Shocks to Terms of Trade and Risk-premium in an Intertemporal Model: The Dutch Disease and a Dutch Party

In this paper, we analyze the impact of terms of trade and risk-premium shocks on a small open economy in an intertemporal Dutch disease model, with international capital mobility. Given that an improvement in the terms of trade is associated with a decrease in the risk-premium on lending to this economy, we find that this can lead to a Dutch party (rather than Dutch disease) in which real exchange rate appreciation is associated with an expansion of the capital-intensive traded sector, hence, pro-industrialization. The economy also accumulates more debt in the long-run in response to the lower borrowing costs.

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.

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.

Trade in Capital Goods and International Co-movements of Macroeconomic Variables

This paper contributes to the ongoing debate on the causes of international co-movements of macroeconomic variables. In particular, existing real business cycle models predict cross-country consumption correlations to be higher than in the actual data, cross-country output correlations to be lower than in the actual data, and cross-country consumption correlations to be relatively higher than the output correlations. We show that cross-country correlations of consumption, investment, employment and output predicted by a standard international real business cycle model are highly sensitive to the share of capital goods in total trade. Our calibrated model shows that when capital goods account for a share of total traded goods greater than 50%, the apparent discrepancy between the data and the simulations is resolved.

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 Pegs, Fiscal Policy and Credibility

In a fixed exchange rate regime, an exchange rate change can be a swift way to change the real exchange rate in the short run. Fiscal policy also affects relative prices, and fiscal policy response to various types of shocks can therefore be crucial for the credibility of an exchange rate peg. We develop a model within which fiscal policy plays a crucial role for ensuring the viability and thus credibility of an exchange rate peg. We use the insights of this model to take a closer look at Denmark, which has successfully pursued a fixed exchange rate policy since 1982.

On the Equality of Real Interest Rates Across Borders in Integrated Capital Markets

The purpose in this note is first to review briefly the empirical results on the relationship between real interest rates and real exchange rates; this empirical literature provides little support for the hypothesis of Roll that expected real interest rates are equal in general. Our second aim is to discuss the theoretical conditions that have to be met for his hypothesis to hold.

Is reversion to PPP in euro exchange rates non-linear?

The paper tests for nonlinearities in the adjustment of the euro exchange rate towards purchasing power parity (PPP). It presents new survey based evidence consistent with non-linear patterns in euro exchange rate dynamics. Moreover, based on an exponential smooth transition autoregressive (ESTAR-) model, it finds strong evidence that the speed of mean reversion in euro exchange rates increases non-linearly with the magnitude of the PPP deviation. Accordingly, while the euro real exchange rate can be well approximated by a random walk if PPP deviations are small, in periods of significant deviations, gravitational forces are set to take root and bring the exchange rate back towards its long-term trend. Deviations from the PPP equilibrium for the euro-dollar rate need to be stronger in order to reach the same adjustment intensity as for other rates.

Exchange Rates and Concurrent Leasing and Selling in Durable-Goods Monopoly

Theoretical durable-goods models suggest that a monopolist will prefer to lease rather than sell units of output due to the seller’s commitment problem with potential buyers. However, many monopolistic durable-goods manufactures are commonly observed simultaneously leasing and selling output. We provide a theoretical rationale for this observed behavior in firms engaged in trade with a foreign country. In a simple two-period setting we show that a foreign durable-goods monopolist will concurrently lease and sell output if the expected future exchange rate is lower than the current rate. With this concurrent strategy the firm earns higher profit than a pure rental or sales regime. Additionally, our model provides additional theoretical underpinnings for the empirical finding that increases in expected future exchange rates increase the current sales price of durable products. Finally, our analysis examines the role of product durability in determining exchange rate pass-though to domestic prices.

Beggar thy Neighbor? The Transmission of Fiscal Shocks from the US to Canada

This paper investigates how innovations in income taxes and government expenditures originating in the US affect the US economy, and how these effects are transmitted to the Canadian economy. Using a semi-structural VAR model and data for both countries for the 1961:1–2004:3 period, we find that fiscal policy innovations originating in the US are transmitted to the Canadian economy by international trade and capital flows through interest rate and exchange rate channels. Unanticipated shocks to US government expenditures have beggar thy neighbor effects on Canada. US output increases and Canadian output decreases in response to a positive shock to US government expenditures. In response to an unanticipated increase in US income taxes, US output declines while US and Canadian real interest rates rise. The response of Canadian output, however, is not significantly different from zero.

The Transfer Problem in the Euro Area

Building on the celebrated Keynes–Ohlin debate and on Lane and Milesi-Ferretti (Rev Econ Stat 86:841–857, 2004), the paper investigates the transfer problem for the Euro area vis-à-vis the rest of the world. The analysis is developed in a theoretically and statistically consistent way and is intended as a contribution to the empirical literature on EMU. The main result of the paper is that the accumulation of net foreign asset in the Euro area is consistent with real exchange appreciation, largely through the relative price of nontradables rather than through the terms of trade.

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.

Dutch Disease Scare in Kazakhstan: Is it real?

In this paper we explore the evidence that would establish that Dutch disease is at work in, or poses a threat to, the Kazakh economy. Assessing the mechanism by which fluctuations in the price of oil can damage non-oil manufacturing—and thus long-term growth prospects in an economy that relies heavily on oil production—we find that non-oil manufacturing has so far been spared the perverse effects of oil price increases from 1996 to 2005. The real exchange rate in the open sector has appreciated over the last couple of years, largely due to the appreciation of the nominal exchange rate. We analyze to what extent this appreciation is linked to movements in oil prices and oil revenues. Econometric evidence from the monetary model of the exchange rate and a variety of real exchange rate models show that the rise in the price of oil and in oil revenues might be linked to an appreciation of the U.S. dollar exchange rate of the oil and non-oil sectors. But appreciation is mainly limited to the real effective exchange rate for oil sector and is statistically insignificant for non-oil manufacturing.

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.

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.

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.

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.

Partitions and Coalitional Stability with Non-dominant and Dominant Members

The analysis presented in this paper applies coalitional game theory to an analysis of imperfectly competitive firms producing a homogeneous product. Coalitions consisting of equal partners and no capacity constraints tend to be stable. Grand coalitions consisting of unequal members tend to be unstable. In this case, an intra-coalitional utility transfer may cement the coalition, but the outcome tends to be the same as that in coalitions consisting of equal partners. Coalitions consisting of fewer, unequal members may be possible, however, even in the absence of intra-coalitional utility transfers. Finally, grand coalitions may be possible if subordinate members are capacity constrained.

Testing the Unstable Middle and Two Corners Hypotheses About Exchange Rate Regimes

The recent rash of international currency crises has generated considerable interest in the role that exchange rate regimes have played in contributing to these crises. Many economists have argued that efforts to operate adjustably pegged exchange rate regimes have been a major contributor to “the unstable middle” hypothesis and some have argued that this unstable middle is so broad that only the two corners of hard fixes or floating rates will be stable in a world of high capital mobility—the two corners or bipolar hypothesis. Two recent empirical studies by researchers at the International Monetary Fund reach opposing conclusions on these issues. We examine the issue further and show that conclusions can be quite sensitive to how exchange rate regimes are grouped into categories and the measures of currency crises that are used. In general we find that the dead center of the adjustable peg is by far the most crisis prone broad type of exchange rate regimes, but that countries need not go all the way to freely floating rates or hard fixes to substantially reduce the risks of currency crises.

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.