The Australian Economic Review, vol. 32, no. 2, pp. 172–4

The University of Melbourne, Melbourne Institute of Applied Economic and Social Research 1999Published by Blackwell Publishers Ltd, 108 Cowley Road, Oxford OX4 1JF, UK and

350 Main Street, Malden, MA 02148, USA

Sept.’70

Sept.’74

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-15

-10

-5

0

5

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15 Change in $US/$A

US minus Australian inflation

Figure 1 Exchange Rate Changes and US minus Australian Inflation

(quarterly changes)

1. Introduction

Since the Asian currency crisis began in 1997there has been renewed debate about the desir-ability of capital controls and other measures toreduce volatility in exchange rates and capitalflows. In this policy forum are presented fourpapers which give some background to this de-bate.

1

The first two papers, by Steven Husted,and by Mark Crosby and Graham Voss, providean overview of recent theoretical and empiricalwork on exchange rate determination. Hustedargues that the empirical work suggests thatreal exchange rates are essentially unpredict-able in the short and medium run, but are pre-

dictable in the longer run. Inflation differencesbetween countries predict nominal exchangerate movements at a horizon greater than threeyears, though not at shorter horizons. Anotherway of thinking about this is to imagine twocountries, one (home) having inflation always5 per cent above the inflation rate of the othercountry (foreign). The empirical evidence sug-gests that the average rate of depreciation of thehome currency over a period greater than threeyears will be around 5 per cent. However, ratesof depreciation on a month-to-month or year-over-year basis will be unpredictable. In the lit-erature this is described as purchasing powerparity (PPP), being a long-run phenomenon.

Policy Forum: Exchange Rates and Capital Controls

Exchange Rates and Capital Controls

Mark CrosbyDepartment of EconomicsThe University of Melbourne

Per cent change

Source

: DX database.

Crosby: Exchange Rates and Capital Controls 173

The University of Melbourne, Melbourne Institute of Applied Economic and Social Research

Husted suggests that this short- to medium-run volatility in exchange rates was not ex-pected when exchange rates began to be floatedafter the collapse of the Bretton Woods systemof fixed exchange rates in 1971. The then pre-vailing models of exchange rate determinationpredicted some exchange rate overshooting,but the subsequent variability of exchange ratesand their unpredictability were not expected.Both the unpredictability and the volatility areevident in Figure 1, which shows changes inthe $US/$A exchange rate and the inflation dif-ference between Australia and the UnitedStates. If PPP held exactly in each quarter thenthe two lines should be sitting on top of one an-other. Clearly this is not the case. Quarterly ex-change rate changes have much greatervariance than inflation differentials, and thetwo series are not highly correlated—the corre-lation is 0.09, significantly different from thecorrelation of 1 which would be observed ifPPP held at a quarterly frequency.

The paper by Crosby and Voss describessome recent theoretical research which at-tempts to explain these empirical facts. In par-ticular, general equilibrium sticky price modelsare used to explain the rigidity of tradablegoods prices in the face of exchange rate fluc-tuations, and hence the excess volatility of theexchange rate relative to inflation differentials.

The other two papers in this policy forumfocus on the issue of capital controls. Gordonde Brouwer outlines the literature in favour of,and in opposition to, capital controls, whileGuay Lim details the role played by hedgefunds in some recent exchange rate crises. Inhis prologue to a book on the Tobin tax (ul Haq,Kaul & Grunberg 1996) Tobin wrote that econ-omists showed little interest in his 1972 taxproposal until at least 1995. During this periodeconomists focused on means of freeing up,rather than limiting, flows of capital. However,some recent exchange rate crises, outlined byLim, have renewed interest in proposals tolimit these flows. Some prominent economists,most notably Paul Krugman (see

Australian Fi-nancial Review

24 August 1998),

2

have joinedTobin in calling for limits to capital flows todeveloping economies so as to avoid currencycrises. The Reserve Bank of Australia has

joined the chorus, with Grenville (1998) argu-ing that Chilean-style capital controls may berequired to augment the financial market re-forms required in developing countries to limitthe volatility of capital flows in the future.

2. Capital Controls for Australia?

Should Australia contemplate the introductionof capital controls of some form? My answer tothis would be an emphatic no. There is stillmuch debate about the potential role of capitalcontrols in developing countries, where thereasons for controls seem much more persua-sive. There is no question that floating ex-change rates bring short-run exchange ratevolatility. For capital controls to be beneficialhowever, we need to consider the followingquestions. Do capital controls really reduce thevolatility of capital flows and exchange rates?For example, a rule which required capital toremain in a country for a month will probablyreduce the weekly and monthly volatility offlows, but may not reduce the annual volatility.It is this volatility at the annual frequencywhich is presumably more relevant to ex-change rate determination and trade flows, andhence economic welfare. Relatedly, de Brou-wer points out that there is some debate inChile over whether controls on short-term cap-ital flows have in fact also reduced beneficiallonger term flows, while Dooley (1996) arguesthat there is no evidence that increasing trans-actions costs reduces speculation. A second ar-gument concerns the feasibility of capitalcontrols (see Kenen 1996 for an overview ofthe feasibility of a Tobin tax). Here it seemsthat it would be feasible for a country such asAustralia to introduce certain forms of capitalcontrols, but this would also increase the likeli-hood that policymakers would offer financialmarket players one-way bets on currency mar-kets.

A further question relates to the cost of ex-change rate volatility. The exchange rate issimply a price, and prices do not typically enterour social welfare functions. If exchange ratevolatility does not translate into real volatility,then there does not seem to be any reason to re-duce this volatility. Particularly since doing so

174 The Australian Economic Review June 1999

The University of Melbourne, Melbourne Institute of Applied Economic and Social Research

may in fact increase real volatility. The tradi-tional argument for flexible exchange rates isthat they limit real volatility by transmittingreal shocks into nominal, rather than real, fluc-tuations. Baxter and Stockman (1989) comparethe volatility of real variables under fixed andflexible exchange rate regimes, and find no dif-ference between real volatility under the differ-ent regimes. While this suggests that flexibleexchange rates do not seem to be buying muchin terms of reduced real volatility, it is also con-sistent with the idea that the higher exchangerate volatility is not increasing real volatility. Itseems that the links between exchange rate vol-atility and real volatility is a fruitful area forfurther research, and important to helping usunderstand the costs and benefits of capitalcontrols.

3. Conclusions

Over the last fifty years Australia has movedfrom exchange rates fixed to the British poundand the US dollar, to a pegged exchange rate,and eventually to a floating exchange rate. Thebenefits of a floating exchange rate have beenevident in the past eighteen months, when theAustralian dollar has exhibited large move-ments against our major trading partners in re-sponse to falling commodity prices and theanticipated impact of the Asian crisis on theAustralian economy. The depreciation of thedollar against European and the US currencyhas helped offset the impact of decliningAsian currencies and trade on Australian mar-kets.

What of a role for capital controls in Asianmarkets? There is little doubt that short-termcapital flows, pegged exchange rates and weakfinancial systems combined to precipitate theAsian crisis. As Grenville (1998) notes, there isno debate about the desirability of financialmarket reforms in countries such as Indonesia,Thailand and Malaysia. However, there is stillmuch debate about the desirability of capitalcontrols. In a sense, it seems that to introduce

capital controls now would be too little too late.The problem for Asian crisis countries in themedium term will be to attract capital, and re-strictions on the duration of flows will presum-ably not help this effort. The benefit of capitalcontrols is also reduced now that these coun-tries have flexible, rather than fixed, exchangerates—capital controls might be necessary toprotect a fixed exchange rate, but they are notnecessary when a country has a flexible ex-change rate.

February 1999

Endnote

1. The papers in this policy forum were pre-sented in two sessions of the 1998 Conferenceof Economists in Sydney, on the theme of mac-roeconomics in the global economy.

2. See his website http://web.mit.edu/krugman/www/ for further details.

References

Baxter, M. & Stockman, A. 1989, ‘Businesscycles and the exchange rate regime’,

Jour-nal of Monetary Economics

, vol. 23, pp.377–400.

Dooley, M. 1996, ‘The Tobin tax: Good the-ory, weak evidence, questionable policy’, in

The Tobin Tax: Coping with Financial Vola-tility,

eds M.

ul Haq, I. Kaul & I. Grunberg,Oxford University Press, New York.

Grenville, S. 1998, ‘Capital flows and crises’,

Reserve Bank of Australia Bulletin

, Decem-ber, pp. 16–31.

Kenen, P. 1996, ‘The feasibility of taxing for-eign exchange transactions’, in

The TobinTax: Coping with Financial Volatility,

edsM.

ul Haq, I. Kaul & I. Grunberg, OxfordUniversity Press, New York.

ul Haq, M., Kaul, I. & Grunberg, I. (eds) 1996,

The Tobin Tax: Coping with Financial Vola-tility

, Oxford University Press, New York.