2003 Reports

Exchange Rate Policy and Development

Williamson, John

This paper describes the Nominal Anchor Approach, the Real Targets Approach, and the Exchange Stability Approach to the formulation of exchange-rate policy, as presented by Max Corden. It argues that these approaches need to be supplemented by a fourth approach, which it terms the Development Strategy Approach, to represent the thought especially of Bela Balassa. The Development Strategy Approach regards choice of the exchange rate as a key strategic element in whether an economy will grow or stagnate. A growth strategy requires an exchange rate sufficiently competitive to motivate entrepreneurs to invest with the objective of going out and selling non-traditional exports on the world market. But it is silly to conclude from this, as some supporters of China's policies have done, that a more competitive exchange rate is always better for growth, and that currency revaluation is necessarily bad for growth. While the incentive to invest will necessarily be greater with a more competitive exchange rate, the ability to invest may be curtailed by a shortage of investible resources as real resources are diverted into a current account surplus and low-yielding reserve accumulation. Growth is maximized where the increased incentive to invest (demand side) is just balanced by the decreased ability to invest (supply side). The paper constructs a formal model to illustrate this trade-off. It also discusses the range of instruments that may help a government to limit the capital inflows that might otherwise threaten to produce an overvalued currency in good times, and it discusses the problem of inconsistent payments objectives that could arise in a world such as that portrayed.