Wednesday, December 28, 2016

Interview with Gita Gopinath: The Dollar and Effects of Exchange Rate Fluctuations

Douglas Clement has an "Interview with Gita Gopinath" in The Region, published by the Federal Reserve Bank of Minneapolis (December 20, 2016). As the subheading says, the main topics include
the "dollar’s unique status, crises & productivity, and policy spillover to emerging markets." Here are a couple of comments that caught my eye:

On the role of the fluctuations in the US dollar exchange rate in inflation and output: 
"What we have known for a while is that the dollar has a unique role in international trade since most of trade invoicing is done in dollars. More recent research shows that these dollar prices tend to be sticky—that is, these dollar prices are far more stable than exchange rates. For non-U.S. economies, therefore, a depreciation of their currency relative to the dollar leads to almost a one-to-one increase in the price of imported goods in their own currency and, therefore, the pressures on inflation are high. On the other hand, because dollar prices of traded goods are relatively stable, the inflationary pressures on the U.S. economy are weak.
"This, of course, begs the question, why do most exporters rely on dollar pricing? There are a couple of explanations. Firstly, as world trade has become more competitive, firms that wish to preserve their market shares prefer to keep their prices stable relative to their competitors’. If your competitors price in dollars and keep these prices sticky, this gives the firm an incentive to also price in dollars. ... Secondly, most exporters also use imported inputs for their production. If these inputs are priced in dollars that are relatively stable, then the exporters’ cost of production is relatively stable in dollar terms and, consequently, they prefer to price in dollars. ... Outside of the U.S., most nations are far more exposed to inflation driven by exchange rate fluctuations. What this also points to is that from most countries’ perspective, the exchange rate that matters is the value of their currency relative to the dollar. ...

"A weaker dollar has very little effect on inflation in the U.S., has an expansionary effect on exports and has a negligible effect on imports. On the other hand, a weaker rupee is highly inflationary for India, has a significant impact on its imports and has a negligible impact on exports. This expectation that a weaker currency for a non-U.S. economy is good for a country’s exports does not line up with the facts. ... What it basically means is that central bankers in developing countries have to respond pretty aggressively to exchange rate depreciations."
Using fiscal policy as a substitute for exchange rate policy: 
"So what we analyzed in our paper is a set of fiscal instruments that would deliver the same outcomes as a currency devaluation. This idea goes back to Keynes, as you said, who proposed import tariffs and export subsidies as a substitute for currency devaluation. Given the illegality of using tariffs of this nature, we instead explored the role of value-added taxes and payroll subsidies or, more specifically, raising value-added taxes and cutting payroll taxes. What we found, surprisingly, is that this form of intervention did extremely well in mimicking the outcomes of a currency devaluation, not approximately but exactly.

"The mechanism works as follows. When a country raises its value-added tax, foreign exporters selling to the country increase their prices, making them less competitive. Domestic firms that sell locally also face the high value-added taxes, but because these prices are slow to adjust and because the government provides them with a payroll tax cut, their prices do not rise as much. That makes them more competitive in the same way that an exchange rate devaluation would. Moreover, a fiscal devaluation has the same effect on inflation and the same effect on redistribution as an exchange rate devaluation.

"In terms of policy traction, France did implement a partial fiscal devaluation. They cut payroll taxes but did not raise value-added taxes, despite the announcement that they would. So they went only halfway there. Despite the virtues, there are political challenges to implementing a large fiscal devaluation. Countries live through a 10 percent exchange rate depreciation without immense anxiety, but if you raise value-added taxes by 10 percent, that would be very salient and likely politically infeasible.
But the broader point we made was that there are instruments other than exchange rate devaluations that a country can use to gain trade competitiveness."