Current account and exchange rate dynamics
THE 46th annual Caribbean Monetary Studies Conference is under way this week at the Central Bank of Trinidad and Tobago, under the theme, 'Macro prudential supervision, financial stability and monetary policy'.
Every year, the conference provides a high-quality discussion forum for aspects of macroeconomics, monetary policy and international financial economics for academics, professionals and central bankers. It is held in a different Caribbean country each year, and gives researchers the opportunity to present their work and engage in meaningful discussions on regional and global financial issues. I will present today.
What is the focus of my research paper?
My research, titled 'Current Account and Real Exchange Rate Dynamics in the Caribbean and Latin America', analyses the current account as a percentage of gross domestic product (GDP) interacting with the real effective exchange rate in response to temporary monetary shocks and permanent productivity shocks in Jamaica and four Latin American countries; Brazil, Chile, Costa Rica and Mexico. Data on the real effective exchange rates, the current account and real gross domestic product from 2005 to 2014 for all countries are regressed in appropriate econometric models to provide useful results.
Why is the issue relevant?
The relationship between current account and the exchange rate must be investigated thoroughly, since Jamaica, for example, has recently entered a new Extended Fund Facility arrangement with the International Monetary Fund. Recommenda-tions here imply that Jamaica can improve competitiveness by facilitating a depreciation of the exchange rate relative to the benchmark US dollar.
Jamaica's high propensity to consume foreign goods and services, with less to supply to the rest of the world, has resulted in continuous negative current-account balances. The usual policy recommendation to correct a weak current account position is to allow the exchange rate to depreciate to increase a country's competitiveness, such that the country's exports appear cheaper to foreigners and imports appear more expensive.
How should this work?
The increase in external prices should reduce the country's demand for foreign currency, given less demand for foreign goods with higher prices. At the same time, exports should increase as Jamaica's goods and services become cheaper to the rest of the world. This should gradually eliminate any discrepancy between imports and exports, resulting in an improved current-account balance. This approach, however, might present some problems if a country has inelastic demand for imports (oil, etc), if the country has high volume of imported inputs in its production process or if a country has high volume of debt denominated in foreign currency.
In this case, the price of domestic goods and debt servicing are direct functions of the exchange rate depreciation. The cost of finished goods increases as the exchange rate depreciates, mitigating any favourable price advantage it might have received.
What are my results?
For all five countries, the exchange rate appreciates over the first two quarters in response to a positive temporary monetary shock as the effect gradually disappears around the fourth quarter. As the exchange rate appreciates, the current account position improves marginally in Brazil, Chile, Jamaica and Mexico over the first couple of periods as the effect disappears after about four quarters. Costa Rica's current account position worsens in response to a temporary monetary shock, but the effect disappeared after about three quarters - similar to the other countries.
How does the exchange rate and current account respond to productivity shock?
The real effective exchange rate showed appreciation to a positive permanent productivity shock in Brazil, Chile, Jamaica and Mexico, but depreciated in Costa Rica. Additionally, the current-account balance for Brazil, Chile, Jamaica and Mexico improved in response to a positive permanent productivity shock. Our results pose a puzzle similar to the research of Lee and Chinn (2006) who found similar results for the G7 countries, except the US. The puzzle arises since it is expected that a current account should only improve when exchange rate depreciates based on economic theory; whether the shocks are interpreted as productivity shocks or the portion of monetary shocks that affect the current account. The data have revealed otherwise. This is not so in the Caribbean, Latin America and the G7 countries. Overall, the results have highlighted that a permanent positive shock to productivity can result in an improved exchange rate, as well as a better current account position not only in Jamaica but in Latin America and the G7 countries as well.
Dr André Haughton is a lecturer in the Department of Economics on the Mona campus of the University of the West Indies. Follow him on twitter @DrAndreHaughton, or email firstname.lastname@example.org.