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JOURNAL OF ECONOMIC DEVELOPMENT 85
Volume 29, Number 1, June 2004
EXCHANGE RATE FLUCTUATIONS AND ECONOMIC ACTIVITY
IN DEVELOPING COUNTRIES: THEORY AND EVIDENCE
MAGDA KANDIL
International Monetary Fund
This paper examines the effects of exchange rate fluctuations on real output growth and
price inflation in a sample of twenty-two developing countries. The analysis introduces a
theoretical rational expectation model that decomposes movements in the exchange rate into
anticipated and unanticipated components. The model demonstrates the effects of demand
and supply channels on the output and price responses to changes in the exchange rate. In
general, exchange rate depreciation, both anticipated and unanticipated, decreases real
output growth and increases price inflation. The evidence confirms concerns about the
negative effects of currency depreciation on economic performance in developing countries.
Keywords: Exchange Rate, Output Growth, Price Inflation, Supply vs. Demand Shifts
JEL classification: F41, F43, E31
1. INTRODUCTION
There has been an ongoing debate on the appropriate exchange rate policy in
developing countries. The debate focuses on the degree of fluctuations in the exchange
rate in the face of internal and external shocks. Exchange rate fluctuations are likely, in
turn, to determine economic performance. In judging the desirability of exchange rate
fluctuations, it becomes, therefore, necessary to evaluate their effects on output growth
and price inflation. Demand and supply channels determine these effects.
A depreciation (or devaluation) of the domestic currency may stimulate economic
activity through the initial increase in the price of foreign goods relative to home goods.
By increasing the international competitiveness of domestic industries, exchange rate
depreciation diverts spending from foreign goods to domestic goods. As illustrated in
Guitian (1976) and Dornbusch (1988), the success of currency depreciation in promoting
trade balance largely depends on switching demand in proper direction and amount, as
well as on the capacity of the home economy to meet the additional demand by
MAGDA KANDIL
86
supplying more goods.
1
While the traditional view indicates that currency depreciation is expansionary, other
theoretical developments have stressed some contractionary effects. This possibility is
discussed theoretically in a model by Meade (1951). If the Marshall-Lerner condition is
not satisfied, currency depreciation could produce contraction.
2
Hirschman (1949)
points out that currency depreciation from an initial trade deficit reduces real national
income and may lead to a fall in aggregate demand. Currency depreciation gives with
one hand, by lowering export prices, while taking away with the other hand, by raising
import prices. If trade is in balance and terms of trade are not changed these price
changes offset each other. But if imports exceed exports, the net result is a reduction in
real income within the country. Cooper (1971) confirms this point in a general
equilibrium model.
Diaz-Alejandro (1963) introduced another argument for contraction following
devaluation. Depreciation may raise the windfall profits in export and import-competing
industries. If money wages lag the price increase and if the marginal propensity to save
from profits is higher than from wages, national savings will go up and real output will
decrease. Krugman and Taylor (1978) and Barbone and Rivera-Batiz (1987) have
formalized the same views.
Supply-side channels further complicate the effects of currency depreciation on
economic performance. Bruno (1979) and van Wijnbergen (1989) postulate that in a
typical semi-industrialized country where inputs for manufacturing are largely imported
and cannot be easily produced domestically, firms’ input cost will increase following a
devaluation. As a result, the negative impact from the higher cost of imported inputs
may dominate the production stimulus from lower relative prices for domestically traded
goods. Gylfason and Schmid (1983) provide evidence that the final effect depends on
the magnitude by which demand and supply curves shift because of devaluation.
3
To summarize, currency depreciation increases net exports and increases the cost of
production. Similarly, currency appreciation decreases net exports and the cost of
production. The combined effects of demand and supply channels determine the net
results of exchange rate fluctuations on real output and prices.
4
1
Empirical support of this proposition for Group 7 countries over the 1960-89 period is provided in
Mendoza (1992).
2
The Marshall-Lerner condition states that devaluation will improve the trade balance if the devaluing
nation’s demand elasticity for imports plus the foreign demand elasticity for the nation’s exports exceed 1.
3
Hanson (1983) provides theoretical evidence that the effect of currency depreciation on output depends
on the assumptions regarding the labor market. Solimano (1986) studies the effect of devaluation by focusing
on the structure of the trade sector. Age’nor (1991) introduces a theoretical model for a small open economy
and distinguishes between anticipated and unanticipated movement in the exchange rate. Examples of
empirical investigation include Edwards (1986), Gylfason and Radetzki (1991) and Bahmani (1998).
4
For an analytical overview, see Lizondo and Montiel (1989), Edwards (1989), and Age’nor and Montiel
EXCHANGE RATE FLUCTUATIONS AND ECONOMIC ACTIVITY 87
This paper revisits the relationship between exchange rate fluctuations and economic
activity in developing countries. The theoretical investigation introduces a model that
decomposes movements in the exchange rate into anticipated and unanticipated
components using rational expectations. In this context, the output supplied varies with
unanticipated price movements and the cost of the output produced. Anticipated
exchange rate movements determine the cost of the output produced, resulting in
long-run effects. In contrast, unanticipated exchange rate movements determine
economic conditions, in the short-run, in three directions: net exports, money demand,
and the output supplied. Both long-run and short-run effects matter to economic
performance. The long-run effect determines output growth over time. Nonetheless,
cyclical short-run effects may lead to a crisis, as recent experiences of emerging markets
have demonstrated.
The solution of the model demonstrates the effects of demand and supply channels
on the output and price responses to unanticipated changes in the exchange rate. Based
on theory’s solutions, empirical models are formulated for output and price. The models
incorporate demand and supply shifts as well as exchange rate shifts. Exchange rate
fluctuations are assumed to be randomly and symmetrically distributed around a
steady-state stochastic trend over time. This trend varies with agents’ observations of
macroeconomic fundamentals. Positive shocks to the exchange rate indicate an
unanticipated increase in the domestic currency price of foreign currency, i.e.,
unanticipated currency depreciation (devaluation).
5
A negative shock to the exchange
rate represents an unanticipated currency appreciation.
6
Further, the analysis employs
new data for the real effective exchange rate in developing countries.
7
These data have
the advantage of (i) calculating the exchange rate as a weighted average of bilateral rates
according to trade volumes with major trading partners, and (ii) accounting for the
relative prices in domestic and foreign economies. The latter channel is particularly
important given the high inflationary experience in developing countries. Accordingly,
the empirical investigation will combine the nominal exchange rate policy with
movements in domestic price inflation relative to that of major trading partners to
determine the implications of fluctuations in the real effective exchange rate on
economic performance in developing countries.
(1996).
5
Throughout the paper, depreciation will describe a reduction in the domestic currency price of foreign
currency attributed to either market forces, for example an equilibrium adjustment in the context of trade
liberalization, or a managed policy, for example devaluation as a result of a currency crisis.
6
For example, an overvalued peg that cannot be sustained based on rational expectations. As the evidence
of Southeast Asian countries demonstrated, unanticipated currency appreciation decreased net exports and
money demand, as agents started the process of speculative attacks. Of course, subsequent devaluation further
accelerated inflation and reinforced output contraction through the supply-side channel.
7
The data are constructed following the approach discussed in Bahmani (1995).
MAGDA KANDIL
88
The estimation highlights the relative importance of exchange rate fluctuations in
determining real output and price in developing countries. Consistent with the results of
early research, the evidence indicates that the contractionary effects dominate in
determining real output growth in the face of exchange rate depreciation. The
contractionary effects do not appear to be positively correlated with the size of the trade
deficit in the face of exchange rate fluctuations. Nonetheless, output contraction is
explained in the theoretical model by two factors. Domestic currency is expected to
return to its steady state value following unexpected depreciation. Agents, therefore,
may increase the demand for domestic currency. This channel slows down velocity,
decreasing spending and output growth. More importantly, exchange rate depreciation
increases the cost of imported intermediate goods, decreasing the output supplied in
developing countries. Given the evidence of a higher inflation in the face of currency
depreciation, the supply channel appears to be more dominant. The reduction in
aggregate supply is consistent with a reduction in output growth and an increase in price
inflation in the face of currency depreciation, both anticipated and unanticipated, in
various developing countries. This evidence supports the results of earlier research
concerning the importance of supply-side channels in determining the effects of
exchange rate depreciation on economic performance in developing countries.
The remainder of the paper is organized as follows. Section 2 presents the theoretical
model. Section 3 outlines the empirical models. Section 4 presents empirical results. The
summary and conclusion are presented in Section 5.
2. THEORETICAL BACKGROUND
In the real world, stochastic uncertainty may arise on the demand or supply sides of
the economy. Economic agents are assumed to be rational. Accordingly, rational
expectations of demand and supply shifts enter the theoretical model. Economic
fluctuations are then determined by unexpected demand and supply shocks impinging on
the economic system.
The paper introduces a macroeconomic model that incorporates exchange rate
fluctuations. Uncertainty enters the model in the form of disturbances to both aggregate
demand and aggregate supply. Within this framework, currency depreciation determines
aggregate demand through exports, imports, and the demand for domestic currency, and
determines aggregate supply through the cost of imported intermediate goods. The
model demonstrates theoretically that the effects of currency depreciation is
contractionary via the effect of the supply side. However, the effects on aggregate
demand make the final outcome inconclusive.
2.1. Aggregate Demand
The demand side of the economy is specified using standard IS-LM equations with a
EXCHANGE RATE FLUCTUATIONS AND ECONOMIC ACTIVITY 89
modification for an open economy. The demand side of the economy combines
equilibrium conditions in the Goods and Money markets. In the specifications below, all
coefficients are positive and throughout the paper, lower case denotes the logarithm of
the corresponding level variable. The subscript
t denotes the current value of the
variable.
dtt
yccc
10
+= , 10
1
<< c (1)
ttdt
tyy −= (2)
tt
yttt
10
+= , 0
1
>t (3)
tt
riii
10
−= , 0
1
>i (4)
*
*
)log()log(
ttt
t
tt
t
pps
P
PS
R −+== (5)
)log(
10 tt
Rxxx −= , 0
1
>x (6)
)log(
210 ttt
Rmymmim −+= , 0,
21
>mm (7)
tttttt
imxgicy −+++= (8)
)()]([
11 tttttttttt
ssEyppErpm −−+−+−=−
++
θφλ
, 0,, >
θ
φ
λ
(9)
Equations (1) through (8) describe equilibrium conditions in the Goods market. In
Equation (1), real consumption expenditure,
c , varies positively with real disposable
income,
d
y . In Equation (2), disposable income is defined to be the net of real income,
y , minus taxes, t . In Equation (3), real taxes are specified as a linear function of real
income. In Equation (4), real investment expenditure,
i , varies negatively with the real
interest rate,
r
. In Equation (5), let the domestic price level be represented by
P
and
the foreign price level in foreign currency by
*
P
. The spot price of foreign currency is
denoted by
S and defined as the number of domestic currency units per units of
foreign currency.
R is the price of foreign produced goods and services relative to the
prices of domestically produced goods and services, i.e., the real effective exchange rate
of the foreign currency. When
R increases, the domestic currency depreciates in real
terms. The value of
R measures the degree of competitiveness of foreign produced
MAGDA KANDIL
90
goods and services relative to those produced domestically.
8
In Equation (6), real
exports are related to an autonomous element,
0
x , which rises when the income level
abroad rises, and to relative prices. The positive relationship between
R and
x
, in (6),
refers to the fact that when the foreign price is higher relative to domestic goods, exports
will increase. In Equation (7), real imports,
im , are assumed to rise with the level of
real income and decrease with the real effective exchange rate of the foreign currency.
Equation (8) describes the equilibrium condition in the goods market. Real government
spending,
g
, is assumed to be exogenous. The total expenditure by domestic residents
in real terms )(
y is the sum of real consumption expenditure )(c , real investment )(i ,
real government spending )(
g , and net exports (the real value of exports,
x
, minus the
real value of imports,
im ).
After substituting all equations into the equilibrium condition for the goods market,
we obtain the expression for real income which is a function of the exchange rate, the
domestic price level, the foreign price level, and the domestic interest rate. This
expression is the IS equation which describes the negative relationship between real
income and the real interest rate (See APPENDIX A).
In Equation (9), equilibrium in the money market is obtained by equating the
demand and supply of real money balances. The real money supply is equal to an
exogenously determined nominal balances,
m , deflated by price, p . The demand for
real money balances is positively related to real income and inversely related to the
nominal interest rate. The nominal interest rate is defined as the sum of the real interest
rate and inflation expectation at time
t .
1+tt
sE is the expected future value of the
foreign currency at time
t . Agents in each country must hold domestic money for
transactions purposes but they may speculate by holding foreign money.
9
An
unexpected depreciation of the domestic currency in period
t would lead to
speculation of appreciation in period
1
+
t to restore the steady-state normal trend of
the exchange rate, i.e., 0
1
<−
+ ttt
ssE .
10
Consequently, agents increase the speculative
demand for domestic currency, establishing a negative relationship between the demand
for real money balances and agents’ expectation of the future value of the domestic
currency relative to its current value.
The LM equation is determined by the equilibrium condition in the money market,
establishing a positive relationship between real income and the real interest rate.
Solving for the interest rate,
r
, from the LM equation and substituting the result into
the IS equation gives us the equation for aggregate demand (See APPENDIX A).
8
For a similar definition, see Shone (1989).
9
For a similar discussion, see Buiter (1990).
10
Agents are reluctant to dispose of domestic currency given expectations of future appreciations in its
value.
EXCHANGE RATE FLUCTUATIONS AND ECONOMIC ACTIVITY 91
2.2. Aggregate Supply
On the supply side, output is produced using a production function that combines
labor, capital, energy and imported intermediate goods. When the currency depreciates,
it is more expensive to buy intermediate goods from abroad. The price of energy is paid
in domestic currency to isolate this variable from exchange rate fluctuations.
To illustrate, the level of gross domestic output, Q , is produced using a production
function that combines imported intermediate goods, N , labor, L , and the capital
stock,
K
. The production function is Cobb-Douglas in N and L , assuming fixed
capital stock.
11
In addition, the production function is dependent on changes in the
energy price,
Z
. Accordingly, the supply-side of this economy can be summarized in
Equations (10) through (14) as follows:
t
Z
ttt
eNLQ
−
−
=
δδ
1
(10)
tttt
NRQY −= (11)
}log{
δη
−+−−=
tttt
d
t
zpwnl , 0
1
1
>
−
=
δ
η
(12)
)}log()1{log(
1
tttt
Rzln −−−+=
δ
δ
(13)
}{log
1 ttt
s
t
pEwl
−
−+=
ωδη
, 0>
ω
(14)
Equation (10) specifies the level of gross domestic output produced, assuming
complementary relation between the labor input and imported intermediate goods.
Equation (11) defines domestic value added (output supplied) or the difference between
gross domestic output and the amount of real intermediate imports.
12
The demand for inputs is derived by calculating the marginal product of L and N
and equating the results with the real cost of labor (the real wage) and the real price in
domestic currency of imported intermediate goods (the real exchange rate). Taking log
transformation of the first-order conditions and rearranging produces Equations (12) and
(13). The demand for labor varies negatively with the real wage and positively with
11
To exclude the possibility that depreciation may increase labor productivity by stimulating capital
accumulation, the capital stock is assumed to be fixed. Alternatively, changes in the capital stock may not
affect output if the marginal product of additional capital units equals the marginal cost.
12
This definition follows Age’nor (1991) where he introduces a model and assumes intermediate goods
are necessary for the production process and cannot be produced domestically.
MAGDA KANDIL
92
imported intermediate goods. Similarly, the demand for imported intermediate goods
increases with the labor input. Exchange rate depreciation increases the real price of
imported intermediate goods and, hence, decreases the demand for these goods. Further,
a rise in the energy price decreases the demand for labor and imported intermediate
goods.
Equation (14) hypothesizes a positive log-linear relationship between labor supply
and the expected real wage. The supply of labor increases with an increase in the
nominal wage relative to workers’ expected price at time 1
−
t .
Equating labor demand and labor supply results in the nominal wage. Substituting
the result into labor demand produces employment and, in turn, imported intermediate
goods. Substituting for l and n into the log transformation of Equation (10), results
in gross domestic output supplied (see APPENDIX A). Substituting the result into the
log transformation of Equation (11) yields an equation for aggregate supply of domestic
value added (See APPENDIX A).
Aggregate supply has a direct positive relationship with output price surprises.
Workers decide on labor supply based on their expectation of the aggregate price level.
An increase in aggregate price relative to workers’ expectations increases the demand
for labor and, hence, the nominal wage. A rise in the expected real wage increases
employment and, hence, the output supplied. In addition, aggregate supply moves
negatively with the domestic price of foreign currency. Depreciation increases the cost
of imported goods and decreases the output supplied. Further, the output supplied varies
negatively with changes in the energy price.
2.3. Market Equilibrium
Internal balance requires that aggregate demand for domestic output be equal to
aggregate supply of domestic output at full employment. It is assumed that demand and
supply shifts in the model are constructed of two components: anticipated (steady-state)
component and an unanticipated (random) component (See APPENDIX A). The
combination of demand and supply-side channels indicates that real output depends on
unanticipated movements in the exchange rate, the money supply, government spending,
and the energy price.
13
In addition, supply-side channels establish that output varies
with anticipated changes in the exchange rate and the energy price.
Given demand-side channels, aggregate demand increases with an unexpected
increase in government spending or the money supply, creating positive price surprises
and, hence, increasing output and price in the short-run. Changes in the energy price,
both anticipated and unanticipated, increase the cost of the output produced, decreasing
13
Shocks to these variables are assumed to fluctuate in response to domestic conditions or in response to
external vulnerability, e.g., capital mobility or fluctuations in foreign reserves.
EXCHANGE RATE FLUCTUATIONS AND ECONOMIC ACTIVITY 93
output and raising prices.
14
The effects of real exchange rate fluctuations on the price level and output are
complicated by demand and supply channels as follows:
1. In the goods market, an unexpected depreciation of the domestic currency will
make exports less expensive and imports more expensive. As a result, the
competition from foreign markets will increase the demand for domestic products,
increasing domestic output and price.
2. In the money market, an unexpected depreciation of the domestic currency,
relative to its anticipated future value, prompts agents to hold more domestic
currency and increases the interest rate. This channel moderates the positive effect of
the exchange rate shock on aggregate demand, output, and price.
15
3. On the supply side, changes in the exchange rate, both anticipated and
unanticipated, determine the cost of imported intermediate goods. As the domestic
currency depreciates, producers are inclined to decrease imports of intermediate
goods, decreasing domestic output and increasing the cost of production and, hence,
the aggregate price level.
3. EMPIRICAL MODELS
The empirical investigation analyzes annual time-series data of real output and price
for a sample of developing countries.
16
The sample period for investigation varies
according to data availability (see APPENDIX C for details). Over time, it is assumed
that real output growth and price inflation fluctuate in response to aggregate domestic
demand shocks, energy price shocks and exchange rate shocks. Shocks are randomly
distributed over the time span under investigation. Exchange rate shocks are distributed
around an anticipated stochastic steady-state trend. This trend varies with agents’
observations of macro-economic fundamentals that are likely to determine the exchange
14
The price level may rise unexpectedly in response to energy price shocks, creating incentives to
increase the output produced. This channel moderates the reduction in output and the rise in price in response
to energy price shocks. For a detailed theoretical illustration, see Kandil and Woods (1997). The moderating
effect of the rise in price is further reinforced in this paper’s model through the reduction in the real effective
exchange rate, reducing the real cost of intermediate imported goods.
15
The speculative effect of money demand is likely to be important in developing countries, where
agents’ incentives to hedge against potential fluctuations in the exchange rate are high.
16
For an analysis of the implications of the theoretical model using sectoral data in the United States, see
Kandil and Mirzaie (2002).
MAGDA KANDIL
94
rate.
17
Detailed econometric methodology is provided in APPENDIX B. Detailed
description and sources of all data are described in APPENDIX C.
Empirical models are formulated to approximate the solutions of output and price in
the theoretical model. Accordingly, the empirical model of real output is specified as
follows:
)()(
1141312110 tttttttttttt
DmEDmEADmEADzEDzADzEAADy
−−−−−
−++−++=
y
tttttttttttt
vDsEDsADsEADgEDgEADgEA +−++−++
−−−−−
)()(
181711615
(15)
The model specification is based on the results of the test for non-stationarity of real
output.
18
The test results are consistent with non-stationary real output for all countries
under investigation. Given these results, the empirical model of real output is specified
in first-difference form where (.)D is the first-difference operator.
19
Accordingly, all
variables in the model enter in first-difference form.
20
The unexplained residual is
denoted by
y
t
v .
Theory predicts that output varies with unanticipated demand shifts in the economy.
Agents are expected to negotiate higher wages in anticipation of expansionary demand
shifts, neutralizing the effects of these shifts on output.
21
Nonetheless, anticipated
17
The theoretical model does not determine the exchange rate or other policy variables endogenously.
Instead, the model is solved for the reduced forms that determine the responses of variables to exogenous
policy shocks. In theory, shocks approximate unanticipated components of policy variables based on rational
expectations. Econometrically, the anticipated component varies with agents’ observations of macro-
economic fundamentals, as described in APPENDIX B. Random shocks capture exogenous fluctuations
around the moving trend over time.
18
For details, see Kwiatkowski et al. (1992). Test results are available upon request. The non-stationary
output is not jointly co-integrated with the non-stationary variables on the right-hand side. Hence, the
empirical model does not include an error correction term.
19
Given the non-stationarity of the estimated dependent variables, the empirical models are estimated in
first-difference form. Hence, the anticipated component measures anticipated change in the policy variable.
Shocks approximate unanticipated change (growth) in the policy variable.
20
Test results indicate the non-stationarity of the energy price, the money supply, government spending,
and the exchange rate. Nonetheless, the nonstationary component of these variables, the anticipated
component, is not jointly co-integrated with the non-stationary dependent variables. Hence, the empirical
models are estimated in first-difference form, without an error correction term.
21
In the real world, institutional rigidity may interfere with agents’ ability to adjust fully to anticipated
demand shifts. In the labor market, contracts may be longer than one year, preventing wages at time
t
from
adjusting fully to anticipated demand shifts at time
1
−
t . Accordingly, anticipated demand shifts are not
absorbed fully in price. Alternatively, institutional rigidity may be attributed to price rigidity in the product
EXCHANGE RATE FLUCTUATIONS AND ECONOMIC ACTIVITY 95
demand shifts may determine real output through their effects on anticipated real
effective exchange rate.
22
Consequently, anticipated demand shifts may increase real
output.
To illustrate, let
t
z be the log value of the energy price. Agents’ expectation of a
variable at time
t based on information available at time 1
−
t is denoted by
1−t
E .
Based on theory’s forecast, output growth is expected to vary negatively with changes in
the energy price, both anticipated and unanticipated, at time 1
−
t . Accordingly,
1
A ,
0
2
<A .
23
These predictions assume energy is an input into the production process. If a
country is an energy producer, higher energy prices stimulate output growth.
Two sources of domestic policies, government spending and the money supply,
approximate demand shifts in the model. The log values of government spending and the
money supply are denoted by
t
g and
t
m . Unanticipated growth in government
spending and the money supply increase aggregate demand, creating positive price
surprises. Hence,
4
A , 0
6
>A . Anticipated growth in government spending and the
money supply may also increase real output growth. Accordingly,
3
A , 0
5
>A .
Finally, anticipated depreciation of the real exchange rate determines the cost of the
output supplied. Let
t
s be the log value of the real effective exchange rate (a weighted
average of the real domestic currency price of foreign currencies for major trading
partners).
24
As producers anticipate a higher cost of imported intermediate goods, they
decrease the output supplied. Accordingly, 0
7
<A . Unanticipated change in the
exchange rate is likely, however, to determine both aggregate demand and supply. The
higher cost of buying intermediate imports decreases the output supplied. However,
demand-side channels render the effect of exchange rate fluctuations indeterminate.
Accordingly, 0
8
≥A or 0
8
<A .
To demonstrate fluctuations in output price, an empirical model is specified as
follows:
market. Given the cost of adjusting prices, producers may resort to adjusting prices at specific intervals over
time. Hence, anticipated demand shifts at time 1
−
t may determine real output growth in the short-run. For
a discussion of the implications of sticky-wage and sticky-price models, see Kandil (1996).
22
Anticipated demand shifts increase price, decreasing anticipated real effective exchange rate. This
channel moderates anticipated increase in the real cost of imported intermediate goods.
23
The energy price is measured by the international energy price. For oil exporting countries, changes in
the oil price are likely to contribute positively to output growth. The increased capacity is likely to slow down
price inflation.
24
Empirically, the exchange rate is measured by the real effective exchange rate (see APPENDIX C).
This measure captures shifts attributed to the nominal exchange rate,
s
, and the foreign price of imports,
*
p , in theory.
MAGDA KANDIL
96
)()(
1141312110 tttttttttttt
DmEDmEBDmEBDzEDzBDzEBBDp
−−−−−
−++−++=
p
tttttttttttt
vDsEDsBDsEBDgEDgEBDgEB +−++−++
−−−−−
)()(
181711615
(16)
Test results indicate that the output price is non-stationary for the various countries
under investigation. The dependent variable is differenced to achieve stationarity.
25
For countries in which energy is an input into the production function, energy price
shifts, both anticipated and unanticipated, increase the cost of the output produced and,
hence, prices. Accordingly,
1
B , 0
2
>B . Both anticipated and unanticipated demand
shifts increase price inflation. Accordingly,
3
B ,
4
B ,
5
B , 0
6
>B . If a country is an
energy producer, higher energy price may stimulate output growth and, hence, lower
price inflation.
Given the effect of anticipated currency depreciation in decreasing the output supply,
0
7
>B . In contrast, an unanticipated depreciation decreases the output supply and may
expand (goods market effect) or contract (money demand effect) aggregate demand. The
former two channels are inflationary while the latter decreases price inflation.
4. EMPIRICAL RESULTS
The results of estimating the empirical model of real output are presented in Table 1
for the sample of developing countries under investigation. Table 2 contains the results
of estimating the empirical models of price.
4.1. The Output Equation
Table 1 summarizes the evidence of estimating the empirical model of real output for
the various countries under investigation. The non-neutral effects of anticipated
monetary shifts are evident by the positive and statistically effect on real output growth
in Algeria, Colombia, Cyprus, Ecuador, Guatemala, Honduras, India, Malaysia, and
Peru (41% of the sample). The non-neutral effects of anticipated government spending
shifts are evident by the positive and statistically significant effect on real output growth
in Guatemala, Iran, and Syria (14% of the sample). That is, output growth increases as
agents anticipate expansion in aggregate demand. Nominal rigidity in labor and/or
product markets may prevent agents from adjusting fully to anticipated demand shifts,
creating long-lasting non-neutral effect on real output growth. In addition, anticipated
25
Test results are available upon request. For some countries, the series was differenced twice to achieve
stationarity. The non-stationary price is not jointly cointegrated with non-stationary variables on the
right-hand side. Hence, the empirical model does not include an error correction term.
EXCHANGE RATE FLUCTUATIONS AND ECONOMIC ACTIVITY 97
demand shifts increase the price level, decreasing the real effective exchange rate, which
has an expansionary effect on the output supplied.
The exchange rate is measured by the real domestic price of foreign currency.
Accordingly, a rise in the exchange rate indicates real depreciation of the domestic
currency. Anticipated depreciation increases the cost of imported goods, decreasing
output growth. The contractionary effects of anticipated currency depreciation are
evident by the statistically significant negative response of real output growth in Costa
Rica, Iran, Malaysia, and Peru (18% of the sample).
A rise in the price of energy increases the cost of producing output, decreasing the
output supplied in oil-importing countries. This is evident by the negative and
statistically significant response of output growth in Cyprus and Iran (9% of the
sample).
26
It is likely, however, that a rise in the energy price increases the output
supplied in oil-producing countries. This is evident by the positive and statistically
significant response of real output growth to an anticipated rise in the energy price in
Algeria.
Unanticipated demand shifts are likely to be distributed between real output growth
and price inflation in the short-run. The flatter the aggregate supply curve, the bigger is
the response of real output growth to unanticipated demand shifts.
27
The short-run
expansionary effect of monetary shocks is evident by the positive and statistically
significant response of output growth in Algeria, Colombia, Cyprus, Ecuador,
Guatemala, Iran, Malaysia, and Morocco (36% of the sample). Similarly, evidence of the
expansionary effect of government spending shocks is consistent with the positive and
statistically significant response in Guatemala, and Iran (9% of the sample).
Unanticipated depreciation of the domestic currency affects the demand and supply
sides of the economy. Specifically, depreciation decreases the output supplied with an
indeterminate effect on aggregate demand. The contractionary effects of an
unanticipated depreciation are evident by the negative and statistically significant
response of output growth in Costa Rica, India, Iran, Malaysia, and Turkey (23% of the
sample). Nonetheless, the expansionary effect of an unanticipated depreciation is evident
by the positive and statistically significant response of output growth in Colombia (4%
of the sample).
Finally, unanticipated energy price shocks are likely to increase the cost of
production, decreasing real output growth. The contractionary effect of energy price
26
It is rather surprising that output is adversely affected by the energy price shock in Iran, an
oil-producing country. This may be the result of domestic pricing policies.
27
In theory, the short-run response of output to policy shocks is determined by two factors. First, is the
size of the output price surprise in response to a policy shock, which is determined, in part, by the elasticity of
aggregate demand with respect to the policy shock. Second, is the slope of the aggregate supply curve, which
is determined by the elasticity underlying the supply side, i.e., conditions in the labor market as well as the
output elasticity with respect to a change in the labor input.
MAGDA KANDIL
98
shocks is evident by the negative and statistically significant response of output growth
in Cyprus, India, Iran, and Jordan (18% of the sample). In oil-producing countries,
however, energy price shocks may have a positive effect on real output growth, as
evident by the positive and statistically significant response for Algeria.
4.2. The Price Equation
Table 2 summarizes the evidence of estimating the empirical models of price for the
various countries under investigation. Anticipated monetary changes induce inflationary
effects, as evident by the positive and statistically significant response of price in Cyprus,
Ghana, Honduras, Iran, Jordan, Malaysia, and Sri Lanka (32% of the sample). The
inflationary effect of anticipated government spending shifts is also evident in Algeria,
Costa Rica, Greece, Honduras, Korea, Peru, and Turkey (32% of the sample).
Anticipated currency depreciation increases the cost of imported raw materials and,
hence, price inflation. This is evident by the positive and statistically significant
response in Costa Rica, Ecuador, Guatemala, India, Morocco, Peru, Syria, and Turkey
(36% of the sample).
Anticipated increase in the energy price increases the price of the output produced
and, hence, price inflation. The inflationary effect of anticipated energy price is evident
in Ecuador, Honduras, Jordan, Morocco, Nepal, Sri Lanka, and Turkey (32% of the
sample). There is, however, evidence of deflation in the face of anticipated energy price
shifts in Algeria. As noted above, higher energy price increases output growth in Algeria.
Output expansion moderates price inflation in the face of energy price shocks.
Depending on the slope of the short-run supply curve and demand elasticity, price
inflation rises in the face of policy shocks. The inflationary effect of monetary shocks is
evident by the positive and statistically significant response of price inflation in Cyprus,
Ecuador, Ghana, Guatemala, Jordan, and Peru (27% of the sample). Similarly, the effect
of government spending shocks is positive and statistically significant on price inflation
in Algeria, Costa Rica, Ghana, Honduras, and Turkey (23% of the sample).
The combined effects of demand and supply channels determine the response of
price inflation to unanticipated currency depreciation. The evidence of price inflation in
the face of depreciation shocks is consistent with the positive and statistically significant
response in Costa Rica, Ghana, India, and Turkey (18% of the sample). That is,
combining demand and supply channels, the inflationary effect of an unanticipated
currency depreciation more than offsets the deflationary effect.
The inflationary effect of energy price shocks is evident by the positive and
statistically significant response in Cyprus, Ecuador, Guatemala, Honduras, India,
Jordan, Morocco, Sri Lanka, and Turkey (41% of the sample).
Overall, exchange rate depreciation appears to induce contractionary effects that
slow down output growth and raise price inflation in the majority of developing
countries under investigation. Output contraction is particularly pronounced in Costa
Rica, India, Iran, Malaysia, Peru, and Turkey. Price inflation is particularly pronounced
EXCHANGE RATE FLUCTUATIONS AND ECONOMIC ACTIVITY 99
in Costa Rica, Ecuador, Ghana, Guatemala, India, Morocco, Peru, Syria, and Turkey.
Table 3 illustrates the average time-series for three measures of openness in various
countries: the ratio of imports to GNP or GDP, the ratio of exports to GNP or GDP, and
the ratio of the sum of exports and imports to GNP or GDP. Countries that are most
vulnerable to exchange rate fluctuations are not characterized with a pronouncedly
higher degree of openness compared to other countries in the sample. Earlier research
has suggested, however, that the effects of devaluation are likely to depend on the trade
account. The contractionary effect of devaluation on real output growth is likely to be
more pronounced the larger the deficit of the trade account.
28
Table 3 presents the
difference between exports and imports as a share of GNP or GDP. The effects of
exchange rate fluctuations on output and price do not vary systematically with the share
of the trade deficit of nominal income. As illustrated theoretically, structural parameters
on the demand or supply sides are likely to differentiate the response of output growth
and price inflation to exchange rate fluctuations across countries. The higher the
dependency of the output supplied on intermediate imported goods the bigger are the
adverse effects of currency depreciation on economic performance in developing
countries.
V. SUMMARY AND CONCLUSION
This investigation has focused on the effect of exchange rate fluctuations on
economic performance in developing countries. Towards this investigation, the paper
presents a theoretical model that decomposes movements in the exchange rate into
anticipated and unanticipated components. Anticipated exchange rate depreciation
determines the cost of imported intermediate goods and, hence, the output supplied. In
contrast, unanticipated currency fluctuations determine aggregate demand through
exports, imports, and the demand for currency, and determine aggregate supply through
the cost of imported intermediate goods. The first channel increases aggregate demand;
currency depreciation increases exports and decreases imports. The second channel
decreases aggregate demand. An unexpected depreciation of the domestic currency,
relative to its anticipated steady-state value, increases the demand for domestic currency.
On the supply side, currency depreciation increases the cost to buy intermediate goods
and decreases the output supplied. The combined effects of the three channels are
indeterminate on output and price.
Let the exchange rate be the real domestic currency price of a composite of foreign
currency for major trading partners. Anticipated movement in the exchange rate is
assumed to vary with agents’ observations of macro-economic fundamentals that
28
Devaluation increases the cost of imports which may not be offset by an increase in the value of
exports.
MAGDA KANDIL
100
determine changes in the exchange rate over time. The unanticipated component of the
exchange rate captures fluctuations in its realized value compared to agents’
anticipation.
The paper investigates the effects of exchange rate fluctuations (both anticipated and
unanticipated) using output and price data for a sample of twenty-two developing
countries. The long-run impact is measured by the significant reduction of output growth
and the significant increase in price inflation in the face of anticipated exchange rate
shifts. In contrast, the short-run effects capture fluctuations in output growth and price
inflation in the face of unanticipated exchange rate shifts. Given demand and supply
channels, there is evidence of a significant contraction of output growth in the face of
unanticipated currency depreciation. Consistently, demand expansion and supply
contraction determine price inflation in the face of unanticipated currency depreciation.
To conclude: for a varying degree of openness, exchange rate fluctuations generate
adverse effects on economic performance in a variety of developing countries. These
effects are evident by output contraction and price inflation in the face of currency
depreciation. Indeed, concerns about the adverse effects of exchange rate depreciation
on economic performance are supported by the evidence of macroeconomic
performance for a sample of twenty-two developing countries.
For policy implications, higher variability of exchange rate fluctuations, around its
anticipated value, exacerbates adverse effects on economic performance in developing
countries. Given this evidence, exchange rate policies should aim at minimizing
unanticipated currency fluctuations to insulate economic performance from the adverse
effects of this variability in developing countries. To that end, the paper’s empirical
evidence establishes the desirability of stabilizing the exchange rate at a level that is
consistent with variation in macroeconomic fundamentals over time.
The desirability of managed exchange rate regimes should not imply that the paper’s
findings are in support of the currency peg as the exchange rate regime for developing
countries. The recent experience of emerging market countries, e.g., the Southeast Asian
countries and Mexico, demonstrated that the major underlying problem that probably
triggered the financial crises in these countries was the currency peg. The paper’s
findings are consistent with the lessons of recent experiences: developing countries
cannot and should not sustain a peg that is inconsistent with underlying macroeconomic
fundamentals. Instead, exchange rate policy should aim at managing the rate over time
in line with macroeconomic fundamentals to avoid the adverse effects implied by the
analysis of this paper.
EXCHANGE RATE FLUCTUATIONS AND ECONOMIC ACTIVITY 101
APPENDIX A
Theory Appendix
Substituting Equations (1)-(7) into the equilibrium condition for the goods market
(8) results in the expression for real income. Real income is a function of the exchange
rate, the domestic price level, the foreign price level, and the domestic interest rate:
{}
ttt
tt
t
riRxmmxgitcc
mtc
y
112000010
1
)log()(
)1(1
1
−++−+++−
+−−
=
This expression is the IS equation describing the relationship between real income
and the real interest rate.
Solving for the interest rate,
r
, from the LM Equation (9) and substituting the result
into the IS equation gives us the equation for aggregate demand as follows:
−+++−+++−= )()log()(
1
12000010 ttttt
pm
i
RxmmxgitccAy
λ
−+−+
++
)()(
1
1
11 tttttt
ssE
i
ppEi
λ
θ
where, 0
)1(1
1
1
1
>
++−−
=
λ
θ
i
mtc
A
tt
and
pspR −+=
*
)log( .
Solving for l and n from (12) and (13) and substituting the results into the log
transformation of Q in (10), we obtain gross domestic output supplied as follows:
)()1log(
)1(
log)(
1 tttt
pEpq
−
−+−
−+
++=
ωδ
ηδ
δ
η
ω
δηω
tt
zR
ηδ
ω
η
δ
ω
η
ηδ
δ
η
ω
+
+
−
−+
− )log(
)1(
Substituting the result into the log transformation of Equation (11),
MAGDA KANDIL
102
)log(
tttt
NRQy −=
Applying Taylor expansion and substituting for l and n , we obtain the equation
for aggregate supply of domestic value added as follows:
tttttt
zRpEpy
ηδ
ω
δ
ωη
ηδ
ω
ωδ
ηδ
ω
δηω
+
+
−−−+−++=
−
)log()()1log(log)(
1
Sources of demand and supply shifts are assumed to follow the following processes:
tgt
gg
ε
+=
tmt
mm
ε
+=
tzt
zz
ε
+=
tst
ss
ε
+=
=
*
t
p
tp
p
ε
∗
∗
+
where
g
, m ,
z
,
s
, and
p
∗
are anticipated (steady-state) changes and
tg
ε
,
tm
ε
,
tz
ε
,
ts
ε
, and
*
tp
ε
are random unanticipated changes that have zero means and constant
variances.
Equating aggregate demand and supply yields the price of output. Taking
expectation of the resulting expression at time
t results in
1+tt
pE . Substituting for
1+tt
pE back into the equilibrium condition, taking expectation at time 1−t and
subtracting the results from the original condition results in the expression for output
price surprises:
tztmtgttt
BB
Ai
B
A
pEp
ε
ω
η
δ
ωλ
ε
ωηδλ
η
δ
λ
ε
ωηδλ
η
δ
λ
+
+
+
+
+
=−
−
1
1
ts
tp
B
AiBC
B
BC
ε
λωηδλ
η
θδ
λ
λ
ε
ωηδλ
)(
1
*
+
−
+
+
+
where,
0)(
1121
>++++=
ηδληδηδλλω
AiAimxAB
EXCHANGE RATE FLUCTUATIONS AND ECONOMIC ACTIVITY 103
and, 0
)(
21
22
>
++
=
B
mxA
C
ηδ
ωηδλλδη
A positive shock to
tg
ε
or
tm
ε
increases the demand for domestic output, creating
positive price surprises. A positive shock to
tz
ε
increases the cost of the output
produced, creating positive price surprises. A positive shock to
*
tp
ε
increases the
demand for domestic goods and increases the cost of imported intermediate goods,
creating positive price surprises. In contrast, a positive shock to
ts
ε
has an
indeterminate effect on price through demand and supply channels.
Substituting the solution for output price surprises into the equilibrium conditions,
the solutions for output and price are obtained as follows:
+
+−++
+
+= z
B
scpcm
B
Ai
g
B
A
B
iB
ttanconsp
pt
ωηδωηδληδληδλ
*
11
*
)(
1
tp
tmtg
B
BC
BB
BAi
B
A
ε
ωηδ
ε
ωηδλ
η
δ
λ
ε
ωηδλ
η
δ
λ
+
+
+
+
+
+
tstz
B
CAiBC
B
ε
ωηδλ
ω
ηδ
λ
θ
η
δ
ε
ωηδλ
λ
ω
η
δ
ω
+
−
−
+
+
+
+
1
)(
m
B
iAAiB
g
B
AiAB
ttanconsy
yt
+
+
+
+=
2
22
11
2
2
1
ηδλωηωηδλωωλ
s
B
BiBC
p
B
BiB
−+
+
−+
+
ηδ
ωηδλω
ηδ
ωηδλω
)()(
1
*
1
z
B
BiB
+−++
+
ηδ
ωωηδωηδωηδλωηδ
2
2
1
)())((
tmtg
B
AiAi
B
AA
ε
ηδλω
λωηδλω
ε
ωηδλ
λωωηδλ
++
+
+
+
+
+
11
*
)(
)())((
1
2
tp
BB
BBBiBCCB
ε
ηδλωηδ
ωηδλωωηδληδλωωηδ
++
+−+++
+
MAGDA KANDIL
104
tz
BB
BBBB
ε
ωηδληω
ωωλωηδλωωηδωηδλλωηδωωηδληω
+
++++−++
+
)(
)())(())((
22
ts
B
CAiBCBAiBC
ε
ωηδληδ
ωηδλθηδωωηδλωθωδηωηδ
+
−−++−−+
+
)(
)(
1
22
1
where
y
constant and
p
constant are determined by constant terms on the demand and
supply sides of the economy. Based on the model’s solutions, the following observations
can be made:
• Anticipated changes in government spending and the money supply,
g
, m , shift
aggregate demand, increasing price. Given a constant level of nominal effective
exchange rate, the rise in domestic price decreases the real effective exchange rate,
reducing the real cost of imported intermediate goods. Accordingly,
g
, and m
have positive effects on real output.
• Anticipated changes in imports price,
*
p , the energy price,
z
, and the exchange
rate,
s
, enter the production function. A rise in imports price, the energy price, and
the exchange rate increase the cost of the output produced, decreasing output and
increasing price. The rise in price decreases the real effective exchange rate,
moderating the reduction in real output in the face of
*
p ,
z
, and
s
.
• Unanticipated demand shifts in the face of government spending and the money
supply,
tg
ε
,
tm
ε
, increase output and price in the short-run. The rise in price
decreases the real effective exchange rate, reinforcing output expansion in the face of
tg
ε
and
tm
ε
.
• Unanticipated increase in imports price,
*
tp
ε
, increases demand and decreases
supply. Accordingly, the price rises with an indeterminate effect on output.
• An unanticipated increase in the energy price,
tz
ε
, decreases output supply. The
rise in price decreases the real effective exchange rate, moderating the reduction in
real output in the face of
tz
ε
.
• Finally,
ts
ε
, enters the demand and supply sides of the economy. Specifically,
ts
ε
decreases the output supplied and results in an indeterminate effect on aggregate
demand (an increase in net exports and an increase in money demand). Hence, the
EXCHANGE RATE FLUCTUATIONS AND ECONOMIC ACTIVITY 105
effects of
ts
ε
are indeterminate on output and price.
APPENDIX B
Econometric Methodology
The surprise terms that enter models (15) and (16) are unobservable, necessitating
the construction of empirical proxies before estimation can take place. Thus, the
empirical models include equations describing agents’ forecast of demand growth, the
change in energy price, and the change in the real domestic price of weighted foreign
currencies for major trading partners (the real effective exchange rate).
To decide on variables in the forecast equations for each of the demand and supply
shifts, a formal causality test is followed. Each variable is regressed on two of its lags as
well as two lags of all variables that enter the model: the change in the log value of the
energy price, real output, price, the real effective exchange rate, government spending,
and the money supply. The joint significance of the lags is tested for each variable.
Accordingly, the forecast equations account for the lags of variables proven to be
statistically significant.
Obtaining a proxy for ex-ante forecasts of the energy price is complicated by the
assumption that the generating process experienced a structural change between 1973
and 1974. This assumption is supported by the results of a formal test suggested in
Dufour (1982). For both the period 1955-73 and the period 1974-95, the generating
process is modelled as described above. Where test results support structural break,
dummy variables are included in the equations describing agents’ forecasts of other
variables. Upon accounting for these dummy variables, testing for structural break in the
estimated empirical models for output and price proved insignificant.
Subtracting the above forecasts from the actual change in the variable results in
surprises that enter the empirical model. In order to obtain efficient estimates and ensure
correct inferences (i.e., to obtain consistent variance estimates), the empirical models are
estimated
jointly with the equation that determines the proxy variables following the
suggestions of Pagan (1984 and 1986). To account for the endogeneity of forecasted
variables, instrumental variables are used in the estimation of the empirical models. The
instrument list includes three lags for each of the first-difference of the log value of the
energy price, the exchange rate, the money supply, government spending, real output,
and price.
Following the suggestions of Engle (1982), the results of the test for serial
correlation in simultaneous equation models are consistent with the presence of
first-order autoregressive errors for some countries. To maintain comparability, it is
assumed in all models that the error term follows an AR(1) process. The estimated
models are transformed, therefore, to eliminate any possibility for serial correlation. The
estimated residuals from the transformed models have zero means and are serially
MAGDA KANDIL
106
independent.
The qualitative results remain robust upon varying variables or the lag length in the
forecast equations and/or the instruments list. Details are available upon request.
APPENDIX C
Data Sources
The sample period for investigation varies according to data availability as follows:
Algeria, Colombia, Cyprus, Ecuador, Ghana, Guatemala, Honduras, Jordan, Korea,
Malawi, Nepal, Peru, Sri Lanka, Syria, Turkey, 1955-1995. Morocco, 1957-1995. Egypt,
Iran, Malaysia, 1959-1995. Costa Rica, India, 1960-1995. Kenya, 1964-1995.
Annual data for the above countries are described as follows:
1. Real Output: Real output of GDP or GNP measured in terms of 1982 dollars.
2. The Price Level: The deflator for GDP or GNP.
3. The Real Energy Price: the price of Venezuelan Petroleum deflated by the
GDP/GNP deflator for each country. The empirical models were also estimated
using an alternative series for the real energy price that is measured by deflating the
price of Saudi Arabian Petroleum by the GNP/GDP deflator for each country. The
qualitative results of the estimated models are similar to that reported in the paper.
4. Short-Term Interest Rate: Representatives of short-term market rates for the
various countries, i.e., rates at which short-term borrowing is affected between
financial institutions or rates at which short-term government paper is issued or
traded in the market.
5. Government Spending: Nominal values of all payments by the government.
6. Money Supply: the sum of currency plus demand deposits.
7. Real Effective Exchange Rate: Real value of weighted exchange rate with major
trading partners (the domestic price of foreign currency).
Sources: 1 through 6 are taken from the
International Financial Statistics, year
books issued by the International Monetary Fund, Washington, D.C. 7 is from Bahmani
(1995) and Bahmani and Mirzaie (2000), as well as other details from the authors.
EXCHANGE RATE FLUCTUATIONS AND ECONOMIC ACTIVITY 107
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Manuscript received October, 2002; final revision received July, 2003.
