Are World Financial Markets More Open?: If so Why and With What Effects?

Comparative exchange rate simulations

For all economies open to substantial trade and capital flows, exchange rates are central macroeconomic variables. As such, they influence, and are influenced by, all of the important forces of the economy. The general move during the seventies to more flexible exchange rates has given rise to a variety of apparently competing theories of exchange-rate determination. Some of these theories have been subjected to single-equation tests of quasi-reduced-form equations explaining the exchange rate. The partial nature of many of these competing models poses problems of interpretation. On the purely theoretical level,2 the apparently conflicting implications of the various theories are often the consequence of alternative assumptions about what is held constant elsewhere in the economy, and vanish when the theories are embedded in a broader macroeconomic framework. Similarly, the empirical tests depend on different sets of macroeconomic variables that cannot generally be assumed to be independent of each other. In addition, estimation procedures and data samples are seldom used comparably for alternative theories. This poses problems of two types. First, it is not easy to tell to what extent the various models are competitors, rather than alternative renormalizations of the same broad system; and, to the extent that there is competition it is difficult to find comparable tests.

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Macroeconomic Implications of Alternative Exchange-Rate Models

The aim of this paper is to report on our experience concerning the exchange-rate modelling in the EPA World Economic Model which is currently in the process of development at the Economic Planning Agency. The model is a multicountry model involving nine individual country models and a small regional block, which are linked together through a trade-linkage submodel and other channels of direct linkages. Section II of this paper will summarize the main features of this model. In Section III I shall first discuss some problems involved in endogenizing exchange rates in macroeconometric models, and then explain a particular approach to be used extensively in individual country modelling. It is based on a search method that determines the exchange rate which equilibrates the foreign exchange market in each period. Section IV then reports how this approach has worked out in our country models of Japan, the United States, West Germany, and the United Kingdom. It will also report on the Canadian and Australian models which adopt somewhat different approaches. Finally, in Section V, I shall discuss the differences in macroeconomic behaviour under alternative exchange-rate arrangements, based on simulation analyses of those models mentioned above. The discussion will reveal various important channels through which exchange-rate flexibility transmits the effects of exogenous and policy disturbances to the entire economy.

Akihiro Amano

Papers

Exchange-Rate Modelling in the EPA World Economic Model