Showing papers on "Exchange rate published in 2005"
TL;DR: In this paper, the authors revisited the saving and investment nexus as postulated by Feldstein and Horioka (1980) and found that the saving investment correlation for China is estimated over the periods 1952-1998 and 1952-1994, the latter culminating in a fixed exchange rate regime.
Abstract: The saving and investment nexus as postulated by Feldstein and Horioka (FH) (1980) is revisited. The saving investment correlation for China is estimated over the periods 1952-1998 and 1952-1994, the latter culminating in a period of fixed exchange rate regime. Amongst the key results, it is found that saving and investment are correlated for China for both the period of the fixed exchange rate and the entire sample period. With high saving-investment correlation, the results suggest that the Chinese economy is in conformity with the FH hypothesis. This is a valid outcome, for in China capital mobility was fairly restricted over the 1952-1994 period as indicated by the relatively low foreign direct investment.
2,757 citations
TL;DR: In this article, the authors present a small open economy version of the Calvo sticky price model, and show how the equilibrium dynamics can be reduced to a simple representation in domestic inflation and the output gap.
Abstract: We lay out a small open economy version of the Calvo sticky price model, and show how the equilibrium dynamics can be reduced to a simple representation in domestic inflation and the output gap. We use the resulting framework to analyse the macroeconomic implications of three alternative rulebased policy regimes for the small open economy: domestic inflation and CPI-based Taylor rules, and an exchange rate peg. We show that a key difference among these regimes lies in the relative amount of exchange rate volatility that they entail. We also discuss a special case for which domestic inflation targeting constitutes the optimal policy, and where a simple second order approximation to the utility of the representative consumer can be derived and used to evaluate the welfare losses associated with the suboptimal rules.
1,311 citations
TL;DR: The authors compare 330 ARCH-type models in terms of their ability to describe the conditional variance and find no evidence that a GARCH(1,1) is outperformed by more sophisticated models in their analysis of exchange rates.
Abstract: We compare 330 ARCH-type models in terms of their ability to describe the conditional variance. The models are compared out-of-sample using DM–$ exchange rate data and IBM return data, where the latter is based on a new data set of realized variance. We find no evidence that a GARCH(1,1) is outperformed by more sophisticated models in our analysis of exchange rates, whereas the GARCH(1,1) is clearly inferior to models that can accommodate a leverage effect in our analysis of IBM returns. The models are compared with the test for superior predictive ability (SPA) and the reality check for data snooping (RC). Our empirical results show that the RC lacks power to an extent that makes it unable to distinguish ‘good’ and ‘bad’ models in our analysis. Copyright © 2005 John Wiley & Sons, Ltd.
1,254 citations
TL;DR: The authors argued that low import price pass-through means that nominal exchange rate fluctuations may lead to lower expenditure-switching effects of domestic monetary policy and as a consequence, monetary policy effectiveness is greater for stimulating the domestic economy.
Abstract: Though exchange rate pass-through has long been of interest, the focus of this interest has evolved considerably over time. After a long period of debate over the law of one price and convergence across countries, beginning in the late 1980s exchange rate pass-through studies emphasized industrial organization and the role of segmentation and price discrimination across geographically distinct product markets. More recently pass-through issues have played a central role in heated debates over appropriate monetary policies and exchange rate regime optimality in general equilibrium models. 1 These debates have broad implications for the conduct of monetary policy, for macroeconomic stability, for international transmission of shocks, and for efforts to contain large imbalances in trade and international capital flows. These debates hinge on the issue of the prevalence of producer-currency pricing (PCP) versus local-currency pricing (LCP) of imports, and on whether exchange rate pass-through rates are endogenous to a country’s monetary performance. Low import price pass-through means that nominal exchange rate fluctuations may lead to lower expenditure-switching effects of domestic monetary policy. As a consequence of this insulation, monetary policy effectiveness is greater for stimulating the domestic economy. Taylor (2000) also has noted the potential complementarity between monetary stability and monetary effectiveness as a policy instrument. The idea is that if pass-through rates are endogenous to a country’s relative monetary stability, periods of more stable inflation and monetary performance also will be periods when monetary policy may be more effective as a stabilization instrument. Concerns
870 citations
TL;DR: In this article, the authors show that in a rational expectations present-value model, an asset price manifests near-random walk behavior if fundamentals are I(1) and the factor for discounting future fundamentals is near one.
Abstract: We show analytically that in a rational expectations present-value model, an asset price manifests near–random walk behavior if fundamentals are I(1) and the factor for discounting future fundamentals is near one. We argue that this result helps explain the well-known puzzle that fundamental variables such as relative money supplies, outputs, inflation, and interest rates provide little help in predicting changes in floating exchange rates. As well, we show that the data do exhibit a related link suggested by standard models—that the exchange rate helps predict these fundamentals. The implication is that exchange rates and fundamentals are linked in a way that is broadly consistent with asset-pricing models of the exchange rate.
739 citations
TL;DR: In this paper, the authors re-assess exchange rate prediction using a wider set of models that have been proposed in the last decade: interest rate parity, productivity based models, and behavioral equilibrium exchange rate' models.
Abstract: Previous assessments of nominal exchange rate determination have focused upon a narrow set of models typically of the 1970's vintage. The canonical papers in this literature are by Meese and Rogoff (1983, 1988), who examined monetary and portfolio balance models. Succeeding works by Mark (1995) and Chinn and Meese (1995) focused on similar models. In this paper we re-assess exchange rate prediction using a wider set of models that have been proposed in the last decade: interest rate parity, productivity based models, and behavioral equilibrium exchange rate' models. The performance of these models is compared against a benchmark model the Dornbusch-Frankel sticky price monetary model. The models are estimated in error correction and first-difference specifications. Rather than estimating the cointegrating vector over the entire sample and treating it as part of the ex ante information set as is commonly done in the literature, we recursively update the cointegrating vector, thereby generating true ex ante forecasts. We examine model performance at various forecast horizons (1 quarter, 4 quarters, 20 quarters) using differing metrics (mean squared error, direction of change), as well as the consistency' test of Cheung and Chinn (1998). No model consistently outperforms a random walk, by a mean squared error measure; however, along a direction-of-change dimension, certain structural models do outperform a random walk with statistical significance. Moreover, one finds that these forecasts are cointegrated with the actual values of exchange rates, although in a large number of cases, the elasticity of the forecasts with respect to the actual values is different from unity. Overall, model/specification/currency combinations that work well in one period will not necessarily work well in another period.
719 citations
22 Mar 2005
TL;DR: The U.S. current account deficit today is running at around 6 percent of GDP, an all-time record as mentioned in this paper, and the potential for sharp exchange rate movements any future adjustment toward current account balance might imply.
Abstract: THIS IS THE third in a series of papers we have written over the past five years about the growing U.S. current account deficit and the potentially sharp exchange rate movements any future adjustment toward current account balance might imply. (1) The problem has hardly gone away in those five years. Indeed, the U.S. current account deficit today is running at around 6 percent of GDP, an all-time record. Incredibly, the U.S. deficit now soaks up about 75 percent of the combined current account surpluses of Germany, Japan, China, and all the world's other surplus countries. (2) To balance its current account simply through higher exports, the United States would have to increase export revenue by a staggering 58 percent over 2004 levels. And, as we argue in this paper, the speed at which the U.S. current account ultimately returns toward balance, the triggers that drive that adjustment, and the way in which the burden of adjustment is allocated across Europe and Asia all have enormous implications for global exchange rates. Each scenario for returning to balance poses, in turn, its own risks to financial markets and to general economic stability. Our assessment is that the risks of collateral damage--beyond the risks to exchange rate stability--have grown substantially over the five years since our first research paper on the topic, partly because the U.S. current account deficit itself has grown, but mainly because of a mix of other factors. These include, not least, the stunningly low U.S. personal saving rate (which, driven by unsustainable rates of housing appreciation and record low interest rates, fell to 1 percent of disposable personal income in 2004). But additional major risks are posed by the sharp deterioration in the U.S. federal government's fiscal trajectory since 2000, rising energy prices, and the fact that the United States has become increasingly dependent on Asian central banks and politically unstable oil producers to finance its deficits. To these vulnerabilities must be added Europe's conspicuously inflexible economy, Japan's continuing dependence on export-driven growth, the susceptibility of emerging markets to any kind of global financial volatility, and the fact that, increasingly, the counterparties in international asset transactions are insurance companies, hedge funds, and other relatively unregulated nonbank financial entities. Perhaps above all, geopolitical risks and the threat of international terror have risen markedly since September 2001, confronting the United States with open-ended long-term costs for financing wars and homeland security. True, if some shock (such as a rise in foreign demand for U.S. exports) were to close up these global imbalances quickly without exposing any concomitant weaknesses, the damage might well be contained to exchange rates and to the collapse of a few large banks and financial firms--along with, perhaps, mild recession in Europe and Japan. But, given the broader risks, it seems prudent to try to find policies that will gradually reduce global imbalances now rather than later. Such policies would include finding ways to reverse the decline in U.S. saving, particularly by developing a more credible strategy to eliminate the structural federal budget deficit and to tackle the country's actuarially insolvent old-age pension and medical benefit programs. More rapid productivity growth in the rest of the world would be particularly helpful in achieving a benign adjustment, but only, as the model we develop in this paper illustrates, if that growth is concentrated in nontraded (domestically produced and consumed) goods rather than the export sector, where such productivity growth could actually widen the U.S. trade deficit. It is also essential that Asia, which now accounts for more than one-third of global output on a purchasing power parity basis, take responsibility for bearing its share of the burden of adjustment. Otherwise, if demand shifts caused the U. …
621 citations
TL;DR: This article found that the de facto pegs have remained stable throughout the last decade, although an increasing number of countries shy away from an explicit commitment to a fixed regime (hidden pegs).
615 citations
TL;DR: In this article, the authors re-assess exchange rate prediction using a wider set of models that have been proposed in the last decade: interest rate parity, productivity based models, and a composite specification.
592 citations
TL;DR: The extent to which gold has acted as an exchange rate hedge is assessed using weekly data for the last thirty years on the gold price and sterling-dollar and yen-dollar exchange rates.
524 citations
TL;DR: In this article, the authors provide a baseline general equilibrium model of optimal monetary policy among interdependent economies with monopolistic firms and nominal rigidities, and show that optimal monetary rules in a world Nash equilibrium lead to less exchange rate volatility relative to both inward-looking rules and discretionary policies, even when the latter do not suffer from any inflationary bias.
TL;DR: In this article, the authors studied whether and how US shocks are transmitted to eight Latin American countries, using sign restrictions and treating US shocks as exogenous with respect to Latin American economies.
Abstract: I study whether and how US shocks are transmitted to eight Latin American countries. US shocks are identified using sign restrictions and treated as exogenous with respect to Latin American economies. Posterior estimates for individual and average effects are constructed. US monetary shocks produce significant fluctuations in Latin America, but real demand and supply shocks do not. Floaters and currency boarders display similar output but different inflation and interest rate responses. The financial channel plays a crucial role in the transmission. US disturbances explain important portions of the variability of Latin American macrovariables, producing continental cyclical fluctuations and, in two episodes, destabilizing nominal exchange rate effects. Policy implications are discussed. Copyright © 2005 John Wiley & Sons, Ltd.
01 Jan 2005
TL;DR: Other people's money as mentioned in this paper suggests that the problem is linked to the operation of international financial markets, which prevent countries from borrowing in their own currencies, and proposes a solution that would involve having the World Bank and regional development banks themselves borrow and lend in emerging market currencies.
Abstract: Recent crises in emerging markets have been heavily driven by balance-sheet or net-worth effects. Episodes in countries as far-flung as Indonesia and Argentina have shown that exchange rate adjustments that would normally help to restore balance can be destabilizing, even catastrophic, for countries whose debts are denominated in foreign currencies. Many economists instinctually assume that developing countries allow their foreign debts to be denominated in dollars, yen, or euros because they simply don't know better. Presenting evidence that even emerging markets with strong policies and institutions experience this problem, "Other People's Money" recognizes that the situation must be attributed to more than ignorance. Instead, the contributors suggest that the problem is linked to the operation of international financial markets, which prevent countries from borrowing in their own currencies. A comprehensive analysis of the sources of this problem and its consequences, "Other People's Money" takes the study one step further, proposing a solution that would involve having the World Bank and regional development banks themselves borrow and lend in emerging market currencies.
TL;DR: The authors showed that the aggregate real exchange rate is persistent because its components have heterogeneous dynamics and showed that when heterogeneity is taken into account, the estimated persistence of real exchange rates falls dramatically.
Abstract: We show the importance of a dynamic aggregation bias in accounting for the PPP puzzle. We prove that the aggregate real exchange rate is persistent because its components have heterogeneous dynamics. Established time series and panel methods fail to control for this. Using Eurostat data, we find that when heterogeneity is taken into account, the estimated persistence of real exchange rates falls dramatically. Its half-life, for instance, may fall to as low as eleven months, significantly below the "consensus view" of three to five years.
TL;DR: In this article, the authors introduce incomplete exchange rate pass-through on import prices, which renders the analysis of monetary policy of an open economy fundamentally different from the one of a closed economy.
Abstract: In a dynamic New Keynesian optimizing model, we introduce incomplete exchange rate pass-through on import prices. Three results stand out. First, unlike canonical models with perfect pass-through which emphasize a type of isomorphism, incomplete pass-through renders the analysis of monetary policy of an open economy fundamentally different from the one of a closed economy. Second, productivity-driven deviations from the law of one price assume the interpretation of endogenous cost-push shocks. Third, the optimal commitment policy, relative to discretion, entails a smoothing of the deviations from the law of one price and requires more stable nominal and real exchange rates.
TL;DR: In this paper, the authors argue that the primary force behind the large drop in real exchange rates that occurs after large devaluations is the slow adjustment in the prices of nontradable goods and services, and they assess the robustness of their findings by studying large real exchange rate appreciations, medium devaluations, and small exchange rate movements.
Abstract: In this paper we argue that the primary force behind the large drop in real exchange rates that occurs after large devaluations is the slow adjustment in the prices of nontradable goods and services. Our empirical analysis uses data from five large devaluation episodes: Argentina (2002), Brazil (1999), Korea (1997), Mexico (1994), and Thailand (1997). We conduct a detailed analysis of the Argentinian case using disaggregated consumer price index data, data from our own survey of prices in Buenos Aires, and scanner data from supermarkets. We assess the robustness of our findings by studying large real exchange rate appreciations, medium devaluations, and small exchange rate movements.
TL;DR: In this paper, the authors studied the long-run and short-run dynamics between stock prices and exchange rates and the channels through which exogenous shocks impact on these markets by using cointegration methodology and multivariate Granger causality tests.
TL;DR: In this paper, the authors provide a framework for non-parametric measurement of the jump component in asset return volatility and find that jumps are both highly prevalent and distinctly less persistent than the continuous sample path variation process.
Abstract: A rapidly growing literature has documented important improvements in financial return volatility measurement and forecasting via use of realized variation measures constructed from high-frequency returns coupled with simple modeling procedures. Building on recent theoretical results in Barndorff-Nielsen and Shephard (2004a, 2005) for related bi-power variation measures, the present paper provides a practical and robust framework for non-parametrically measuring the jump component in asset return volatility. In an application to the DM/$ exchange rate, the S&P500 market index, and the 30-year U.S. Treasury bond yield, we find that jumps are both highly prevalent and distinctly less persistent than the continuous sample path variation process. Moreover, many jumps appear directly associated with specific macroeconomic news announcements. Separating jump from non-jump movements in a simple but sophisticated volatility forecasting model, we find that almost all of the predictability in daily, weekly, and monthly return volatilities comes from the non-jump component. Our results thus set the stage for a number of interesting future econometric developments and important financial applications by separately modeling, forecasting, and pricing the continuous and jump components of the total return variation process.
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TL;DR: In this article, the authors examined a possible offset to the beneficial effects of aid using a methodology that exploits both cross-country and within-country variation, and found that it is hard to find a robust effect of aid on the long-term growth of poor countries.
Abstract: Why it is so hard to find a robust effect of aid on the long-term growth of poor countries, even those with good policies. A possible offset to the beneficial effects of aid is examined using a methodology that exploits both cross-country and within-country variation.
TL;DR: In this article, the authors investigated the leading causes of nonperforming loans during the economic and banking crises that affected a large number of countries in Sub-Saharan Africa in the 1990s.
Abstract: This paper investigates the leading causes of nonperforming loans during the economic and banking crises that affected a large number of countries in Sub-Saharan Africa in the 1990s. Empirical analysis shows a dramatic increase in these loans and extremely high credit risk, with significant differences between the CFA and non-CFA countries, and substantially higher financial costs for the latter sub-panel of countries. The results also highlight a strong causality between these loans and economic growth, real exchange rate appreciation, the real interest rate, net interest margins, and interbank loans consistent with the causality and econometric analysis, which reveal the significance of macroeconomic and microeconomic factors. The dramatic increase in these loans is largely driven by macroeconomic volatility and reflects the vulnerability of undiversified African economies, which remain heavily exposed to external shocks. Simulated results show that macroeconomic stability and economic growth are associated with a declining level of nonperforming loans; whereas adverse macroeconomic shocks coupled with higher cost of capital and lower interest margins are associated with a rising scope of nonperforming loans. These results are supported by long-term estimates of nonperforming loans derived from pseudo panel-based prediction models.
TL;DR: The authors found that for developing countries with little exposure to international capital markets, pegs are notable for their durability and relatively low inflation, while floats are distinctly more durable and also appear to be associated with higher growth.
TL;DR: This paper developed a simple model of exchange rate and current account determination based on imperfect substitutability in both goods and asset markets, and used it to interpret the past and explore alternative scenarios for the future.
Abstract: There are two main forces behind the large U.S. current account deficits. First, an increase in the U.S. demand for foreign goods. Second, an increase in the foreign demand for U.S. assets. Both forces have contributed to steadily increasing current account deficits since the mid-1990s. This increase has been accompanied by a real dollar appreciation until late 2001, and a real depreciation since. The depreciation accelerated in late 2004, raising the questions of whether and how much more is to come, and if so, against which currencies, the euro, the yen, or the renminbi. Our purpose in this paper is to explore these issues. Our theoretical contribution is to develop a simple model of exchange rate and current account determination based on imperfect substitutability in both goods and asset markets, and to use it to interpret the past and explore alternative scenarios for the future. Our practical conclusions are that substantially more depreciation is to come, surely against the yen and the renminbi, and probably against the euro.
TL;DR: The authors provide a selective overview of exchange rate economics and speculate on potential solutions to the forward bias and disconnection puzzles, and discuss several potential solutions. But they do not discuss the problem of the deconnexion of the nominal exchange rate.
Abstract: . This paper provides a selective overview of puzzles in exchange rate economics. We begin with the forward bias puzzle: high interest rate currencies appreciate when one might guess that investors would demand higher interest rates on currencies expected to fall in value. We then analyse the purchasing power parity puzzle: the real exchange rate displays no (strong) reversion to a stable long-run equilibrium level. Finally, we cover the exchange rate disconnect puzzle: the lack of a link between the nominal exchange rate and economic fundamentals. For each puzzle, we critically review the literature and speculate on potential solutions. JEL classification: F31
Vers une solution a certaines enigmes dans l’economie des taux de change: ou en sommes-nous? Ce memoire fait un survol selectif de certaines enigmes dans l’economie des taux de change. On examine d’abord l’enigme du biais a la hausse vers l’avant: les monnaies a fort taux d’interet s’apprecient alors qu’on s’attendrait a ce que les investisseurs reclament des taux d’interet plus eleves dans les monnaies susceptibles de perdre de la valeur. On analyse ensuite l’enigme de la parite du pouvoir d’achat: le taux de change reel ne montre pas une tendance forte a revenir vers le niveau d’equilibre stable a long terme. Finalement, on examine l’enigme de la deconnexion du taux de change: le manque d’un lien entre le taux de change nominal et les elements economiques de base. Pour chaque enigme, on examine la litterature specialisee de maniere critique et on specule sur certaines solutions potentielles.
TL;DR: Yang et al. as mentioned in this paper examined the impact of economic shocks on domestic households' responses to overseas members' economic shocks and found that favorable exchange rate shocks lead to increased educational expenditure in origin households, increased hours worked in self-employment and increased entry into relatively capital intensive enterprises by migrants' origin households.
Abstract: Millions of households in developing countries receive financial support from family members working overseas. How do the economic prospects of overseas migrants affect origin-household investments-in particular, in child human capital and household enterprises? Yang examines Philippine households' responses to overseas members' economic shocks. Overseas Filipinos work in dozens of foreign countries which experienced sudden (and heterogeneous) changes in exchange rates due to the 1997 Asian financial crisis. Appreciation of a migrant's currency against the Philippine peso leads to increases in household remittances received from overseas. The estimated elasticity of Philippine peso remittances with respect to the Philippine/foreign exchange rate is 0.60. In addition, these positive income shocks lead to enhanced human capital accumulation and entrepreneurship in origin households. Favorable migrant shocks lead to greater child schooling, reduced child labor, and increased educational expenditure in origin households. More favorable exchange rate shocks also raise hours worked in self-employment and lead to greater entry into relatively capital-intensive enterprises by migrants' origin households.
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TL;DR: The authors argue that the normal evolution of the international monetary system involves the emergence of a periphery for which the development strategy is export-led growth supported by undervalued exchange rates, capital controls and official capital outflows in the form of accumulation of reserve asset claims on the center country.
Abstract: The economic emergence of a fixed exchange rate periphery in Asia has reestablished the United States as the center country in the Bretton Woods international monetary system. We argue that the normal evolution of the international monetary system involves the emergence of a periphery for which the development strategy is export-led growth supported by undervalued exchange rates, capital controls and official capital outflows in the form of accumulation of reserve asset claims on the center country. The success of this strategy in fostering economic growth allows the periphery to graduate to the center. Financial liberalization, in turn, requires floating exchange rates among the center countries. But there is a line of countries waiting to follow the Europe of the 1950s/60s and Asia today sufficient to keep the system intact for the foreseeable future.
TL;DR: In this article, the authors provide a simple accounting framework that disentangles the factors driving the accumulation of external assets and liabilities (such as trade imbalances, investment income flows, and capital gains) for major external creditors and debtors.
Abstract: The paper highlights the increased dispersion in net external positions in recent years, particularly among industrial countries. It provides a simple accounting framework that disentangles the factors driving the accumulation of external assets and liabilities (such as trade imbalances, investment income flows, and capital gains) for major external creditors and debtors. It also examines the factors driving the foreign asset portfolio of international investors, with a special focus on the weight of U.S. liabilities in the rest of the world’s stock of external assets. Finally, it relates the empirical evidence to the current debate about the roles of portfolio balance effects and exchange rate adjustment in shaping the external adjustment process.
TL;DR: This paper analyzed exchange rates along with equity quotes for three German firms from New York (NYSE) and Frankfurt (XETRA) during overlapping trading hours to see where price discovery occurs and how stock prices adjust to an exchange rate shock.
TL;DR: In this paper, the authors find empirical support for some of the factors that have been hypothesized in the literature, but not for others, using a new data set, prices of eight narrowly defined brand commodities, observed in 76 countries.
Abstract: Developing countries traditionally exhibit passthrough of exchange rate changes that is greater and more rapid than high-income countries, but have experienced a rapid downward trend in recent years in the degree of short-run passthrough, and in the adjustment speed. As a consequence, slow and incomplete passthrough is no longer exclusively a luxury of industrial countries. Using a new data set -- prices of eight narrowly defined brand commodities, observed in 76 countries -- we find empirical support for some of the factors that have been hypothesized in the literature, but not for others. Significant determinants of the passthrough coefficient include per capita incomes, bilateral distance, tariffs, country size, wages, long-term inflation, and long-term exchange rate variability. Some of these factors changed during the 1990s. Part (and only part) of the downward trend in passthrough to imported goods prices, and in turn to competitors' prices and the CPI, can be explained by changes in the monetary environment. Real wages also work to reduce passthrough to competitors' prices and the CPI, confirming the hypothesized role of distribution and retail costs in pricing to market. Rising distribution costs, due perhaps to the Balassa-Samuelson-Baumol effect, could contribute to the decline in the passthrough coefficient in some developing countries.
22 Mar 2005
TL;DR: The authors developed a simple model of exchange rate and current account determination, which they then use to interpret the recent behavior of the U.S. current account and the dollar and explore what might happen in alternative future scenarios.
Abstract: TWO MAIN FORCES underlie the large U.S. current account deficits of the past decade. The first is an increase in U.S. demand for foreign goods, partly due to relatively faster U.S. growth and partly to shifts in demand away from U.S. goods toward foreign goods. The second is an increase in foreign demand for U.S. assets, starting with high foreign private demand for U.S. equities in the second half of the 1990s, and later shifting to foreign private and then central bank demand for U.S. bonds in the 2000s. Both forces have contributed to steadily increasing current account deficits since the mid-1990s, accompanied by a real dollar appreciation until late 2001 and a real depreciation since. The depreciation accelerated in late 2004, raising the issues of whether and how much more is to come and, if so, against which currencies: the euro, the yen, or the Chinese renminbi. We address these issues by developing a simple model of exchange rate and current account determination, which we then use to interpret the recent behavior of the U.S. current account and the dollar and explore what might happen in alternative future scenarios. The model's central assumption is that there is imperfect substitutability not only between U.S. and foreign goods, but also between U.S. and foreign assets. This allows us to discuss the effects not only of shifts in the relative demand for goods, but also of shifts in the relative demand for assets. We show that increases in U.S. demand for foreign goods lead to an initial real dollar depreciation, followed by further, more gradual depreciation over time. Increases in foreign demand for U.S. assets lead instead to an initial appreciation, followed by depreciation over time, to a level lower than before the shift. The model provides a natural interpretation of the recent behavior of the U.S. current account and the dollar exchange rate. The initial net effect of the shifts in U.S. demand for foreign goods and in foreign demand for U.S. assets was a dollar appreciation. Both shifts, however, imply an eventual depreciation. The United States appears to have entered this depreciation phase. How much depreciation is to come, and at what rate, depends on how far the process has come and on future shifts in the demand for goods and the demand for assets. This raises two main issues. First, can one expect the deficit to largely reverse itself without changes in the exchange rate? If it does, the needed depreciation will obviously be smaller. Second, can one expect foreign demand for U.S. assets to continue to increase? If it does, the depreciation will be delayed, although it will still have to come eventually. Although there is substantial uncertainty about the answers, we conclude that neither scenario is likely. This leads us to anticipate, in the absence of surprises, more dollar depreciation to come at a slow but steady rate. Surprises will, however, take place; only their sign is unknown. We again use the model as a guide to discuss a number of alternative scenarios, from the abandonment of the renminbi's peg against the dollar, to changes in the composition of reserves held by Asian central banks, to changes in U.S. interest rates. This leads us to the last part of the paper, where we ask how much of the dollar's future depreciation is likely to take place against the euro, and how much against Asian currencies. We extend our model to allow for four "countries": the United States, the euro area, Japan, and China. We conclude that, again absent surprises, the path of adjustment is likely to be associated primarily with an appreciation of the Asian currencies, but also with a further appreciation of the euro against the dollar. A Model of the Exchange Rate and the Current Account Much of economists' intuition about joint movements in the exchange rate and the current account is based on the assumption of perfect substitutability between domestic and foreign assets. …
TL;DR: In this article, the authors review the recent conduct of monetary policy and the central banks' interest rate setting behavior in emerging market economies and test whether central banks in emerging markets react to changes in inflation, output gap, and the exchange rate in a consistent and predictable manner.
Abstract: The paper reviews the recent conduct of monetary policy and the central banks’ interest rate setting behaviour in emerging market economies. Using a standard open economy reaction function, we test whether central banks in emerging market economies react to changes in inflation, output gap, and the exchange rate in a consistent and predictable manner. In most emerging market economies, the interest rate responds strongly to the exchange rate; in some, the response is higher than that to changes in the inflation rate or the output gap. The result is robust to alternative specification and estimation methods. This highlights the importance of the exchange rate as a source of shock and supports the “fear of floating” hypothesis. Evidence also suggests that in some countries the central bank’s response to a negative inflation shock might be weaker than to a positive shock.