Exchange rates and currency
Riding the wave: monetary responses to aid surges in low-income countries
Managed float regimes with little sterilisation deal best with aid surges
Authors:
C. Adam; E. Buffie; S. O'Connell
Publisher:
Centre for the Study of African Economies, Oxford, 2007
Highly persistent shocks to aid flows such as HIPC or MDG-related increases in net flows have beneficial long-run effects. However, they produce dramatic macroeconomic management problems in the short-run when there is currency substitution by the domestic private sector. To avoid excessive floating of the exchange rate due to capital inflows, authorities intervene in the foreign exchange market. The intervention has to be sterilised through bond sales to prevent inflation, but this will drive up real interest rates.
This paper proposes an appropriate mix of money and exchange rate targeting and defines the role of temporary sterilisation. It uses an inter-temporal optimising model that allows a portion of the aid to be devoted to reducing the government's seigniorage requirements.
The model shows that a pure floating regime performs poorly and leads to excessive appreciation and deep recession. A crawling peg regime performs better, but allows a short-run spike in inflation which can only be sterilised at the cost of high interest rates. The most attractive approach is a managed float regime with little or no sterilisation. Intervention should target a modest appreciation that absorbs the aid inflow, while it keeps real interest rates low and allows for a rapid macroeconomic adjustment.
