Exchange rate policy, the real exchange rate, and inflation : lessons from Latin America

Exchange rate policy is usually driven by two different, often conflicting, objectives: to support a competitive real exchange rate and to serve as a nominal anchor for low inflation. The author focuses on whether exchange rate policy can affect the real exchange rate in the longer run, and examines the trade-offs that typically arise between real depreciation and inflation. The author argues that exchange rate policy has only a limited ability to achieve durable real depreciation. Devaluations can be effective in the short run, but have a limited impact in the longer run, when the underlying factors affecting demand and the supply of foreign exchange dominate. As a rule of thumb, the author argues that maxi-devaluations are most effective in economies with low and moderate inflation (below twenty percent a year), especially when the underlying causes call for real depreciation. Latin America is a rich laboratory in which to study different exchange rate regimes. The real exchange rate varies over time in countries that have adopted the crawling peg (such as Colombia and Brazil) and in those that use the exchange rate more actively for disinflation. Colombia in the mid-1980s is an example of successful real depreciation. Colombia achieved a 40 percent real depreciation in two years with no significant increase in inflation. This was achieved by avoiding maxi-devaluations and by limiting the size of the desired real depreciation.