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Gligor Bishev, Ph.D. RELIABILITY of the EXCHANGE RATE AS A

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Gligor Bishev, Ph.D. RELIABILITY of the EXCHANGE RATE AS A Gligor Bishev, Ph.D. RELIABILITY OF THE EXCHANGE RATE AS A MONETARY TARGET IN AN UNOPTIMAL CURRENCY AREA - MACEDONIAN CASE Vienna, December, 1997 ABSTRACT The main topic of the research work is, whether the exchange rate targeting is an efficient strategy for maintaining price stability without decelerating the economic growth below the potential one in a situation when national currency area is not an optimum currency area with the anchor currency country in the Mundell-McKinnon style. The research work is devided into six chapters. In the first introductory chapter the set up of the Macedonian monetary order is presented, together with the outline what is following in next five chapters. The main topic of investigation in the second chapter is, if there is an alternative efficient strategy, except exchange rate targeting, for maintaining price stability in a small and open economy that is highly integrated into the international trade and financial flows. The research topic in third chapter is what are preconditions for a national currency area to be an optimum currency area. In the fourth chapter the benefits and costs of exchange rate targeting strategy in Macedonia are presented regarding the monetary policy (money supply growth and interest rates), domestic prices, international competitiveness and employment and output. In the fifth chapter, the regime of the exchange rate that is appropriate for intermediate monetary target and viable on long-run is analyzed from the point of view of eight factors: openness and integration into the world economy, the scope of concentration of trade towards particular regions or countries, the level of currency substitution in the domestic economy, the depth of financial and foreign exchange market, the level of wage elasticity and labour mobility, the degree of capital mobility, the stability/instability of money demand, the scope of product and export diversification and the level of economic development and expected future potential growth. The concluding remarks are presented in the sixth chapter. The econometric technique is widely used in the assessment of the relationships between some economic variables. It is especially used in testing the stability of money demand, the assessment of the volatility of the real exchange rate, and assessment of the elasticity of nominal wages with respect to prices and unemployment. The research period is January - June 1997 and it is constrained by two factors. First, the monetary order in Macedonia was set up at the end of April 1992, when Macedonia came out from the Yugoslav dinar zone. Second, the period before January 1994 is not included in the research work, because of the disrupted data and relations due to the very high inflation (near to hyperinflation) in the period before and immediately after the monetary independence (April 1992 - December 1993). Furthermore, taking in mind the research topics, the period April 1992 - December 1993 is not relevant, and even can lead to wrong conclusions. In some cases the research period is extended to September 1997, in order effects of devaluation that occurred on July 9th, 1997 to be analyzed. RELIABILITY OF THE EXCHANGE RATE AS A MONETARY TARGET IN AN UNOPTIMAL CURRENCY AREA - MACEDONIAN CASE CONTENTS 1. Introduction 2. Monetary Strategies for Maintaining Price Stability 2.1. Monetary Targeting 2.2. Inflation Targeting 2.3. Exchange Rate Targeting 3. Optimum Currency Area as a Precondition for Absolutely Fixed Exchange Rate Targeting - Theoretical Basis 3.1. High Degree of Factor Mobility 3.1.1. Labor Mobility and Flexibility of Wages 3.1.2. Capital Mobility 3.2. Openness of the Economy 3.3. Sound Fiscal Policy 3.4. Product and Trade Diversification 3.5. Similar Monetary Sensitiveness Among Countries 3.6. Long Term Growth 4. Effects of the Macedonian Exchange Rate Targeting Strategy 4.1. Monetary Policy Effects 4.1.1. Money Supply Effects 4.1.2. Interest Rate Effects 4.2. Price Effects 4.3. International Competitiveness Effects 4.4. Employment and Output Effects 5. Is the Fixed Exchange Rate Targeting Aviable Strategy for Macedonia? 5.1. Degree of Convergence of Macedonian to German Economy 5.2. Possibility for Sterilization of Asymmetric Demand and Supply Shocks by Higher Factor Mobility 5.2.1. Labor Mobility and Wage Flexibility 5.2.2. Capital Mobility 5.3. Effectiveness of the Exchange Rate Targeting Strategy in a country with Different Potential Growth 5.4. Long-term Effectiveness of the Exchange Rate Changes as Means of Balance of Payments Adjustment 6. Conclusion Gligor Bishev, Ph.D. RELIABILITY OF THE EXCHANGE RATE AS A MONETARY TARGET IN AN UNOPTIMAL CURRENCY AREA - MACEDONIAN CASE 1. INTRODUCTION The monetary order in the Republic of Macedonia was set up on April 26, 1992, when the Act for the Macedonian currency unit, the Act for the usage of the Macedonian currency unit and the Act for the National Bank of the Republic of Macedonia (the Central Bank) were adopted by the Parliament. Until, April 26, 1992, the Republic of Macedonia was part of the Yugoslav currency area where Yugoslav dinar was used as legal tender. In accordance to these acts, in the period 28-30 of April 1992, total amount of currency in circulation denominated in Yugoslav Dinars was replaced by the new Macedonian currency - Denar. In the period of three days, the two currencies - Yugoslav Dinar and Macedonian Denar had been in parallel used as legal tender. On April 30, 1992 at 8 p.m. the Yugoslav Dinar stopped to be a legal tender in Macedonia. The Macedonian currency was issued in the form of coupons in the following denominations: 10, 25, 50, 100, 500, 1,000, 5,000 and 10,000 Denars. The rate of exchange of Yugoslav Dinars for Macedonian Denars was 1:1. The Macedonian currency - Denar, was born in an hyperinflationary environment emanating from the money overhang and monetization of federal government deficit of former Yugoslavia. Furthermore, the Denar was born as a pure paper currency that was not backed either by gold or foreign exchange reserves. The international reserves in Former Yugoslavia were centralized on the federal level, concentrated at the National Bank of Former Yugoslavia. On the anniversary of the monetary independence (April 27, 1993), the definite paper money were introduced in circulation. Simultaneously, the denomination (reduction of the value of money) by 100 times was executed. The main goal of the National bank of Macedonia is maintaining price stability through the manipulation of money supply and interest rates. The Central Bank is also responsible for the stability of the financial system, that determines the National Bank of Macedonia to perform supervisory and settlement functions. The Central Bank is fully independent in achieving its main functions, which means it is independent in selecting the monetary strategy for maintaining price stability and it can unlimitedly use monetary policy instruments in order to achieve the final goal. This research work is concentrated mainly on four topics and each is investigated in separate chapter. The main research topics are: what is the most appropriate monetary strategy for maintaining price stability (second chapter), what are preconditions for a 1 Gligor Bishev, Ph.D. national currency area to be an optimum currency area or few national currency areas to be an optimum currency area (third chapter), what are benefits and costs of exchange rate targeting strategy (fourth chapter), and whether the exchange rate targeting strategy is viable on long run and does it leads to convergence of Macedonia to the level of economic development of Germany (fifth chapter). Concluding remarks are presented in sixth chapter. All these topics are analyzed from the point of view of the Macedonian case. The research period is January 1994 - June 1997. In some cases the research period is extended to September 1997 in order to be analyzed the effects of devaluation that occurred on July 9, 1997. The period before January 1994 is not included in the research work, because of the disrupted data and relationships due to the very high inflation (near to hyperinflation) in the period before and immediately after the monetary independence (April 1992 - December 1993). Furthermore, taking in mind the research topics, the period April 1992-December 1993 is not relevant, and even can lead to wrong conclusions. 2 Gligor Bishev, Ph.D. 2. MONETARY STRATEGIES FOR MAINTAINING PRICE STABILITY A general rule in economics is that the basic objective of the macroeconomic policy in a long run is an increase in the society’s prosperity, represented through an increase in the employment and the living standard. Accordingly, the monetary policy, as one of the major instruments of the economic policy, has to contribute in achieving the objective of increasing the society's prosperity. In the contemporary monetary theory and policy dominates the view that in a long run the price stability creates the best conditions for an increase in the production and employment. Nowadays, this view is accepted by almost all the Central Banks in the world. There is a consensus that in conducting the monetary policy the Central Banks should rely on the following six principles:1 1. In a long run there is no “trade-off” between the inflation and the unemployment, so that one can not choose the combination between the rate of inflation and the employment. The inflation unavoidably leads to an increase in the unemployment. An increase in the money supply is neutral in the medium to long run, i. e., a monetary expansion has lasting effects only on the price level, not on output or unemployment. 2. The depreciation of the exchange rate improves the competitiveness only temporarily and illusionarilly. 3. The business community invests only if it expects permanent economic development and stable economic environment. Inflation is costly, either in terms of resource allocation (efficiency costs) or in terms of long-run economic growth.
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