small economies are almost completely ignored. This thesis aims at filling in the gap in the NOEM literature and illustrates how the macroeconomic effects of fiscal policy in a small open economy depend on the specification of preferences. The research method is to present two theoretical model that are extensions to the model contained in the Appendix to Obstfeld and Rogoff (1995). The first model analyzes the macroeconomic effects of fiscal policy, making use of a model that exploits the idea of modelling private and government consumption as substitutes in private utility. The model offers intuitive predictions on how the effects of fiscal policy depend on the marginal rate of substitution between private and government consumption. The findings illustrate that the higher the substitutability between private and government consumption, (i) the bigger is the crowding out effect on private consumption (ii) and the smaller is the positive effect on output. The welfare analysis shows that the less fiscal policy decreases welfare the higher is the marginal rate of substitution between private and government consumption. The second model of this thesis studies how the macroeconomic effects of fiscal policy depend on the elasticity of substitution between traded and nontraded goods. This model reveals that this elasticity a key variable to explain the exchange rate, current account and output response to a permanent rise in government spending. Finally, the model demonstrates that temporary changes in government spending are an effective stabilization tool when used wisely and timely in response to undesired fluctuations in output. Undesired fluctuations in output can be perfectly offset by an opposite change in government spending without causing any side-effects.

Prices and the Real Exchange Rate in Hong Kong: 1985-2006

This paper has been presented at the XIII Encuentros de Economía Aplicada, Sevilla, Spain, 2010.

Going Multinational under Exchange Rate Uncertainty

Published as an article in: Journal of International Money and Finance, 2010, vol. 29, issue 6, pages 1171-1191.

A multivariate generalized ARCH approach to modeling risk premia in forward foreign exchange rate markets

Assuming that daily spot exchange rates follow a martingale process, we derive the implied time series process for the vector of 30-day forward rate forecast errors from using weekly data. The conditional second moment matrix of this vector is modelled as a multivariate generalized ARCH process. The estimated model is used to test the hypothesis that the risk premium is a linear function of the conditional variances and covariances as suggested by the standard asset pricing theory literature. Little supportt is found for this theory; instead lagged changes in the forward rate appear to be correlated with the 'risk premium.'. © 1990.