FRBSF Economic Letter
2004-22; August 20, 2004
Measuring the Costs of Exchange Rate Volatility
Many countries go to great lengths
to manage their exchange rates. Probably the most prominent recent
example is the European Monetary Union, where all the members abandoned
their national currencies and adopted the euro. A number of developing
countries maintain other kinds of regimes of managed exchange rates,
even though they face potent market pressures to let their exchange
rates float. One of the main motives for these arrangements stems
from the extreme volatility of exchange rates. This volatility
introduces an element of uncertainty into doing business across
borders. Arguably, this uncertainty hinders international trade
and, therefore, takes a toll in terms of economic welfare.
Recent work in economics has turned to re-examining the question
of whether having a stable exchange rate is worth these efforts.
This research has used new tools to assess the economic welfare
costs of exchange rate volatility. Specifically, the aim is to
measure the costs of exchange rate volatility as a loss in the
utility that people expect on average over time. This Economic
Letter summarizes this literature and draws preliminary conclusions.
How to approach the issue
Attempting to measure the welfare costs of exchange rate variability
requires a theoretical model with some key features. First, it
must specify the objectives of the people in the economy, as they
decide about how much time to devote to work and how much money
to spend on consumption. Summarizing these objectives formally
in a utility function has the benefit of providing a means of measuring
whether people are better or worse off. The typical utility function
assumes that people like both consumption and leisure and that
the more they get of them, the higher their utility. But people
also know that consumption and leisure are part of a tradeoff—to
increase consumption they have to give up some leisure time and
devote it to work, and vice versa. People also balance enjoying
consumption now against enjoying it in the future, and models generally
imply that people prefer to consume roughly the same amounts in
all periods rather than a lot in some periods and less in others.
Second, a model must specify the objectives of firms that produce
and sell goods. Typically, firms are viewed as simply hiring workers
at a going wage rate to produce output, which then is sold in either
domestic or foreign markets. Key to the analysis is an understanding
of the frictions and imperfections in economic markets. For example,
the typical friction assumed is that firms must set prices before
they know what conditions will prevail in the market; they then
must adjust production to meet the level of demand for their good,
given the preset price. This realistically captures how firms operate
in many markets, for example, automobiles and durable goods.
Combining these features in a theoretical model suitable for welfare
analysis is a technical challenge, because the model must be solved
so as to retain the elements that form the basis for how risk affects
behavior. Only in the last few years have theorists developed methods
for examining these issues.
Exchange rate volatility may be
costly for welfare
Leading the search into this issue was a paper by Obstfeld and
Rogoff (1998). Their theoretical analysis finds that exchange rate
volatility could lower welfare through both direct and indirect
channels. The direct channel has been understood for some time.
It is based on the assumption that people have a distaste for fluctuations;
in other words, they would choose a constant value of consumption
over an uncertain value that is sometimes higher and sometimes
lower.
For example, take the case of a domestic firm that sets a price
in terms of its own currency for goods that it exports abroad.
If the domestic currency appreciates, it implies that the price
the foreign consumer faces in terms of his own currency is higher
than the exporting firm intended. As a result, demand will be lower
than planned, so the domestic firm will hire less labor; in turn,
domestic workers will earn less and likely will have less consumption.
Of course, the domestic currency also may depreciate, implying
that consumption would then likely rise rather than fall. But averaging
over cases of currency appreciation and depreciation, people are
less happy overall because they don't like fluctuations in their
consumption and leisure.
The indirect channel by which exchange rate volatility can lead
to welfare loss is a new result. If firms that preset prices understand
the risks of future exchange rate movements, they will try to hedge
against those risks. When setting the price for their good, they
will attach a risk premium as an extra markup to cover the costs
of fluctuations. This higher price dampens demand, production,
and, hence, consumption to levels that are less than optimal for
society.
The indirect channel provides a more compelling reason to expect
exchange rate volatility to have a negative effect on economic
welfare. The significance of the welfare losses via the direct
channel depends on the particular form of a person's utility function
and on whether consumption volatility per se should be assigned
a large weight, issues that may be debatable. But everyone can
agree that a lower average level of consumption via the indirect
channel will make people worse off. Such a negative effect could
be a reason for a central bank to adopt a fixed exchange rate regime.
More recent results: volatility
may be benign or even beneficial…
Several papers have extended the work of Obstfeld and Rogoff by
introducing different characteristics into the model and have argued
that the volatility of exchange rates may not always imply negative
welfare effects. Devereux and Engel (2003) examined the case where
prices are not fixed in the currency units of the exporter, but
instead they are set in the currency units of their foreign customers.
This case is well grounded in reality, especially when firms sell
to a large market, such as the U.S.; for example, it is not uncommon
for Japanese firms to invoice their exports in dollars. In this
case, the consumer is not affected by exchange rate volatility.
A second extension looks at different preferences. Bacchetta and
van Wincoop (2000) consider a case where consumption and leisure
are complements, not substitutes, in utility. In other words, people
derive more happiness from consumption when it is combined with
extra leisure time; for example, the welfare benefit of buying
a sailboat is greater when there is more time to sail.
To explore this case, the authors focus on monetary policy changes
as a source of exchange rate volatility and on how those shocks
affect other elements in the economy as well. For example, when
the Fed eases monetary policy, the value of the U.S. dollar tends
to fall against other currencies, so the policy change generates
more volatility. At the same time, the easing tends to stimulate
the U.S. economy. As a result, U.S. consumption and production
increases and leisure decreases. Since consumption and leisure
are viewed as complements in utility in this scenario, the decline
in leisure dampens the welfare gains associated with greater consumption.
But there is more to the scenario, because one also has to factor
in the way monetary policy changes from abroad affect exchange
rates and the domestic economy. Of course, when a foreign central
bank is trying to maintain a fixed rate regime vis-à-vis
the U.S., it essentially would have to mimic U.S. policy changes,
so that would only serve to intensify the effects in the scenario
above. In other words, the foreign central bank would also ease
policy, stimulating its domestic demand for all goods, including
imports from the U.S., which then would increase U.S. production
and reduce U.S. leisure even more. But when a foreign central bank
maintains a flexible exchange rate regime vis-à-vis the
U.S., its policy is independent of U.S. policy, and its policy
changes may lessen the extent to which consumption and leisure
move in opposite directions. For example, contractionary Japanese
monetary policy lowers consumption in Japan without much effect
on U.S. consumption. But if Japanese consumers purchase U.S. exports,
Japanese policy may lower the demand for U.S. goods and hence,
lower U.S. production and increase leisure. Everything works in
the opposite direction, of course, when the Japanese follow an
expansionary policy. But the point is that the Japanese action
either way has no impact on U.S. consumption and thereby weakens
the link between consumption and leisure. Thus, a monetary policy
change by a foreign central bank can increase volatility in the
exchange rate and also have a positive effect on utility on average,
because it means that a rise in consumption does not always imply
a decline in leisure. This result provides an example that a higher
degree of exchange rate variability may be associated with higher
rather than lower economic welfare.
…and, the costs
may be small
Another reason to doubt the costliness of exchange rate variability
comes from quantitative studies of the issue. One early such investigation
is Bergin and Tchakarov (2003). This paper fleshes out the theoretical
models used above with additional economic features that are thought
to be important for realism. These include more general forms for
consumers' utility, more general specifications for production,
and imperfect asset markets. The model is able to reflect key facts
about the macroeconomy of a country, so it produces predictions
that can be taken more seriously in a quantitative sense.
The main quantitative finding is that the welfare effects of exchange
rate volatility are likely to be very small for many countries.
When numbers are chosen to permit the model to reproduce basic
characteristics of the U.S. economy, the model indicates that the
loss of utility is equal in size to only about 0.1% of annual consumption;
that is, people would be willing to exchange only about 0.1% of
their annual consumption level to eliminate the exchange rate volatility
in the economy.
Two caveats to this conclusion are in order. First, it is possible
that countries with particular characteristics could face higher
costs. One example might be a country that depends heavily on international
trade, as do some of the small Asian economies, for which annual
exports exceed annual GDP. Another example might be the case where
international financial markets are not willing to purchase the
country's domestic currency debt; such countries may find it very
difficult to use financial markets to hedge against exchange rate
risk. But neither case affects the U.S. or other large developed
countries. Second, it is important to note that the welfare costs
analyzed here do not take account of the costs of economic adjustment
as labor and capital are reallocated within the economy in response
to the up and down movements of the exchange rate. Therefore, even
if the welfare costs of exchange rate volatility are small when
averaged over a country's whole population, they may fall especially
heavily on selected individuals and firms.
The general conclusion in the literature to date is that exchange
rate variability probably does not impose substantial overall costs
on the U.S. in terms of economic welfare. While further work should
be done, this conclusion is receiving support from recent theoretical
as well as quantitative exercises.
Paul Bergin
Associate Professor of Economics, U.C. Davis,
and Visiting Scholar, FRBSF
References
[URLs accessed August 2004.] Bacchetta, P., and E. van Wincoop. 2000. "Does
Exchange Rate Stability Increase Trade and Welfare?" American
Economic Review 90, pp. 1093-1109.
Bergin, P., and I. Tchakarov. 2003. "Does
Exchange Rate Risk Matter for Welfare? A Quantitative Investigation." NBER
Working Paper #9900. http://papers.nber.org/papers/w9900.pdf
Devereux, M., and C. Engel. 2003. "Monetary
Policy in the Open Economy Revisited: Price Setting and Exchange
Rate Flexibility." Review of Economic Studies 70, pp. 765-783.
Obstfeld, M., and K. Rogoff. 1998. "Risk
and Exchange Rates." NBER Working Paper #6694. http://papers.nber.org/papers/w6694.pdf
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