Analytical framework

The Australian model or the ‘dependent economy’ model provides the analytical framework to trace the impact of the real exchange rate arising from a resource boom or capital inflows on the domestic sectors of an economy (Salter 1959; Swan 1960). The model assumes a small, open economy with two sectors: tradables and nontradables. The price of tradables (exports and importables) is determined in the world market. Prices of non-tradable goods (that is, those that are not traded internationally due to high transportation costs or restrictive trade measures) are determined solely by domestic supply and demand. Any excess demand or supply of nontradables is mitigated through adjustment of prices and quantities in the domestic market.19

Figure 3.1 Capital inflows and real exchange rate

19 _{The real exchange rate can also be defined as the ratio of price of tradables to nontradables.} However, to be consistent with definitions later, I define the RER as the ratio of prices of nontradables to tradables. Figure 3.1 is drawn based on Warr (2006) and Snape (1977)

In Figure 3.1, the NT curve shows the production possibility frontier for the tradable and non-tradable goods. The curve OZ, which is obtained by joining the points on the possibility frontier and the highest attainable social indifference curve, traces out the pattern of demand between tradables and nontradables as expenditure changes. This curve can be interpreted as the demand curve for different levels of expenditure. It is upward sloping as both goods are assumed to be normal. At point A, where U1 is tangent to NT, the economy is at both internal and external equilibrium.

In other words, domestic demand and supply for both goods are equal. The economy is in internal equilibrium as it is producing in its production possibility frontier, and in external equilibrium, due to a zero trade balance. The slope of the price line Pa which

is tangent to NT at A, indicates the domestic relative price of tradables to nontradables, (that is, the RER) which is consistent with the internal and external balance.

The remittance inflow is characterized as an increment in the foreign exchange of the domestic economy. The resultant increase in remittance inflows shifts the production possibility frontier upwards vertically from TN to T’N’. By construction, the slope of the curve at point B (which lies vertically above point A), is equal to the slope of the curve TN at point A. But point B is not an equilibrium because the slope

of the indifference curve at point C. In other words, the value placed by the consumers on nontradables relative to tradables at point C is higher than at point B.

The real income of the consumer is higher at point B than at point A. At a higher income, the consumer desires to consume more of both tradables and nontradables. However, compared to point A, point B has equal amount of nontradables and higher amount of tradables. Thus, point B is not an equilibrium point, provided the expenditure elasticity of demand for nontradables is not zero. The consumer substitutes nontradables for tradables, moving to the south-east direction from B. The new equilibrium occurs at point C, where the highest attainable indifference curve U2

intersects the possibility frontier T’N’. Thus the increase in demand for the nontradables pushes up the relative price of nontradables to tradables, as the slope of the tangent Pc is higher than that of the tangent Pa. This, by definition, leads to the

increase in real exchange rate.

Remittance inflows can potentially have Dutch disease effects along the similar channels to the natural resource boom or capital inflows such as aid or the FDI (Adenauer & Vagassky 1998; Bourdet & Falck 2006; Rajan & Subramanian 2011; Wijnbergen 1985). The RER appreciation can be more pronounced in the case of a restrictive trade regime, the existence of full employment and a limited ability of consumers to switch between domestic and imported goods (Gupta et al. 2005). The impact on RER appreciation also depends on the exchange rate regime. In a floating exchange rate regime, the central bank sells foreign exchange, thus causing nominal and RER appreciation. In the fixed exchange rate regime, sustained domestic inflation raises the RER, with the higher accommodating government expenditure by the central bank (Gupta et al. 2005).

Remittances can affect the RER mainly through three channels (Lopez et al. 2007). First, the inflow of remittances increases the net foreign asset position of a country, which in turn affects the external equilibrium of the economy. Given that remittances are unrequited transfers to households, the impact of remittances and other capital inflows is likely to be different. For example, in the case of foreign aid there is an associated liability to repay the loan, and this will decrease the net foreign assets. Similarly, in case of foreign direct investment (FDI), the repatriation of the profits will decrease net foreign assets position.

Second, remittances exert an upward pressure on the price of nontradables due to increased demand and also through the potential increase of reservation wage (Lopez et al. 2007, pp. 7-8). If an increase in prices in the non-tradable sectors is passed on to the consumers (but not in case of tradable sector to maintain competitiveness), this can lead to higher productivity in tradable sectors. This Balassa-Samuelson effect can cause real appreciation of the domestic currency (Balassa 1964; Samuelson 1964). The extent of this real appreciation depends on how remittances are spent in the home country. The impact of the RER tends to be higher if the money is spent on consuming goods and services, rather than on investments.

The third channel is the impact on the RER through economic growth. However, the impact in this case is ambiguous, due to the offsetting impact of growth on the net foreign asset to GDP position, and any internal adjustment due to the Balassa- Samuelson effect. Higher growth will lower the net foreign asset to GDP ratio, and this tends to decrease the RER while the higher internal demand will tend to fuel the prices of nontradables, thus causing real appreciation. Therefore, the net impact on the RER can be one that is appreciating, depreciating or has zero impact, depending on the relative strengths of these effects.

The RER appreciation effect of remittances and capital inflows is complicated by the fact that the central banks often pursue an active policy of avoiding the appreciation of domestic currency. Thus, several countries adopt implicit RER targeting as a major objective of their monetary policy framework. Central banks often intervene in the foreign exchange market for several reasons: to stabilize the exchange rate as in exchange rate, e.g. pegs, crawls, or bands; to contain excessive exchange rate volatility; to correct any misalignment of the exchange rate which is considered inconsistent with the macroeconomic fundamentals of the country; and managing foreign exchange reserves (Basu 2014). Thus, the observed real exchange rate movement may not be a sufficient indicator of Dutch Disease effects of remittances.

The theoretical discussion on the Australian model suggests that if the assumptions of the models are valid, then remittances inflows will increase the price of nontradables in response to an increased demand for both tradables and nontradables—that is, RER appreciates in the remittances recipient countries.