Expectations and Exchange Rate Dynamics

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Expectations and Exchange Rate Dynamics

Journal Article•DOI•

Expectations and Exchange Rate Dynamics

01 Dec 1976-Journal of Political Economy (JOURNAL OF POLITICAL ECONOMY)-Vol. 84, Iss: 6, pp 1161-1176

TL;DR: In this paper, the authors developed a theory of exchange rate movements under perfect capital mobility, a slow adjustment of goods markets relative to asset markets, and consistent expectations, and showed that along that path a monetary expansion causes the exchange rate to depreciate.

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Abstract: The paper develops a theory of exchange rate movements under perfect capital mobility, a slow adjustment of goods markets relative to asset markets, and consistent expectations. The perfect foresight path is derived and it is shown that along that path a monetary expansion causes the exchange rate to depreciate. An initial overshooting of exchange rates is shown to derive from the differential adjustment speed of markets. The magnitude and persistence of the overshooting is developed in terms of the structural parameters of the model. To the extent that output responds to a monetary expansion in the short run, this acts as a dampening effect on exchange depreciation and may, in fact, lead to an increase in interest rates.

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Journal Article•DOI•

Empirical exchange rate models of the seventies: Do they fit out of sample?

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Richard Meese¹, Kenneth Rogoff²•Institutions (2)

University of California, Berkeley¹, Federal Reserve System²

01 Feb 1983-Journal of International Economics

TL;DR: The authors compared the performance of various structural and time series exchange rate models, and found that a random walk model performs as well as any estimated model at one to twelve month horizons for the dollar/pound, dollar/mark, dollar /yen and trade-weighted dollar exchange rates.

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3,621 citations

Posted Content•

The Purchasing Power Parity Puzzle

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Kenneth Rogoff

01 Jan 1996-Journal of Economic Literature

TL;DR: A number of recent studies have weighed in with fairly persuasive evidence that real exchange rates (nominal exchange rates adjusted for differences in national price levels) tend toward purchasing power parity in the very long run as discussed by the authors.

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Abstract: FIRST ARTICULATED by scholars of the ISalamanca school in sixteenth century Spain,1 purchasing power parity (PPP) is the disarmingly simple empirical proposition that, once converted to a common currency, national price levels should be equal. The basic idea is that if goods market arbitrage enforces broad parity in prices across a sufficient range of individual goods (the law of one price), then there should also be a high correlation in aggregate price levels. While few empirically literate economists take PPP seriously as a short-term proposition, most instinctively believe in some variant of purchasing power parity as an anchor for long-run real exchange rates. Warm, fuzzy feelings about PPP are not, of course, a substitute for hard evidence. There is today an enormous and evergrowing empirical literature on PPP, one that has arrived at a surprising degree of consensus on a couple of basic facts. First, at long last, a number of recent studies have weighed in with fairly persuasive evidence that real exchange rates (nominal exchange rates adjusted for differences in national price levels) tend toward purchasing power parity in the very long run. Consensus estimates suggest, however, that the speed of convergence to PPP is extremely slow; deviations appear to damp out at a rate of roughly 15 percent per year. Second, short-run deviations from PPP are large and volatile. Indeed, the one-month conditional volatility of real exchange rates (the volatility of deviations from PPP) is of the same order of magnitude as the conditional volatility of nominal exchange rates. Price differential volatility is surprisingly large even when one confines attention to relatively homogenous classes of highly traded goods. The purchasing power parity puzzle then is this: How can one reconcile the enormous short-term volatility of real exchange rates with the extremely slow rate at which shocks appear to damp out? Most explanations of short-term exchange rate volatility point to financial factors such as changes in portfolio preferences, short-term asset price bubbles, and monetary shocks (see, for example, Maurice Obstfeld and Rogoff forthcoming). Such shocks can have substantial effects on the real economy in the presence of sticky nominal wages and prices. I See Lawrence H. Officer (1982, ch. 3) for an extensive discussion of the origins of PPP theory; see also Dornbusch (1987).

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2,901 citations

Book•

Monetary Theory and Policy

[...]

Carl E. Walsh

27 Oct 1998

TL;DR: In this article, empirical evidence on money and output is presented, including the Tobin effect and the MIU approximation problems, and a general equilibrium framework for monetary analysis is presented.

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Abstract: Part 1 Empirical evidence on money and output: introduction some basic correlations estimating the effect of money on output summary. Part 2 Money in a general equilibrium framework: introduction the Tobin effect money in the utility function summary appendix - the MIU approximation problems. Part 3 Money and transactions: introduction shopping-time models cash-in-advance models other approaches summary appendix - the CIA approximation problems. Part 4 Money and public finance: introduction bugdet accounting equilibrium seigniorage optimal taxation and seigniorage Friedman's rule revisited nonindexed tax systems problems. Part 5 Money and output in the short run: introduction flexible prices sticky prices and wages a framework for monetary analysis inflation persistence summary appendix problems. Part 6 Money and the open economy: introduction the Obstfeld-Rogoff two-country model policy coordination the small open economy summary appendix problems. Part 7 The credit channel of monetary policy: introduction imperfect information in credit markets macroeconomic implications does credit matter? summary. Part 8 Discretionary policy and time inconsistency: introduction inflation under discretionary policy solutions to the inflation bias is the inflation bias important? do central banking institutions matter? lessons and conclusions problems. Part 9 Monetary-policy operating procedures: introduction from instruments to goals the instrument-choice problem operating procedures and policy measures problems. Part 10 Interest rates and monetary policy: introduction interest-rate rule and the price level interest rate policies in general equilibrium models the term structure of interest rates a model for policy analysis summary problems.

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2,049 citations

Cites background from "Expectations and Exchange Rate Dyna..."

...But as Dotsey and Ireland (1995) showed, this class of models does not account for interest rate e¤ects of the magnitude actually observed in the data....
[...]
...The Dornbusch overshooting result stands in contrast to Obstfeld and Rogo¤ ’s conclusion, derived in section 9.2.3, that a permanent change in the nominal money supply does not lead to overshooting. Instead, the nominal exchange rate jumps immediately to its new long-run level. This di¤erence results from the ad hoc nature of aggregate demand in the model of this section. In the Obstfeld-Rogo¤ model, consumption is derived from the decision problem of the representative agent, with the Euler condition for consumption linking consumption choices over time. The desire to smooth consumption implies that consumption immediately jumps to its new equilibrium level. As a result, exchange rate overshooting is eliminated in the basic Obstfeld-Rogo¤ model. One implication of the overshooting hypothesis is that exchange rate movements should follow a predictable or forecastable pattern in response to monetary shocks. A positive monetary shock leads to an immediate depreciation followed by an appreciation. The path of adjustment will depend on the extent of nominal rigidities in the economy because these influence the speed with which the economy adjusts in response to shocks. Such a predictable pattern is not clearly evident in the data. In fact, nominal exchange rates display close to random walk behavior over short time periods (Meese and Rogo¤ 1983). In a VAR-based study of exchange rate responses to U.S. monetary shocks, Eichenbaum and Evans (1995) did not find evidence of overshooting, but they did find sustained and predictable exchange rate movements following monetary policy shocks. A monetary contraction produces a small initial appreciation, with the e¤ect growing so that the dollar appreciates for some time. However, in a study based on more direct measurement of policy changes, Bonser-Neal, Roley, and Sellon (1998) found general support for the overshooting hypothesis....
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...Gomme (1993) and Dotsey and Ireland (1996) examined the e¤ects of inflation in general equilibrium frameworks that allow for the supply of labor and the average rate of economic growth to be affected (in models that do not display superneutrality; see section 2....
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...The Dornbusch overshooting result stands in contrast to Obstfeld and Rogo¤ ’s conclusion, derived in section 9.2.3, that a permanent change in the nominal money supply does not lead to overshooting. Instead, the nominal exchange rate jumps immediately to its new long-run level. This di¤erence results from the ad hoc nature of aggregate demand in the model of this section. In the Obstfeld-Rogo¤ model, consumption is derived from the decision problem of the representative agent, with the Euler condition for consumption linking consumption choices over time. The desire to smooth consumption implies that consumption immediately jumps to its new equilibrium level. As a result, exchange rate overshooting is eliminated in the basic Obstfeld-Rogo¤ model. One implication of the overshooting hypothesis is that exchange rate movements should follow a predictable or forecastable pattern in response to monetary shocks. A positive monetary shock leads to an immediate depreciation followed by an appreciation. The path of adjustment will depend on the extent of nominal rigidities in the economy because these influence the speed with which the economy adjusts in response to shocks. Such a predictable pattern is not clearly evident in the data. In fact, nominal exchange rates display close to random walk behavior over short time periods (Meese and Rogo¤ 1983). In a VAR-based study of exchange rate responses to U.S. monetary shocks, Eichenbaum and Evans (1995) did not find evidence of overshooting, but they did find sustained and predictable exchange rate movements following monetary policy shocks....
[...]
...But as Dotsey and Ireland (1995) showed, this class of models does not account for interest rate e¤ects of the magnitude actually observed in the data. Similarly, R. King and Watson (1996) found that monetary shocks do not produce significant business cycle fluctuations in their version of a limited-participation model (which they call a liquidity-e¤ect model )....
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Journal Article•DOI•

Testing structural hypotheses in a multivariate cointegration analysis of the PPP and the UIP for UK

[...]

S∅ren Johansen¹, Katarina Juselius¹•Institutions (1)

University of Copenhagen¹

01 Jul 1992-Journal of Econometrics

TL;DR: In this paper, the authors developed some new tests for structural hypotheses in the framework of a multivariate error correction model with Gaussian errors, based on an analysis of the likelihood function and motivated by an empirical investigation of the PPP relation and the UIP relation for the United Kingdom.

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1,822 citations

Cites background from "Expectations and Exchange Rate Dyna..."

...The most popular models that have been applied for exchange rate determination include the flexible price monetary model of Frenkel (1976) and the overshooting monetary model of Dornbusch (1976)....
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Posted Content•

Exchange Rate Dynamics Redux

[...]

Maurice Obstfeld, Kenneth Rogoff

01 Jan 1995-Research Papers in Economics

TL;DR: This paper developed an analytically tractable two-country model that marries a full account of global macroeconomic dynamics to a supply framework based on monopolistic competition and sticky nominal prices.

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Abstract: We develop an analytically tractable two-country model that marries a full account of global macroeconomic dynamics to a supply framework based on monopolistic competition and sticky nominal prices The model offers simple and intuitive predictions about exchange rates and current accounts that sometimes differ sharply from those of either modern flexible-price intertemporal models or traditional sticky-price Keynesian models Our analysis leads to a novel perspective on the international welfare spillovers due to monetary and fiscal policies

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1,763 citations

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References

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Journal Article•DOI•

Domestic Financial Policies Under Fixed and Under Floating Exchange Rates

[...]

J. Marcus Fleming¹•Institutions (1)

International Monetary Fund¹

01 Nov 1962

TL;DR: In this paper, it is shown that the expansionary effect of a given increase in money supply will always be greater if the country has a floating exchange rate than if it has a fixed rate.

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Abstract: T HE BEARING of exchange rate systems on the relative effectiveness of monetary policy on the one hand, and of budgetary policy on the other, as techniques for influencing the level of monetary demand for domestic output, is not always kept in mind when such systems are compared. In this paper it is shown that the expansionary effect of a given increase in money supply will always be greater if the country has a floating exchange rate than if it has a fixed rate. By contrast, it is uncertain whether the expansionary effect on the demand for domestic output of a given increase in budgetary expenditure or a given reduction in tax rates will be larger or smaller with a floating than with a fixed rate. In all but extreme cases, the stimulus to monetary demand arising from an increase in money supply will be greater, relative to that arising from an expansionary change in budgetary policy, with a floating than with a fixed rate of exchange.

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1,449 citations

Book Chapter•DOI•

The Exchange Rate, The Balance Of Payments and Monetary and Fiscal Policy Under A Regime of Controlled Floating

[...]

Michael Mussa¹•Institutions (1)

University of Rochester¹

01 Jun 1976-The Scandinavian Journal of Economics

TL;DR: In this paper, the authors consider the extension of the fundamental principles of the monetary approach to balance of payments analysis to a regime of floating exchange rates, with active intervention by the authorities to control rate movements.

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Abstract: This paper considers the extension of the fundamental principles of the monetary approach to balance of payments analysis to a regime of floating exchange rates, with active intervention by the authorities to control rate movements It makes four main points First, the exchange rate is the relative price of different national monies, rather than national outputs, and is determined primarily by the demands and supplies of stocks of different national monies Second, exchange rates are strongly influenced by asset holder’s expectations of future exchange rates and these expectations are influenced by beliefs concerning the future course of monetary policy Third, “real” factors, as well as monetary factors, are important in determining the behavior of exchange rates Fourth, the problems of policy conflict which exist under a system of fixed rates are reduced, but not eliminated, under a regime of controlled floating A brief appendix develops some of the implications of “rational expectations” for the theory of exchange rates

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611 citations

Journal Article•DOI•

Exchange rate expectations and monetary policy

[...]

Rudiger Dornbusch¹•Institutions (1)

Massachusetts Institute of Technology¹

01 Aug 1976-Journal of International Economics

TL;DR: In this paper, the adjustment process to a monetary disturbance is studied in a model of perfect capital mobility and flexible exchange rates, where exchange rate expectations are emphasized and used to establish an adjustment process.

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150 citations

Book Chapter•DOI•

Stability and Exchange Rate Systems in a Monetarist Model of the Balance of Payments

[...]

Stanley Fischer

01 Jan 1977

TL;DR: In this paper, the effects of the exchange rate system on economic stability were investigated in a single country and in a two-country world under regimes of fixed and of floating exchange rates.

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Abstract: The fixed versus floating exchange rates debate appears destined for as long a life as any of the standing controversies in economics. The standard arguments are outlined by Johnson (1969) and Kindleberger (1969). This paper focuses on the effects of the exchange rate system on economic stability. We construct a simple model in which real disturbances affect the level of output each period and nominal disturbances affect the demand for money, and examine the resultant variability of the rate of consumption and the price level in a single country and in a two-country world under regimes of fixed and of floating exchange rates.

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102 citations

"Expectations and Exchange Rate Dyna..." refers methods in this paper

...Fischer (1976) has used a stochastic framework to evaluate fixed versus flexible exchange rate systems....
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Journal Article•DOI•

Some doubts about the efficacy of monetary policy under flexible exchange rates

[...]

Jürg Niehans¹•Institutions (1)

Johns Hopkins University¹

01 Aug 1975-Journal of International Economics

TL;DR: In this paper, it is argued that if the price elasticities of the demands for exports and imports are affected by the transition to flexible rates, and capital flows are assumed to be dependent on the exchange rate, the efficacy of monetary policy under flexible rates will not necessarily follow.

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86 citations