Exchange rate and relative monetary expansions: The case of simultaneous hyperinflation and rational expectations

The relationship between the exchange rate and relative monetary expansions of Poland and Germany in the 1920s when the countries are under simultaneous hyperinflation is studied. The results show that for this period of predominantly monetary shocks, the conventional specifications of the monetary model of exchange rate determination with rational expectations cannot be rejected. The results therefore support the monetary approach in its most conducive environment.     

Bulgaria’s hyperinflation in 1997: transition,banking fragility and foreign exchange

This article has two objectives: to study the 1997 episode of hyperinflation in Bulgaria, and to compare and contrast this analysis with the post-Keynesian theoretical approach. This approach highlights the role of three components observed simultaneously in order to understand the emergence of hyperinflation: a virulent distributive conflict; the presence of indexing mechanisms; and finally, flight from domestic currency into one or more foreign currencies. The article reveals that a transitional economy like that of Bulgaria in the 1990s may generate hyperinflation in the absence of any violent distribution conflict: the transition and the banking crisis engender inflation. The foreign exchange rate is decisive in the emergence of hyperinflationary dynamics (and therefore mistrust of domestic currency). This interpretation of hyperinflation is confirmed by an econometric analysis.     

Exchange Rates,Expectations, and Monetary Policy: a NOEM Perspective*

We use a dynamic general‐equilibrium optimizing two‐country model to analyze how the formation of exchange rate expectations shapes the effects of a monetary policy shock in an open economy. We also provide empirical evidence on how traders in foreign exchange markets form exchange rate expectations. Our model implies that the short‐run output effect of a permanent monetary policy shock diminishes if “technical traders” form the type of regressive exchange rate expectations we find in our empirical analysis. If the influence of technical traders is strong enough, a permanent expansionary monetary policy shock can result in a temporary decline of the output in the country in which it takes place. The output effect of a temporary monetary policy shock is magnified when technical traders form regressive exchange rate expectations.     

Financial Instability under a Flexible Exchange Rate*

Many governments in developing countries contemplate the possibility of increasing the flexibility of their exchange rates despite having accumulated substantial dollar‐denominated debt. Using a model of corporate dollar debt in which the future exchange rate is uncertain, this paper studies the financial risks that might arise as a consequence of increased exchange rate flexibility. Since a firm may default on its debt either because its dollar income is too low or because investors refuse to roll over its debt, the measure of the overall risk of default should take into account both factors, as well as their interaction. Solving the model for the no‐default rational expectations equilibrium, we find that a small risk of insolvency may bring about a substantial risk of illiquidity.     

Inflation and output dynamics with a floating exchange rate

The purpose of this paper is to extend a simple monetarist model of price output fluctuations in a closed economy to the case of a small open economy with a floating exchange rate. Trade and capital flows are explicitly incorporated into the model, exchange rate expectations and inflation expectations are treated separately and exchange rate expectations are integrated into the demand for money function. The properties of the model are investigated under the limiting cases of perfect capital mobility and zero capital mobility. Stability conditions and short run price-output trade-offs are derived and the conclusions for cyclical output patterns are deduced. It is also shown how the short run movement of the exchange rate deviates from purchasing power parity in a systematic fashion.     

Fiscal Policy,Expectations, and Exchange-Rate Dynamics*

This paper uses the sticky-price monetary model to analyze the effects of fiscal policy on the exchange rate under alternative assumptions about exchange-rate expectations. the use of different expectations mechanisms-specifically the perfect-foresight model and the popular models tested by Frankel and Froot: regressive, adaptive, and distributed-lag-is based on recent empirical evidence suggesting that exchange-rate expectations may not be rational. the most surprising finding in the paper is that with adaptive and distributed-lag expectations, fiscal expansion has no initial impact on the exchange rate, and the same may be true for regressive expectations.     

Avoiding hyperinflation: Evidence from a laboratory economy

Hyperinflation results from the creation and injection of fiat money into the economy. Using laboratory methods, this paper examines conditions under which fiat money can serve as a medium of exchange in a finite horizon economy while the government is active in the markets for goods. Consistent with the rational expectations hypothesis, issuing new fiat currency does not stabilize a hyperinflation; however, restricting government spending to the amount of tax revenue or reverting to backed money does. These findings are consistent with previous studies of historical data; thus this work confirms those findings from an alternative data source, the laboratory.     

Testing the currency-substitution model under the German hyperinflation

In this paper the currency-substitution model is tested under the German hyperinflation using several expectations-formation mechanisms. The maximum-likelihood estimates of the currency-substitution model reveal that extrapolative and adaptive expectations seem to have been predominant and that there was a significant degree of currency substitution. The results also reveal that expectation was destabilizing and that it was not possible to distinguish between the effects of the expected change in the exchange rate and the expected inflation.     

Random Walk or Bandwagon: Some Evidence From Foreign Exchanges in the 1980s

The predicitive performance of the bandwagon expectations model foe weekly spot exchange rates over the 1980–6 period is evaluated. Empirical results generally indicate the presence of significant bandwagon effects in the exchange rate dynamics, as found in survey expectations data. Specifically, we find the the bandwagon forecasting scheme can improve the forecasting accuracy in terms of both mean squared errors and market timing upon the random walk and vector autoregressive models. The results illustrate that bandwagon expectations can be rational, and the exchange rate appears to follow a more general integrated process than a random walk.     

Supply-side effects of exchange rates, exchange rate expectations and induced currency depreciation

Within the context of a small open economy model, this paper examines the repercussions of induced currency depreciation. The results presented in this paper are based on a model with firm microeconomic foundations and which takes into account both the supply and demand-side effects of exchange rate variations. The distinguishing feature of the model is the role of exchange rate expectations. We consider three kinds of expectations; adaptive, extrapolative, and regressive expectations. We also perform several sensitivity tests based on these expectations. Our simulation exercise shows that the effect of induced currency depreciation depends largely on supply-side effects. In most cases, we find that currency depreciation results in (i) a fall in output, (ii) an increase in prices and (iii) an improvement in the balance of trade. In the absence of weak supply-side effects of exchange rates, we find that, if the Marshall-Lerner conditions hold, then depreciation of the home currency has a favorable effect on output but its effect on the balance of trade is negative.     

Exchange rate models and exchange rate expectations: an empirical investigation

A non parametrictest of popular modern exchange rate models under alternative expectation specifications is presented. It is found that there is little difference in the predictive success of the alternative exchange rate models, however, there are significant differences in the performance of a model depending upon the expectations mechanism specified. Our most important finding is that the flexible price monetary model, the portfolio balance model and a hybrid model under extrapolative and adaptive expectations mechanisms provide statistically significant information about the direction of exchange rate movements. By contrast, the same models when employing static, regressive and rational expectation mechanisms do not provideany satistically significant information.     

Monetary policy channels in Brazil through the lens of a semi-structural model

We develop and estimate a medium-sized, semi-structural model for the Brazilian economy during the inflation targeting period. The model describes fairly well key features of the economy and allows us to decompose the transmission mechanism of monetary policy. In the baseline decomposition, the transmission mechanism is broken down into household interest rate, firm interest rate, and exchange rate channels. In addition, we carry out an alternative decomposition that allows us to evaluate the expectations channel as well. In both procedures, the household interest rate channel is the most important for explaining the response of output to a monetary policy shock. In the baseline decomposition of inflation, both the household interest rate and the exchange rate channels are the main transmission channels. However, in the alternative decomposition, the expectations channel accounts for the bulk of the inflation response.     

Exchange rate puzzles: A tale of switching attractors

The rational expectations efficient market model of the exchange rate has failed empirically. In this paper, we develop a model of the exchange rate in which agents use simple forecasting rules. Based on an ex post evaluation of the relative profitability of these rules they decide whether to switch or not. In addition, transactions costs in the goods market are introduced. We show that this simple model creates great complexity in the market which is characterised by the fact that the exchange rate is disconnected from its fundamental most of the time. Finally we show that this model mimicks most of the empirical puzzles uncovered in the literature.     

Expectation formation in the foreign exchange market: a time-varying heterogeneity approach using survey data

Using Consensus Economics survey data on JPY/USD and GBP/USD exchange rate expectations for the 3- and 12-month horizons over the period November 1989–December 2012, we first show that expectations fail the conventional tests of unbiasedness and do not exhibit a learning process towards rationality. Our approach is consistent with the economically rational expectations theory (Feige and Pearce, 1976), which states that information costs and agents’ aversion to misestimating future exchange rates determine the optimal amounts of information on which they base their expectations. The time variability of the cost/aversion ratios justifies at the aggregate level a representation of expectations as a linear combination of the traditional extrapolative, adaptive and regressive processes augmented by a forward market component, whose parameters are allowed to change over time. This mixed expectation model with unstable heterogeneity is validated by our Kalman filter estimation results for the two currencies and the two horizons considered. Although the relative importance of the ‘fundamentalists’ (‘chartists’) is found to increase (decrease) with the time-horizon, chartist behaviour appears to dominate fundamentalist behaviour for both horizons. Central bank intervention is then effective in stabilizing the foreign exchange markets if it encourages fundamentalist activity.     

Cryptocurrencies and Cagan’s model of hyperinflation

The drivers of the prices of Bitcoin and Ethereum are studied within a framework based on Cagan’s model of hyperinflation. In the model, the prices of the cryptocurrencies are driven by stochastic adoption and velocity shocks as well as endogenous expectations of future prices. The model is estimated with data for prices, transaction volumes, and money supplies. A majority of price fluctuations in both currencies can be attributed to shocks in adoption, velocity shocks are much less important. The money demand sensitivity to expected price changes is estimated to be larger for Bitcoin than for Ethereum, and both have higher sensitivity than fiat currencies during episodes of hyperinflation.     

The Exchange Rate and Inflation in Argentina: A Classical Critique of Orthodox and Heterodox Policy Prescriptions

In this paper we present an alternative framework to neoclassical theory of international trade and exchange rate determination. Our model, inspired in the classical tradition, provides support for the assertion that an exchange rate policy aiming to improve national competitiveness and to bring about a sustained trade surplus is a viable option. In fact, the success of this strategy does not depend on the effectiveness of monetary sterilization —as many argentinean heterodox authors claim— but on the ability to overcome the boundaries imposed by the evolution of the domestic wage rate and the potential emergence of competitive devaluations. In the particular case of Argentina, the introduction of export taxes on land-intensive commodities, in which the economy has absolute advantages, brings an additional policy tool that can make both the exchange rate target and the workers claims consistent.     

Economic Fundamentals and Exchange Rate Movements

This paper provides a non-parametric test of modern exchange rate models that is an alternative to econometric methods. The economic fundamentals from three well-known exchange rate theories are used to devise quarterly net predictions for the movement of sterling against four major currencies over the period 1973-98. Each model is examined under six expectations mechanisms. Although the test can lead to very diverse predictions from different models, it is shown that there is very little difference in the predictive success of rival exchange rate theories. The paper shows that the role assigned to market expectations is more crucial to the success of the models than the particular specification of the fundamental variables.We find some weak evidence to suggest that extrapolative and adaptive expectations mechanisms seem to offer a better specification of exchange rate expectations as compared to regressive and rational expectation mechanisms. One significant advantage of the test is that it can readily deal with hybrid models and heterogeneous expectations; however, neither route seems to improve exchange rate forecasts.     

The Exchange Rate and Inflation in Argentina: A Classical Critique of Orthodox and Heterodox Policy Prescriptions

In this paper we present an alternative framework to neoclassical theory of international trade and exchange rate determination. Our model, inspired in the classical tradition, provides support for the assertion that an exchange rate policy aiming to improve national competitiveness and to bring about a sustained trade surplus is a viable option. In fact, the success of this strategy does not depend on the effectiveness of monetary sterilization —as many argentinean heterodox authors claim— but on the ability to overcome the boundaries imposed by the evolution of the domestic wage rate and the potential emergence of competitive devaluations. In the particular case of Argentina, the introduction of export taxes on land-intensive commodities, in which the economy has absolute advantages, brings an additional policy tool that can make both the exchange rate target and the workers claims consistent.     

Currency Boards when Interest Rates are Zero

In a fixed exchange rate system, any expectation that the peg may be abandoned will normally be reflected in an interest rate differential between instruments denominated in domestic and anchor currencies: the possibility of a revaluation will drive domestic interest rates below those in the anchor currency, for example. However, when interest rates are close to the zero lower bound, there is limited scope for exchange rate expectations to be reflected in interest rate differentials. Here we introduce a new mechanism, based on the central bank balance sheet, which works to bring about equilibrium in currency markets even when interest rates are zero. An expectation of exchange rate appreciation will cause foreign exchange reserves to swell, increasing the cost to policy‐makers of allowing an appreciation and, therefore, lowering the likelihood of the fixed exchange rate being abandoned. Under normal circumstances, this channel reinforces the equilibrating effect of interest rate differentials. When interest rates cannot adjust only this channel operates, implying that much larger changes in reserves are required to equilibrate currency markets. We develop a simple model to illustrate these arguments and find support for the predictions of the model using data for Hong Kong, the world's largest economy with a currency board.     

Currency returns and downside risk: Debt,volatility, and the gap from benchmark values

The paper considers competing portfolio-balance specifications of currency returns, including one based on expected utility theory and another on prospect theory. The prospect theory specification relates downside risk to the gap between the exchange rate and its benchmark value. The empirical analysis uses survey data on exchange rate expectations to test directly the models’ predictions concerning ex ante excess returns. It also relies on the cointegrated VAR framework, which is well suited for testing competing models and dealing with unit roots. Like earlier studies, we find little support for the expected utility theory model in three major currency markets. By contrast, the prospect theory model’s predictions are largely borne out in the data, including those about sign reversals. We find the strongest support for a hybrid model that incorporates the risk factors of both models.