RESEARCH INSTITUTE

POLITICAL ECONOMY
Real Exchange Rate, Monetary Policy
and Employment: Economic Development
in a Garden of Forking Paths
Roberto Frenkel and Lance Taylor

September 2006

Alternatives to Gordon Hall

Inflation Targeting:
418 North Pleasant Street
Amherst, MA 01002

Central Bank Policy for

Employment Creation,
[email protected]
www.umass.edu/peri/

Poverty Reduction and

Number 2
January 2006

Real Exchange Rate, Monetary Policy and Employment: Economic

by

Roberto Frenkel

Principal Research Associate at the Centro de Estudios de Estado y Sociedad (CEDES)

and

Lance Taylor

Arnhold Professor and Schwartz Center for Economic Policy Analysis (CEPA), New School
University, New York

Abstract An appropriate level of the real exchange rate (RER) can be a key support for growth,

employment creation, and overall development of the “real economy,” but programming the RER

is macroeconomically complicated. The coordination issues it raises must be addressed with due

attention given to controlling inflation, reducing financial fragility and risk, and aiming toward full

employment of available resources. Thus, managing the exchange rate necessarily encompasses

monetary and expectational considerations. A key challenge is to provide enough degrees of

freedom for the monetary authorities to carry through these tasks.

The exchange rate affects any economy through many channels. It scales the national price

system to the world’s, influences key macro price ratios such as those between tradable and non-

tradable goods, capital goods and labor, and even exports and imports (via the costs of

intermediate inputs and capital goods, for example). The exchange rate is an asset price, partially

determines inflation rates through the cost side and as a monetary transmission vector, and can

have significant effects (both short and long run) on effective demand.

Correspondingly the exchange rate can be targeted toward many policy objectives. In

developing and transition economies, five have been of primary importance in recent decades:

Resource allocation: Through its effects on the price ratios just mentioned, the exchange

rate can significantly influence resource allocation, especially if it stays stable in real terms for an

extended period of time. Through effects on both resource allocation and aggregate demand, a

relatively weak rate can help boost employment, a point of concern in light of stagnant job

creation in many developing economies over the past 10-15 years.

Economic development: often in conjunction with commercial and industrial policies, the

exchange rate can be deployed to enhance overall competitiveness and thereby boost

productivity and growth.

Finance: The rate shapes and can be used to control expectations and behavior in

financial markets. Exchange rate policy “mistakes” can easily lead to highly destabilizing

consequences.

External balance: The trade and other components of the current account usually

respond to the exchange rate, directly via “substitution” responses and (at times more

importantly) to shifts it can cause in effective demand.

Inflation: The exchange rate can serve as a nominal anchor, holding down price

increases via real appreciation and/or maintenance by the authorities of a consistently strong

2
rate. As will be seen below, it can also serve as an important transmission mechanism for the

effects of monetary policy.

All these objectives have figured in recent policy experience. Use of the exchange rate to

try to improve external balance has been central to countless stabilization packages over the

decades, especially in small poor economies. The inflation objective became crucial in middle-

income countries in the last quarter of the 20th century (and is notably less urgent as of 2005).

Along with capital market liberalization, fixed rates were significant contributors to the wave of

financial crises in the 1990s.

But in many ways the resource allocation and developmental objectives can be the most

important in the long run – the central point of this paper. We trace the reasons why in the

following section on channels of influence. We then take up the policy implications, contrasting

the use of the exchange rate as a development tool in conjunction with its other uses (often in

coordination with monetary policy) to maintain external balance, contain inflation, and stabilize

asset markets,

1. Resource Allocation, Labor Intensity, Macroeconomics, and Development

Following Frenkel (2004), in this section we trace out three ways in which the exchange

rate can have medium- to long-term impacts on development. We begin with overall resource

allocation, and go on to the labor market and macroeconomics.

Resource Allocation

The traditional 2 x 2 trade theory model is a useful starting point. It does focus on the key

role of relative prices. It does not take into consideration important non-price components of

industrial and commercial polices. Both themes are woven into the following discussion.

The Lerner Symmetry Theorem (1936) is a key early result. Its basic insight is that if only

the import/export price ratio is relevant to resource allocation, then it can be manipulated by either

an import or an export tax-cum-subsidy. There is “symmetry” between the two instruments, so

that “under appropriate conditions” (at hand in the textbooks) only one need be employed.

A now-obvious extension is to bring three goods into the discussion: exportable,

importable, and non-tradeable in a “Ricardo-Viner” model. Two price ratios – say importable/non-

3
tradeable and exportable/non-tradeable – in principle guide allocation. The real exchange rate

(RER or ρ ) naturally comes into play as the relative price between the non-tradeable and a

Hicksian aggregate of the two tradeable goods. 1 These observations lead to two important policy

puzzles.

The first has to do with “level playing fields.” As applied in East Asia and elsewhere,

industrial policy often involved both protection of domestic industry against imports by the use of

tariffs and quotas, and promotion of exports through subsidies or cheap credits. In the case of a

tariff on imports, the domestic price Pm becomes

Pm = e(1 + t )Pm* (1)

with e as the nominal exchange rate (defined as units of local currency per unit of foreign), t the

tariff, and Pm* the world price. Similarly if the internal price Pe for exports is set from abroad we

have

Pe = ePe* /(1 − s ) (2a)

with Pe* as the world price and s as the subsidy rate.

The level playing field rests on the trade theorists’ notion that internal and external

relative prices of tradeable goods should be equal, Pm / Pe = Pm* / Pe* . This situation can be

arranged if t = s = 0 or more generally (1 + t ) = 1 /(1 − s ) . The mainstream argument asserts that if

all that industrial policy does is give more or less equal protection to both imports and exports,

then its costs, administrative complications, and risks of rent-seeking and corruption are

unjustifiable. You might as well set t = s = 0 and go to a free trade equilibrium.

In a Ricardo-Viner set-up, with Pn as a price index for non-tradeables the price ratios

Pe / Pn and Pm / Pn become of interest. Positive values of t and s move domestic relative prices

in favor of tradeable goods. From a more or less mainstream perspective (Woo, 2005) this

outcome can be interpreted as a justification for industrial policy.

1
Just to be clear, we will treat the RER as the ratio of tradeable to non-tradeable price indexes.
Real devaluation or weakening the RER means that ρ increases.

4
 The world, however, is a bit more complicated. If the home country is exporting a

differentiated product, for example, a more appropriate version of (2a) is

Pe* = Pe (1 − s ) / e (2b)

so that the foreign price of home exports is set by the subsidy and exchange rate. Presumably, a

lower value of Pe* stimulates sales abroad. Moreover, if the economic bureaucracy has the

requisite motivation and organization, it can tie export subsidies to the attainment of export,

productivity, and other targets and so pursue a proactive industrial policy. In such a context,

import protection and export promotion serve different purposes: the former allows domestic

production to get started along traditional infant industry lines, while the latter enables national

firms to break into international markets. 2

Now focus on the exchange rate. An increase in the nominal rate e would also switch

incentives toward production of tradeables, without the need for extravagant values of s and t.

This simple observation is in fact a strong argument in support of the use of a depreciated RER

as a developmental tool. If we define ρ as

ρ = [ μPm + (1 − μ )Pe ] / Pn (3)

with μ as the weight in a tradeable goods price index, then a high value of e means that the real

rate ρ will also be weak or depreciated.

Of course, a weak RER may not be a sufficient condition for long-term term development.

For example it may usefully be supplemented by an export subsidy or tariff protection to infant

industries with their additional potential benefits as mentioned above. Even without an effective

bureaucracy, generalizing Lerner symmetry to a Ricardo-Viner world suggests that more than one

policy instrument may be helpful because there are two relative price ratios that can be

manipulated. The rub is that a strong exchange rate implies that commercial/industry policy

interventions also have to be strong, with correspondingly high intervention costs. A weak RER

may be only a necessary condition for beneficial resource reallocation to occur, but a highly

appreciated real exchange rate is likely to be a sufficient condition for “excessive intervention” in

2
Again, these arguments are old. Ocampo and Taylor (1998) provide a recent summary.

5
a situation in which development cannot happen. It is hard to find examples of economies with

strong exchange rates that kept up growth for extended periods of time.

Labor Intensity

Continuing with the allocational theme, it is clear that the exchange rate will affect relative

prices of imported intermediates and capital goods on the one hand, and labor on the other.

Moreover, the RER largely determines the economy’s unit labor costs in terms of foreign

currency.

To explore the implications, we can consider the effects of sustained real appreciation on

different sectors. Producers of importables will face tougher foreign competition. To stay in

business they will have to cut costs, often by shedding labor. If they fail and close down, more

jobs will be destroyed. If home’s export prices Pe* are determined by a relationship like (2b),

similar logic applies to that sector. In non-tradables, which will have to absorb labor displaced

from the tradeable sectors, jobs are less likely to open up insofar as cheaper foreign imports in

the form of intermediates and capital goods substitute for domestic labor. On the whole, real

appreciation is not likely to induce sustained job creation and could well provoke a big decrease

in tradeable sector employment. Reasoning in the other direction, RER depreciation may prove

employment-friendly.

In both cases, it is important to recognize that a new set of relative prices must be

expected to stay in place for a relatively long period if these effects are going to work through.

Changes in employment/output ratios will not happen swiftly because they involve restructuring

firms and sectoral labor market behavior. This must take place via changes in the pattern of

output among firms and sectors, by shifts in the production basket of each firm and sector, and

adjustments in the technology and organization of production. These effects arise from a

restructuring process in which individual firms and the organization of economic activity adapt to a

new set of relative prices. Gradual adjustment processes are necessarily involved.

Finally, in the long run if per capita income is to increase there will have to be sustained

labor productivity growth with employment creation supported by even more rapid growth in

effective demand. Macroeconomics comes into play.

6
Macroeconomics

The question is how a weak exchange rate (possibly in combination with other policies

aimed at influencing resource allocation among traded goods) fits into the macroeconomic

system. Much depends on labor market behavior in the non-traded sector. Following Rada (2005)

we work through one scenario here, to illustrate possible outcomes.

Assume that output in the tradable sector is driven by effective demand, responding to

investment, exports, and import substitution as well as fiscal and monetary policy. The level of

imports depends on economic activity and the exchange rate (along with commercial/industrial

policies). A worker not utilized in tradable sectors must find employment in non-tradables,

become under- or unemployed, or leave the labor force.

For concreteness, we assume that almost all labor not employed in tradeables finds

something to do in non-tradeable production as a means of survival. Typical activities would be

providing labor services in urban areas or engaging in labor-intensive agriculture. If Lt is

tradeable sector employment and L is the economically active population, then employment in

non-tradeables is Ln = L − Lt . With w n as the non-tradable wage, the value of labor services

provided is Yn = w n Ln . The tradeable sector wage rate w t is determined institutionally, at a level

substantially higher than w n .

The non-tradable sector’s demand-supply balance thus takes the form

Y n − w n L n = Y n − w n (L − L t ) = 0 . (4)

Demand for Y n is generated from the value of tradable sector output Pt X t . At the same time,

real output X t determines Lt and thereby L n . Suppose that Pt is set by mark-up pricing on

variable costs including labor and imports. Then from both the demand and supply sides an

increase in X t leads to a tighter non-traded labor market which should result in an increase in

w n . Equation (4) becomes the upward-sloping “Non-tradable equilibrium” schedule in Figure 1.

Non-tradable labor services become more valuable when economic activity rises. In national

7
accounting terms this signals a productivity increase in the sector because each worker

producers a higher value of output in terms of tradable goods, or a general price index. In other

words, an endogenous productivity level is built into the specification.

FIGURE 1

If workers in both sectors don’t save, then their behavior does not influence overall

macroeconomic balance. Leaving aside a formal treatment of fiscal and monetary instruments for

simplicity, the equation takes the form

I t + E t − sπX t − ePm* (1 + t )aX t / Pt = 0 . (5)

Demand injections come from investment I t , exports E t and changes in the magnitude of the

import coefficient a via import substitution. Saving leakages come from profits with π as the

tradeable sector profit share and s the saving rate as well as from “foreign saving” in the form of

imports. Equation (5) is the vertical “Macroeconomic equilibrium” line in Figure 1. Together, the

two schedules determine X t and w n . In the lower quadrant, the trade deficit is assumed to be

an increasing function of tradeable sector output in the short run.

Now consider the outcomes of a devaluation. It will have impacts all over the economy,

including a loss in national purchasing power if imports initially exceed exports, redistribution of

purchasing power away from low-saving workers whose real wages decrease, a decline in the

real value of the money stock, and capital losses on the part of net debtors in international

currency terms. Presumably exports will respond positively to an RER depreciation but that may

take time if “J-curve” and similar effects matter. Another positive impact on the demand for

tradables will come form import substitution, reducing the magnitude of the coefficient a.

One implication is that for a given level of output, the trade deficit should fall with

devaluation, or the corresponding schedule should shift toward the horizontal axis in the lower

quadrant. If devaluation is contractionary, the Macro equilibrium schedule will shift leftward in the

upper quadrant, reducing X t , w n , and the trade deficit further still. In this case, real devaluation

8
should presumably be implemented together with expansionary fiscal and monetary policies. As

discussed in detail below, exchange rate strategies must be coordinated with other policy moves.

If export demand and production of import substitutes are stimulated immediately or over

time by a sustained weak RER, the macroeconomic equilibrium curve should drift to the right,

driving up economic activity and employment in the medium to long run.

So far, the analysis has taken labor productivity as a constant. Medium and long run

considerations have to take into account the evolution of productivity. For the tradeable sector,

this question can be analyzed in terms of Figure 2, sketched verbally but not actually drawn by

Kaldor in his 1966 Inaugural Lecture (published in Kaldor, 1978). To the traditional diagram we

follow Rada and Taylor (2004) by adding dashed “Employment growth contours” with slopes of 45

degrees. Each one shows combinations of the output growth rate ( Xˆ t = (dX t / dt ) / X t = X& t / X t )

and labor productivity growth rate ( ξ Lt ) that hold the employment growth rate ( Lˆt = Xˆ t − ξ Lt )

constant. Employment growth is more rapid along contours further to the SE.

FIGURE 2

Movements across contours show the effects on employment growth of shifts in the

diagram’s two solid curves. The “Kaldor-Verdoorn” schedule represents a “technical progress”

function of the form proposed by Verdoorn (1949) and Okun (1962),

ξ Lt = ξ Lt + γX̂ t (5)

in which the productivity trend term ξ Lt could be affected by human capital growth, industrial

policy, international openness, population growth, and other factors.

The “Output growth” curve reflects the assumption that more rapid productivity growth

can make output expand faster, for example by reducing the unit cost of exports. The diagram

presupposes that this effect is rather strong because the slope of the Output growth line is less

than 45 degrees, implying that ∂Xˆ t / ∂ξ Lt > 1 .

9
 If a depreciated RER stimulates net export growth, the Output growth curve will shift to

&& , and L̂ all to increase. One might also imagine that the trend rate
the right, causing ξ Lt , X t t

ξ Lt of productivity growth could rise in the new regime. The Kaldor-Verdoorn schedule would shift

upward, and with a relatively flat output growth curve, all three growth rates would rise.

However, if the slope of the Output growth curve were to exceed 45 degrees, effective

demand would not increase as rapidly as productivity so that L̂t would have to fall.

What happens to wages and productivity in the non-tradable sector? Let λ = Lt / L be

the share of tradable sector employment in the total. Then λLˆ t + (1 − λ )Lˆ n = Lˆ where L̂ is overall

employment growth. Non-tradable employment expansion becomes

1 ˆ
Lˆ n = [L − λ ( Xˆ t − ξ Lt )] .
1− λ

Let the elasticity of demand for non-tradables with respect to X t be υ .Differentiating (4) then

gives

1
wˆ n = υXˆ t + [λ ( Xˆ t − ξ Lt ) − Lˆ ]
1− λ

Even taking into account the favorable effects on employment of a weak exchange rate that were

mentioned above, a low demand elasticity υ and fast labor force growth Lˆ could mean that a

strong export performance translates into weak or even negative wage and productivity growth in

the non-traded sector. A case like this calls for fiscal and social policies intended to foster

demand for non-tradables and compensate for the negative effects on income distribution and

employment.

2. Macroeconomic Policy Regimes for a Stable Competitive RER

For the reasons just indicated, a competitive and stable RER can make a substantial

contribution to economic growth and employment creation. Programming the RER, however, is

no easy task. It is most directly impacted by the nominal exchange rate, itself influenced by many

factors, but also depends on the overall inflation rate and shifting relative prices. Nor can the RER

be the only macro policy objective. In any economy, there are bound to be multiple and partially

10
conflicting objectives. And all policies – exchange rate, fiscal, monetary, and

commercial/industrial – are interconnected and have to be coherently designed and implemented.

The following discussion focuses on these exchange rate coordination issues in the

context of middle income economies with at least sporadic access to private international capital

markets. Although they are not addressed in detail here, somewhat similar questions can easily

arise in low income countries receiving official capital inflows, especially if they jump to levels of

10-20% of GDP as suggested in the discussion of the Millenium Development Goals (MDG).

So how can policy-makers target the RER while at the same time controlling inflation,

reducing financial fragility and risk, and aiming toward full employment of available resources?

Our focus necessarily has to shift from the “real economy” to encompass monetary and

expectational considerations. The principal emphasis is on the degrees of freedom available to

the monetary authorities, if only because they have been at center stage in recent policy debates.

What Determines the Nominal Exchange Rate?

To set the stage, a few observations about how the nominal exchange rate fits into the

macroeconomic system make sense.

Theories that can reliably predict the level of the rate and its changes over time when it is

not strictly pegged do not exist. (The fact that pegs not infrequently break down means they do

not have 100% predictive power either.) In present circumstances in developing and transition

economies (especially those at middle income levels) it is not unreasonable to assume that a

more-or-less floating rate is determined in spot and future asset markets; in effect the spot rate

floats against its “expected” future values. The quotation marks mean that we view expectations

along Keynesian lines as emerging from diverse opinions on the part of market participants about

how the rate may move. “Beauty contests” which magnify small shifts in average market opinion

and other sources of seemingly capricious market behavior can easily come into play (Eatwell

and Taylor, 2000).

With regard to the level of the rate, it is useful to think about a simple bond market

equilibrium condition such as

11
 i = f (e, e& exp , M ) (6)

with i as the local interest rate, e the spot exchange rate, e& exp the expected (as an aggregate of

by market perceptions) change in the rate over time, and M an index of monetary relaxation. A

high or depreciated value of e means that national liabilities are cheap as seen from abroad. It

should be associated with high local bond prices or low interest rates. If expected depreciation

e& exp rises, on the other hand, foreign wealth-holders will want to shift away from local liabilities

and i will increase. Open market bond purchases will increase M and be associated with a

reduction in i .

Over the past couple of decades under conditions of external liberalization, most

developing economies have been afflicted by high local interest rates and appreciated currencies.

This unfavorable constellation of “macro prices” is consistent with (6).

The dynamics of the exchange rate will be influenced by interest rates, because it is an

asset price. One crucial question is whether lower domestic rates will tend to make the nominal

rate depreciate or appreciate. If it tends to rise (or depreciate) over time, then exchange rate

dynamics can be a powerful mechanism for transmitting the effects of expansionary monetary

policy into inflation by driving up local production costs.

Standard arbitrage arguments as built into interest rate parity theorems imply that the

expected change in the spot rate e& exp should be an increasing function of the difference between

domestic and foreign rates. If myopic perfect foresight applies, the expected change will be equal

to the observed change (up to a “small” error term). Hence a lower local interest rate should

cause appreciation over time. On Wall Street, such an analysis of exchange rate movements is

called an “operational” view.

A “speculative” view is that the exchange rate will depreciate when the local interest rate

decreases. 3 This view makes intuitive sense insofar as low interest rates should make national

liabilities less attractive. It was perhaps first advanced macroeconomically by Minsky (1983) and

can be made consistent with the parity theorems if it is assumed that there is a relatively strong

3
To be more precise, the change over time in the spot rate e& = de / dt will turn negative when i
decreases if the operational view applies and positive when the speculative view is true.

12
positive feedback of expected exchange rate increases into the domestic interest rate via the

bond market equilibrium condition (6).

Recent macroeconomic history (Frenkel, 2004) suggests that the speculative view is the

more accurate description of exchange rate behavior in middle income economies.

Avoiding Catastrophes

The most fundamental justification for avoiding a persistently strong exchange rate is that

it is an invitation to disaster. Exchange appreciation is always welcome politically because it may

be expansionary (at least in the short run), is anti-inflationary and reduces import costs (including

foreign junkets for those who can afford them). However, for the reasons discussed above it can

have devastating effects on resource allocation and prospects for development. Moreover, fixed

or quasi-fixed strong real rates can easily provoke destabilizing capital flow cycles as perhaps

first described analytically by Frenkel (1983) and re-enacted many times since

.The existence and severity of these cycles is in practice a powerful argument for a stable

exchange rate regime built around some sort of managed float (details below). A floating rate

does appear to moderate destabilizing capital movements in the short run, and is therefore a

useful tool to deploy. At the same time, the central bank has to prevent the formation of

expectations that there will be RER appreciation, which can easily become self-fulfilling along

beauty contest lines. An commitment to a stable rate, back up by forceful intervention if

necessary, is one way the bank can orient expectations around a competitive RER.

Trilemmas

Possibilities for central bank intervention are often said to be constrained by a “trilemma”

among (1) full capital mobility, (2) a controlled exchange rate, and (3) independent monetary

policy. Supposedly, only two of these policy lines can be consistently maintained. If the authorities

try to pursue all three, they will sooner or later be punished by destabilizing capital flows, as in the

run-up to the Great Depression around 1930 and Britain and Italy's difficulties during the ERM

crisis more than 60 years later.

13
 The trilemma as just stated is a textbook theorem which is, in fact, invalid. Even with free

capital mobility, a central bank can undertake transactions in both foreign and domestic bonds

(not to mention other monetary control maneuvers) to regulate the money supply, regardless of

whatever forces determine the exchange rate (Taylor, 2004).

Nevertheless, something like a trilemma can exist in the eye of a beholder. There are

practical limits to the volume of interventions that a central bank can practice, along with

complicated feedbacks. Possibilities for sterilizing capital inflows or outflows are bounded by

available asset holdings. Volumes of flows depend on exchange rate expectations which in turn

can be influenced by central bank behavior and signaling.

So how does the market decide when a perceived trilemma is ripe to be pricked? The

fact that no single form of transaction or arbitrage operation determines the exchange rate means

that monetary authorities have some leeway in setting both the scaling factor between their

country's price system and the rest of the world's and the rules by which it changes. However,

their sailing room is not unlimited. A fixed rate is always in danger of violating what average

market opinion regards as a fundamental. Even a floating rate amply supported by forward

markets can be an invitation to extreme volatility. Volatility can lead to disaster if asset

preferences shift markedly away from the home country's liabilities in response to shifting

perceptions about fundamentals or adverse "news." Unregulated international capital markets are

at the root of any perceived trilemma. It is a practical problem that must be evaluated in each

case, taking into account the context and circumstances of policy implementation.

Monetary and Exchange Rate Policies and Capital Flows

The implication is that if it wishes to target the RER, the central bank has to maintain

tolerable control over the macroeconomic impacts of cross-border financial flows in a world with

relatively open foreign capital markets. For the sake of clarity, it makes sense to analyze

situations of excess supply and excess demand for foreign capital separately.

Large capital inflows can easily imperil macro stability. Indeed, central bank attempts to

sterilize them by selling domestic liabilities from its portfolio may even bid up local interest rates

14
and draw more hot money. Preservation of monetary independence in this case may well require

capital market regulation. Measures are available for this task. 4 They do not work perfectly, but

can certainly moderate inflows during a boom. Booms never last forever; the point is that the

authorities can use capital market interventions to slow one down to avoid an otherwise inevitable

crash.

If there are capital outflows too large to manage with normal exchange rate and monetary

policies, the authorities certainly do not want to engage in recession-triggering monetary

contraction. If the exchange rate has been maintained at a relatively weak level, the external

deficit is not setting off financial alarm bells, and inflation is under control, then there are no

“fundamental” reasons for market participants to expect a maxi-devaluation. Under such

circumstances, the way for the authorities to maintain a policy regime consistent with a targeted

RER is to impose exchange controls and restrictions of capital outflows.

Contrary to IMF-style opinion that all runs against a currency must be triggered by poor

fundamentals (even if they momentarily escape the notice of the authorities and IMF officials), it is

perfectly clear that they can arise for reasons extraneous to economic policy – think of a political

crisis, the fallout from mismanagement of an important bank, or the impacts of financial contagion

from a regional neighbor. In all such cases, outflow controls can be used to maintain an existing

policy package in place. They may not have to be utilized for very long. 5

Monetary Policy

In a developmental policy regime, monetary policy must be designed in view of its likely

effects on the RER, inflation control, and the level of economic activity. There is nothing very

surprising here – in practice central banks always have multiple objectives. In the United States,

despite lip service to controlling price inflation, the Federal Reserve certainly responds to the level

of economic activity and financial turmoil (witness the 1990s stock market bubble and the LTCM

4
For an ample menu, see papers by Deepak Nayyer, Eric Helleiner, and Gabriel Palma in
Eatwell and Taylor (2002) and Epstein, Grabel and Jomo (2003). Salih Neftci and Randall Dodd
assess the possibilities of using financial engineering to circumvent controls.
5
Argentina, for example, successfully managed exchange controls and capital outflow restrictions
in mid-2002. The measures were transitory. They were gradually softened as buying pressure in
the exchange market diminished.

15
near-crisis). In many developing countries, central banks intervene more or less systematically in

the exchange markets. The proposal here is that these interventions should help support a

developmentally oriented RER for the reasons presented above. That is, the nominal rate should

move to hold the RER in the vicinity of a stable competitive level for an extended period of time.

Inflation targeting, on the other hand, is the current orthodox buzzword. The nominal

exchange rate and other policies should be programmed to ensure a low, stable rate of inflation.

A trilemma-like argument is involved. If exchange market interventions target the RER as

opposed to the nominal exchange rate and the central bank cannot manage the money supply,

there is no nominal anchor on inflationary expectations. The inflation rate cannot be controlled.

As we have seen, in practical terms the trilemma can be circumvented, allowing the

monetary authorities to bring developmental objectives into their remit. But they have to take at

least five important considerations into account in monetary management.

First, many developing countries now have low to moderate inflation rates, demoting

inflation control in the hierarchy of policy objectives.

Second, will low interest rates tend to set off inflationary nominal depreciation (under

“speculative” exchange rate dynamics as discussed above)? RER targeting can help the central

bank steer away from this problem.

Third, shifts in aggregate demand likely to result from changes in the exchange rate and

monetary policy must be taken into account, and appropriate offsetting policies deployed.

Fourth, also as mentioned above, some mix of temporary capital inflow or outflow

controls may be needed to allow the central bank to regulate monetary aggregates and interest

rates rather than be overwhelmed by attempts at sterilization.

Finally, unstable money demand and other unpredictable factors mean that the monetary

authorities have to be alert and flexible. Indeed, “inflation targeting” is a codeword for orthodox

recognition that quantitative monetary and even interest rate targets are impractical. It is a means

for giving more discretion in trying to attain a single target.

The point being made here is that discretion can and should serve other ends. A stable

competitive RER in coordination with sensible industrial and commercial policies can substantially

16
improve prospects for economic development. Surely that should be the over-riding goal of the

monetary and all other economic authorities in any developing or transition economy.

References

Eatwell, John, and Lance Taylor (2000) Global Finance at Risk: The Case for International

Regulation, New York:The New Press

Eatwell, John, and Lance Taylor (eds., 2002) International Capital Markets: Systems in

Transition, New York: Oxford University Press.

Epstein, G., I. Grabel, and K.S. Jomo (2003): “Capital Management Techniques in Developing

Countries: An Assessment of Experiences from the 1990s and Lessons for the Future,”

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 Non-tradeable Macroeconomic Equilibrium
sector wage
wn
Non-tradeable
equilbrium

Tradeable sector
output X t

Trade deficit

Figure 1: Equilibrium between tradeable and non-tradeable sectors

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 Labor Employment
productivity growth
ξ Lt rate
growth contours

Output growth

Kaldor-Verdoorn

Output growth
rate X̂
t

Figure 2: Output, labor productivity, and employment growth in the tradeable sector

20