Showing papers on "Exchange rate published in 1988"

The logic of currency crises

Abstract: Once one recognizes that governments borrow international reserves and exercise other policy options to defend fixed exchange rates during currency crises, the question arises: What factors determine a government’s decision to abandon a currency peg or hang on? In a setting of purposeful action by the authorities, the possibility of self-fulfilling crises becomes important. Speculative anticipations depend on conjectured government responses, which depend, in turn, on how price changes that are themselves fueled by expectations affect the government’s economic and political positions. This circular dynamic implies a potential for crises that need not have occurred, but that do because market participants expect them to. In contrast to this picture, most literature on balance-of-payments crises ignores the response of government behavior to markets. That literature, I argue, throws little light on events such as the European Exchange Rate Mechanism collapse of 1992–1993. This article presents two different models in which crisis and realignment result from the interaction of rational private economic actors and a government that pursues well-defined policy goals. In both, arbitrary expectational shifts can turn a fairly credible exchange-rate peg into a fragile one.

Was It Real? The Exchange Rate‐Interest Differential Relation over the Modern Floating‐Rate Period

Abstract: In this paper, we explore the relationship between real exchange rates and real interest rate differentials in the United States, Germany, Japan, and the United Kingdom. Contrary to theories based on the joint hypothesis that domestic prices are sticky and monetary disturbances are predominant, we find little evidence of a stable relationship between real interest rates and real exchange rates. We consider both in-sample and out-of-sample tests. One hypothesis that is consistent with our findings is that real disturbances (such as productivity shocks) may be a major source of exchange rate volatility. THIS PAPER INVESTIGATES THE empirical relationship between major currency real exchange rates and real interest rates over the modern (post-March 1973) flexible rate experience. The exchange rates examined here include the dollar/ mark, dollar/yen, and dollar/pound rates. Our two major findings are as follows. First, the data do not indicate a strong correspondence between real interest rate differentials (short-term or long-term) and real exchange rates. This finding appears to conflict with the predictions of most monetary and portfolio balance models of exchange rate determination, though the conflict can be substantially reconciled if aggregate disturbances are primarily real in nature (i.e., changes in productivity, tastes, etc.). It is true that in many cases the sign of the estimated exchange rate-interest rate differential relationship is consistent with the possible predominance of financial market disturbances, but the relationship is not stable enough to be statistically significant. Second, although one does find some evidence of a unit root in both real exchange rates and long-term (but not shortterm) real interest differentials, these two series do not appear to be linearly cointegrated. Hence, the nonstationarity (or near nonstationarity) in the two series cannot be attributed to the same factor. In Section I, we briefly describe a class of small-scale monetary models of exchange rate determination. The importance of this class of models for empirical work derives from its strong predictions about how the exchange rate will move

On Jump Processes in the Foreign Exchange and Stock Markets

Abstract: exchange rates exhibit systematic discontinuities, even after allowingfor conditional heteroskedasticity in the diffusion process. The results are much more significant in theforeign exchange market than in the stock market, which suggests differences in the structure of these markets. Finally, this jump component is shown to explain some of the empirically observed mispricings in the currency options market. The objective of this article is to analyze and compare the empirical distribution of returns in the stock market and in the foreign exchange market. There are a number of reasons why a better understanding of the stochastic processes driving prices in these markets would be useful. Many financial models rely heavily on the assumption of a particular stochastic process, while relatively little attention is paid to the empirical fit of the postulated distribution. As a result, models like option pricing models are applied indiscriminately to various markets such as the stock market and the foreign exchange market when the underlying processes may be fundamentally different. The foreign exchange market, for instance, is characterized by active exchange rate man

Exchange Rate Variability and the Slowdown in Growth of International Trade

Abstract: The growth rate of international trade among industrial countries has declined by more than half since the inception of floating exchange rates. To explain the slowdown, the effects of exchange rate volatility are separated from those of other shocks since 1973--in particular, changes in oil prices and in trade regimes. The paper focuses on the effects of exchange rate variability with lags longer than a few months or quarters.

Exchange Rate Pass-Through When Market Share Matters

Abstract: We investigate pricing to market when the exchange rate changes in cases where firms' future demands depend on their current market shares. We show that i) profit maximizing foreign firms may either raise or lower their domestic currency export prices when the domestic exchange rate appreciates temporarily (i.e. the "pass-through" from exchange rate changes to import prices may be perverse); ii) current import prices may be more sensitive to the expected future exchange rate than to the current exchange rate; iii) current import prices fall in response to an increase in uncertainty about the future exchange rate. We present evidence that suggests the behavior of expected future exchange rates may provide a clue to the puzzling behavior of U.S. import prices during the 1980s.

Hyteresis in Import Prices: The Beachhead Effect

Abstract: This paper shows that temporary real exchange rate fluctuations can have persistent (hysteretic) effects on trade. Specifically, when market-entry costs are sunk, sufficiently large exchange rate shocks alter domestic market structure and thereby induce hysteresis. This simple result has strong implications for exchange rate theory, t rade policy, and estimation of trade equations. Empirical evidence su ggests that the recent dollar overvaluation induced hysteresis in U.S. import prices. Namely, the aggregate pass-through equation (of exchange rates to import prices) shifted in the 1980s. The shift's nature and timing is broadly consistent with the hysteresis hypothesis. Copyright 1988 by American Economic Association.

Business Cycles and the Exchange Rate System: Some International Evidence

Abstract: This paper investigates empirically the differences in time?series behavior of key economic aggregates under alternative exchange rate systems. We use a postwar sample of 49 countries to compare the behavior of output. consumption, trade flows, government consumption spending, and real exchange rates under alternative exchange rate systems (pegged, floating, and systems such as the EMS). We then examine evidence from two particular episodes, involving Canada and Ireland, of changes in the exchange rate system. Aside from greater variability of real exchange rates under flexible than under pegged nominal exchange rate systems, we find little evidence of systematic differences in the behavior of other macroeconomic aggregates or international trade flows under alternative exchange rate systems. These results are of interest because a large class of theoretical models implies that the nominal exchange rate system has important effects on a number of macroeconomic quantities.

Exchange-rate instability

Abstract: In an intriguing synthesis of current theories of international finance, trade, and industrial organization, Paul Krugman presents a provocative analysis of the extraordinary volatility of exchange rates in the 1980s.Krugman focuses on imperfect integration of the world economy, showing how this has become both a cause and effect of exchange rate instability. He outlines the costs and benefits of recent flexible-exchange rate policies and offers fresh insight into why the models that worked in the first half of the 1980s don't work in the growing uncertainty of the latter half. Krugman's analysis is succinct and accessible, with technical appendixes that offer powerful backing to his ideas."Exchange Rate Instability "contains a surprising reevaluation of the author's own work on exchange rates. Krugman questions the need for further devaluation of the dollar, arguing that uncertainty - rather than the lack of cost-competitiveness explains the failure of current policies to reduce the United States trade deficit. He proposes an eventual return to fixed exchange rates.Paul R. Krugman is Professor of Economics at MIT "Exchange Rate Instability "inaugurates the Lionel Robbins Lectures series.

An empirical examination of long-run purchasing power parity using cointegration techniques

Abstract: This paper presents an empirical analysis of long-run purchasing power parity (PPP) for five major exchange rates using recently developed econometric techniques on the cointegration of economic time series. Our empirical results are extremely unfavourable to the PPP hypothesis as a long-run equilibrium condition, even with an allowance made for measurement error and/or tranportation costs. In particular, we are unable to reject the hypothesis of non-cointegration of the exchange rate and relative prices for any of the countries concerned. Far from finding a stable, long-run proportionality between exchange rates and relative prices, our results therefore suggest that they tend to drift apart without bound.

Exchange rate misalignment in developing countries

Abstract: This article analyzes the theory of equilibrium real exchange rates and defines misalignment as a deviation of the real exchange rate (RER) from its equilibrium level. The role of macroeconomic policies is then analyzed under three alternative nominal exchange rate regimes: predetermined nominal exchange rates; floating nominal rates; and dual or black market nominal exchange rates. This discussion points out how inconsistent macroeconomic policies often lead to real exchange rate misalignment. Corrective measures, including nominal devaluation and several alternative approaches, are then evaluated.

Exchange Rate Uncertainty, Forward Contracts, and International Portfolio Selection

Abstract: In this paper, ex ante efficient portfolio selection strategies are developed to realize potential gains from international diversification under flexible exchange rates. It is shown that exchange rate uncertainty is a largely nondiversiflable factor adversely affecting the performance of international portfolios. Therefore, it is essential to effectively control exchange rate volatility. For that purpose, two methods of exchange risk reduction are simultaneously employed: multicurrency diversification and hedging via forward exchange contracts. The empirical findings show that international portfolio selection strategies designed to control both estimation and exchange risks almost consistently outperform the U.S. domestic portfolio in out-of-sample periods. SINCE GRUBEL [11] APPLIED MODERN portfolio theory (MPT) to international investment, various authors, such as Levy and Sarnat [17], Solnik [20], and Lessard [16], have examined the gains from international diversification of investment portfolios. For the purpose of establishing the gains from international diversification, these studies constructed international portfolios using historical risk and return data from a period of fixed or relatively stable exchange rates and showed that internationally diversified portfolios dominated purely domestic portfolios in terms of mean-variance efficiency. From the standpoint of today's investors, however, the previous studies fail to offer operational guidance for international diversification for two important reasons. First, it is now questionable whether the past findings are still relevant under the current flexible exchange rate regime. Second, by being "ex post" in nature, the past studies ignored the issue of estimation risk, or parameter uncertainty, and therefore may have overstated the realizable portion of the potential gains from international diversification. Fluctuating exchange rates are likely to mitigate the potential gains from international diversification by making investment in foreign securities more risky. As will be shown later, a fluctuating exchange rate contributes to the risk of foreign investment not only through its own variance but also through its "positive" covariances with the local stock market returns. During our sample period of 1980 through 1985, for example, exchange rate volatility is found to account for about fifty percent of the volatility of dollar returns from investment in the stock markets of such major countries as Germany, Japan, and the U.K. Furthermore, the exchange rate changes vis-'a-vis the U.S. dollar are found to be

Arima and Cointegration Tests of PPP under Fixed and Flexible Exchange Rate Regimes

Abstract: Real exchange rates between the United States and its major trading partners were calculated for the Bretton Woods and flexible exchange rate periods. Unit root tests indicate that Purchasing Power Parity performed poorly in both periods. Tests for cointegration reveal limited instances in which it is possible to estimate the deviations from PPP as an error correcting model. The estimated error correcting models indicate that foreign, but not U.S., prices responded to deviations from PPP. Frenkel's (1981b) finding that Purchasing Power Parity (PPP) worked better during the 1920s than the 1970s caused considerable controversy. For example, Davutyan and Pippenger (1985) contend that the socalled "collapse" of PPP is a result of an increase in the relative importance of real versus monetary shocks. They argue that the 1970s, as opposed to the 1920s, was characterized by real supply shocks and the international coordination of monetary policies. The argument is that PPP did not fail; rather, there was an increase in the volatility of those factors giving rise to deviations from PPP. Hakkio (1984) reestimated PPP over the 1920s and 1970s; using cross-country tests (i.e., SURE estimates) to improve the efficiency of his estimates, he was able to support the hypothesis that PPP worked better in the 1970s than in the 1920s. On the other hand, papers by Adler and Lehman (1983), Dornbusch (1980), Frenkel (1981a), Junge (1985), and Krugman (1978) report findings contrary to the PPP hypothesis. Moreover, Kenen and Rodrik (1986) find that the volatility of real exchange rates has increased throughout the flexible rate period. This paper tries to shed some light on the importance and persistence of the observed deviations from Purchasing Power Parity under alternative exchange rate systems. While it is interesting to compare PPP in the 1920s versus the 1970s, it is equally useful to compare the 1960s versus the 1970s and 1980s. If real supply shocks and lack of monetary coordination are characteristic of the latter period, PPP should perform better in the 1960s. To illustrate the issues involved, consider the following econometric model of (Relative) Purchasing Power

Determinants of the equilibrium real exchange rate

Abstract: N.B. Professor Neary was based at University College Dublin and Queen's University, Ontario, Canada when this article was first published. The full-text of this article is not available in ORA at this time. Citation: Neary, J. P. (1988). 'Determinants of the equilibrium real exchange rate', American Economic Review, 78(1), 210-215.

Exchange Rate Risk, Exchange Rate Regime and the Volume of International Trade

Abstract: The authors examine the effect of exchange-rate regimes on the volume of internatio nal trade. Bilateral trade flows among countries with floating exchan ge rates are higher than those among countries with fixed rates. Whil e exchange-rate risk does reduce the volume of trade among countries regardless of the nature of their exchange-rate regime, the greater r isk faced by traders in floating exchange-rate countries is more than offset by the trade-reducing effects of restrictive commercial polic ies imposed by fixed exchange rate countries. Copyright 1988 by WWZ and Helbing & Lichtenhahn Verlag AG

World Business Cycles under Fixed and Flexible Exchange Rates

Abstract: This paper studies the behavior of monthly industrial production indices during the recent periods of fixed and flexible exchange rate s. The central conclusions are as follows: industrial production indices are subject to stochastic trend growth; the variances of the monthly growth rates are higher in the flexible exchange rate period than in the fixed exchange rate period, and are related to the degree of openness and to national income-more open economies tend to experience more variability while richer, more diversified economies experience less; and output movements have been correlated across countries under both exchange rate regimes, and there is evidence of a world business cycle. Copyright 1988 by Ohio State University Press.

Monetary and Exchange Rate Policies for International Financial Stability: A Proposal

Abstract: W v ithout a common monetary standard, the remarkable integration of Western European, North American, and the industrialized Asian economies in both commodity trade and financial flows is less efficient, and becoming untenable. Dissatisfaction with wildly fluctuating relative currency values, euphemistically called " floating" or " flexible" exchange rates, is a prime cause of the resurgence in protectionism. In 1986-87, the overvalued yen forced Japanese industrialists to close factories, retire workers, and write off once valuable investments in plant and equipment. This parallels what their American counterparts were forced to do between 1981 and 1985, when the dollar suddenly became overvalued. Similarly, the paring down of the British manufacturing base was precipitated when the pound unexpectedly became a strong petrocurrency in 1979-81. In agriculture, Japan and European countries are determined to insulate their domestic prices of farm products from unsettling international influences, including volatile fluctuations in the yen/dollar or mark/dollar exchange rates. Thus, unless exchange stability is first achieved, the American government's attempt to broaden the General Agreement on Tariffs and Trade to encompass agriculture and services is likely to fail. But what keeps the three major industrial blocs from developing a common monetary standard to prevent exchange-rate fluctuations? Although many people

Exchange Rate Economics: Theories and Evidence

Abstract: 1. Introduction: Some Basic Concepts and Stylised facts and the Case For (and Against) Floating Exchange Rates 2. Purchasing Power Parity and the PPP Puzzle 3. The Economics of the PPP Puzzle 4. The Flexible Price Monetary Model 5. The Sticky Price Monetary Model 6. Empirical Evidence on the Monetary Exchange Rate Model 7. Currency Substitution and Portfolio Balance Models 8. Real Exchange Rate Determination: Theory and Evidence 9. Equilibrium Exchange Rates: Measurement and Misalignment 10. The New Open Economy Macroeconomics and Exchange Rate Behaviour 11. The New Open Economy Macroeconomics: Pricing to Market and Exchange Rate Volatility Redux 12. The Economics of Fixed Exchange Rates, Part 1: Target Zone Models 13. The Economics of Fixed Exchange Rates, Part 2: Speculative Attack Models and Contagion 14. The Market Microstructure Approach to the Foreign Exchange Market 15. Spot and Forward Exchange Rates and the Forward Premium Puzzle

Mixed Diffusion-Jump Process Modeling of Exchange Rate Movements

Abstract: This study demonstrates that the mixed diffusion-jump process is superior to the stable laws or a mixture of normals as a model of exchange rate changes for the British pound, French franc, and the We st German mark relative to the United States dollar The parameter value s for the mixed diffusion-jump process are dependent on the monetary policy regime in force in the United States, with the estimates for the franc and mark being intertemporally similar but different from the pound Copyright 1988 by MIT Press

Hysteresis In Import Prices: The Beachhead Effect

Abstract: International economists typically assume that temporary real exchange rate shocks can have only temporary real effects -and no effect at all on the underlying structure of the economy. This paper shows that even in a simple "off-the-shelf" industrial organization model, this assumption is unfounded; if market-entry costs are sunk, exchange rate shocks can alter domestic market structure and thereby have lasting real effects. In other words, a sufficiently large exchange rate shock can cause hysteresis in import prices and quantities. This simple idea has strong implications for exchange rate theory (Baldwin and Krugman 1986 shows this), for trade policy (Dixit 1987a discusses this), and for the estimation of trade equations as the present paper shows. To show that the theoretical point is not just empirically empty theorizing, we present evidence which suggests that the recent dollar overvaluation is an example of a hysteresis-inducing shock. To this end we demonstrate that the pass-through relationship shifted in a manner that 13 consistent with the nature and timing of the market structure changes predicted by the model. In particular, we find evidence that the structural break occurred during the rising dollar phase rather than In 1985 as is commonly asserted. A direct test of the model is not performed due to data limitations.

The World Economy: Trade and Finance

Abstract: Part I: International Microeconomics. Introduction to the World Economy. Comparative Advantage I: Labour Productivity and the Ricardian Model. Comparative Advantage II: Factor Endowments and the Neoclassical Model. Trade, Distribution, and Welfare Introduction. Beyond Comparative Advantage: Empirical Evidence and New Trade Theories. Tariffs. Nontariff Trade Barriers and the New Protectionism. Arguments for Restricting Trade. The Political Economy of Trade Policy and Borders. Growth, Immigration and Multinationals. Development, Transition, and Trade. Part II: International Macroeconomics. Currency Markets and Exchange Rates. The Balance of Payments Accounts. The Market for Goods and Services in an Open Economy. Money, the Banking System and Foreign Exchange. Short-Run Macroeconomic Policy under Fixed Exchange Rates. Short-Run Macroeconomic Policy under Flexible Exchange Rates. The Exchange Rate in Long-Run Equilibrium. Prices and Output in an Open Economy. Alternative International Monetary Regimes. Macroeconomics of Development and Transition.

Floating Exchange Rates: Theories and Evidence

Abstract: 1. Introduction: Some Basic Concepts and Stylised facts and the Case For (and Against) Floating Exchange Rates 2. Purchasing Power Parity and the PPP Puzzle 3. The Economics of the PPP Puzzle 4. The Flexible Price Monetary Model 5. The Sticky Price Monetary Model 6. Empirical Evidence on the Monetary Exchange Rate Model 7. Currency Substitution and Portfolio Balance Models 8. Real Exchange Rate Determination: Theory and Evidence 9. Equilibrium Exchange Rates: Measurement and Misalignment 10. The New Open Economy Macroeconomics and Exchange Rate Behaviour 11. The New Open Economy Macroeconomics: Pricing to Market and Exchange Rate Volatility Redux 12. The Economics of Fixed Exchange Rates, Part 1: Target Zone Models 13. The Economics of Fixed Exchange Rates, Part 2: Speculative Attack Models and Contagion 14. The Market Microstructure Approach to the Foreign Exchange Market 15. Spot and Forward Exchange Rates and the Forward Premium Puzzle

Black market premia, exchange rate unification, and inflation in Sub-Saharan Africa

Abstract: World Bank and International Monetary Fund (IMF) programs favor unification of official and black market exchange rates on the argument that multiple exchange rates misallocate resources. This article shows that such policy advice sometimes overlooks an important consideration : when multiple rates are a means of taxation, the widened deficit from unification increases inflation. This article uses the experience of Ghana, Nigeria, and Sierra Leone to illustrate the tradeoff between the benefits of unification for resource allocation and its cost for inflation.

Real Exchange Rate Variability Under Pegged and Floating Nominal Exchange Rate Systems: an Equilibrium Theory

Abstract: This paper proposes a new explanation for the greater variability of real exchange rates under pegged than under floating nominal exchange rate systems. The explanation hinges on the propensity of governments to use international trade restrictions and financial restrictions for balance-of-payments purposes under pegged exchange rates. In particular. these restrictions become more likely during periods of time when countries suffer losses of international reserves than might. without policy changes. lead to a balance-of-payments crisis. This covariation of restrictions with reserve changes implies that real exchange rates will vary less under pegged than under floating exchange rates.

The Balance of Trade, Terms of Trade, and Real Exchange Rate: An Intertemporal Optimizing Framework

Abstract: An intertemporal optimizing model of a small open economy is used to analyze how terms of trade changes affect real exchange rates and the trade balance. Temporary current, (expected) future, and permanent changes in the terms of trade are considered. The results suggest that the relationship between the terms of trade and the current account (the so-called Harberger-Laursen-Metzler effect) is sensitive to whether the model incorporates nontradable goods. Thus, the real exchange rate may be an important variable through which terms of trade shocks are transmitted to the current account.