Expectations,monetary policy rules,and macroeconomic stability: Analysis of an open economy with flexible exchange rates

This paper makes use of a dynamic model of an open economy with flexible exchange rates to examine the dynamic characteristics of the system for different specifications of monetary authority behavior. The model contains dynamic adjustment equations for both output and prices. Two policy rules are examined: (a) maintaining a constant nominal money supply growth, and (b) maintaining a constant nominal interest rate. With the former the system is found to be self-equilibrating. The latter, however, could easily give rise to self-perpetuating disequilibrium situations. In both cases expectations play a crucial role in the adjustment process.     

Economic stability under fixed and flexible exchange rates

This paper analytically compares macroeconomic performance under fixed and flexible exchange-rate regimes. A model is developed in which the economy is stable around full employment, but subject to periodic random shocks. From the model, conditions are derived which allow comparison (across exchange-rate regimes) of the size of the expected squared deviation from full employment income in any arbitrarily selected period. These conditions are stated in terms of the variances and elasticities of particular behavioral relations.     

On the unstable relationship between exchange rates and macroeconomic fundamentals

Survey evidence shows that the relationship between the exchange rate and macro fundamentals is perceived to be highly unstable. We argue that this unstable relationship naturally develops when structural parameters in the economy are unknown. We show that the reduced form relationship between exchange rates and fundamentals is then driven not by the structural parameters themselves, but rather by expectations of these parameters. These expectations can vary significantly over time as a result of perfectly rational “scapegoat” effects. These effects can be expected to hold more broadly in macro and finance beyond the application to exchange rates in this paper.     

Purchasing power parity under fixed and flexible exchange rates

The relationship between exchange rates and relative price levels in a sample of fourteen countries is studied for periods of fixed and of floating exchange rates. In comparing the deviations of the exchange rates from their purchasing power parity levels in the two cases it turns out that both the average size of the divergencies and their duration are smaller under the fixed rate period 1957–1966 than under the recent period of floating rates. The adjustable beg years of the late sixties fall in between. Evidence is also found which indicates a bias in purchasing power parity calculations using consumer price indexes, and the hypothesis that purchasing power parity relationships shifted as a result of changes in relative prices occuring at the end of 1973 cannot be rejected. The findings are related to the empirical literature on the international transmission of inflation and to recent comparisons of exchange rates and relative inflation rates.     

The international assignment of stabilization policies under fixed and flexible exchange rates

This paper investigates the ability of policymakers to achieve stabilization targets in the face of spillover effects from abroad. In the context of a two-country Keynesian model, each country's stabilization policy turns out to have a comparative advantage over domestic economic activity under fixed exchange rates and sterilization. By assigning policy domestically, both employment targets can be eventually achieved despite trade linkage spillovers. The same conclusion is reached for the case of floating exchange rates despite spillover effects associated with capital mobility. Finally, it is discovered that coordination under fixed exchange rates may benefit one country and injure the other.     

A dynamic model of tariffs,output and employment under flexible exchange rates

A portfolio balance model of the open economy with imperfectly flexible wages and rational expectations is used to analyze the macroeconomic effects of commercial policy. Previous analyses have led to the ‘counterintuitive’ and ‘almost inconceivable’ conclusion that, under flexible exchange rates, a tariff is contractionary. By considering a tariff in a dynamic setting and focusing on the process of adjustment, it is shown that there may exist a tradeoff between a tariffs short-run and long-run effects. In certain circumstances, a tariff imposed under flexible exchange rates increases output and employment initially while reducing them subsequently.     

Twenty years of flexible exchange rates: Experiences and developments

The Bretton Woods system of fixed exchange rates was abandoned at the beginning of March 1973 when currencies were allowed to float. Has the system of flexible exchange rates fulfilled the expectations placed in it? How should experiences with regional systems of fixed exchange rates be assessed, and what are the prospects for a return to such a system worldwide?     

The resource reallocation costs of fixed and flexible exchange rates: A counterexample

This paper questions the view that resource reallocation costs are a disadvantage of a flexible exchange rate system relative to a fixed exchange rate. It is shown that reallocation costs of a flexible exchange rate are not necessarily greater than and indeed may be less than, those under a fixed exchange rate. A method is developed for testing this hypothesis. Applying the technique to Canadian exchange rate policy for 1953–1977 provides a counterexample to the view that reallocation costs are a disadvantage of flexible exchange rates.     

The resource reallocation costs of fixed and flexible exchange rates: A multi-country extension

For a sample of nineteen countries for 1972–79 we test the hypothesis that reallocation costs associated with temporary disturbances to the export sector of an economy are equal under fixed and flexible exchange rates. This test is an extension of earlier work indicating that in the special case of Canada, reallocation costs do not differ significantly under fixed and flexible rates. The degree of industrialization and openness of the countries included in the sample varies greatly; so it is interesting that the Canadian result generalizes to all but two cases. These results suggest that even during periods of considerable exchange rate variability, unnecessary resource reallocation costs may not be a significant disadvantage of a flexible exchange-rate system.     

Protectionism and the case for flexible exchange rates: A reexamination

This paper reexamines the arguments by early proponents that flexible exchange rates would lessen the incentives for protectionism and also permit countries to pursue independent monetary policies. We argue that there is a basic inconsistency between these two arguments; the pursuit of independent monetary policy can lead to situations which involve very strong pressures on policy-makers to engage in protection. A theoretical analysis supporting our argument is developed, and some circumstantial evidence is presented.     

Real exchange rate targeting and macroeconomic instability

Using an optimizing model of a small open economy, this paper studies the macroeconomic effects of PPP rules whereby the government increases the devaluation rate when the real exchange rate—defined as the price of tradables in terms of nontradables—is below its long-run level and reduces the devaluation rate when the real exchange rate is above its long-run level. The paper shows that the mere existence of such a rule can generate aggregate instability due to self-fulfilling expectations. The result is shown to obtain in both flexible- and sluggish-price environments.     

Currency board,dollarisation or flexible exchange rates for emerging economies? Reflections on Argentina

Since the 1990s many emerging countries have adopted a fixed exchange-rate peg vis-à-vis a reserve currency in order to cope with economic imbalances such as buoyant inflation, high unemployment or staggering economic growth. However, after a period of economic stabilisation and prosperity, overheating effects showed up in several countries that were often coupled with difficulties in the banking and/or the real estate sector. Sticking with a fixed peg, the likelihood of a currency crisis increased. The case of Argentina shows that even with a currency board it is difficult to restore confidence if a crisis has already been developing for several years. This article presents an economic analysis of the Argentina crisis.     

Doctrine of relative purchasing power parity under fixed and flexible exchange rates reconsidered

The doctrine of relative purchasing power parity during periods of fixed and flexible exchange rates is investigated. Using cointegration techniques and data for the Group of Seven countries, a subset of the results suggests, that purchasing power parity held only between the United States and the United Kingdom over the period 1957 QI to 1973 QII. Different results are obtained for the 1973 QIII to 1990 QIV period. Based on the maximum likelihood approach of Johansen and Juselius and an error correction model, it is concluded that purchasing power parity held between the United States and Canada, the United States and France, the United States and Italy, and the United States and the United Kingdom.     

Some doubts about the efficacy of monetary policy under flexible exchange rates

This paper raises doubts about the proposition that monetary policy is effective, under flexible exchange rates, in stabilizing domestic output. It is argued that if the price elasticities of the demands for exports and imports are affected by the transition to flexible rates, and capital flows are assumed to be dependent on the exchange rate, the efficacy of monetary policy under flexible rates will not necessarily follow.     

Imports,monopoly power,profits and exchange rates

This study uses pooled data on U.S. manufacturing industries and on U.S. imports to analyze the level of monopoly power and the restraining influence of the import penetration ratio at the industry level. In general, industries with higher levels of imports have lower levels of monopoly power. In addition, imports have a greater impact on industries with more monopoly power (i.e., higher concentration), even though the level of imports may be lower. Finally, the impact of imports on monopoly power appears to be increasing over time indicating that U.S. manufacturing has become significantly more competitive over the 1961 to 1984 period. (JEL F14, L12)     

Flexible exchange rates,unemployment and stabilization policy effectiveness

The paper presents a general equilibrium model of a small flexible exchange rate economy comprising asset, goods, and labor markets. Viewing the exchange rate as determined proximately in asset markets, the study examines its influence on the excess demand for labor and for output and, correspondingly, its impact on the level of unemployment and external imbalance. The role of exchange rate expectations is central to the present analysis, which reconsiders, in that light, the conventional conclusions about monetary and fiscal policy effectiveness under flexible exchange rates.     

Fixed exchange rates and trade

A classic argument for a fixed exchange rate is its promotion of trade. Empirical support for this, however, is mixed. While one branch of research consistently shows a small negative effect of exchange rate volatility on trade, another, more recent, branch presents evidence of a large positive impact of currency unions on trade. This paper helps resolve this disconnect. Our results, which use a new data-based classification of fixed exchange rate regimes, show a large, significant effect of a fixed exchange rate on bilateral trade between a base country and a country that pegs to it. These results suggest an economically relevant role for exchange rate regimes in trade determination since a significant amount of world trade is conducted between countries with fixed exchange rates.