Intervention to smooth the economic adjustment pro...

Intervention to smooth the economic adjustment process

There may exist a rationale for the authorities to intervene in the foreign exchange market to achieve a preferable exchange rate in the short run to permit a smoothing of the necessary adjustments that the economy must for various reasons undergo.The rationale for smoothing the adjustment process is that it is a painful process for those who have to adjust and is more acceptable at a controlled pace than a market-determined one.

Suppose that a country has a persistent balance-of-payments surplus because the traded goods sector is too large relative to the non-traded sector.There will consequently be a tendency for an appreciation of the real exchange rate which will encourage factors to move from the traded goods to the non-traded goods sector.If the authorities are concerned about the possibility of large transitional unemployment resulting from such an appreciation, they may try to moderate the appreciation to allow time for the traded goods sector to contract and the non-tradable sector to expand, so as to avoid what they consider to be excessive transitional unemployment costs.Corden (1982)has coined the phrase “exchange rate protection” to describe an exchange-rate policy whereby a country protects its tradable goods sector relative to the non-tradable sector by either devaluing the real exchange rate, allowing the exchange rate to depreciate by more than it otherwise would, or preventing an exchange-rate appreciation that would otherwise take place.

The preceding case is only one variant of the need to switch resources in the economy; another may occur when the tradable sector itself is divided into “booming” and “lagging” sectors.The booming sector will cause the real exchange rate to have a tendency to appreciate and in so doing will speed up the demise of the lagging sector.In either of the two cases cited, the case for exchange-rate protection is clearly linked to the speed at which adjustment can take place, be it between the traded and non-traded sector or within the tradable sector.

Exchange market intervention can slow down the necessary adjustment such as tariff protection.This is because exchange-rate protection, which involves influencing the real exchange rate, and the accumulation of reserves, must necessarily be a temporary method of protection; whereas tariffs and subsidies have a habit of becoming permanent features and because of their explicit protective nature tend to invite retaliation.Nevertheless, it is difficult to say that either form of protection is to be preferred, for while tariffs distort production patterns within the tradable sector in favor of the lagging (protected)sector, exchange-rate protection protects all tradable whether they require assistance or not, and it could be argued that because it is a more widespread means of protection it is more likely to invite retaliation.

Another rationale for intervention may exist if the economy is caught in a “vicious circle”.Consider, for example, a country experiencing for whatever reason a current account deficit that it is trying to eliminate by permitting the depreciation of its currency.If wages adjust fully and instantaneously to the increased domestic price level implied by such a policy, and the authorities adopt an accommodating monetary policy to avoid an increase in unemployment, the country will be back where it started.A further depreciation will be necessary and via the same process this will again lead the country back where it started; the country will be caught in a “vicious circle” of depreciation, price and wage rises, and further depreciation.Under such circumstances intervention in the foreign exchange market may serve to slow down or even avoid the spiral, allowing the authorities to adopt a more appropriate policy designed to bring about the necessary reduction in real wages, or to await productivity improvements in the economy which means that real wages do not have to fall.

It should be noted, however, that the real issue behind the vicious-circle argument for intervention concerns the effectiveness of different policy instruments in bringing about the ultimate reduction in real wages that is essential for adjustment (in the absence of productivity improvements), while minimizing the harmful consequences for other macro-objectives such as the maintenance of full employment and reasonable price stability.Here one should recall Keynes’ argument that price changes may prove a more acceptable method of reducing real wages because they hit the labor force more or less equally and by so doing do not upset to any great extent wage differentials.The alternative policy of deflation may prove a more painful process of reducing real wages, especially with regard to the employment objective, because it may require a large rise in unemployment before the principle of real wage cuts is accepted by the labor force.Thus, there may be a case in the vicious-circle argument for government intervention to slow down the rate of depreciation so that real wages are reduced only gradually at a more accepted pace.

Before concluding this section, it is worth emphasizing that the adjustment arguments advances for exchange-rate management involve smoothing the adjustment process, not preventing it.Ideally, the exchange rate should be allowed to adjust towards its equilibrium rate at an optimum pace, the determination of which is clearly a policy problem.It is the acceptance of the principle of exchange-rate adjustment that ensures that the required changes in the economy do take place.