To update an old statistic: a political leader in a developing country is almost twice as likely to lose office in the six months following a currency crash as otherwise. This difference, which is highly significant statistically, holds regardless of whether the devaluation takes place in the context of an IMF program. Why are devaluations so costly? Many of the currency crises of the last 10 years have been associated with output loss. Is this, as alleged, because of excessive reliance on raising the interest rate as a policy response? More likely it is because of contractionary effects of devaluation. There are various possible contractionary effects of devaluation, but it is appropriate that the balance sheet effect receives the most emphasis. Pass-through from exchange rate changes to import prices in developing countries is not the problem: this coefficient fell in the 1990s, as a look at some narrowly defined products shows. Rather, balance sheets are the problem. How can countries mitigate the fall in output resulting from the balance sheet effect in crises? In the shorter term, adjusting promptly after inflows cease is better than procrastinating by shifting to short-term dollar debt, which raises the costliness of the devaluation when it finally comes. In the longer term, greater openness to trade reduces vulnerability to both sudden stops and currency crashes.
The question of the optimal monetary regime for small open economies is still wide open. On the one hand, the big selling points of floating exchange rates – monetary independence and accommodation of terms of trade shocks – have not lived up to their promise. On the other hand, proposals for credible institutional monetary commitments to nominal anchors have each run aground on their own peculiar shoals. Rigid pegs to the dollar are dangerous when the dollar appreciates. Money targeting doesn’t work when there is a velocity shock. CPI targeting is not viable when there is a large import price shock. And the gold standard fails when there are large fluctuations in the world gold market. This paper advances a new proposal called PEP: Peg the Export Price. Most applicable for countries that are specialized in the production of a particular mineral or agricultural product, the proposal calls on them to commit to fix the price of that commodity in terms of domestic currency. A series of simulations shows how such a proposal would have worked for oil producers over the period 1970-2000. The paths of real oil prices, exports, and debt are simulated under alternative regimes. An illustrative finding is that countries that suffered a declining world market in oil or other export commodities in the late 1990s, would under the PEP proposal have automatically experienced a depreciation and a boost to exports when it was most needed. The argument for PEP is that it simultaneously delivers automatic accommodation to terms of trade shocks, as floating exchange rates are supposed to do, while retaining the credibility-enhancing advantages of a nominal anchor, as dollar pegs are supposed to do.
The author, a member of President Bill Clinton's Council of Economic Advisers, traces a fascinating history, about how fundamental policy differences between economic advisers and presidents have been resolved. Some of the history, which includes two resignations on principle, has never been told, But what to do under President George W. Bush as budget deficits quickly rise? The author offers his advice to economic advisers.
Frankel J. Foreword. In: Sarno L, Taylor M The Economics of Exchange Rates. Cambridge, UK: Cambridge University Press ; 2002. Link