Exchange Rate Economics

The paper summarizes the current theory of how a floating exchange rate is determined, dividing the subject into what determines the steady state and what determines the transition to steady state. The inadequacies of this model are examined, and an alternative “behavioral” model, which recognizes that the foreign exchange market is populated by both fundamentalists and chartists is presented. It is argued that the main importance of understanding the foreign exchange market for development strategy is to permit a correct appraisal of the dangers of Dutch disease. Empirically it seems that from the standpoint of promoting development it is preferable to have a mildly undervalued rate. The paper concludes by examining implications for exchange rate regimes.

Asian Currency Baskets: An Answer in Search of a Question?

This paper considers whether an intra regional currency basket and the associated divergence indicators could play a useful role in official exchange rate surveillance. Recently, proponents of an Asian currency basket have referred to the role the European Currency Unit played in constructing exchange rate divergence indicators as evidence of the usefulness of intra regional currency baskets for exchange rate monitoring. The paper shows that such indicators have a number of features that can lead to them obscuring underlying changes in exchange rates and that the signals they emit will often be difficult to interpret. In addition, the use of regional currency baskets for surveillance can lead to potentially serious N − 1 problems in circumstances when there is not agreement about which regional currencies will be the anchor currencies.

Exchange rates in the modern floating era: what do we really know?

Forecasting nominal exchange rates remains a remarkably difficult task, despite the proliferation of new floating currencies, the maturation of the floating rate period, the deepening of financial markets, and the development of more sophisticated econometric tests that make use of today’s more powerful computing possibilities. Despite these advances, the basic results of Meese and Rogoff in the 1980s stand up remarkably well—it is still extremely difficult to forecast exchange rates. To the extent that there is any forecasting power, the most promising models are those based on purchasing power parity or the current account, although it must be noted that these mainly predict the real exchange rate, rather than the nominal exchange rate. Thus, some of the adjustment takes place in prices. Finally, it should be noted that panel methods help in exchange rate forecasting, albeit mainly by allowing better estimation of nonstructural factors such as shift parameters.

Fear of Floating and Pegging: A Simultaneous Choice Model of De Jure and De Facto Exchange Rate Regimes in Developing Countries

We present an analysis of the determinants of de jure and de facto exchange rate regimes based on a panel probit model with simultaneous equations. The model is estimated using simulation-based maximum likelihood methods. The empirical results suggest a triangular structure of the model such that the choice of de facto regimes depends on the choice of de jure regimes but not vice versa. This gives rise to a novel interpretation of regime discrepancies.

Devaluation,Debt, and Default in Emerging Economies

We explore the interactions between exchange rate and fiscal policy, and default on external debt. Exchange rate policy affects the supply of short-term debt facing the government. Under a conventional soft peg, it can be optimal for the government to set the exchange rate at a level in which partial default occurs. In this case multiple equilibria exist, with one featuring high interest rate, overvalued exchange rate, low level of output, and default. Default is also an equilibrium under a hard peg, precisely because devaluation is not an option. Under a hard peg, however, there is a unique equilibrium.

Policy coordination in East Asia and across the Pacific

In this paper, we construct a macro-econometric model that describes the economic activity in the Asia-Pacific area and provide quantitative insights into the recent policy debates on monetary and currency coordination among the East Asian economies. The model includes a wide variety of monetary and currency policy rules that the East Asian economies adopt and allows for one country's policymaking to have substantial effects on foreign countries. We apply the model to three current policy issues: (1) the desirability of currency basket pegs in East Asia, (2) the anticipated effects of China's currency policy reform, and (3) the non-negativity constraint on Japanese nominal interest rates. The simulation analyses show the external economy effects of policy rules quantitatively and suggest the difficulty of monetary and currency policy coordination among the East Asian economies.

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Real Exchange Rate Stationarity in Latin America and Relative Purchasing Power Parity: A Regime Switching Approach

This paper tests for long-run purchasing power (PPP) among a sample of six Latin American economies. The key contribution of this paper is in terms of the econometric methodology where non-stationarity of the real exchange rate is tested within a Markov regime-switching framework. In contrast to existing studies, this paper defines two new concepts of PPP where one allows for the possibility that real exchange behaviour either switches between stationary and non-stationary regimes (partial PPP), or switches between stationary regimes characterised by differing degrees of persistence (varied PPP). Whereas standard univariate unit root testing suggests that Latin American real exchange rates are generally non-stationary, employment of the regime-switching methodology indicates that most of the sample is characterised by the existence of two distinct stationary regimes. Further analysis indicates that the high rates of inflation and exchange rate volatility experienced in Latin American have given some impetus towards facilitating long-run PPP.

Implicit exchange regimes in Central and Eastern Europe: a first exploration

This paper attempts to identify implicit exchange rate regimes for currencies of the Central and Eastern European Countries vis-à-vis the euro. To that end, we apply a sequential procedure that considers the dynamics of exchange rates to data covering the period from 1977:01 to 2006:02. Our results would suggest that implicit bands have existed in many subperiods for almost all currencies under study. Once we detect de facto discrepancies between de facto and de iure exchange rate regimes, we propose a model in order to explain these decisions. Our results suggest a positive association between the previous inflation rate and the probability of a peg with the euro, and a negative association with past unemployment rate.

A structural break in the effects of Japanese foreign exchange intervention on yen/dollar exchange rate volatility

We study the impact of Japanese foreign exchange intervention on the volatility of the yen/dollar exchange rate since the early 1990’s in a GARCH framework with interventions as exogenous variables. Using daily intervention data provided by the Japanese Ministry of Finance, we show that the effect of interventions varies over time. From 1991 up to the late 1990’s, Japanese foreign exchange intervention is associated with an increase in volatility of the yen/dollar exchange rate. After the year 1997, Japanese foreign exchange intervention correlates with reductions in exchange rate volatility. This can be explained by the fact that Japanese foreign exchange intervention remained quasi unsterilized in the liquidity trap.

Labour Market Adjustments to Exchange Rate Fluctuations: Evidence from Canadian Manufacturing Industries

This paper provides some of the first empirical evidence on labour market adjustments to exchange rate movements in Canadian manufacturing industries. Controlling for endogeneity using generalized method of moments estimation, it is found that during the 1981–1997 period, exchange movements have a substantial impact on labour input and that this impact has grown over time as the manufacturing industries have become more exposed to trade. In contrast, the exchange rate effect on real wages is estimated to be virtually zero for all manufacturing industries.

Modeling the Impact of Real and Financial Shocks on Mercosur: The Role of the Exchange Rate Regime

This paper studies to what extent the diversity of exchange rate regimes within Mercosur exerts an influence on the feasibility of a monetary union in this area. A semi-structural vector autoregression model is built for each country, including a set of international and domestic variables. Based on impulse response functions and forecast error decomposition, we conclude that differences in exchange rate regimes explain significantly the divergences of economic dynamics triggered by foreign or domestic shocks. Second, we decompose the structural innovations generated by each country model into unobservable common and idiosyncratic components, using a state-space model. This last exercise, intended to assess the degree of policy coordination between the Mercado Común del Sur members, did not disclose any common component for the structural innovations generated by the three national models.

Fiscal policy in central and Eastern Europe: what happened in the run-up to EU accession?

This paper analyses the evolution of fiscal policy in central and eastern European countries during the EU accession process, testing for country and time specific effects. This is done by constructing Taylor-type policy rules and by calculating three measures of fiscal stance. A key finding is that the differences across countries are more significant than those across time. Baltic countries tended to have had tighter fiscal policy which responded to the output gap, larger central European countries had more lax (and increasingly lax) fiscal policies which were unresponsive to the output gap. These differences correlate closely with cross-country differences in exchange rate regimes and no link is found to either spending composition or political variables. Taken together the results suggest that the exchange rate regime is by far the most significant determinant of fiscal performance. These results suggest that the “soft power” of the prospect of EU entry did not act as a spur to greater fiscal discipline and that higher budget deficits in recent years cannot be blamed on costs of accession.

UK External Imbalances and the Sterling: Are they on a Sustainable Path?

An updated version of Krugman’s 1993 MMF framework is used to consider the implications of buoyant domestic demand for the real exchange rate and debt dynamics. The updating includes a Taylor rule for monetary policy and explicit treatment of external assets and liabilities. In response to an exogenous rise in the aggregate demand, short-run appreciation of the real exchange rate is followed by a prolonged decline as external debt accumulates and net wealth deteriorates. Whether in equilibrium the real exchange rate is stronger or weaker depends crucially on a comparison of real interest rates and the growth rate. If the domestic growth rate is higher than global real interest rates, the currency may strengthen in the long run despite the deterioration of net external assets. To see whether the strength of sterling is sustainable, the analysis is briefly calibrated to UK data over the last decade. Blanchard et al. (The US current account and the dollar. CEPR DP no 4888, 2005) suggest that international liabilities to be treated as imperfect substitutes: so we check to see how this would affect our results.

Resurrecting Keynes to Stabilize the International Monetary System

We adapt the basic principles of the Keynes Plan and argue for the creation of a supranational bank money (SBM) that would coexist along side national currencies and for the establishment of a new international clearing union (NICU). These principles remain timely because the fundamental causes of the instability of the international monetary system are as valid today as they were in the early forties. The new supranational money would be created against domestic earning assets of the Fed and the ECB and its quantity would be demand-driven. Our proposal is not an agreement on exchange rates, which while possible is not essential to the functioning of the SBM. NICU would not hold open positions in assets denominated in national currency and consequently would not bear exchange rate risk. NICU would be more than an office recording credit and debit entries of the supranational bank money. The financial tsunami that hit the world economy in 2007–2008 provides a unique opportunity for a coordinated strategy.

Monetary Policy in Austria–Hungary, 1876–1913: An Econometric Analysis of the Determinants of the Central Bank’s Discount Rate and the Liquidity Ratio

This paper presents a model to explain the official discount rate of the Central Bank of Austria–Hungary from 1876 to 1913. The discount rate is assumed to depend on the liquidity ratio of the Bank, defined as the ratio of its stock of metals to banknotes issued, and on changes in foreign discount rates. The paper also presents an equation explaining the liquidity ratio. We use “not equally spaced chronologically ordered data” referring to the 50 discount rate changes enacted. The regressions confirm that the liquidity ratio was the main determinant of the discount rate and that Germany (and not Great Britain) played a significant role in determining the Austro–Hungarian discount rate and the liquidity ratios, supporting the view that the classical gold standard was a decentralized multipolar system rather than a system fully dominated by London as suggested by Keynes. The regressions also suggest that, although Austria–Hungary had an inconvertible paper currency (1879–1892) and fluctuating exchange rates (1876–1895) and formally joined the gold standard only in 1902, it “shadowed” the behaviour of gold standard Central Banks with such consistency that the stability of the estimated regressions was relatively unaffected by the frequent institutional changes.

The Determinants of the Secondary Market Price of Less Developed Countries’ Debt

A present-value model of less developed countries’ (LDC) debt is developed to understand the factors that affect the discount on the secondary market. LDC debt trades at a substantial discount on the secondary market. This paper investigates the determinants of the discount for a sample of 13 countries over a 9 year period. The findings show that debt–exports, foreign currency reserves–imports and total debt service to exports ratios are significant determinants of the secondary market prices of LDC debt. The discount is higher in countries where debt–exports ratios are higher and is lower for those with lower foreign currency reserves–imports ratios. Concentration of debt with money center banks has a positive and significant effect on the secondary market price of debt.

Openness and Real Exchange Rate Volatility: In Search of an Explanation

The puzzle that real exchange rates are less volatile in open economies is an important challenge to exchange rate theory. Adjustment of domestic prices to nominal exchange rate movements can account for only a small proportion of this effect. Real and nominal shocks display no obvious correlation with openness. It is shown here that real effective exchange rates are more strongly mean-reverting in more open economies, even after controlling for exchange rate regime effects. This is predicted by the theory of current account sustainability, because of its emphasis on ratios to GDP rather than to trade flows.

Exchange Rate Regime and Demand for Reserves: Evidence from Kenya,Mexico and Philippines

This paper empirically investigates the demand for international reserves (and foreign exchange reserves) during fixed and floating exchange rates periods in three developing countries: Kenya, Mexico and Philippines. Based on theoretical models, three factors are identified as important for the demand of international reserves and foreign reserves: average propensity to import, volume of imports and variability of reserves. The paper employs the cointegration methodology and error correction method to investigate the relationships. Cointegration tests results indicate a reliable long-run stationary relationship between the international reserves (and foreign exchange reserves) and the stated explanatory variables across countries and sub-periods of fixed and clean float. The error correction results indicate causality from the explanatory variables to the reserves during both the short and long run. This is true during both the fixed and the floating periods.

Implications of Monetary Union for Catching-up Member States

We examine the implications of monetary union for macroeconomic stabilization in catching-up participating countries. We allow member states’ supply conditions to differ, especially with regard to sectoral characteristics. Sectoral productivity shocks of the type associated with the Balassa–Samuelson effect tend to hamper the stabilization properties of a currency union. In the face of aggregate supply disturbances, the stabilization costs of renouncing monetary autonomy diminish with a steeper supply curve (as induced by higher trade openness) and—barring idiosyncratic shocks—with a larger reference country size, more homogeneous supply slopes and a higher preference for price stability.