Exchange-rate targeting

Orthodox economics considers the exchange rate as a nominal anchor against inflation to provide long-run macroeconomic stability (Snowdon et al., 1994). Along with this general position, after the breakdown of the Bretton Woods exchange-rate pegs, it was suggested that a target zone for the exchange rate would benefit from some flexibility and its maintenance would be less demanding than a strict peg (Williamson, 1985; Krugman, 1991).

By contrast, policy makers, especially in developing countries, tend to be more con- cerned with real variables, short-term dynamics and real exchange-rate targeting. In this respect, Chile was one of the first countries to adopt, in 1965, an exchange-rate rule based on purchasing-power parity (PPP), followed by Brazil in 1968. This rule deter- mined the nominal exchange rate that was changed at irregular intervals depending on the inflation-rate differential between Brazil and the United States (Calvo et al., 1995).

Analytically, stabilizing the real exchange rate means targeting the product of the nominal exchange rate and the ratio of foreign prices to domestic prices:

 \( \displaystyle S_{R}=S_{N} \frac{P_{f}}{P_{d}} \)

where \(S_N \)is the nominal exchange rate, defined as domestic currency units per unit of foreign currency; \(P_{f}\) is the general price level of the foreign economy; \(P_{d}\) is the general price level of the domestic economy; and \(S_{R}\) is the real exchange rate, defined here so that an increase of the index represents an exchange-rate depreciation in real terms. The periodical manipulation of \(S_{N} \) allows the maintenance of the real exchange rate around its target.

In the 1990s, the consensus monetary policy migrated towards inflation targeting, which assumes flexible exchange rates, dismissing intermediate exchange-rate arrange- ments (Fisher, 2001; Frankel et al., 2001). However, policy makers still face the problem of mixing inflation and exchange-rate objectives, as in practice not many countries adopt a pure free-floating regime.

This policy dilemma inspired a series of orthodox studies on the trade-off between inflation and exchange-rate targeting: on the one hand, an undervaluation of the exchange rate improves the current account but, on the other hand, it has unde- sired effects on inflation and output, leading to permanent higher inflation (Montiel and Ostry, 1992; Calvo et al., 1995). However, these models fail to consider the dynam- ics of the real variables within the economy such as the structural adjustment in terms of sectoral breakdown of the economy as a result of an undervaluation of the exchange rate.

The critique to these orthodox models is particularly important for small econo- mies dependent on the export of one or few primary commodities: with a free-floating exchange rate, typical of inflation targeting regimes, a nominal exchange rate is pro- cyclical because it comoves with the price of the exported commodities, emphasizing the volatility of the business cycle and inhibiting the diversification of the economy away from primary commodities (Nissanke, 1993).

With the dynamics typical of small developing economies in mind, Edwards (1986) offered a definition of the exchange-rate alternative to the one provided above, where the real exchange rate is expressed as the price of traded goods in terms of non-traded goods:

\( \displaystyle S_{R}=S_{N}\frac{P_{Tf}}{P_{N}}\)

where \(P_{Tf}\) is the price of tradeables in the foreign economy and \(P_{N}\) is the price of non- tradeables in the local economy.

Finally, the benefits of a countercyclical exchange-rate policy are part of a research agenda in the structuralist tradition: Frenkel and Taylor (2009) argued that the exchange rate can serve multiple objectives for developing and transition economies through differ- ent channels. First, through the macroeconomic channel, it influences resource allocation and aggregate demand via its effects on imports, exports, tradeables and non-tradeable prices. Thus, a relatively weak exchange rate can boost employment. Second, through the labour intensity channel, it influences real wages in terms of foreign currency, which, in turn, have an impact on production. Finally, through the finance channel, since a fraction of firms' debt may be in foreign currency while their income and assets may be mostly in domestic currency, the exchange rate can influence balance sheets' currency mismatches. In conclusion, the exchange-rate target is considered a developmental tool in conjunction with commercial and industrial policies.

See also:

Bretton Woods regime; Inflation targeting; Monetary policy in a small open economy.