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Tia Aviv 56-2,6 TIA AVIV 56-2,6 THE FOERDER INSTITUTE FOR ECONOMIC RESEARCH' 'TEL-AVIV UNIVERSITY RAMAT AVIV ISRAEL GIANNINI fTON OF AGRICULTURtLWONOMILIBA CS 28 1986 51 11119 1T1PYVP 1.1 vrYt5353 lpnn5 113n 1tatr5n nutTr12P31m v'y EXCHANGE RATE MANAGEMENT: INTERTEMPORAL TRADEOFFS by Elhanan Helpman and Assaf Razin Working Paper No.36-85 December, 1985 This research was supported by funds granted to the Foerder Institute for Economic Research by the NUR MOSHE FUND. FOERDER INSTITUTE FOR ECONOMIC RESEARCH Faculty of Social Sciences, Tel—Aviv University Ramat Aviv,Israe 1. EXCHANGE RATE MANAGEMENT: Intertemporal Tradeoffs By Elhanan Helpman and Assaf Razin* 1. INTRODUCTION It is now understood that exchange rates cannot be managed without the pursuit of other policies which make the entire package internally consistent (e.g., Polak (1957)). Governments or central banks can only temporarily target exchange rates without giving due attention to other policies. However, eventually they have to choose or are forced to choose measures which validate ex—post the feasibility of their exchange rate policy. These measures will typically be anticipated by economic agents during the initial periods of exchange rate management, thereby generating immediate pressure in various markets. Hence, the success of the exchange rate management policy depends to a large extent on other policies, commitments to future policies, and their effects on expectations. A major purpose of this paper is to study the effects of policy—induced slowdowns in the rate of currency devaluation which are not accompanied by an immediate fiscal contraction that prevents reserve losses, thereby implying the need for a contraction in future periods. An extreme form of this policy is an exchange rate freeze. Our interest in experiments of this type stems This is an expanded version of NBER Working Paper No.1590. We wish to thank the Horowitz Institute and the Foerder Institute for Economic Research, Tel—Aviv University for financial aid and to participants at the Tel—Aviv Workshop on International Economics, the Maale Hachamisha Conference on Exchange Rate Management, the Paris Macroeconomic Seminar, Western Ontario Money Workshop, the New University of Lisbon Seminar and the NBER Summer Institute, for comments. EXCHANGE RATE MANAGEMENT: INTERTEMPORAL TRADEOFFS Elhanan Helpman and Assaf Razin ABSTRACT The management 1f the exchange rate is possible only if the government pursues a monetary—fiscal policy mix which is consistent with its exchange rate targets. In this paper we construct a model in which the real consequences of exchange rate management depend on the precise time pattern of the accompanying fiscal and thonetary policies. We study the macroeconomic constraints on feasible policies and the comparative dynamics of disinflation by means of exchange rate targetting that takes place with an initially overvalued currency and a delayed accompanying contractionary policy. The policy brings about an intergenerational redistribution of wealth, and as a result, spending rises during the initial time periods and falls during later periods, the real exchange rate declines initially and rises eventually, and the country's external debt rises in all time periods. These results are consistent with recent exchange—rate—managed—disinflation attempts in Argentina, Chile and Israel. Elhanan Helpman and Assaf Razin, Department of Economics Tel—Aviv University Tel—Aviv 69978 ISRAEL 2 from the fact that several countries have attempted in recent years to disinflate by means of slowdowns in the rate of currency depreciations, with Argentina, Chile and Israel being the prime examples. Argentina used a preannounced pattern of exchange rate movements (Tablita) from December 1978 to February 1982; Chile used a Tablita from February 1978 which culminated in an exchange rate freeze in June 1979. The frozen exchange rate was maintained until June 1982. Israel used a preannounced rate of currency devaluation from September 1982 until October 1983 (5 percent per month). In all cases the currency was overvalued and the managed rate of currency devaluation was below the inflation rate. Table 1 presents data for these countries. It is clear from these data that in all cases the policy brought about an appreciation in the real exchange rate; an increase in private consuiption; a worsening of the trade balance and a loss of reserves. In all cases the exchange rate management policy turned out to be unsustainable. [Insert Table 1 about here] In order to study these issues we construct a model of overlapping—generations in which consumers have finitely expected horizons, as in Blanchard (1985). This model is particularly suitable for the purpose at hand because it is free of distortions but nevertheless does not have the Ricardo—Barro neutrality property (see Barro (1974)). It is well known that in economies without distortions in which individuals have infinite horizons exchange rate managements have no real effects (e.g., Helpman and Razin (1979)), and therefore these types of models cannot explain the facts depicted in Table 1. On the other hand, in economies with distortions exchange rate management may have real effgcts even when individual horizons are infinitely 3 long (e.g., Aschauer and Greenwood (1981), Helpman and Razin (1984) and Feenstra (1985)), but it seems to us that it is more reasonable to rely on finite horizons than on distortions in order to explain the macroeconomic performance reported in Table 1. We present our model in Section 2 and discuss there a benchmark equilibrium with a freely floating exchange rate. In that framework the time pattern of real variables does not depend on monetary injections or withdrawals through the tax—transfer system and the resulting equilibrium is identical with the equilibrium that would have resulted in a barter economy. This naturally leads to an efficient allocation of resources. Efficiency is also preserved when the exchange rate is managed, but the time pattern of real variables does depend on the policies that support the exchange rate path . (contrast with Helpman and Razin (1979), Helpman (1981) and Lucas (1982)). Hence, in this case there exist significant differences between a managed and a floating exchange rate regime. In section 3 we study these issues in general terms. In particular, we explore the feasibility of various exchange rate policies in conjunction with the accompanying fiscal and monetary policy mix. The real effects of exchange rate targetting that arise in this analysis are closely related to the real effects of budget financing that were discussed by Blanchard (1985) and Frenkel and Razin (1984) in frameworks without money. We, naturally, take explicit account of monetary considerations. In section 4 we study in detail the -extreme form of exchange rate management -- the case of an exchange rate freeze. This is designed to shed light on the economic mechanism underlying disinflation policies by means of exchange rate targetting that were described above. We show that when this 4 policy is pursued with an initially overvalued currency and a delayed accompanying absorption policy, the result is higher spending and a low real exchange rate following the inception of exchange rate management, lower spending and higher real exchange rates in later periods, and larger aggregate external debt in all time periods. The twist in the time profile of spending and the real exchange rate, and the upward shift in the time profile of debt, are larger the larger the initial overvaluation and the longer the delay in the absorption policy. However, the delay in the absorption policy is bounded by the government's taxing capacity. Therefore the feasible delay in the absorption policji is also bounded. The beneficiaries of this policy combination are individuals who are alive during its inception, while all future generations suffer. 2. Floating Exchange Rate We consider an economy with overlapping generations in which a cohort of size 1 is born in every period. Individuals survive to the next period with probability y and this probability is age independent. The event of death is independent across individuals. Therefore, the proportion of a cohort alive at time t1 which survives to period t2 is: (t,—t1) Y The age distribution of the population is constant over time and in every period there are ya individuals of age a. The size of the population is also constant and equal to: -\ 1:=6*( a = 1/(1-Y) 5 We assume that those individuals live in a small country facing a given one—period world real interest rate r on sure loans in terms of traded goods. All loans are indexed and foreign prices of traded goods are constant and equal to one. Thus if one borrows b he has to repay Rb the next period, where R = l+r is the interest factor. Since an individual survives to the next period only with probability y, he cannot obtain a loan with this interest rate. Foreign financial institutions who lend to domestic residents will obtain a sure repayment Rb if they charge a real interest rate of (R/y) — 1. In order to see this, suppose that b is being lent to every individual of a given cohort. Then those who will survive to the next period will repay Mph. However, only a proportion y of the individuals will survive. Therefore total payments by the cohort will be Rb. Clearly, (R/y) — 1 is the risk—adjusted real interest rate (see Blanchard (1985)). There exist firms that produce yT units of 'traded goods per capita and yN units of nontraded goods per capita. The sectoral output levels are functions of the relative price of nontradables pt and so is GDP per capita in terms of traded goods, which we denote by y(p ). Clearly, dy(pt)/dp t =yN. Firms sell their output in exchange for domestic money and distribute the proceeds to the living individuals at the beginning of the following period.
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