Friday, October 12, 2007

Special interest ´s groups and economic policy

Economic policy is not neutral when it comes to analyze its distributional effect. A policy designed to reduce inflation ,in the short run might benefit some groups and hurt another. Those who get higher interest rate for their banks deposit are the “winners”, but those who lose their jobs because of unemployment increase are the “losers”. However the overall effect in the long run of such a right policy, is to increase the welfare level for all, because low inflation support economic growth. The same distributional analysis applies with taxes, exchange rates and fiscal expenditure.
These days ,there is a debate in Chile concerning the current level of the exchange rate level .The higher copper prices ,plus the interest rate differential between US and the Chilean economy(almost 100 bsp),has created such excess of foreign currency (dollars), at the rather small foreign exchange rate market, than the local currency (peso) has appreciated by roughly 6,5 %throughout the year 2007. There is also a similar situation in Brazil and Colombia.
Since the year 2000, the Central Bank has applied a “clean” flexible exchange rate policy ,allowing exchange rate instead of real variables and domestic activity, to absorb the effect of any external shock. However this free floating approach, means that sometimes exchange rates appreciates ,and sometime it depreciates.
When it appreciates consumers can get cheaper good from abroad , besides they can take more foreign vacation program. Producers can get capital good also at a cheaper price. On the other hand, the appreciation of local currency hurt exporters specially those who concentrate their export to markets in the US, assuming they export product with high price elasticity, which means substitutable products. Therefore there is a distributional effect which is no neutral because while one group win (consumers),the other one (exporter) loss . While consumers get the benefit ,exporter get the cost of the appreciation. Thus the local authority confront a cruel dilemma, which group should they support? . either one have their own weight for GDP growth , consumption on the one hand, export on the other hand. This is the reason because free floating exchange rate policy , develops the so called “fear of floating” , because there are no minor distributional effect with such fluctuations.-
But that is not the end of the story, exporters are better prepared than consumers to speak out . They are fewer than consumer, therefore they have lower transaction cost to get organize . So, they are in a better position to try to influence authorities to intervene in local markets to push exchange rate to depreciate. But if local authority do so, then economic policy is designed by special interest ´s groups, because any group with strong media influence to get their message across, will try to do the same . In such a case economic policy becomes discretionary, which no one will be in the position to anticipate, increasing the risk level for long term investment and for the country as a whole .-
What it is important in this case is to understand the overall issue. The Chilean economy is growing at a steady pace ,such that it induces to appreciate its local currency because it worth more. In fact on the long term trend ,the exchange rate has been moving downward as the economy get higher GDP level. It follows that ,the real issue is how far is the current exchange rate level form its long term trend ?.Available data suggest that it is not that much further away.-

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