6. Monetary and exchange rate policy assignment

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Based on this review of exchange rate and monetary policies adopted by different Pacific island countries during the global economic crisis it is possible to sketch out a number of policy assignment benchmarks that seem to have relevance to the special circumstances that developed for a number of these countries during the crisis. (These benchmarks are based on unchanged fiscal policy69):

  1. Overvaluation. Significant and persistent overvaluation of the real exchange rate should be avoided.
  2. Devaluation. For a devaluation of the nominal exchange rate to successfully achieve and maintain a devaluation in the real exchange rate, nominal unit wage costs should be kept stable and monetary policy should be sufficiently tight to avoid second-round price increases arising from the devaluation. If nominal wages increase faster than prices and productivity, then inflation will be boosted further, the devaluation of the real exchange rate will be undone, real unit wage costs will increase, profits will drop and output could fall, taking the economy away from internal and external balance.
  3. Balance of payments difficulties. Assume GDP is contracting and foreign currency reserves are dropping through critically low levels. In this crisis situation monetary policy and exchange rate policy should be directed toward protecting reserves and external stability and maintaining adequate liquidity in the financial sector, rather than toward stimulating domestic demand and economic activity.
    • If the exchange rate is fixed but the trade and current account deficits are high and unsustainable, and inflation is higher than in trading partner countries, the exchange rate becomes increasingly overvalued as the real exchange rate rises. Any pre-existing trade and current account deficits increase, capital outflow takes hold and foreign currency reserves fall. As a band-aid measure a country might strengthen controls to restrict international capital movements and exchange transactions and to ration imports.
    • However, to (fundamentally) work out of these multiple problems - to lower inflation, bring inflation into line with inflation in trading partner countries, to reduce the demand for imports, to raise domestic savings and protect foreign currency reserves - monetary policy may need to be tightened. In order to take the weight off monetary policy (and to reduce the contraction in expenditure, activity and employment, and to speed up the adjustment process) the exchange rate may be devalued in an attempt to re-establish an equilibrium competitive exchange rate and switch activity toward traded goods activity.
    • If reliance is placed only on devaluation to solve the current account problem, substantially higher inflation could be the consequence. If reliance is placed solely on the tightening of monetary policy to address high inflation, capital outflow and the high current account deficit, the fall in expenditure and output, employment and living standards could all be substantial.
    • For some countries a mix of expenditure-reduction and expenditure-switching policies may be appropriate, accompanied by appropriate structural reforms aimed at improving competitiveness and export diversification. In combination these policy responses might be expected to return the economy closer toward external and internal balance over the medium term.
  4. Exchange rate regime. Many different considerations bear on the choice of exchange rate regimes, and no single regime is necessarily appropriate for all Pacific island microstates. Compared to a completely fixed exchange rate regime, an exchange rate arrangement that provides for more frequent and timelier exchange rate adjustment may be better able to absorb terms-of-trade shocks, counter structural weaknesses in the export sector, avoid overvaluation, protect competitiveness and maintain exports. However, slow supply-side responsiveness and limited diversification possibilities in Pacific island countries may limit the ability of flexible exchange rates to act as a short-run shock absorber. Compared to flexible exchange rate regimes, a fixed exchange rate regime appears to be associated with more disciplined macroeconomic policies and better inflation outcomes. The choice made between a tightly fixed exchange rate regime and an exchange rate regime that offers greater ability to more regularly adjust the exchange rate to address structural trade weaknesses, terms-of-trade changes and avoid exchange rate misalignments, hinges, in part, on judgements made about the relative benefits of short-term inflation control versus the maintenance of exchange rate competitiveness. Particularly for many Pacific island countries with high import dependency and low export performance, maintaining competitiveness is essential to securing adequate medium-term external balance.

69 Suffice to say here that large budget deficits may increase domestic demand, reduce savings and add to current account deficits. Reducing large budget deficits could contribute substantially to external account adjustments in Pacific island countries.