metadata: authors: 0: author: Hong-Ghi Min
docna: 0: docna: Inequality, the price of nontradables, and
            the real exchange rate : theory and cross-country evidence
docty: Policy Research Working Paper
subtopic: Economic Theory & Research,Industrial Economics,Poverty Reduction Strategies,International Trade and Trade Rules,Economic Growth,Macroeconomic Management,Inequality
teratopic: Poverty Reduction
abstracts: cdata!: The author provides theoretical and
            empirical evidence of a negative association between income
            inequality and real exchange rates. First, he builds a
            theoretical model showing the transmission mechanism from
            inequality to real exchange rates. Second, using
            cross-country data, he demonstrates that the theoretical
            argument has empirical support. The association is large,
            significant, and robust to alternative specifications of the
            reduced form model and estimation methodologies. These
            findings provide empirical support for Poverty Reduction
            Strategy Papers, government strategies agreed on with the
            World Bank that hinge on four major objectives: accelerating
            equity-based growth, guaranteeing access to basic social
            services for the poor, expanding opportunities for
            employment and income-generating activities for the poor,
            and promoting good governance. The author's analysis
            indicates that "equity-based growth" and
            "export-driven growth" are compatible policy
            goals. But the negative relationship between inequality and
            real exchange rates does not imply that policies aimed at
            dramatic redistribution will automatically lead to real
            depreciation of the domestic currency, improve the external
            balance, and accelerate economic growth.
repnme: repnme: Inequality, the price of nontradables, and
            the real exchange rate : theory and cross-country evidence
display_title: Inequality, the price of
            nontradables, and the real exchange rate : theory and
            cross-country evidence
listing_relative_url: /research/2002/01/1687151/inequality-price-nontradables-real-exchange-rate-theory-cross-country-evidence
topicv3: Economic Growth m1326241 471,Current Account m1326278 1135,Poverty m1326687 695,Trade m1326924 698,Income Inequality m1503891 2668
publishtoextweb_dt: 2010-07-01T00:00:00Z
historic_topic: Poverty Reduction
origu: Poverty Reduction and Equity (PRMPR)
no_of_pages: 36
model_extractions: | POLICY RESEARCH WORKING PAPER 2758

# Summary findings

Min provides theoretical and empirical evidence of a negative association between income inequality and real exchange rates. First, he builds a theoretical model showing the transmission mechanism from inequality to real exchange rates. Second, using cross-country data, he demonstrates that the theoretical argument has empirical support. The association is large, significant, and robust to alternative specifications of the reduced form model and estimation methodologies.

These findings provide empirical support for Poverty Reduction Strategy Papers, government strategies agreed on with the World Bank that hinge on four major

## objectives: accelerating equity-based growth,

guaranteeing access to basic social services for the poor, expanding opportunities for employment and incomegenerating activities for the poor, and promoting good governance. The author's analysis indicates that "equitybased growth" and "export-driven growth" are compatible policy goals. But the negative relationship between inequality and real exchange rates does not imply that policies aimed at dramatic redistribution will automatically lead to real depreciation of the domestic currency, improve the external balance, and accelerate economic growth.

This paper-a product of the Poverty Reduction Group, Poverty Reduction and Economic Management Network-is part of a larger effort in the network to provide theoretical and empirical evidences for the Poverty Reduction Strategy Papers. Copies of the paper are available free from the World Bank, 1818 H Street NW, Washington, DC 20433. Please contact Esteban Hernandez, room MC4-828, telephone 202-473-3721, fax 202-522-7496, email address ehernandezlCa@worldbank.org. Policy Research Working Papers are also posted on the Web at http://econ.worldbank.org. The author may be contacted at hmin@worldbank.org. January 2002. (32 pages)

> _The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the view of the World Bank, its Executive Directors, or the countries they represent._

Produced by the Policy Research Dissemination Center
Inequality, the Price of Nontradables, and the Real Exchange Rate: Theory and Cross-Country Evidence* By Hong-Ghi Min Poverty Reduction Group The World Bank JEL Classification Numbers: D31, F41 Keywords: Inequality, Price of Nontradables, Real Exchange Rate Author's E-Mail Address: hmin@worldbank.org

* I am grateful to Richard Adams Jr., Robert Cull, and David Dollar for their very helpful comments but all remaining errors are my own.
# I. **Introduction**

_RecentW much attention has been paid to whether income inequa/i~tfavors or hinders economic growth. Does it encourage investment and saing ? Is aggregate consumption higher i anequaIihy is greater?_ (Akinson and Brandolini, 2001) A large body of studies on inequality focus inequality's impact on mactoeconornic performance across countries. Especially they tried to find the link (1) between inequality and growth [ Ahluwalia, 1976: Alesina and Perotti,1996: Alesina and Rodrick, 1994: Barro, 1997: Deininger and Squire, 1996: Kuznets, 1955: Persson and Tabellini, 1994: Sunmmers and Heston, 1991], and (2) between inequality and inflation [Alesina and Tabelini, 1992: Cukierman, 1992: Fisher and Easterly, 1990: Lane, 1997: Rogoff, 1985: Romer, 1993].

In this paper, we try to provide theoretical and empirical evidence as to whether equitybased growth and current account improvement through real exchange rate depreciation are compatible. The Poverty Reduction Strategy Paper (PRSP hereafter) describes the strategy which the government can implement during the next 3-5 years in order to wage a more effective fight against poverty and inequality. The strategy hinges on four majot objectives. Acceleration of equity-based growth, guarantee that the poor have access to basic social services, expanding opportunities for employment and income-generating activities for the poor, and promoting good governance. Among others, (1) acceleration of equity-based growth and (2) major structural reforms in order to fully open up the economy to the outside are two major aspects of this strategy.

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In other words, PRSP has implications for equity-based growth and export-driven policy. From this point of view, the major channel of connection between "export drive" and "equity-based growth" depends on how a country can maintain the international competitiveness of her exporting industry through sound exchange rate management. Especially, most PRSPs provide a target level of current account to GDP ratio to secure an inflow of physical and financial resources sufficient to achieve their medium to long-term growth target.

However, no attempt has been made to look at how a county's inequality affects the current account performance and thus growth through inequality's impact on real exchange rates. Since real exchange rate affect the external sector performance directly thorough its impact on exporting sector's international competitiveness identification of relationship between inequality and real exchange rate will cast important linkages between inequality and external sector performance. This link is an issue of major concern with important policy implications. A negative relationship would imply that policy makers should be concerned with the distributional implications of government policies not only for social and political reasons but also because inequality has long-run effects on depreciation of the real exchange rate through the changes in the price of nontradables.

Policy makers should take into account the fact that the real exchange rate can affect the poor directly [ Adams, R, 2000: Kreuger, A., M. Schiff, and A. Valdes, 1991: The World Bank, 20011.

To test the relevance, significance, and policy implications of the relationship between inequality and the real exchange rate, we build a theoretical model which shows that inequality is negatively associated with real exchange rates. In this way, decreased inequality, through the depreciation of the real exchange rate, improves the current account 4
performance of a country'. Next, we provide cross-country tests of that theoretical proposition.

In section II, we develop a theoretical model of inequality and the real exchange rate. First, we show how changes in inequality affect the price of nontradables. Second, we show how changes in the price of nontradables affects real exchange rates. In section III, we provide empirical evidence for the conceptual arguments established in section II using cross-country data. Section IV concludes the paper.

**II. Inequality, the Price of Non-Tradables, and the Real Exchange Rate: A Theoretical Framework**

Consider a **small** open economy that produces two composite goods, tradables and nontradables, which is composed of two heterogeneous **income** groups that have the same income share, a high income group and a low income group. We can think of the high income group as the highest quartile of the income group in table 3 (53 percent of total income) and the lower income group as the aggregation of other three quartiles (some 55 percent of the total income). The figure does not necessarily sum to 100 since we are using an average of averaged figures over a 10 year period. Statistical test shows that the mean difference between the two groups is 0.0168 (standard error is 0.0075 and p-value is 0.0295).

> 1 Agenor (2001) showed that the real exchange rate depreciation increases the welfare of the poor.

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_Assumption 1._ We assume that prices of nontradables are flexible and that the high income group's income elasticity of demand for non-tradables **(e'TH)** is larger than that of low income group (SNTL) 2.

ENT > EPL (1) _Assumption 2._ Purchasing power parity holds only for tradables.

_e +P; -PT = °_ (2) where e is the nominal exchange rate, P; and _PT_ are the foreign price of tradables and the domestic price of tradables.

**Proposition: If income inequality decreases (increases), ceteris paribus, real**

# **exchange rate depreciates (appreciates).**

We can write the real exchange rate using the following implicit function: (3)

> 2 Chinn (1997) and Samuelson (1964), using the Penn effect, claimed that higher levels of income are associated with gmeater demnand for nontradables such as services, and higher relative pice of nontradables. Theoretically, Bergstrand (1991) showed that increased income, under non-homothetic preferences, can lead to a shift in derand toward nontradables and increase in the price of nontradables.

6
where Z is the real exchange rate, _PNT_ is the price of nontradables, and G3 is the Gini coefficient.

<!-- Start of picture text --> ___ <0 (4)<br>d G<br>Proof:<br><!-- End of picture text --> From equation (1), the price of nontradables will be determined by the income changes of the high income group. As a result, the price of nontradables is positively associated with inequality and it can be expressed as follows: _a_ **PNT > 0** _a G_ Next, we define the nominal exchange rate as follows: _e =PT PT_ (5) _(_ 6) Home and foreign prices can be expressed as in equations (7) and (8).

_P =(1-(0) PT_ + CO _PNT_ (7)

**3** We use the Gini coefficient as a measure of inequality. The income shares of lowest and highest quartiles are employed as supplements to the Gini coefficient.

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(8) _P*=(1-(O)PT_ + _° PNT_ where * denotes the foreign economy, 0c is the share of non-traded goods in<sup>the economy,</sup> and _e_ the nominal exchange rate, which reptesents the price of<sup>foreigncurrency.</sup> All variables are expressed in logs. Equations (7) and (8) assume that the shares of traded and non-traded goods are constant and this is consistent with the data since<sup>themanufacturing</sup> sector of most countries varies little over long time horizons<sup>4</sup> .

We can define real exchange rates, Z, as: Z _=e+ P* -P._ (9) Substituting equation (6) - (8) into equation (9) yields the real exchange<sup>rate asafunctionof</sup> the domestic and foreign relative prices of non-tradables: Substituting equation (7) and (8) into equation (6) yields a nomninal exchange<sup>rateequation</sup> as: _e p- p (P, -PT) + o*_ (P,; - _PT*)_ (11)

> 4 Strauss (1999) showed that, for most economies over 30<sup>years, themanufacturing sectorvaried only1 to</sup> 3.5% of GDP.

8
If we use equation (3), _( e_ + _P'_ - _P)_ = 0, and thus equation (10) boils down to: _Z -o(PT -PT) +_ CO (pNT _- PT*)_ (12)

> Partially differentiating equation (12) with respect to PNT yields equation (13):

Equation (13) shows that the real exchange rate is a negative function of the price of domestic non-tradables.

Finally, differentiating equation (4) results in equation (14).

From the first assumption in equation (5)5 and equation (13), equation (14) has a negative sign: 5 Since nontradables' demand elasticity for the high income group is greater than that of the low income group, improved income distribution implies decreased demand for nontradables and a decrease in its price.

9
Equation (15) proposes that improved income distribution, or a decrease in inequality is associated with depreciation of real exchange rates which is denoted by increasing Z .

For the case of worsened income distribution, the proof of real exchange rate appreciation is obvious from the flexible price assumption.

III. Cross-country Evidence on Inequality and the Real Exchange Rate

1. Empirical Model of Inequality and Real Exchange Rates

- (1) A Reduced Form Model of Inequality and Real Exchange Rates

To reduce the endogeneity problems we use the real exchange rate as a dependent variable. Alternatively, we can put a measure of inequality as the dependent variable.

However, since we do not have any theoretical prior or empirical evidence indicating what determines cross-country differences in inequality, we use the real exchange rate as a dependent variable<sup>6</sup> .

We can construct a reduced form model of real exchange rates including as explanatory variables a measure of inequality and identified macroeconomic controls: Z = (G, X;) where i= 1 to 9. (15)

> 6 Tanzi (1998) provides some descriptive arguments on what determines inequality but his hypothesis does not provide any theoretical or empirical evidence.

10
where G is a measure of inequality which is often the Gini coefficient and X i is a vector of control vatiables identified in the litetature [Faruqee, 1995: Min, 1996]. The literature indicates that the relation between the terms of trade and the real exchange rate is the result of income and substitution effects that depend on the source of the tetms of trade variation. The likely result is that a deterioration (improvement) in the terms of trade leads to a real depreciation (appteciation). Liquidity of a country is an important variable that can affects the real exchange rate. The total liquid liabilities of a country are used to capture the effect of inflationary pressure on the real exchange rate.

Net foreign assets (external wealth) are also included in the analysis. Unless the increased foreign assets are stetilized, the likely effect of an increase in net foreign assets will be the appreciation of the real exchange rate (Faruqee, 1995).

Finally, fixed capital formation is included as a proxy for manufactuting sector productivity. According to the Harrod-Balassa-Samuelson effect (Obstfeld and Rogoff, 1996) increased productivity in the manufacturing sector is associated with real depreciation of exchange rates. However, since a reliable measure of productivity in the manufacturing sector is not available for all countries included in this study, fixed capital formation is used as a proxy for the productivity of the manufacturing sector.

Although the focus here is on the relationship between inequality and the real exchange rate, additional structural factors can be included in the analysis whenever proxies are 11
available for estimation since the literature on the real exchange rate confirms that it responds to the structural development of an economy.

# (2) Control variables

To isolate the effect of the macroeconomic policy on the variation of real exchange rates, other than income inequality, we use control variables which are identified in the literature as having long-run stable relationship with the real exchange rate.

Acronyms and definitions are as follows. TOT: terms of trade, NFA: Net foreign assets which are measured by accumulating current account balances with the bench mark figure of 1978, LL: Liquid liabilities of the economy as a measure of liquidity or a measure of inflationary pressure in the economy, PCGDP: Real per capita GDP, TROPEN: Trade openness as measured by export plus import divided by GDP, FIXK: Public investment on fixed capital, OECD: OECD member country dummy, EASIA: East Asia regional dummy, LATIN: Latin America regional dummy.

# 2. Estimation of Inequality and Real Exchange Rate

# (1) Data

The analysis is based on 73 countries and all variables are averaged over 1980-89. Time averaged data are used since the focus of the study is explaining the sustained level of real exchange appreciation or depreciation rather than temporary movements in the real exchange rate. The most important data series is the Gini coefficient which is averaged over ten years and reported in Table 1 .

12
As supplements to the Gini coefficient, we use the lowest and highest quartile of income shares and those are reported in Table 2 and Table 3. Data for these two quartiles are from Deininger and Squire (1998) and we again avetage over ten years. Other data are from the IMF's International Financial Statistics CD-Rom (April 1999 version) and World Bank database (2001). Detailed descriptions of definitions and sources of the data are given in the Data Appendix..

# (2). Empirical Findings

We used OLS (ordinary least squares), WLS (weighted least squares) to remove the possible heteroscedasticity in the cross-country data. Estimation results for OLS are reported in Table 5 and those for WLS are reported in Table 6.

As we can see from Table 5 and Table 6, the adjusted R-squared tends to be fairly high (around 40 to 50 percent) and estimation results are robust. Most of the control variables and our measure of inequality are significant and the significance and magnitude of the estimates do not vary much across specifications.

First of all, the log of Gini coefficient has the expected sign and is significant throughout all the specifications of the reduced form model. This provides support for the proposition raised in the theoretical part of the paper and it suggests that improvement in income distribution is associated with real exchange rate depreciation. It offers the imnportant policy implication that reducing inequality, by decreasing the price of non-tradables, will depreciate the real exchange rate. This depreciation will, by increasing the international competitiveness of tradable sector, improve the current account balance and accelerate the 13
economic growth of the economy. Since appreciation of the real exchange rate will hurt the international competitiveness of an economy, inequality has negative implications for sound macroeconomic management. However, the robustly negative relationship between real exchange rates and inequality does not imply that huge redistributive policies will automatically bring real depreciation of domestic currency, improve the external balance, and accelerate economic growth. Among other damaging effects, excessively expansionary redistributive policies motivated by inequality may cause domestic inflation and can distort incentives and hurt productivity which slow down long-term economic growth (Al-Marhubi, 2000).

Log of terms of trade, liquidity, real per capita GDP, and trade openness all have the expected signs and are significant in different specifications. Terms of trade improvement leads to an appreciation as is consistent with theory and other empirical studies [ Edwards and van Wijnbergen, 1987: Neary, 1988: Kahn and Ostry, 1991: Tokarick, 1995]. However, regional dummy variables for east Asia and Latin America are insignificant in most cases, and thus we could not find any regional impact on the cross-country behavior of inequality and real exchange rates. Also, the log of net foreign assets (CCA) measured as a cumulative current account with the bench mark figure of 1978 is insignificant throughout the different specification of the model.

Another question is whether different income level have different transmission mechanism from inequality to the real exchange rate. Since we do not have sufficient number of observations for two different categories, OECD dummy variable is included in the estimation to capture the possible role of income level to the transmission mechanism. Estimation results are reported in Table 7.

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Table 7 shows that OECD dummy variable is insignificant but all other variables have the same sign, similar estimates and significance varies little. In other words, we could not find any significantly different relationship between inequality and the real exchange rate for the OECD member countries.

Supplementary regressions for equation (15) are run using the highest and lowest quartiles as a proxy for Gini coefficients and estimation results are reported in Table 8 and Table 9. Table 8 reports estimation results of the reduced form model when inequality is measured by the income share of lowest quartile of the population. With different specifications of the reduced form model the data fit the model quite well (adjusted R- squared is about 50 percent). If we focus on the effect of increasing the income share of lowest quartile (a decrease in inequality) on the real exchange rate, the estimate has the expected positive sign and is significant at a 5 percent level. An increased income of the lowest quartile will decrease the demand for non-tradables and reduce the price of nontradables. This causes real depreciation of the exchange rate. This is consistent with the previous findings where we used the Gini coefficient as an inequality measure. Table 9 shows the estimation results of the reduced form model when the income share of the highest quartile is used as an inequality measure. However, estimates are insignificant. One possible explanation is that using the highest and lowest quartiles impose the joint hypothesis that income shares of other three quartiles are zero. As we can see from Table 4, this is not the case and regression results in Table 8 and Table 9 provide only suggestive information.

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# IV. Conclusions.

This paper provides theoretical and empirical support for the notion that "equity-based growth" and "export-drive" are compatible as outlined in the PRSP. More specifically, this paper finds a negative association between income inequality and the real exchange rate. First, we showed that inequality is positively related with the price of nontradables. Second, we showed that improvement in income distribution, through the decline of the price of nontradables, depreciates the real exchange rate. The magnitude of the association is large and estimation results are robust to alternative specifications of the reduced form equations and alternative estimation methodologies. Policy recommendation follow directly from those findings. A sustainable redistributive policy which does not distort incentives can accelerate the growth momentum of the economy through its impact on the real exchange rate depreciation.

Finally, although the analysis has demonstrated a robust negative correlation between the real exchange rate and inequality, the direction of causation has not been determined. This study may serve as a keystone for further theoretical and empirical analysis. Of course the most important task will be the identification of the more sophisticated transmission mechanism for inequality to the price of nontradables. It may also be desirable to look into specific countries' experience as a complement to this cross-country study.

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# **Data Appendix.**

## _(1). Dependent Variables_

Gini: Gini coefficients are from Deininger and Squire (1996).

LQ1 - LQ4: Lowest to highest quartile of the income share from Deininger and Squire (1996).

## _(2). Dummy Variables_

EASIA: 1 for East Asia, 0 otherwise.

LATIN: 1 for Latin America, 0 otherwise.

OECD: I for member countries, 0 otherwise.

### _(3). Predetermined Variables_

TOT: Terms of trade calculated by dividing export price (IFS line 76) by import price (IFS line 76.x). For those countries whose value is missing in IFS, we get the export price by dividing current export (import) of goods and non-factor services by 1995 constant price export (import) of goods and non-factor services in the World Bank database.

FIXK: Fixed capital formation to GDP (IFS line 99.b) measured by domestic public (and private) investment to GDP. This is used as a proxy for the manufacturing sector productivity since many developing countries do not have good data to estimate it.

LL: Liquid liability to GDP. Liquid liability equals currency plus demand and interest bearing liabilities of banks and other financial intermediaries.

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NFA: Net foreign asset measured by cumulative current account (IFS line 77.ad) deficit/surplus with a benchmark figure of 1987.

RCGDP: Real per capita GDP, nominal per capital GDP is deflated by GDP deflator.

TROPEN: Trade openness is measured as a sum of export (IFS line 70) and import (IFS line 71) divided by GDP.

18