The first chapter of Trade and Competitiveness in Argentina, Brazil and Chile analyses how exchange rate regimes have affected the relative price of tradables to non-tradables and factor allocation in A-B-C and Mexico from 1990 to 2002. This relative price, also referred to as the real exchange rate, showed a bell-shaped form in all countries that introduced, and finally abandoned, a fixed exchange rate regime. In all four countries fixed exchange rates were introduced to different degrees in the late 1980s-early 1990s in order to overcome hyper- or double-digit inflation.
Large swings in ratio of prices indices of non-tradables to tradables (1)
1. PPI for tradables and CPI for non-tradable.
Source: National sources, see Annex 1.A2.
Being mostly price-takers (under the law of one price), tradable goods producers were forced to stem price increases of their products due to the fixed exchange rates. In contrast, non-tradable producers faced no international competition and had fewer incentives to control their output prices. The combined result was a steep rise of the relative price of non-tradables to tradables. Except in Chile, this effect was exacerbated by the entry of substantial inflows of portfolio capital. These contributed to higher final demand, which in turn caused increasingly higher prices of non-tradables compared to tradables. With the demise of fixed exchange rate regimes, the currencies strongly depreciated, capital fled and relative price trends reverted, at least for some time.
The model used by the authors to assess the importance of these changes in exchange rate regimes relative to other factors explaining relative price movements incorporates the traditional Balassa-Samuelson effect, together with short and medium term demand effects such as government expenditure and terms of trade. In this framework, fixed exchange rate regimes affect the price of tradables through the law of one price and that of non-tradables via capital inflows.
The econometric results show that Chile's monetary policies were the most neutral. Exchange rate management, before floating in 1999, was in reality very flexible. Moreover, Chile succeeded in preventing excessive short-term capital inflows. In contrast, in Argentina and Brazil, the fixed exchange rate regimes did distort relative prices, this effect being exacerbated by large portfolio capital inflows during the fixed exchange regime period. The other variables 'explaining' relative price movements are the Balassa-Samuelson effect (all countries), government expenditure (Brazil and Mexico) and terms of trade (Chile and Mexico).
Fixed exchange rate regimes, via their impact on relative prices, also affected the allocation of resources. During the fixed regime periods in A-B-C and Mexico, the share of the tradable sector in employment fell more than proportionally. This reallocation is also visible in terms of GDP shares. Exchange rate regimes, via their impact on relative prices, also altered the composition of the tradable sector. Although the share of agriculture and mining seems mostly unaffected by exchange rate regimes, the size of manufacturing was negatively (positively) affected by fixed (flexible) regimes.
Share of tradables in employment fell more rapidly during fixed exchange rate regimes
Source: National sources, see Annex 1.A2.
Exchange rate policies should be carefully gauged in terms of their impact on relative prices, the structure of the economy and the development of the tradable sector. When a fixed regime is adopted, it is difficult to create enough flexibility elsewhere in the economy in order to compensate for this source of rigidity (see chapter 5).
See also Baldi and Mulder,"The impact of exchange rate regimes on real exchange rates in South America, 1990-2002," OECD Economic Working Paper No. 396, June 2004.
For further information contact the chapter co-author Nanno Mulder at email@example.com.
Return to the Trade and Competitiveness in Argentina, Brazil and Chile homepage.
The complete edition of Trade and Competitiveness in Argentina, Brazil and Chile is available from: