What Does the Exchange Rate Do? A Status Symbol?

1. Capital, Income, and PricesThis paper describes some of the economic and social losses to a country from currency devaluation or depreciation and the mechanisms that cause them. During the time of fixed exchange rates-especially the first quarter-century after the Second World War-devaluation was something to be avoided. For governments, it was a sign of weakness; for the public, it was a national humiliation. Attitudes have changed since then. A lower price of a currency in terms of other currencies is thought to bring economic benefits and the readiness of the monetary authorities of low-wage countries to let their currency prices fall gains approval from the authorities of high-wage countries and from multinational institutions, most of all the International Monetary Fund (IMF)-all the more if it seems to be in response to the market. In many countries, including Pakistan, the monetary authorities take pride in this approval. However, there has been no systematic discussion of the harm that can follow and no empirical or theoretical assessment of whether Pakistan has benefited overall from the depreciation of its currency over the last 40 or so years.We begin with a point of theory: the exchange rate is a macroeconomic quantity or variable. In principle, a change in the exchange rate results in changes in the price of tradable goods through the whole economy as well as in financial and fiscal quantities such as foreign debt and revenue from import duties. Why does this matter? It matters because it implies that partial equilibrium arguments cannot be used to discuss the effects of changes in the exchange rate; devaluation has effects throughout the economy and these have to be taken into account before anything can be said with confidence about the gains and losses that follow.1.1. Expectations and Capital FlightDevaluation leads to expectations about the future course of the exchange rate and, with this, can make further devaluation more likely. In the time of fixed exchange rates, when a country did devalue it was in the hope that the new exchange rate would be permanent. By the 1960s and 1970s, however, there was little doubt as to which countries would devalue again and which would not: expectations had been formed. Speculation on exchange rates became so profitable and the consequent capital movements so great that countries sometimes had to devalue to avoid losing all their international reserves. The inability to cope with these speculative capital movements caused the system of fixed exchange rates to be abandoned. Since then, any inhibitions about devaluing have been lost. Most high-wage countries let their currency exchange rates be determined by the market, i.e., they let them "float."The ways in which expectations are formed have also changed. In the case of Pakistan, as with many others, repeated devaluations gave rise to the expectation that the rupee would depreciate continually, which experience continued to justify and confirm. Until 1972, the official exchange rate was PRs 4.76 to the dollar, though, because of the Bonus Vouchers scheme, the rupee cost of the dollar was, for many imports, two or three times as high. With the abolition of the scheme in 1972, the exchange rate was fixed at PRs 9.91 to the dollar until 1981, after which it depreciated unsteadily. In 2000, it was about PRs 58 to the dollar; by March 2014, it was about PRs 105. No one doubts that the Pakistani rupee will continue to depreciate and if ever anybody had expectations of appreciation, except for occasional short fluctuations, it was long ago. Official attitudes confirm these expectations: depreciation of the currency is considered to be, in the case of Pakistan, somehow a good thing.Speculative capital movements are a natural consequence of expectations of currency depreciation, but speculative capital from a high-wage country can be expected to return home after the country devalues. This has happened each time countries such as France and the UK devalued in the 1960s or 1970s. …