Targeting the Real Exchange Rate: Theory and Evidence


WP/94/22-EA
The paper analyzes the two questions in the context of a simple,
arguments in Lizondo (1991, 1993) and Montiel and Ostry (1991,
1992).

The analysis uses a representative-consumer, cash-in-advance model with
flexible prices. It is shown that, in the absence of fiscal policy, the
steady-state real exchange rate is independent of (permanent) changes in the
rate of devaluation. Hence, policymakers can hope to target the real
exchange rate for only a limited period of time.

Under perfect capital mobility, a more depreciated level of the real
exchange rate can be achieved by generating higher inflation today than in
the future. Numerical simulations of the model suggest that, since the
intertemporal elasticity of substitution for most developing countries is
low, the inflationary effects of real exchange rate targeting might be
substantial.

Under no capital mobility, the paper shows that a temporary
depreciation of the real exchange rate can be achieved without inflation.
However, the domestic real interest rate will rise and keep increasing as
long as the real exchange rate remains at its depreciated level. Again,
simulations of the model indicate that the rise in the domestic real
interest rate may be substantial. In sum, the model suggests that real
exchange rate targeting will lead to some combination of higher inflation
and high domestic real interest rates.

The empirical section of the paper assesses the relative importance of
temporary shocks to the real exchange rate for Brazil, Chile, and Colombia.
In all three countries considered, it is found that temporary shocks account
for a sizable share of the variance of real exchange rate (between 43 and 62
percent). The paper also finds that in all three cases the correlation has
the expected sign and is statistically different from zero, with values
ranging from 0.26 to 0.42. Finally, the paper provides evidence on the
long-run relationship between revenues from the inflation tax and the real
exchange rate. The results suggest an indirect link between the two via
wealth effects.