The Economics of Real Exchange Rate Management

The intention of my previous blog (“Argentina’s Bogus Miracle,” September 21) was not to imply that the real exchange rate (RER) cannot be managed, but to argue that there are good and bad ways of doing so. Since many people attribute Argentina’s recent growth performance to a deliberate and successful decision to actively depreciate the RER, I expressed my opinion that what Argentina has been doing, particularly since 2005, is bad RER management.

To clarify my point, allow me to use a simple analytical framework in the form of a Swan diagram (as in T.W. Swan, the Australian economist who, along with W. Salter and M. Corden, popularized the celebrated tradables-nontradables small-open economy model). The application of the Swan-Salter-Corden model to Argentina requires some adaptation. Suppose that we divide the goods and services produced in Argentina in three categories: exportables, importables, and nontradables. Since the economy is small, international prices for exportables and importables are given. To capture the fact that export prices are more volatile than import ones, assume that the latter are fixed while the former fluctuate. Also, to represent that the government stabilizes exportable prices domestically due to their high incidence in the consumption basket, assume that every time international prices rise the government increases export taxes, and viceversa. These assumptions are not unrealistic and imply that the relative price of exportables in terms of importables is more or less constant, which allows me to lump them together in a single composite good called tradables (T). Following the convention typically used in emerging markets, we define the RER as the relative price of tradables in terms of nontradables (N). An increase in the RER (denoted by e) therefore represents real depreciation.

The following figure shows the economy in a hypothetical full (internal and external) macroeconomic equilibrium. At points A and A’, the N market clears and the current account is in balance. In other words, e0 is an “equilibrium RER.”


Now, suppose that the government attempts to increase competitiveness by devaluing and nothing else. Because economic agents do not perceive that the RER is misaligned, this will simply cause the prices of T and N to rise proportionately withouth affecting the RER. The transmission mechanism leading to this result is like this: the increase in the nominal exchange rate will induce the public to sell dollars to the central bank leading the latter to expand the money supply. Since the economy is in full employment, more money merely means more inflation. Real money balances are not affected, hence real interest rates do not change. In short, nominal devaluation (tantamount to expansionary monetary policy in this example) is neutral.

Knowing that this was the case, Argentina avoided to engage in a futile devaluation-inflation spiral after the economy reached near full employment in 2005, but rather set the RER above the equilibrium level by restricting the upward flexibility of nontradable prices – including but not limited to public utility tariffs, which have been frozen to the public since December 2001 despite accumulated inflation of 125%. The result of this particular strategy is depicted in the next figure.


At e1, there is excess demand for nontradables (EDN) and a current account surplus (CAS). Since output in the N sector is demand-determined, the economy is overheated: actual GNP (Nd1+e1Ts1) exceeds potential GNP (Ns1+e1Ts1). Clearly, this situation is one of disequilibrium or RER undervaluation. Two chief manifestations of this kind of disequilibrium are strong inflationary pressures and supply constraints in those sectors where relative prices are severly distorted (e.g., energy).

What are the options? One would be to liberalize domestic prices. This would bring the economy to points A and A’. The new government of Argentina, led by CFK after her predictable win in last Sunday’s election, may not like this option for obvious reasons: inflation would increase and GNP growth would decelerate. True, the effect on inflation could be ameliorated by letting the nominal exchange rate appreciate. But this is a political non-starter, as avoiding nominal appreciation has become a Kirchner mantra. And to be honest, I am not sure this is a good option either. To the extent commodity prices and capital inflows are still high, letting the peso float withouth intervention would result in strong appreciation. While this would be an equilibrium rather than a disequilibrium movement, the effect would be Dutch disease.

A better option, in my opinion, is to try to keep the RER genuinely depreciated by bringing the equilibrium RER closer to the actual one. To achieve this, what the government needs to do is to complement domestic price liberalization with a mix of tight monetary and fiscal policies and trade liberalization. The effect would be as follows.


Monetary and fiscal contraction, achieved via a combination of a more aggressive sterilization and a 2-3% of GDP increase in the consolidated (national and provincial governments combined) primary surplus would shift the N demand curve to the left eliminating the excess demand in that market. Notice that, in the figure, RER does not appreciate at all. Rather it stays at its current level e1. While devaluation plus sterilized intervention is equivalent to monetary contraction, the same result (monetary absorption) can be attained by increasing the fiscal surplus. Actually, this is a more genuine way to buy reserves, hence bring the peso down, since it does not require the central bank to intervene or sterilize.

As for the market for tradables, my graph assumes that the demand and supply curves do not shift. While this does not need to be necessarily the case, it highlights the fact that the effects of monetary and fiscal contraction, on the one hand, and trade liberalization, on the other, work in opposite directions and may offset each other. For example, a tighter mix of fiscal and monetary policies reduces the demand for tradables. Trade liberalization, on the other hand, increases it. In the case of the supply, trade liberalization (a simultaneous reduction in export and import taxes) has a positive effect on exportables, but a negative effect onimportables, hence the shift in Ts can go either way.

The strategy I just described is not only better than the one implemented by the government so far, and also better than the one favored by inflation targeters (which is based on raising interest rates and letting the RER appreciate) because it eliminates internal disequilibrium (EDN) without provoking Dutch disease. Clearly, it is not without costs. Some acceleration in inflation and growth deceleration is unavoidable. Over time, however, maintaining a strong external position will allow the RER to appreciate gradually. As economic agents will be able to antecipate this, real interest rates will fall and investment will grow.

In brief, when it comes to RER-management, I am not a complete agnostic. Rather, my opinion is that, with the proper combination of fiscal, monetary, and trade policies, the RER can be effectively managed (albeit indirectly) with potentially good results in terms of economic performance. Actually, this was the main message of a paper I wrote many years ago with Domingo Cavallo and M. Shabaz Khan in which we examined the relation between RER behavior and economic performance in 26 developing countries from 1960 to 1986 (see Economic Development and Cultural Change, October 1990).

9 Responses to "The Economics of Real Exchange Rate Management"

  1. Vitoria Saddi   October 31, 2007 at 2:05 pm

    Joaquin, you say:”the same result (monetary absorption) can be attained by increasing the fiscal surplus. Actually, this is a more genuine way to buy reserves, hence bring the peso down, since it does not require the central bank to intervene or sterilize.”Question: Don’t you think that the increase in the fiscal surplus has to be really big to allow the above scenario to happen? In other words, don’t you think it is politically easier to use sterilization policies and devaluation instead? Do you think that the above strategy is a substitute for eliminating the price controls? Why?

  2. Joaquin Cottani
    Joaquin   November 1, 2007 at 11:41 am

    Vitoria: Good questions. Notice that what I propose in the blog is raising the overall surplus by 2-3% of GDP, namely, from the current 2% (at the federal level) to a desirable 4-5%, While this may seem high, it is actually less than what Chile currently has. Under current external conditions, this is perfectly doable in Argentina, but it requires fiscal discipline on the expenditure side. Incidentally, a good part of the increase in fiscal spending in recent quarters has been due to the need to subsidize energy, transportation, and other sectors affected by price controls. Liberalizing prices would therefore produce automatic fiscal savings. Considering that GDP is around AR$700bn, the monetary absorption potential of the proposed fiscal surplus would be AR$28-35bn. Compare this with accumulated FX intervention worth about AR$50bn in the last 12 months, and what you get is some serious monetary absorption power. In relation to the second question, there is no doubt in my mind that if price controls are eliminated there will be a discrete jump in inflation. Lack of monetary and fiscal contraction may help keep contain this effect, but they will not eliminate it. Keeping the exchange rate depreciated in real terms will therefore require nominal depreciation. But, this is where trade, in particular import, liberalization enters the picture. Will CFK ever consider this plan? Naah.

  3. Joaquin Cottani
    Joaquin   November 1, 2007 at 12:17 pm

    Sorry, there was a typo in my previous comment. Where I said “Lack of monetary and fiscal contraction may help contain this effect, but will not eliminate it” I meant “Lack of monetary and fiscal accommodation may help contain etc.”

  4. Anonymous   November 2, 2007 at 12:31 pm

    Joaquin,I enjoyed reading your post. Very well thought and argumented. My question is for how long do you think that the government will be able to maintain the current polict mix?

  5. Guest   November 3, 2007 at 5:34 pm

    Why not to let the RER appreciate more rapidly if the improvement in a country’s terms of trade is permanent? The necessary shift of resources from sector to sector is then unavoidable and should not be slowed down.

  6. Rafael Loring   November 5, 2007 at 12:09 pm

    Hi Joaquin, as always I extremely enjoyed reading your post. Don’t you think that sterilization has its limits in this environment… I wonder if it isn’t inconsistent to pretend to apply a contractionary monetary policy while maintaining the RER in Argentina at this point?I also wonder if the policy mix you recommend would be to much of a shock. You admit “Clearly, it is not without costs. Some acceleration in inflation and growth deceleration is unavoidable”. How do we now that the monetary policy needed to control the effect of price liberalization would be bearable in employment terms?. Isn’t sometimes the remedy worse than the disease -the Dutch disease in this case ;) .

  7. Javier Finkman   November 10, 2007 at 9:37 am

    Joaquín:That’s and easy call! The skepticism on targeting a real variable (in this case the real exchange rate) is usually based in the longstanding tradition that policy cannot change real values but only nominal ones (neutrality-type of outcomes; microfoundations, etc.). In introducing the fiscal surplus you are using a real variable (savings) to target another real variable… this is less subject to dispute I imagine even among more orthodox economists. Not much agnosticism needed there. So the question is not if it works – if you switch from purchasing dollars with the inflation tax to purchasing dollars with the export tax it will work – but what is the political economy behind increasing the primary surplus 2% of GDP!

  8. Joaquin   November 12, 2007 at 11:14 am

    Thank you all for your comments. I apologize for responding late. There are two key questions I want to respond: (a) Is it necessary to avoid RER appreciation if the favorable shock is permanent? (b) Is it politically feasible to increase the primary surplus by 2-3% of GDP.On the first question, the simple answer is: Yes, unless you thing that the rate of national saving is already too high (eg, China). An improvement in terms of trade (whether this one is permanent or not I’m sure, but less assume it is) is an increase in disposable income. Increasing the primary surplus is a way to take advantage of that permanent increase in disposable income to permanently raise the rate of national saving, hence sustainable growth.On the second question, do you know what the fiscal cost of maintaining relative price distortions is in Argentina? 4% of GDP. This includes 1% of subsidies to energy, transportation, farmers, and manufacturers; 0.4% of “loans” to energy sector and Public corporations; and 2.6% of public investment in areas previously covered by the private sector. Eliminate the distortions and the subsidies, loans, and public investment are no longer needed, except perhaps for 1% GDP in targeted subsidies to the poor. Bingo! You saved 3% of GDP without any political cost, unless by “political cost” you mean the cost of the authorities losing access to (i.e., discretionally squandering)public funds.