Exchange Rate Choices with Inflexible Markets and Costly Price Adjustments
IMF Working Papers, July 10, 2017
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- Exchange Rate Choices with Inflexible Markets and Costly Price Adjustments
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Bibliographic details
- Authors: Tara Iyer
- Published: July 10, 2017
- Series: IMF Working Papers
- DOI: https://doi.org/10.5089/9781484305980.001
Overview
- Examines appropriate exchange rate regime choice in agricultural commodity-exporting economies.
- Uses an open economy model that incorporates structural characteristics of agricultural commodity exporters, including dual labor markets.
- Central question: how do labor and product market development affect the welfare gains from exchange rate flexibility versus a nominal peg?
Model and key assumptions
- Open economy framework with:
- Dual labor markets (formal and informal or segmented labor).
- Costly price adjustments.
- Commodity-export dependence and commodity price volatility.
- Policy regimes compared: flexible nominal exchange rate (float) versus nominal exchange rate peg.
Main findings
- The welfare benefits of exchange rate flexibility depend critically on the extent of labor and product market development.
- With developed labor and product markets:
- Flexible exchange rates are preferred.
- Flexibility allows greater relative price fluctuations, which amplify the transmission mechanism of labor reallocation in response to commodity price volatility.
- With underdeveloped labor and product markets:
- International relative price adjustments exacerbate currency and factor misalignments.
- A nominal exchange rate peg mitigates relative wage and price fluctuations and increases welfare relative to a float.
- Given the current low level of labor and product market development across most agricultural commodity exporters, the paper provides a counterpoint to conventional arguments favoring flexible exchange rates and offers a rationale for exchange rate targeting in agricultural economies.
Policy implications and recommendations
- Exchange rate regime choice should be conditioned on domestic market structure:
- Where labor and product markets are well-developed, prioritize exchange rate flexibility to facilitate efficient labor reallocation.
- Where labor and product markets are not well-developed, consider exchange rate targeting or a nominal peg to reduce currency and factor misalignments.
- For agricultural commodity-exporting economies with limited market development, exchange rate targeting can be an appropriate policy to increase welfare by mitigating relative wage and price volatility.
Content in this bundle
- Exchange Rate Choices with Inflexible Markets and Costly Price Adjustments, WP/17/154, July 2017