EQ Vol.10: Exchange Rate Misalignment – For Some a Strategy, for Others a Downfall

Contributing Writer: Abby Fehler | May, 2020

The economies of developing countries face many interesting problems, many of which involve trade. For the leaders of developing nations, economic stability is crucial to maintaining political stability. As seen in countries such as Venezuela, economic instability can cause mass protests, violence, and political turmoil. Therefore, a strong economy is one of the most legitimizing forces for the government of a developing country, and many leaders will go to extreme lengths to maintain a strong economy. Exchange rate misalignment acts as one example. In one way, misalignment can cause the GDP of a country to decrease, and in another, a more purposeful way, exchange rate misalignment can assist in the growth of export- oriented countries, and lead to an increase in GDP. However, this “positive” effect is only temporary and may lead to severe issues in the future. Exchange rate misalignment can be a complex economic problem, requiring immediate government intervention, or it can also be used as an economic strategy, in order to give a temporary illusion of growth.

UW-Madison graduate Diquan Xian researched this distinction amongst developing countries in her senior honors thesis paper, “An Attempt to Understand Exchange Rate Misalignment and its Effects on Developing Countries.” By better understanding how it works, we can both understand how to prevent it in our own country and learn why Xian believes it may be a benefit for some countries. In order to better understand this phenomenon, we must define what misalignment, and more specifically exchange rate misalignment, is. Misalignment is when a variable strays from its long-run sustainable value. When properly aligned, the exchange rate should accurately reflect the ratio of the foreign and domestic price level and is based upon the country’s GDP. When studying economics, there is an idea that as related variables change, in this case, the money supply, inflation, and the growth rate, the exchange rate should change accordingly. Misalignment occurs when the exchange rate does not reflect the true condition of the economy, based on the variables it is supposed to be derived from. When an economy is experiencing misalignment, the currency is either undervalued or overvalued. A currency is undervalued when its exchange rate is higher than equilibrium, and a currency is overvalued when its exchange rate is lower than equilibrium.

Misalignment is when a variable strays from its long-run sustainable value.

When a country is experiencing exchange rate misalignment, resource misallocation can occur, as the relative prices paid do not reflect the true relative cost of production. Such a misallocation can lead to economic instability and a reduction in economic welfare. However, when a currency is undervalued, a country can actually receive temporary benefits, primarily through an increase in demand for exports, and therefore, increased economic growth. Tis phenomenon occurs due to it being relatively cheaper for foreign consumers to purchase undervalued exports. Undervaluation can lead to severe inflation in the home country however, so it is by no means a positive in the long run. Overvaluation has the opposite effect, in which there is a decrease in demand for exports, causing a decrease in economic growth. Tis phenomenon occurs due to it being relatively more expensive for foreign consumers to purchase the overvalued exports. Therefore, while both types of misalignment can cause resource misallocation, which is obviously a negative effect, undervaluation is relatively more positive in the short run than overvaluation because undervaluation can increase demand for the country’s exports. Exchange rate misalignment can occur as a side effect of the exchange rate regime chosen by the government of a developing country. Te two primary choices are a floating exchange rate regime or a fixed rate regime. A floating exchange rate regime allows the rate to change naturally as the economic factors that contribute to the exchange rate change, with minimal government intervention. A fixed exchange rate regime uses government intervention to keep the exchange rate consistent.

However, each of these can pose challenges for developing countries. Under a fixed exchange rate regime, developing countries may fail to keep a consistent rate, which could cause a currency crisis. Nonetheless, prices are also much more susceptible to changes in the exchange rate, meaning that a floating exchange rate could cause extreme price instability. Additionally, misalignment can occur when a country using a fixed exchange rate policy possesses a significant nominal deficit, which the central bank attempts to solve by increasing the money supply. This causes inflation and, consequently, real exchange rate appreciation. Xian argues, however, that a fixed exchange rate is still the most appropriate measure to prevent the adverse effects of external shocks, as long as the government uses monetary and fiscal policy that does not conflict with the exchange rate regime. For example, as stated previously, if a government increases the money supply by exorbitant amounts, it would cause the negative effects of rising inflation and the real exchange rate. However, she argues, once the economy grows stronger, they could switch to a floating exchange rate, in order to gain the positive effects that developed countries enjoy from floating rate policies. Tough most importantly, developing countries must constantly improve institutions such as the central bank, commercial banking, and policymaking groups, as each of which helps determine the health and growth of a nation’s economy. Most of the countries researched by Xian with undervalued currencies were small island nations or key developing countries that have an export-oriented policy. Tis devaluation is purposeful, she argues, and it is often created by constant management of the exchange rate in order to increase export demand, which in turn increases economic growth. Most of the countries researched by Xian with overvalued currencies were countries that utilized some form of floating exchange rate policy.

Countries can correct undesirable exchange rate misalignment in a few ways. Overvaluation can be corrected by devaluation, which is a purposeful lowering of the value of a currency in order to raise the exchange rate. Tis strategy can cause a decrease in real domestic output, raise the domestic price level, and cause a negative wealth effect. These effects cause a decrease in domestic demand, a negative side effect of devaluation both as a method to correct misalignment and as a method to increase exports. However, it may still be useful along with other policies in order to combat a decrease in aggregate demand. Another method would be for a country to apply tariffs on imports and subsidies on exports. However, this method could cause a fiscal deficit, as subsidies can cost a government a significant amount of money. Due to the negative side effects of each reparative method, prevention is the key to solving exchange rate misalignment. Yet, this is not always easy for a developing nation without accurate econometric data. Most of the time, when central banks add exchange rate misalignment to their policy goals, it can be prevented.

Read the full article at: https://issuu.com/uwequilibrium.com/docs/equilibrium_2020_web/37