Political economy

To appreciate or depreciate? Policymakers face choices over the desired level of
the exchange rate. Governments cannot set the real exchange rate at will, but they can
affect trends in the real exchange rate over a period long enough to be of political and
economic significance – typically estimated at three to five years. Under all except fully
fixed-rate regimes, a government must decide whether it prefers a relatively appreciated
or a relatively depreciated currency. Although economists disagree about the determinants of the real exchange rate, we can identify a basic political-economy
tradeoff between competitiveness and purchasing power.
The real exchange rate affects the demand for domestic traded goods in local and
foreign markets; it also affects the purchasing power of those who earn the currency. A
real appreciation increases the purchasing power of local residents, by lowering the
relative price of foreign (and, more generally, tradable) goods. However, by making
domestic goods more expensive relative to foreign goods, it has a negative effect on the
“competitiveness” of local tradables producers. A real depreciation has the opposite
effects, reducing purchasing power but improving “competitiveness” by lowering the
price of domestically produced goods.
There is no clear economic guideline as to the appropriate level of the exchange
rate. A relatively depreciated currency encourages exports and expenditure switching
from imports to domestic goods, thereby boosting aggregate output. However,
depreciation can also have contractionary effects that follow from a higher price level.
While changes in real exchange rates have powerful effects on the national economy,
some positive and some negative, the net effect on overall national welfare is very hard to calculate.
The level of the exchange rate always has distributive consequences domestically,
implying a role for interest group politics. Export and import competing industries lose
and domestically oriented (nontradables) industries gain from currency appreciation
(Frieden 1991). Domestic consumers also gain as the domestic currency price of
imported (and tradable) goods falls, lowering the cost of living. Currency depreciations have the opposite effects, helping exporting and import competing industries at the
expense of domestic consumers and nontraded industries.
Many factors condition the currency preferences and political capabilities of
groups. For example, the degree to which tradable sectors are directly affected by
exchange rate changes affects their sensitivity to currency movements. Where importcompeting firms faced by an appreciation of the home currency are able to keep their
prices high – typically because foreign producers do not in fact “pass through” the
exchange rate change into prices chargedto local consumers – they will be less concerned by such an appreciation (this is typically the case for specialized, highly differentiated, products, such as automobiles). Tradables industries with high pass-through will be more sensitive to the relative price effects of currency movements than those with low passthrough, since their prices respond more directly to changes in exchange rates. By extension, the level of the exchange rate is likely to be more politicized in developing countries than in developed countries, since the former tend to produce standardized goods and primary commodities, for which pass-through is high. The extent to which an
industry relies on imported intermediate inputs will also determine whether it is harmed
or helped by appreciation. An industry with heavy dependence on imported inputs
relative to export revenue may actually see its profitability improve with appreciation
(Campa and Goldberg 1997).
A number of regularities about preferences over the currency level can be
identified. These are related to points made above about regime preferences. For
example, the argument that producers of simple tradables are relatively insensitive to
currency volatility complements the argument that they are very sensitive to the level ofthe exchange rate: producers of commodities and simple manufactures will prefer a
flexible regime and a tendency for a depreciated currency. On the other hand, the
argument that producers of complex and specialized tradables are very sensitive to
currency volatility complements the argument that they are relatively insensitive to the
level of the exchange rate: these producers will prefer a fixed regime. Capturing an
industry’s (or an entire nation’s) sensitivity to exchange rate changes involves measuring the extent to which it sells products to foreign markets, uses foreign-made inputs, and, more indirectly, competes with foreign manufacturers on the basis of price (Frieden, Ghezzi and Stein 2001).
Interest group activity on the level of the exchange rate varies greatly over time
and across country. Such activity faces substantial collective action problems, and
exchange rate policy is only one of a number of potential policy instruments of relevance
to affected groups. For example, traded goods industries have the option of lobbying for
industry-specific trade policies when the currency appreciates. Currency policy and trade
policy are close substitutes: a 10% real depreciation is equivalent to a 10% import tax
plus a 10% export subsidy. Hence, the tradables sector can organize on an industry-byindustry basis to seek trade barriers or export subsidies, thus mitigating the free rider
problem. (Stallings 1993). The panoply of interests in the exchange rate makes the political institutions within which they are expressed particularly important to explaining policy outcomes.
In the absence of some institutional structure, it is indeed hard to know how the cleavages implied by the competitiveness vs. purchasing power tradeoff map to politically relevant interest-group activity. Nor do the distributional effects of the real exchange rate on profits and wages translate into clear partisan political effects of the traditional left-right or labor-capital variety.
Whatever the institutional character taken by interest group and partisan political
pressures on the level of the exchange rate, elections and voting are likely to be of
particular importance. This is because the real exchange rate affects broad aggregates
like purchasing power, growth rates, and the price level, and these broad aggregates are
almost certainly relevant to elections.