Abstract
Exchange rate fluctuations have been particularly large since mid-2014, with the nominal effective exchange rate of the Dollar appreciating 22% between July 2014 and December 2016, well above normal fluctuation range. This article attempts to measure the impact of currency appreciation on domestic activity, accounting for the source of fluctuations. More specifically, by using the multi-country structural model NiGEM, we show that different types of exchange rate shocks can have different macroeconomic outcomes. Focusing on the period going from mid-2014 to December 2016, we show that the initial appreciation of the Dollar (from July 2014 to April 2015), coming from activity gaps and divergence in monetary policy expectations, choke 0.3 pp off US GDP growth, while the following phase of the currency appreciation, stemming from a fall in the Dollar risk premium would have been neutral, and even slightly positive, to US growth. When comparing the US with the euro area as regards the impact on growth, we get that the euro area is more sensitive than the US to a currency appreciation. As a result, a sustained rise in the currency could prove more challenging for the Euro area than for the US.
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Notes
- 1.
The Marshall-Lerner condition is fulfilled if a currency depreciation results in an improvement of the trade balance. It generally implies that the absolute sum of the long-term export and import demand elasticities is greater than 1. The paper considers the full Marshall-Lerner conditions, i.e. taking into account not just the sum of the export and import quantity elasticities, but also the reaction of export and import prices.
- 2.
In this article we use the 2010–2012 update of the trade matrix weights.
- 3.
The shocks are run independently. Exchange rate being calculated relative to the Dollar, the US risk premium shock is derived as a shock to all other economies in the model. The 5% subsequent rise in the NEER is equivalent to a 4% ex-post appreciation in real terms for both the Dollar and the Euro.
- 4.
Obviously the baseline is important for this type of exercise. At the time the simulations were implemented, the baseline scenario assumed a progressive rise in the FF rate, allowing some monetary space. As for the Euro area, official rates were assumed at zero over the simulation period, leaving no monetary space. The risk premium shock in the US leads to a 50 bp cut in policy rates, as the Central Bank responds to more slack in the economy. For a fair comparison with the EA (stuck at ZLB), we assume that interest rates are left unchanged in the risk premium shock. In the foreign demand shock scenario, US and EA official rates hardly move from the baseline; rather, the Dollar and Euro appreciation stems from lower official rates in shocked countries, pushing up the interest rate differentials in favour of the US and EA. The scenario described in Sect. 3, however, allows the Central Bank to react to the various shocks in order to reproduce in vivo the observed 2014–2016 episode.
- 5.
The shocks are run independently.
- 6.
Again, this is stronger than simulation results from the Fed SIGMA model. But the results are not fully comparable as baseline scenarios may be different.
- 7.
For example, in June 2015 the US Energy Department revised down its forecast for world oil consumption in 2016. Likewise, 2015 and 2016 GDP growth forecasts for Emerging market and developing economies were revised by −1.3 pp on average between the April 2014 and the October 2016 WEO, and by the same magnitude over the medium term.
- 8.
NiGEM being a quarterly model, shocks and model results are now expressed on a quarterly basis.
- 9.
A negative demand shock is implemented from 2015Q2 to 2016Q4 in China, Brazil, Russia, Turkey and South Africa, with domestic demand 2% lower than the baseline assumed at the time—amounting to a cumulated revision of −1.1% on GDP by the end of 2016, close to the revisions implemented by the IMF between April 2014 and October 2016 (see footnote 8). On top of the negative demand shock, higher currency risk premium are assumed on the aforementioned countries, excluding China (the Yuan being more or less pegged to the Dollar) but including other commodity producers such as Canada, Mexico and Norway. As a result, the risk premia on the Dollar and the Euro decline. Other assumptions for all simulation exercises are: agents are forward-looking; shocks are temporary; monetary policy reacts to changes in employment and activity gaps.
- 10.
However, policy uncertainties on tax reforms and infrastructure spending have prompted some reconsideration on the probability of a US fiscal boost. Indeed, the June 2016 Article IV on the US economy has seen a revision by the IMF of the US growth forecasts.
- 11.
According to equilibrium models of exchange rates, the Dollar would indeed be dis-aligned today, standing 10–20% above its equilibrium level according to the IMF June 2017 External Sector Report.
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Haincourt, S. (2018). The Nature of the Shock Matters: Some Model-Based Results on the Macroeconomic Effects of Exchange Rate. In: Ferrara, L., Hernando, I., Marconi, D. (eds) International Macroeconomics in the Wake of the Global Financial Crisis. Financial and Monetary Policy Studies, vol 46. Springer, Cham. https://doi.org/10.1007/978-3-319-79075-6_12
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