## wp17154 ## Source details **Canonical URL:** [wp17154](https://www.imf.org/-/media/files/publications/wp/2017/wp17154.pdf) ## Other formats - [Markdown version](/-/media/files/publications/wp/2017/wp17154.pdf.md) - [Structured JSON version](/-/media/files/publications/wp/2017/wp17154.pdf.json) --- ### 1. Introduction — research question, empirical facts, and hypothesis - Research question and motivation - Analyzes the appropriate choice of an exchange rate regime in developing economies that are significantly dependent on labor-intensive agricultural commodity exports. - Motivated by falling agricultural commodity prices, persistent downward trends and volatility in such prices, and the empirical fact that the majority of these economies target their exchange rates. - Policy puzzle: conventional advice (Friedman, 1953) favors flexible exchange rates for stabilization, yet over 70% of agricultural commodity exporters have exchange rate anchors. - Definitions and key empirical facts - Commodity-exporting economies: commodity export revenues constitute more than 35% of overall export revenues. - Alternative wording: "Commodity exporters, defined as those economies where commodity export revenues constitute 35% or more of total export revenues, are uniquely vulnerable..." - Table 2 aggregate statistics: - Average Agri Exports/Total Exports = 57% - Average % Agri Employment = 30% - Exch rate anchor = 73% - Central hypothesis - Preference for exchange rate targeting can be rationalized by low levels of development that produce inflexible labor and product markets and incomplete international financial markets. - Theoretical framing - Open economy DSGE model with: - Heterogeneous production: commodity and non-commodity sectors. - Commodity sector: price-taking in world agricultural goods prices; commodities fully exported; decreasing returns to scale. - Non-commodity sector: monopolistic competition and sticky prices. - Labor market rigidity: imperfect labor mobility across sectors. - Limited financial integration and imperfect international risk-sharing (incomplete markets). - Stylized facts model aims to match (negative agricultural commodity shock) - Aggregate output falls. - Aggregate consumption falls. - Labor moves out of lagging commodity sector. - Aggregate employment falls due to substitution effect from lower wages. - Real exchange rate depreciates. - Main theoretical result on regime choice (summary from Table 1) - Rigid Labor Markets + Rigid Product Markets => Peg - Rigid Labor Markets + Flexible Product Markets => Peg - Flexible Labor Markets + Rigid Product Markets => Float - Flexible Labor Markets + Flexible Product Markets => Float - Policy implication (intuitive) - With inflexible labor and product markets and incomplete financial markets, fixed exchange rate mitigates costly relative price and wage fluctuations and can raise welfare relative to a float. - As labor or product markets become more flexible, floating regimes become welfare-preferred. ### 3.1 Households — preferences, labor structure, assets, and international conditions - Preferences and expectations - Expected utility at time t: U_t = E_t • Σ_{s=0} b^s [ C_{t+s}^{1-s} / (1-s) - N_{t+s}^{1+f} / (1+f) ] (equation (1)) - Parameters: s>0 inverse intertemporal elasticity; f>0 inverse Frisch elasticity. - Expectations operator: E_t(.) = Σ_{x_{t+s+1}} μ(x_{t+s+1}|x_{t+s}); initial state x_0 with μ(x_0)=1. - Labor supply and labor market structure - Aggregate hours index (CES across sectors): N_t = [ h^{-1/l} N_{C,t}^{(1+l)/l} + (1-h)^{-1/l} N_{H,t}^{(1+l)/l} ]^{l/(1+l)} (equation (2)) - l>0 CES elasticity of substitution in hours across sectors (measures labor market rigidity). - h steady-state share of commodity sector labor (h = N_{C,t}/N_t). - Limits: l=0 fully segmented; l→∞ markets flexible; 00; k ∈ [0,∞) captures degree of international risk-sharing. - Euler equations and international conditions - Domestic consumption Euler: 1 = (1+i_t) b E_t [ (C_{t+1}/C_t)^{-s} 1/P_{t+1} ] (equation (11)) - Domestic foreign-bond condition: 1 = (1+i^*_t) (1/(1+ k b_{F,t})) b E_t [ (C_{t+1}/C_t)^{-s} Q_{t+1}/Q_t ] (equation (12)) - Q_t = e_t P^*/P_t ; b_{F,t} = B_{F,t}/P^* ; P^* normalized to one. - Foreign household Euler: 1 = (1+i^*_t) b E_t [ (C^*_{t+1}/C^*_t)^{-s} 1/P^* ] (equation (13)) - Risk-sharing and UIP with adjustment costs - Backus-Smith with incomplete markets: E_t [ (C_{t+1}/C_t)^{-s} ] = E_t [ (C^*_{t+1}/C^*_t)^{-s} (Q_{t+1}/Q_t) ] ( 1/(1+ k b_{F,t}) )^{1/s} (equation (14)) - UIP with adjustment-cost wedge: 1 + i_t = (1 + i^*_t) E_t[ e_{t+1}/e_t ] ( 1/(1+ k b_{F,t}) ) (equation (15)) ### 3.6 Equilibrium — definition, calibration, dynamics, welfare, and policy implications - Equilibrium definition - Sequence {prices and quantities} such that households, firms, and markets optimize and clear given monetary policy rule (equation (31)), no-Ponzi, transversality, and initial symmetric zero net foreign assets. - Households optimize labor (9,10) and consumption (12); consumer optimization of domestic/foreign goods (4,5,6); firms optimize (22,27,28,29,30); goods (32), labor (33), asset (36) markets clear; net foreign assets evolve per (37). - Exogenous processes: {np*C,t, A t, X t, C* t, i* t}t=0 follow stationary AR processes Bt = rb Bt−1 + eb,t with rb = 0.9 for persistence. - SH,t given by (16) is only relative price required for equilibrium characterization. - Calibration (representative agricultural commodity-exporting economy) - l = 0.8 - # = 0.8 - k = 0.1 - s = 2 - a = 0.5 - f = 5 - y = 0.1 - h = 0.3 - q = 0.75 - b = 0.99 (implying a steady state real interest rate of around four percent) - n = 4 (implying a steady state markup of around 30%) - rb = 0.9 - Sensitivity analysis parameter ranges - a ∈ [0.2, 0.8] - k ∈ [0.01, 100] - q ∈ [0.4, 0.8] - s ∈ [0.5, 5] - f ∈ [1, 10] - y ∈ [0.1, 0.6] - n ∈ [4, 8] - rb ∈ [0.5, 0.9] - fe, fp ∈ [1.5, •] - l ∈ [0.5, •] - # ∈ [0.5, 5] - Dynamics under alternate exchange rate regimes (5% negative commodity price shock) - Simulation shock: 5% unexpected fall in international price of agricultural commodities. - Common dynamics: - Commodity export revenues fall → commodity-sector labor demand contracts → commodity wages fall. - Consumption falls due to limited financial deepening and asset market insurance. - Non-commodity labor demand and wages fall; non-commodity prices decline; real depreciation occurs. - Key regime differences: - Flexible exchange rate (float) allows greater real depreciation → non-commodity production increases under float but falls under peg. - Under float, non-commodity wages decline by less; commodity output declines further as labor reallocates to non-commodity sector. - Consumption is more stable under float due to higher wage income compared to peg. - Result 1: Exchange rate flexibility amplifies relative wage and price fluctuations. - Flexible exchange rates allow a greater fall in price of domestic non-commodity goods relative to imports → larger international price differential and more real depreciation. - Wage differential increases: commodity wages fall by more initially; float incentivizes non-commodity production → raises marginal product of non-commodity labor → increases wage differential. - Sensitivity insights (selected) - Increase in a: households consume a higher fraction of relatively more expensive imports → consumption declines by more; non-commodity output is higher; commodity output is lower; wage differential increases. - Increase in k: less international financial integration → dynamics more volatile; consumption decreases more; non-commodity output decreases; commodity output falls by less; wage differential decreases. - As q → 0 (prices more flexible): dynamics under peg and float converge. - Decrease in f (more elastic labor supply): labor supplied can fall more → output across economy falls but aggregate wages are pulled up → smooths consumption and lowers real depreciation. - Decrease in s (more elastic consumption): consumption falls by more → non-commodity output falls → less real depreciation → greater fall in commodity output. - Small adjustments to y, n, or monetary rule flexibility do not produce significant changes in dynamics. - Labor market rigidity - Baseline l = 0.8 (reflecting under-developed labor markets). - As l → ∞ (more flexible labor markets): - For any given wage differential wC,t / wH,t, relative hours N C,t / N H,t adjust more. - Two opposing effects on consumption: - Greater migration to higher-wage sector → relatively higher consumption for given labor effort. - Greater outflow from commodity sector → additional downward pressure on non-commodity wages → relatively lower consumption for given labor effort. - First effect generally dominates → consumption is smoother. - Result 2: Labor market flexibility stabilizes relative wages but increases price differentials. - More mobile labor narrows sectoral wage differentials. - Amplified sectoral output dynamics and increased non-commodity production put downward pressure on non-commodity prices → larger international price differential. - Product market rigidity - Baseline # = 0.8 (limited substitution toward higher-quality imports). - Increase in # (more flexible product markets): - Allows reallocation of expenditure toward cheaper goods → stabilizes consumption with either peg or float. - Result 3: Product market flexibility stabilizes relative prices but increases wage differentials. - Higher # mitigates real depreciation and narrows international price differential. - Non-commodity wages decrease less with product market flexibility → increases wage differential. - Welfare comparison metric and principal welfare result - Consumption equivalent units, G, defined by equality of expected utility streams under peg and float; G > 0 implies Peg preferred; G < 0 implies Float preferred. - Result 4: Exchange rate targeting (peg) leads to higher welfare than a float in agricultural commodity exporters when markets are inflexible. - Inflexible real markets and limited international financial opportunities amplify costly relative wage and price fluctuations → misallocation. - Central bank targeting nominal exchange rate mitigates international relative price and wage fluctuations. - As real markets become more flexible, flexible exchange rates preferred. - Empirical observation: over 70% of agricultural commodity exporters have exchange rate anchors. - Welfare ranking and loss numbers (5% commodity price fall) - Welfare Ranking of Fixed vs Flexible Regimes (by product market # and labor market l) - # = 0.4, 0.6, 0.8, 1.0, 1.6 across columns; l = 0.4, 0.6, 0.8, 1.0, 1.6 down rows. - l = 0.4 → Fixed, Fixed, Fixed, Flex, Flex - l = 0.6 → Fixed, Fixed, Fixed, Flex, Flex - l = 0.8 → Fixed, Fixed, Fixed, Flex, Flex - l = 1.0 → Fixed, Fixed, Fixed, Flex, Flex - l = 1.6 → Fixed, Fixed, Flex, Flex, Flex - Welfare Loss (% Consumption Equivalent), G (matrix) - l = 0.4: 8.21, 12.35, 0.29, -0.06, -0.15 - l = 0.6: 6.07, 1.37, 0.19, -0.10, -0.19 - l = 0.8: 3.81, 0.91, 0.11, -0.13, -0.23 - l = 1.0: 2.35, 0.65, 0.06, -0.16, -0.26 - l = 1.6: 0.93, 0.28, -0.06, -0.23, -0.35 - Robustness and notable alternative calibrations - Two parameters materially affecting welfare rankings: trade openness a and international capital mobility k. - Higher trade openness (a = 0.8) and more limited international financial integration (k = 100) increase the case for fixed exchange rates. - Selected alternate calibrations — Welfare Loss (G) matrices: - Welfare Properties (a = 0.8) - l = 0.4: 15.23, 13.20, 4.10, 1.46, 0.29 - l = 0.6: 9.18, 8.17, 3.11, 1.38, 0.25 - l = 0.8: 6.54, 5.14, 2.48, 1.26, 0.23 - l = 1.0: 5.91, 3.74, 2.07, 1.15, 0.22 - l = 1.6: 3.05, 2.13, 1.42, 0.91, 0.21 - Welfare Properties (k = 100) - l = 0.4: 9.40, 7.62, 1.41, 0.05, -0.47 - l = 0.6: 6.31, 4.28, 1.05, 0.05, -0.46 - l = 0.8: 3.22, 2.88, 0.84, 0.04, -0.44 - l = 1.0: 2.82, 2.14, 0.70, 0.03, -0.43 - l = 1.6: 2.02, 1.41, 0.48, 0.02, -0.32 - Policy conclusion - For agricultural commodity exporters with inflexible labor and product markets and limited international financial integration, fixed exchange rate regimes can be welfare-superior because they mitigate costly relative price and wage adjustments and associated misallocations. - As economies mature and labor and product markets become more flexible, transition to flexible exchange rates and inflation targeting becomes desirable. - Caution against blanket endorsements of exchange rate flexibility without accounting for labor/product market rigidity and financial integration. *Source: IMF Working Paper — wp17154* ### 1. Introduction ........................................................................................................ ### 1. Introduction ### Research question and motivation - Analyzes the appropriate choice of an exchange rate regime in developing economies that are significantly dependent on labor-intensive agricultural commodity exports. - Motivated by falling agricultural commodity prices, persistent downward trends and volatility in such prices, and the empirical fact that the majority of these economies target their exchange rates. - Policy puzzle: conventional advice (Friedman, 1953) favors flexible exchange rates for stabilization, yet over 70% of agricultural commodity exporters have exchange rate anchors. ### Definition and empirical facts highlighted - Commodity-exporting economies are defined in the source as those economies where commodity export revenues constitute more than 35% of overall export revenues. - Alternative wording in the source: "Commodity exporters, defined as those economies where commodity export revenues constitute 35% or more of total export revenues, are uniquely vulnerable..." - Figure referenced: Agricultural Commodity Price Indices (2000=100) and Annualized Volatility Numbers (UNCTAD, 2016) — documents falling levels and volatility of agricultural commodity prices. ### Key empirical statistic on exchange rate regimes and employment - Table 2 aggregate statistics (from FAO 2010 Yearbook and IMF 2014 Exchange Rates Report): - Average Agri Exports/Total Exports = 57% - Average % Agri Employment = 30% - Exch rate anchor = 73% ### Puzzle and central hypothesis - Despite conventional macroeconomic policy advice that flexible exchange rates have superior stabilization properties, many labor-intensive agricultural commodity exporters peg or anchor their exchange rates. - Hypothesis: the preference for exchange rate targeting in practice can be rationalized by low levels of development that produce inflexible labor and product markets and incomplete international financial markets. --- ### Theoretical framework overview - An open economy dynamic stochastic general equilibrium (DSGE) model is developed that incorporates key structural characteristics of agricultural commodity-exporting economies: - Heterogeneous production structure with two sectors: commodity and non-commodity firms. - Both sectors employ workers to capture labor-intensive production. - Commodity sector is price-taking in world agricultural goods prices; commodities are modeled as fully exported. - Non-commodity sector has monopolistic competition and sticky prices (role for monetary policy). - Labor market rigidity: imperfect labor mobility across sectors, implying different wage rates across the economy. - Limited financial integration and imperfect international risk-sharing (incomplete markets). - Agricultural production with decreasing returns to scale; export revenues accrue to domestic households. --- ### Stylized macroeconomic facts the model aims to match - Upon a negative shock to agricultural commodity export revenues: - Aggregate output falls. - Aggregate consumption falls. - Labor tends to move out of the lagging commodity export sector. - Aggregate employment falls due to the substitution effect from lower wages. - The real exchange rate depreciates. - These dynamics are qualitatively matched by the model, particularly under exchange rate targeting. --- ### Main theoretical results (exchange rate regime choice) - The appropriate choice of an exchange rate regime depends on the degree of flexibility of domestic labor and product markets. - Definitions of market rigidities in the model: - Inflexible labor markets: workers cannot efficiently re-allocate hours across sectors in response to wage differentials. - Inflexible product markets: low Armington (1969) trade elasticity (low elasticity of substitution between domestic and imported goods). - Core results summarized (Table 1 in the source): - Rigid Labor Markets + Rigid Product Markets => Peg - Rigid Labor Markets + Flexible Product Markets => Peg - Flexible Labor Markets + Rigid Product Markets => Float - Flexible Labor Markets + Flexible Product Markets => Float - Intuition: - With inflexible labor and product markets and incomplete financial markets, exchange rate fluctuations exacerbate currency and factor misalignments and lead to misallocation of resources. - A fixed exchange rate mitigates international relative price and relative wage fluctuations by stabilizing nominal conditions—raising welfare relative to a float in this environment. - As labor or product markets become more flexible, agents can re-allocate labor and consumption more efficiently in response to relative price changes; flexible exchange rates (floats) permit desirable relative price movements and yield higher welfare. --- ### Contribution to literature - Extends literature on commodity revenue volatility management by incorporating heterogeneous production, factor re-allocation, and financial market incompleteness in an open-economy DSGE context. - Advances open-economy incomplete markets literature by adding dual labor markets and showing desirability of exchange rate targeting is contingent on factor re-allocation efficiency. - Adds to monetary policy and factor re-allocation literature by introducing an open-economy dimension with exchange rates and incomplete financial markets. --- ### Policy implications (from the model) - For less-developed agricultural commodity exporters with inflexible labor and product markets and limited financial integration, exchange rate targeting (pegs/anchors) can be welfare-improving relative to floating exchange rates. - As economies develop and either labor or product markets become more flexible, the welfare case shifts in favor of flexible exchange rates; these economies should transition toward floating regimes as development proceeds. - The model provides benchmark theoretical guidance reconciling empirical reality (widespread exchange rate anchoring) with conventional policy prescriptions by highlighting the role of real-market frictions and financial incompleteness. *Source: IMF Working Paper — wp17154, 1. Introduction.* ### 3.1 Households ### 3.1 Households ### Preferences and expectation structure - Representative household preferences: - Expected utility at time t: U_t = E_t • Σ_{s=0} b^s [ C_{t+s}^{1-s} / (1-s) - N_{t+s}^{1+f} / (1+f) ] (equation (1)) - Parameters: s>0 is the inverse intertemporal elasticity of substitution; f>0 is the inverse Frisch elasticity of labor supply. - Expectations operator: E_t(.) = Σ_{x_{t+s+1}} μ(x_{t+s+1}|x_{t+s}). - Initial state x_0 with μ(x_0)=1. - Preferences imply concave utility in consumption (isoelastic) and convex disutility in labor (isoelastic). ### Labor supply and labor market structure - Aggregate hours index (CES across sectors): N_t = [ h^{-1/l} N_{C,t}^{(1+l)/l} + (1-h)^{-1/l} N_{H,t}^{(1+l)/l} ]^{l/(1+l)} (equation (2)) - l>0 is the CES elasticity of substitution in hours across sectors (measures labor market rigidity). - h is the steady-state share of commodity sector labor (h = N_{C,t}/N_t). - Limits: for l=0 markets fully segmented; as l→∞ markets flexible; for 00. - Varying k ∈ [0,∞) captures degrees of international risk-sharing; as k→∞ capital mobility is increasingly restricted. ### Euler equations and international conditions - Domestic consumption Euler: 1 = (1+i_t) b E_t [ (C_{t+1}/C_t)^{-s} 1/P_{t+1} ] (equation (11)) - Optimality for foreign bond holdings (domestic): 1 = (1+i^*_t) (1/(1+ k b_{F,t})) b E_t [ (C_{t+1}/C_t)^{-s} Q_{t+1}/Q_t ] (equation (12)) - Q_t = e_t P^*/P_t is real exchange rate; b_{F,t} = B_{F,t}/P^* ; P^* normalized to one. - Foreign household Euler: 1 = (1+i^*_t) b E_t [ (C^*_{t+1}/C^*_t)^{-s} 1/P^* ] (equation (13)) ### Risk-sharing (Backus-Smith) and limited international risk-sharing - Combining domestic and foreign bond conditions yields Backus-Smith condition with incomplete markets: E_t [ (C_{t+1}/C_t)^{-s} ] = E_t [ (C^*_{t+1}/C^*_t)^{-s} (Q_{t+1}/Q_t) ] ( 1/(1+ k b_{F,t}) )^{1/s} (equation (14)) - Formalizes limited scope for international risk-sharing in a bond-only world; consumption smoothing limited to borrowing/saving. ### Uncovered interest parity with adjustment costs - UIP with incomplete financial markets (bond adjustment costs induce a wedge): 1 + i_t = (1 + i^*_t) E_t[ e_{t+1}/e_t ] ( 1/(1+ k b_{F,t}) ) (equation (15)) - Implies expected nominal exchange rate adjusts to equalize domestic and foreign returns accounting for adjustment costs. Final source attribution: *Source: wp17154 - 3.1 Households* ### 3.6 Equilibrium ### 3.6 Equilibrium ### Equilibrium definition - Equilibrium is defined from the perspective of the domestic small open economy, assuming the no-Ponzi and transversality conditions are satisfied and initial net foreign asset positions are symmetrically zero across the world. - For any specification of monetary policy (equation (31)) determining the nominal interest rate, it = {sequence of prices and quantities}t=0• such that: - Households optimize labor supply: (9) and (10) - Households optimize consumption: (12) - Consumer optimization of domestic and foreign goods: (4), (5), and (6) - International-risk sharing is imperfect: (14) - Firms, j ∈ [0, 1], optimize: (22), (27), (28), (29), and (30) - Goods (32), labor (33), and asset (36) markets clear - Net foreign assets evolve according to (37) - Exogenous processes taken as given: {np*C,t, A t, X t, C* t, i* t}t=0 (stationary autoregressive processes of the functional form Bt = B1−rB0 B rB t−1 exp{eB}, where Bt ≡ {np*C,t, A t, X t, C* t, i* t}, B0 is the steady state value, and eB is a shock). - SH,t, given by (16), is the only relative price required for the characterization of equilibrium. ### Calibration (representative agricultural commodity-exporting economy) - Elasticity of substitution in hours worked across sectors, l = 0.8. - Armington trade elasticity between domestic non-commodity goods and imports, # = 0.8. - Adjustment costs for household’s holding of foreign bonds, k = 0.1. - Intertemporal elasticity, s = 2. - Degree of openness to trade, a = 0.5. - Inverse Frisch elasticity, f = 5. - Returns to scale in the commodity sector, y = 0.1. - Steady state share of employment in the commodity sector, h = 0.3. - Fraction of monopolistic producers that can reset prices, q = 0.75. - Household discount factor, b = 0.99 (implying a steady state real interest rate of around four percent). - Elasticity of substitution between differentiated monopolistic goods, n = 4 (implying a steady state markup of around 30%). - Persistence of shocks in the stationary AR process bt = rb bt−1 + eb,t, where bt ≡ {ˆp*C,t, a t, x t, c* t, i* t}: rb = 0.9. ### Sensitivity analysis parameter ranges (empirically relevant) - Trade openness, a ∈ [0.2, 0.8] - Bond adjustment costs, k ∈ [0.01, 100] - Price stickiness, q ∈ [0.4, 0.8] - Inverse elasticity of intertemporal substitution, s ∈ [0.5, 5] - Inverse elasticity of labor supply, f ∈ [1, 10] - Decreasing returns to scale, y ∈ [0.1, 0.6] - Elasticity of substitution between individual varieties, n ∈ [4, 8] - Shock persistence, rb ∈ [0.5, 0.9] - Monetary rule flexibility, fe, fp ∈ [1.5, •] - Elasticity of labor supply between sectors, l ∈ [0.5, •] - Elasticity of substitution between domestic and foreign aggregates, # ∈ [0.5, 5] ### Dynamics under alternate exchange rate regimes (5% negative commodity price shock) - Simulation: 5% unexpected fall in the international price of agricultural commodities. - Common dynamics: - Commodity export revenues fall → commodity-sector labor demand contracts → commodity wages fall. - Consumption falls due to limited financial deepening and asset market insurance. - Non-commodity labor demand and wages fall; non-commodity prices decline; real depreciation occurs. - Key difference peg vs float: - Flexible exchange rate (float) allows greater real depreciation → non-commodity production increases under float but falls under peg. - Under float, non-commodity wages decline by less; commodity output declines further as labor reallocates to non-commodity sector. - Consumption is more stable under float due to higher wage income compared to peg. - Result 1: Exchange rate flexibility amplifies relative wage and price fluctuations. - Flexible exchange rates allow a greater fall in the price of domestic non-commodity goods relative to imports → larger international price differential and more real depreciation. - Wage differential (commodity wages relative to non-commodity wages) increases: commodity wages initially fall by more; float incentivizes non-commodity production → raises marginal product of non-commodity labor → increases wage differential. ### Sensitivity insights (selected) - Increase in a: households consume a higher fraction of relatively more expensive imports → consumption declines by more; non-commodity output is higher; commodity output is lower; wage differential increases. - Increase in k: less international financial integration → dynamics more volatile; consumption decreases more; non-commodity output decreases; commodity output falls by less; wage differential decreases. - As q → 0 (prices more flexible): dynamics under peg and float converge. - Decrease in f (more elastic labor supply): labor supplied can fall more → output across the economy falls but aggregate wages are pulled up → smooths consumption and lowers real depreciation. - Decrease in s (more elastic consumption): consumption falls by more → non-commodity output falls → less real depreciation → greater fall in commodity output. - Small adjustments to y, n, or monetary rule flexibility do not produce significant changes in dynamics. ### Labor market rigidity - Baseline l = 0.8 (reflecting under-developed labor markets). - As l → ∞ (more flexible labor markets): - For any given wage differential wC,t / wH,t, relative hours N C,t / N H,t adjust more. - Two opposing effects on consumption: - Greater migration to higher-wage sector → relatively higher consumption for given labor effort. - Greater outflow from commodity sector → additional downward pressure on non-commodity wages → relatively lower consumption for given labor effort. - First effect generally dominates → consumption is smoother. - Result 2: Labor market flexibility stabilizes relative wages but increases price differentials. - More mobile labor narrows sectoral wage differentials. - Amplified sectoral output dynamics and increased non-commodity production put downward pressure on non-commodity prices → larger international price differential. ### Product market rigidity - Baseline # = 0.8 (limited substitution toward higher-quality imports). - Increase in # (more flexible product markets): - Allows reallocation of expenditure toward cheaper goods → stabilizes consumption with either peg or float. - Result 3: Product market flexibility stabilizes relative prices but increases wage differentials. - Higher # mitigates real depreciation and narrows the international price differential. - Non-commodity wages decrease less with product market flexibility → increases wage differential. ### Welfare: fixed vs flexible exchange rates (consumption equivalent G) - Welfare comparison metric: consumption equivalent units, G, solving E0 (Σt=0• b t [ ((1−G) C t,e)1−s /(1−s) − N1+f t,e /(1+f) ]) = E0 (Σt=0• b t [ C1−s t,p /(1−s) − N1+f t,p /(1+f) ]) - C t,e and N t,e: consumption and labor under a peg - C t,p and N t,p: consumption and labor under a float - G > 0 implies Peg is preferred; G < 0 implies Float is preferred. - Result 4: Exchange rate targeting (peg) leads to higher welfare than a float in agricultural commodity exporters when markets are inflexible. - Inflexible real markets and limited international financial opportunities amplify costly relative wage and price fluctuations → misallocation of consumption and employment. - Central Bank prefers to mitigate international relative price and wage fluctuations by targeting the nominal exchange rate. - As real markets become more flexible, flexible exchange rates are preferred since agents can better respond to relative fluctuations, and exchange rate flexibility amplifies adjustment mechanisms. - Empirical observation: over 70% of agricultural commodity exporters have exchange rate anchors. ### Welfare ranking and loss numbers (Table 3) — 5% commodity price fall - Welfare Ranking of Fixed vs Flexible Regimes (by product market # and labor market l) - # = 0.4, 0.6, 0.8, 1.0, 1.6 across columns; l = 0.4, 0.6, 0.8, 1.0, 1.6 down rows. - Preferences: - l = 0.4 → Fixed, Fixed, Fixed, Flex, Flex - l = 0.6 → Fixed, Fixed, Fixed, Flex, Flex - l = 0.8 → Fixed, Fixed, Fixed, Flex, Flex - l = 1.0 → Fixed, Fixed, Fixed, Flex, Flex - l = 1.6 → Fixed, Fixed, Flex, Flex, Flex - Welfare Loss (% Consumption Equivalent), G (matrix corresponding to the above grid): - l = 0.4: 8.21, 12.35, 0.29, -0.06, -0.15 - l = 0.6: 6.07, 1.37, 0.19, -0.10, -0.19 - l = 0.8: 3.81, 0.91, 0.11, -0.13, -0.23 - l = 1.0: 2.35, 0.65, 0.06, -0.16, -0.26 - l = 1.6: 0.93, 0.28, -0.06, -0.23, -0.35 ### Robustness and notable alternative calibrations - Result 4 is robust to alternative calibrations; welfare rankings in Table 3 are robust to most parameter changes. - Two parameters materially affecting welfare rankings: trade openness a and international capital mobility k. - Higher trade openness (a = 0.8) and more limited international financial integration (k = 100) increase the case for fixed exchange rates. - Intuition: - Higher a: more imported products consumed → real exchange rate misalignments cause greater misallocation → peg preferred even with flexible markets. - High k (low financial integration): agents cannot efficiently share risk internationally → flexibility in labor and product markets cannot fully overcome limited international risk sharing → peg preferred. - Welfare results for alternate calibrations presented (selected entries): Welfare Properties (a = 0.8) — Welfare Loss (G) matrix - l = 0.4: 15.23, 13.20, 4.10, 1.46, 0.29 - l = 0.6: 9.18, 8.17, 3.11, 1.38, 0.25 - l = 0.8: 6.54, 5.14, 2.48, 1.26, 0.23 - l = 1.0: 5.91, 3.74, 2.07, 1.15, 0.22 - l = 1.6: 3.05, 2.13, 1.42, 0.91, 0.21 Welfare Properties (k = 100) — Welfare Loss (G) matrix - l = 0.4: 9.40, 7.62, 1.41, 0.05, -0.47 - l = 0.6: 6.31, 4.28, 1.05, 0.05, -0.46 - l = 0.8: 3.22, 2.88, 0.84, 0.04, -0.44 - l = 1.0: 2.82, 2.14, 0.70, 0.03, -0.43 - l = 1.6: 2.02, 1.41, 0.48, 0.02, -0.32 ### Conclusion (policy insight) - For agricultural commodity exporters with inflexible labor and product markets and limited international financial integration, fixed exchange rate regimes (exchange rate anchors) can be welfare-superior because they mitigate costly relative price and wage adjustments and associated misallocations. - As economies mature and labor and product markets become more flexible, transition to flexible exchange rates and inflation targeting becomes desirable because agents can more effectively absorb and adjust to relative price and wage fluctuations. - The analysis cautions against blanket recommendations for exchange rate flexibility without accounting for the degree of labor and product market rigidity. *Source: wp17154 - 3.6 Equilibrium (IMF Working Paper).* ### References ### References ### Monetary policy, open economy, and exchange rates - Aguiar, M. and Gopinath, G. 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Patterns and Channels.International Monetary Fund, 7th Jacques Polak Research Conference. - World Bank (2016). World Bank Lowers 2016 Forecasts for 37 of 46 Commodity Prices, Including Oil. Inhttp://www.worldbank.org/en/news/press-release/2016/01/26/world-bank-lowers-2016-forecasts-for-37-of-46-commodity-prices-including-oil. - World Bank (2017). Commodity Market Outlook: Investment Weakness in Commodity Exporters. World Bank Quarterly Report, January 2017. *Content compiled from: wp17154 - References (wp17154 - References).* --- _Source: https://www.imf.org/-/media/files/publications/wp/2017/wp17154.pdf_