Exchange Rate Volatility at the EMU Periphery

May 2008 Gunther Schnabl, Leipzig University & CESIfo 1

Exchange Rate Stabilization and Growth in Small Open Economies at the EMU

Periphery

Gunther SchnablLeipzig University & CESifo

University of Münster

Münster, 29 May 2008


Exchange Rate Volatility at the EMU Periphery


Exchange Rate Volatility at the EMU Peripheryand East Asia


Exchange Rate Volatility at the EMU PeripherySub-Samples

1,0%

1,5%

2,0%

2,5%

3,0%

3,5%

4,0%

4,5%

5,0%

Jan-94 Jan-96 Jan-98 Jan-00 Jan-02 Jan-04 Jan-06 Jan-08

perc

ent

euro

dollar

EMU Periphery

0,0%

0,5%

1,0%

1,5%

2,0%

2,5%

3,0%

3,5%

4,0%

4,5%

5,0%


perc

ent

euro

dollar

Emerging Europe

0,0%

0,5%

1,0%

1,5%

2,0%

2,5%

3,0%

3,5%

4,0%

4,5%

5,0%


perc

ent

euro

dollar

Non-EMU Developed Europe

0,0%

0,5%

1,0%

1,5%

2,0%

2,5%

3,0%

3,5%

4,0%

4,5%

5,0%

Jan 94 Jan 96 Jan 98 Jan 00 Jan 02 Jan 04 Jan 06 Jan 08

perc

ent

euro

dollar

CIS

0,0%

0,5%

1,0%

1,5%

2,0%

2,5%

3,0%

3,5%

4,0%

4,5%

5,0%

Jan 94 Jan 96 Jan 98 Jan 00 Jan 02 Jan 04 Jan 06 Jan 08

perc

ent

euro

dollar

Mediterranean Countries

0,0%

0,5%

1,0%

1,5%

2,0%

2,5%

3,0%

3,5%

4,0%

4,5%

5,0%


perc

ent

euro

dollar

East Asia


Table of Content

1. Exchange Rate Regime and Growth2. Balassa-Samuelson and Exchange Rate

Regime3. Adjustment on the Nominal Appreciation Path4. Empirical Evidence5. Outlook


1. Exchange Rate Regime and Growth

Mixed empirical evidence• Ghosh, Gulde and Wolf (2003): weak evidence that exchange

rate stability affects growth in a positive or negative way (large sample).

• Edwards and Levy-Yeyati (2003): countries with more flexible exchange rates grow faster (large sample).

• Eichengreen and Leblang (2003): strong negative relationship between exchange rate stability and growth for 12 countries over a period of 120 years.

• Aghion et al. (2006): Positive impact of the exchange rate stability and growth for countries with underdeveloped financial sectors.

• De Grauwe and Schnabl (2005): Positive impact of the exchange rate stability on growth for the EU new member states.

Alternative approach (EMU periphery sample)• Countries in the economic catch-up process (underdeveloped

financial sectors)• with (mostly) open capital accounts.


2. Balassa-Samuelson and Exchange Rate Regime

ii iiii LKAY 1)()( with 0 < i < 1 and i = T, NT (1)

i

i

i

ii

P

W

L

Y )1(

WWW NTT

T

NT

NT

T

P

P

Q

Qc

(perfect markets and profit maximization)

(perfect labor mobility)

(relative productivity gains imply relative increase of non-traded goods prices)


Policy OptionsPurchasing power parity

Pegging the exchange rate and higher inflation

Inflation close to the EMU level and nominal appreciation

T

NT

EATE

NT

NT

T

P

P

EP

P

Q

Qc

/*

EATE

NT

NT

T

EP

P

Q

Qc

/*

TEEA

TA PEP */ (real appreciation)

„pathological appreciation pressure“


3. Adjustment on the Nominal Appreciation Path

Trade and capital flows as (standard) transmission channels

• both micro- and macroeconomic dimensions

Sustained appreciation expectations affect• adjustment of labour markets• adjustment of asset markets• monetary policy decision making

Kinds of uncertainty• exchange rate risk (trade and capital flows)• labour and capital market adjustment

– wage bargaining– international asset market equilibrium

• macroeconomic stabilization – stop-and-go in monetary policies– fiscal policies and structural reforms


Adjustment of Labour MarketsLindbeck (1979) model of wage adjustment• with fixed rates workers bargain for productivity

gains• starting in the tradable sector (extending to non-

tradables)• uncertainty is less if exchange rates are fixed

Equilibrium in labor markets • constant productivity and prices in the anchor

country• • with fixed exchange rate (ê=0, =0)• with flexible exchange rates (ê < 0, < 0)

Stylized adjustment pattern under a free float • in addition to predictions of productivity growth (and

inflation)• exchange rate appreciation has be predicted (ê < 0)• enterprises are less eager to increase real wages• in average real wage increases will be less

)ˆ()ˆ(ˆ eEqEw)ˆ(ˆ qEw)ˆ(ˆ qEw


Japan: Wage Growth and Inflation Differential with US

-10%

-5%

0%

5%

10%

15%

20%

1950

1952

1954

1956

1958

1960

1962

1964

1966

1968

1970

1972

1974

1976

1978

1980

1982

1984

1986

1988

1990

perc

ent

-20

60

140

220

300

380

yen/

doll

ar

wage growth differential

inflation differential

yen/dollar


Adjustment of Asset MarketsForward-looking asset markets • sustained appreciation expectation affect interest rates• exchange rate volatility implies a positive risk premium

()

Augmented equilibrium in international assets markets

• i = i€ + ê + • i = i€ with fixed exchange rates (ê = 0, = 0)• i < > i€ with flexible exchange rates (ê<> 0, > 0)

“Stylized” adjustment pattern of monetary policy• domestic monetary policy tar gets (inflation targets)• exchange rate appreciation (ê < 0)• slow-down of economic growth • (partially) unsterilized intervention or interest rate cuts• stop-and-go in monetary policy making• increasing uncertainty (risk premium)


Short-Term Interest Rates in Bulgaria and Poland

PLBU pp ˆˆ


Short-Term Risk Premia in the New Member States

(1999-2007)


4. Empirical EvidenceTheoretical and empirical evidence has

remained mixed

Sample and Observation Period• Fragmented cross-country panel for 41 EMU

periphery countries– 17 central, eastern and southeastern countries (€)– 6 non-euro area industrialized European countries (€)– 9 CIS countries ($, €)– 9 Mediterranean countries ($, €)

• Observation period– 1994-2005

Volatility Measures• volatility around a constant level (standard

deviation σ)• the trend of the exchange rate path (mean μ)• Z-score (Ghosh, Gulde and Wolf 2003) as a

measure of both• year-over-year percent changes ()• against the dollar, euro and both (min)


Model Specification

Growth is explained by• exchange rate volatility measures (, , z, )• transmission channels

– interest rates (short-term)– exports (percent changes)– macroeconomic stability (inflation)

• dummies– inflation targeting– crisis (1998, 2001)

• capital controls (financial account + errors & omissions)

Estimation model and method• .• GLS / GMM

itiitiit vw '


EMU Periphery Sample 1994-2005 (min) (GMM)

(1) (2) (3) (4) (5) (6)

Growth (-1) 0.085*** (0.017)

0.114*** (0.015)

0.063** (0.029)

0.074** (0.033)

0.305*** (0.015)

0.296*** (0.015)

Standard deviation -0.255*** (0.034)

-0.198*** (0.021)

-0.029 (0.023)

Yearly change 0.013*** (0.003)

0.004* (0.002)

-0.022*** (0.001)

Z-score -0.144*** (0.016)

-0.147*** (0.017)

-0.201*** (0.015)

Interest rate -0.156*** (0.009)

-0.127*** (0.003)

-0.126*** (0.008)

-0.115*** (0.007)

Export growth 0.017*** (0.002)

0.013*** (0.001)

0.011*** (0.001)

0.009*** (0.001)

0.018*** (0.002)

0.023*** (0.001)

Inflation -0.002 (0.003)

-0.002*** (0.001)

-0.016*** (0.001)

-0.015*** (0.001)

Inflation target -0.012*** (0.004)

-0.015*** (0.005)

-0.009*** (0.004)

-0.006 (0.004)

-0.021*** (0.006)

-0.023*** (0.007)

Crisis -0.000 (0.000)

-0.000 (0.000)

-0.000 (0.001)

0.001 (0.001)

0.002*** (0.000)

0.002** (0.001)

Constant -0.000** (0.000)

-0.000 (0.000)

0.000 (0.000)

0.000 (0.000)

0.001*** (0.000)

0.001*** (0.000)

Observations 349 349 360 360 387 387 Number of id 40 40 41 41 40 40 Sargan test Chi² 32.71 35.64 33.64 35.33 36.84 33.56 Prob > Chi² 1.000 1.000 1.000 1.000 1.000 1.000


Emerging Europe 1994-2005 (Min) (GMM) (1) (2) (3) (4) (5) (6)

Growth -0.114 (0.15)

0.049 (0.015)

-0.025 (0.096)

0.038 (0.080)

-0.048 (0.226)

0.254* (0.149)

Standard deviation -0.407 (0.649)

-0.903*** (0.116)

-0.019 (0.639)

Yearly change 0.004 (0.030)

0.033*** (0.010)

-0.029* (0.011)

Z-score -0.373 (0.274)

-0.605*** (0.017)

-1.059*** (0.365)

Interest rate -0.084 (0.071)

-0.098*** (0.037)

-0.189*** (0.039)

-0.106*** (0.027)


0.088*** (0.021)

0.059*** (0.007)

0.045*** (0.009)

0.089*** (0.018)

0.083*** (0.016)

Inflation -0.019 (0.036)

-0.052*** (0.017)

-0.075** (0.039)

-0.007 (0.021)

Inflation target -0.006 (0.009)

-0.003 (0.006)

0.000 (0.008)

-0.003 (0.006)

-0.002 (0.007)

0.004 (0.007)

Crisis 0.000 (0.000)

-0.001 (0.002)

-0.003 (0.003)

-0.001 (0.003)

-0.001 (0.003)

-0.005 (0.003)

Constant 0.000 (0.000)

-0.002 (0.001)

-0.002* (0.001)

-0.002 (0.001)

-0.000 (0.001)

-0.001 (0.001)

Observations 153 153 153 153 164 164 Number of id 17 17 17 17 17 17 Sargan test Chi² 8.66 10.23 13.82 13.71 10.07 11.08 Prob > Chi² 1.000 1.000 1.000 1.000 1.000 1.000


Non-EMU Industrialized Europe 1994-2005 (Min) (GLS)

(1) (2) (3) (4) (5) (6)

Standard deviation -0.415 (0.518)

-0.509 (0.499)

-0.214 (0.560)

Yearly change -0.014 (0.035)

-0.017 (0.037)

-0.002 (0.038)

Z-score -0.361 (0.462)

-0.530 (0.433)

-0.113 (0.497)


-0.132 (0.143)

0.033 (0.141)

0.033 (0.142)

Export growth 0.044 (0.018)

0.043 (0.018)

0.030 (0.019)

0.029 (0.019)

Inflation -0.348 (0.247)

-0.364 (0.244)

-0.401 (0.268)

-0.409 (0.265)

Inflation target 0.000 (0.005)

0.000 (0.005)

-0.002 (0.005)

-0.002 (0.005)

-0.007 (0.005)

-0.007 (0.005)

Crisis 0.011*** (0.004)

0.011*** (0.003)

0.010*** (0.003)

0.010*** (0.003)

0.009** (0.004)

0.009** (0.004)

Capital flows 0.161*** (0.048)

0.159*** (0.048)

0.141*** (0.043)

0.143** (0.042)

Constant 0.031*** (0.007)

0.037*** (0.006)

0.034*** (0.005)

0.034*** (0.005)

0.033*** (0.006)

0.033*** (0.006)

Observations 68 68 72 72 68 68 Number of id 6 6 6 6 6 6 R² within 0.399 0.396 0.276 0.278 0.273 0.271 R² between 0.189 0.208 0.260 0.247 0.266 0.261 R² overall 0.341 0.343 0.250 0.246 0.094 0.099


CIS 1994-2005 (Min) (GLS) (1) (2) (3) (4) (5) (6)

Standard deviation -0.590* (0.314)

-0.672*** (0.238)

-0.764*** (0.251)

Yearly change 0.068* (0.038)

0.009 (0.012)

0.084** (0.032)

Z-score -0.049 (0.089)

-0.421*** (0.102)

-0.139 (0.088)

Interest rate -0.194*** (0.035)

-0.213*** (0.034)

-0.175*** (0.034)

-0.189*** (0.035)

Export growth 0.045** (0.021)

0.031 (0.019)

0.048** (0.019)

0.033* (0.019)

Inflation -0.026* (0.013)

-0.012 (0.011)

-0.019 (0.012)

0.013*** (0.004)

Crisis -0.007 (0.008)

-0.003 (0.008)

0.004 (0.015)

0.005 (0.015)

-0.009 (0.008)

-0.002 (0.008)

Capital flows -0.074 (0.061)

-0.057 (0.061)

-0.049 (0.115)

-0.037 (0.114)

Constant 0.099*** (0.009)

0.097*** (0.009)

0.059*** (0.012)

0.056*** (0.011)

0.093*** (0.008)

0.088*** (0.008)



Mediterranean Countries 1994-2005 (Min) (GLS)

(1) (2) (3) (4) (5) (6)

Standard deviation 0.062 (0.337)

0.069 (0.279)

0.254 (0.279)

Yearly change -0.004 (0.086)

-0.023 (0.073)

-0.066 (0.062)

Z-score 0.043 (0.134)

-0.014 (0.109)

-0.016 (0.114)


-0.104 (0.204)

-0.175 (0.148)

-0.158 (0.148)

Export growth -0.005* (0.008)

-0.005 (0.008)

-0.005 (0.007)

-0.006 (0.007)

Inflation 0.072 (0.149)

0.071 (0.147)

0.096 (0.108)

0.044 (0.096)

Inflation target -0.036 (0.025)

-0.036 (0.025)

-0.036* (0.020)

-0.035** (0.020)

-0.043** (0.021)

-0.045** (0.021)

Crisis 0.006 (0.008)

0.006 (0.008)

0.003 (0.007)

0.003 (0.007)

0.004 (0.007)

0.002 (0.007)

Capital flows 0.126 (0.109)

0.127 (0.106)

0.125 (0.084)

0.128 (0.083)

Constant 0.049*** (0.015)

0.049*** (0.014)

0.041*** (0.005)

0.042*** (0.005)

0.053*** (0.009)

0.056*** (0.009)



East Asia 1980-2005 ($) (GLS) (1) (2) (3) (4) (5) (6)

Standard deviation -0.486*** (0.122)

-0.658*** (0.104)

-0.627*** (0.116)

Yearly change 0.074*** (0.017)

0.074*** (0.019)

0.071*** (0.017)

Z-score -0.156 (0.104)

-0.400*** (0.089)

-0.323*** (0.098)

Interest rate 0.039 (0.079)

-0.000 (0.083)

0.126* (0.074)

0.099 (0.076)


0.137*** (0.018)

0.154*** (0.016)

0.152*** (0.172)

Inflation -0.093* (0.052)

-0.133** (0.055)

-0.091* (0.049)

-0.124** (0.051)

Inflation target 0.002 (0.008)

-0.009 (0.008)

-0.000 (0.007)

-0.007 (0.007)

0.003 (0.008)

-0.007 (0.008)

Crisis -0.032*** (0.009)

-0.029*** (0.010)

-0.036*** (0.010)

-0.031*** (0.011)

-0.027*** (0.008)

-0.025*** (0.008)

Capital flows 0.135*** (0.035)

0.147*** (0.037)

0.120*** (0.039)

0.122*** (0.041)

Constant 0.049*** (0.006)

0.055*** (0.007)

0.067*** (0.003)

0.069*** (0.003)

0.044*** (0.006)

0.049*** (0.006)



5. Conclusion• The panel estimations for the EMU periphery

provide strong evidence in favour of a negative impact of exchange rate volatility on growth.

• This result is independent from the anchor currency. • Trade, capital flows and macroeconomic stability

are important transmission channels from exchange rate stability to growth.

• The effects are most pronounced for Emerging Europe which has widely dismantled capital controls.

• For the industrialized European countries exchange rate stability seem to matter less.

• The effect is less pronounced for the Mediterranean countries where financial repression and capital controls prevail.

• Introducing East Asia into the sample strengthens the evidence in favour of a positive impact of exchange rate stability on growth.


Thank you for your attention!

Münster, May 29 2008

Documents

Exchange Rate Volatility at the EMU Periphery