Effect of Exchange Rate Regime Choice on Inflation
International Market
Exchange rate stability is one crucial factor for managing inflation in a country. Various factors can affect inflation and the exchange rate in an economy.
The government considers all these factors and then implements monetary policy to stabilise the exchange rate and inflation in an economy.
After the breakdown of the Bretton Woods system, there has been uncertainty in terms of value of a currency and how they can be achieved.
At present several developing countries face great challenge in terms of the exchange rate flexibility. Thus they adopt a wide variety of exchange rate regimes ranging from fully pegged to fully flexible.
As the exchange regime can affect other economic outcomes like output and inflation, thus an economy must select the exchange rate regime by taking that into consideration(Binici, Cheung and Lai, 2012). The impact of the exchange rate on inflation and output is one of the major concerns for the economy.
It is known that there is a social cost of inflation, and it is evident that even a moderate rate of inflation can be harmful for the growth and efficiency of an economy and thus it is very important to design and secure a reasonable rate.
Various industrialised countries like Canada, Finland, New Zealand, Sweden and UK have adopted the inflation targeting policy.
It has been contended that the developing countries need to implement pegged exchange rate regime to address the inflation problems(Chia, Cheng and Li, 2012).
Thus the decision to choose the appropriate regime for the exchange rate is complicated by the tradeoffs between inflation and output and the empirical and theoretical evidence can make it difficult for performing better in the economy.
In this paper, some of the factors can be investigated that basically drives inflation in developing countries. The main purpose of the paper is to find whether the fixed or pegged exchange rate regime can lead to a credible and efficient economy by lowering the inflation rate.
On the other hand it needs to be established whether the flexible exchange rate regime is more accommodative of inflation (COOKE, 2010).
Research Question:
The research question for this research paper is “whether the exchange rate regime can significantly affect the inflation rate in an economy”.
Fixed vs. Flexible Exchange Rate Regime and the Inflation Performance:
It is known that even a moderate inflation can lead to a harmful impact on the growth and efficiency of the economy. Thus it is the responsibility of the government to implement various policies that can control and maintain the inflation at a lower level and stabilise the rate.
The extensive nature of macroeconomic effects due to the exchange rate regime has aroused considerable interest in that domain (Gupta, 2008).
Although there are various studies linking inflation performance with the choice of exchange rate regime in the empirical and theoretical literature, it is suggested that there is no systematic relationship between the exchange rate regime and inflation.
It is known that in a pegged or fixed exchange rate regime, there is a narrow margin of parity within which the external value of the currency is maintained. Thus the exchange rate change can be used as a policy instrument for addressing the external disequilibrium in a limited extent.
Here, it can be said that the pegged exchange rate can affect inflation in two ways, which are by altering the relationship between prices and money and by instilling monetary discipline. Thus pegged exchange rate can be considered as anti-inflationary (Herrmann, 2009).
It is found that in pegged exchange rate system the inflation rate performs better as it is found that countries with floating exchange rate regime has inflation rate of 16% where it is 14% for the intermediate regimes and 8% for the pegged regime.
Thus, the pegged exchange rate can communicate with monetary authorities to sustain the monetary policy and target a lower inflation rate.
It can be said that in a pegged exchange rate regime, a country can face severe challenges in terms of the balance of payment deficit and public debt if there is a high inflation rate in the country, and thus, various policy measures must be taken to stabilise the inflation rate in the economy. Such a discipline effect is not seen in the case of a floating exchange rate (HOFFMANN, 2007).
From the discussion, it can be contended that the fixed exchange rate is anti-inflationary, but the situation is not all black and white.
It is claimed by the IMF that, even though the inflationary cost of fiscal imbalances in the economy is not vivid as first in the case of fixed exchange rate but in the long-run it can significantly affect the economy if the fixed range cannot be sustained (Imf.org, 2014).
On the other hand the economic costs of flexible exchange rate may be experienced quickly due to the movements in the price and exchange rate but it can also help the market in the assessment of the situation and thus it is stated that the flexible exchange rate has a stronger discipline than the pegged rate on the policies.
It is stated that the flexible exchange rate can lower economic uncertainty and provide policymakers with the opportunity to react quickly in uncertain situations.
Model:
It is known that there is a little theoretical as well as empirical level of consensus regarding the impact of exchange rate regime on the inflation rate and the growth rate of the economy.
At present it is generally accepted that the main objective of the monetary policy is to lower the inflation and thus more considerations are given for the behaviour of general price levels (Mohanty and Bhanumurthy, 2014). Now a model can be developed for identifying the impact of exchange rate regimes on the inflation rate.
It can be said that inflation is a monetary phenomenon, and non-monetary phenomena cannot determine inflation. It is stated that monetary growth leads to increase in the inflation rate and the inflation cannot be explainedby supply and demand shocks.
It is stated that the P* model is the most effective model that can forecast the inflation and thus the model can also analyse whether exchange rate regime can affect the inflation (OZGR, TELATAR and TELATAR, 2006). It is known that in the developing the sources of inflation are diverse, and these include:
- Fiscal Imbalances: in this approach the deficits in the public sector can be linked with inflation. Monetization is basically a residual form of deficit financing, given the limits on foreign and domestic borrowings (Petreski, 2013). It is known that monetary variables and public sector deficits can affect the process of inflation.
- Output gap: in this approach the deviation of the actual output level of an economy from the potential level can result in excess demand and thus increased inflation. On the other hand, lower inflation can be achieved with positive supply shock.
- Inflation inertia: the inflationary shock can be translated into expectation of higher inflation through price and wage contracts and that can be materialised into rising inflation rate (Pomfret, 2003).
- Economic structure and cost shocks from supply side: the sources of inflation include taxes, price controls, energy shocks, mark-up pricing of the oligopolistic market, central bank independence, openness to trade etc. In a small economy a significant amount of inflation is imported.
In order to answer the question that if the floating or pegged exchange rate is more inflationary or anti-inflationary, the Kamin’smodel can be presented here and it can help in quantifying the impact of the exchange rate regime on inflation.
A small open economy has been assumed in the model (Pomfret, 2003). Here, the economy imports and consumes a foreign good (f), it produces, consumes and exports a home good (d), the exchange rate is E, and the domestic price of the foreign good is Pf, and the exogenous foreign currency price of a foreign good is Pf*, such that:
Pf = E Pf*
Pd is the domestic good price, which is determined by the domestic good market equilibrium. Hypotheses have also been made that the gap between equilibrium and actual real exchange rates is responded to by the domestic good prices. A partial adjustment can be made in the model.
ΔlogPd,t= λlog(Pf / Pd)t-1 – log(P*f / P*d )t-1………………(1)
Where (Pf / Pd) and (P*f / P*d ) are actual and equilibrium real exchange rates respectively.
The equilibrium real exchange rate (RER) is not observable, and that can pose an empirical challenge. But it is also evident that equilibrium RER is not an immutable number contrary to the purchasing power parity approach, but it responds to the fundamental variables (Pontines and Siregar, 2012).
It is hypothesized that in the domestic goods market, equilibrium RER is consistent with the equilibrium condition. Y* is the potential output in the domestic economy.
log (P*f / P*d ) = η – ε log (A/Y*) ………….(2)
Here (P*f / P*d ) is the equilibrium RER, η is a constant, and ε is positive and dependant on the elasticity of supply and demand with respect to the equilibrium RER.
Rearranging some terms after substituting equation 2 into equation 1, it is found that
ΔlogPd,t = -λη + λlog(Pf / Pd)t-1+ λ ε log (A/Y*) ………..(3)
It is indicated in equation 3 that the discrepancy between the potential and absorption output in the domestic market along with the real exchange rate misalignment determines the rate of change in domestic goods prices (Rogoff, 2009). In the following equation the consumer price inflation can be shown as a weighted average of inflation of the foreign goods as well as home goods.
Δlog P = αΔlogPd + (1-α)Δlog Pf…………………….(4)
Now the RER can be represented in the following equation as a function of the log of ratio of foreign prices to domestic prices.
RER = = Pf/ (Pdα Pf1-α) = (Pf/Pd)α……………….(5)
Now substituting equation 3 and 5 in equation 4, and here the actual GDP (Y) has been used as a proxy for A=absorption (A). The lagged dependant variable is also included here.
ΔlogPt = – αλη + λ log RER t-1 + αελ (log Y- log Y*) + (1-α) Δ log Pt* + (1-α) Δ log Et + βΔlog Pt-1
One of the important features of the Kamin’s model is that the extended version of the Phillips curve model is represented here and the foreign price volatility affects the domestic price in the economy so a part of domestic inflation is imported (Toulaboe and Terry, 2014). But some of the important determinants of inflation like fiscal and monetary policy measures are not included in the model.
Conclusion:
In conclusion it can be said that the choice of exchange rate regime is one of the critical decisions that needs to be taken by the economic agents as it can affect the inflation rate of the economy. In this assignment a model has been presented to show the impact of exchange rate regime on the inflation of the economy.
There is debate regarding the effectiveness of each of these regimes for generating better outcomes for the economy.
Where one group believes that a fixed exchange rate can be beneficial for the economy as it can lower inflation, another group believes that the economy can perform better in the long run if a flexible rate is implemented. However, it is evident that the exchange rate regime affects inflation in the economy.
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