Accounting for persistence and volatility of good-level real exchange rates: The role of sticky information

Volatile and persistent real exchange rates are observed not only in aggregate series but also in micro-price data at the retail level. Kehoe and Midrigan (2007) recently showed that, under a standard assumption on nominal price stickiness, empirical frequencies of micro price adjustment cannot replicate the time series properties of the Law of One Price (LOP) deviations. We extend their sticky price model by combining good-specific price adjustment with information stickiness in the sense of Mankiw and Reis (2002). Our framework allows for multiple cities within a country. Using a panel of U.S.-Canadian city pairs, we estimate a dynamic price adjustment process for 165 individual goods. Under a reasonable assumption on the money growth process, we show that the model matches the persistence of the LOP deviation for the median good and accounts for the majority of its volatility when information updates occur every 12 months.     

Monetary policy and exchange rate overshooting: Dornbusch was right after all

Dornbusch's exchange rate overshooting hypothesis is a central building block in international macroeconomics. Yet, empirical studies of monetary policy have typically found exchange rate effects that are inconsistent with overshooting. This puzzling result has been viewed by some researchers as a “stylized fact” to be reckoned with in policy modelling. However, many of these studies, in particular those using vector autoregressive (VARs) approaches, have disregarded the strong contemporaneous interaction between monetary policy and exchange rate movements by placing zero restrictions on them. In contrast, we achieve identification by imposing a long-run neutrality restriction on the real exchange rate, thereby allowing for contemporaneous interaction between the interest rate and the exchange rate. In a study of four open economies, we find that the puzzles disappear. In particular, a contractionary monetary policy shock has a strong effect on the exchange rate, which appreciates on impact. The maximum effect occurs within 1-2 quarters, and the exchange rate thereafter gradually depreciates to baseline, consistent with the Dornbusch overshooting hypothesis and with few exceptions consistent with uncovered interest parity (UIP).     

Causes of nonlinearities in low-order models of the real exchange rate

This paper investigates the extent to which modern DSGE models, which feature local currency pricing, home bias, nontraded goods, and incomplete markets, can generate nonlinear real exchange rate dynamics that are consistent with those found in the time series literature using data from the current floating period. Our key findings are as follows. First, if the true model can be appropriately characterized as a set of linear equations, then linearity tests that utilize univariate autoregressions of the real exchange rate suffer from an omitted variables problem, which leads them to overestimate the true incidence of nonlinearity. Consequently, studies that fail to control for this problem may spuriously find evidence of nonlinearities in the data, despite the fact that the data generating process may be linear. Second, we propose a strategy that can largely eliminate this distortion. Finally, we find that DSGE models solved using higher order approximations are capable of generating true structural nonlinearities in real exchange rates both asymptotically and in short samples.     

Debt deleveraging and the exchange rate

Deleveraging from high debt can provoke deep recession with significant international side effects. Swings in the nominal exchange rate and large variations in consumption, output, and terms of trade can happen during the adjustment. All these movements are inefficient and interesting trade-offs emerge from the perspective of global welfare. The optimal adjustment to global imbalances should not necessarily require large movements in the nominal exchange rate. A global liquidity trap can be desirable when countries are more open to trade.     

Exchange rate forecasting, order flow and macroeconomic information

This paper adds to the research efforts that aim to bridge the divide between macro and micro approaches to exchange rate economics by examining the linkages between exchange rate movements, order flow and expectations of macroeconomic variables. The basic hypothesis tested is that if order flow reflects heterogeneous expectations about macroeconomic fundamentals, and currency markets learn about the state of the economy gradually, then order flow can have both explanatory and forecasting power for exchange rates. Using one year of high frequency data collected via a live feed from Reuters for three major exchange rates, we find that: i) order flow is intimately related to a broad set of current and expected macroeconomic fundamentals; ii) more importantly, order flow is a powerful predictor of daily movements in exchange rates in an out-of-sample exercise, on the basis of economic value criteria such as Sharpe ratios and performance fees implied by utility calculations.     

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.     

Expectations and exchange rate dynamics: A state-dependent pricing approach

This paper presents a two-country DSGE model with state-dependent pricing as in Dotsey et al. [Dotsey, M., King, R.G., and Wolman, A.L., 1999. State-dependent pricing and the general equilibrium dynamics of money and output. Quarterly Journal of Economics 114, 655-690] and variable demand elasticity as in Kimball [Kimball, M.S., 1995. The quantitative analytics of the basis neomonetarist model. Journal of Money, Credit, and Banking 27, 1241-1277]. Following a domestic monetary expansion, the model predicts: (i) positive hump-shaped responses of domestic output and consumption, (ii) positive spillover effects on foreign output and consumption, (iii) a high international output correlation relative to consumption correlation, (iv) a delayed increase in domestic and foreign inflation, (v) a delayed nominal exchange rate overshooting, (vi) a deterioration in the terms of trade, and (vii) a J-curve in the trade balance. The model matches the impulse responses from an identified VAR more closely than an otherwise identical model with time-dependent pricing.     

International real business cycles with endogenous markup variability

The aggregate impact of decisions made at the level of the individual firm has recently attracted a lot of attention in both the macro and trade literatures. We adapt the benchmark international real business cycle model to a game-theoretic environment to add a channel for the strategic interaction among domestic and foreign firms. We show how the sum of strategic pricing decisions made at the level of the individual firm can have significant effects on the volatility and cross country co-movement of GDP and its components. Specifically we show that the addition of this one channel for strategic interaction leads to a significant increase in the cross-country co-movement of production and investment, as well as a significant decrease in the volatility of investment and the trade balance over the benchmark IRBC model.     

State dependent pricing, invoicing currency, and exchange rate pass-through

We analyze exchange rate pass-through and volatility of import prices in a dynamic framework where firms are subject to menu costs and decide on price adjustments in response to exchange rate innovations. The exchange rate pass-through and import price volatility then depend on the invoicing currency in combination with functional forms of cost and demand functions. In particular, there is lower pass-through, less frequent price adjustments, and lower price volatility when prices are set in the importer's currency than when prices are set in the exporter's currency.     

The exchange rate, employment and hours: What firm-level data say

Using a representative panel of manufacturing firms, we estimate the response of job and hours worked to currency swings, showing that it depends primarily on firms' exposure to foreign sales and their reliance on imported inputs. We also show that, for a given international exposure, the response to exchange rate fluctuations is magnified when firms exhibit a lower monopoly power and when they face foreign pressure in the domestic market through import penetration. The degree of substitutability between imported and other inputs and the distribution of workers by type introduce additional degrees of specificity in the employment sensitivity to exchange rate swings. Moreover, we show that episodes of entry and exit in the export market are associated with a heterogeneous employment response depending on the degree of external orientation when the switch of export status occurs.     

Financial liberalization, structural change, and real exchange rate appreciations

The last twenty years have witnessed periods of sustained appreciations of the real exchange rate in emerging economies. The case of Mexico between 1988 and 2002 is representative of several episodes in Latin America and Central and Eastern Europe in which countries opening to capital flows experienced large appreciations accompanied by a significant reallocation of workers towards the non-tradable sector. We account for these facts using a two sector dynamic general equilibrium model of a small open economy with frictions to labor reallocation and two driving forces: (i) A decline in the cost of borrowing in foreign markets, and (ii) differential productivity growth across sectors. These two mechanisms account together for 60% of the decline in the domestic relative price of tradables in Mexico and for a large fraction of the observed reallocation of labor across sectors. The decline in the interest rate faced by Mexico in international markets is quantitatively the most important channel. Our results are robust to the inclusion of terms of trade into the model.     

Temporal dimension and equilibrium exchange rate: A FEER/BEER comparison

This paper investigates the temporal links between two models of equilibrium exchange rate, namely the behavioral and the fundamental approaches. Our results show that, even though in the long-run they are closely related, important differences are observed for some countries and/or some periods. Contrary to previous contributions, we analyze the factors that explain this disconnection. We outline structural changes in matter of competitiveness, the dynamics of foreign assets and valuation effects as explanations. This novel evidence is important if the two approaches for assessing misalignments are used for policy decisions such as setting tariffs to cope with the “currency war”.     

Stuck on gold: Real exchange rate volatility and the rise and fall of the gold standard, 1875-1939

Did the gold standard diminish macroeconomic volatility? Supporters thought so, critics thought not, and theory offers ambiguous messages. Hard regimes like the gold standard limit monetary shocks by tying policymakers' hands; but exchange-rate inflexibility compromises shock absorption in a world of real disturbances and nominal stickiness. A model shows how lack of flexibility affects the transmission of terms-of-trade shocks. Evidence from the late nineteenth and early twentieth century exposes a dramatic change. The classical gold standard did absorb shocks, but the interwar gold standard did not, supporting the view that the interwar gold standard was a poor regime choice.     

Incomplete pass-through and the welfare effects of exchange rate variability

This paper considers the implications of incomplete exchange rate pass-through for optimal monetary and exchange rate policy. A two-country model is presented, which allows an explicit derivation of welfare functions in terms of a weighted sum of the second moments of producer prices and the nominal exchange rate. From a single country perspective, the optimal exchange rate variance depends on the degree of pass-through, the size and openness of the economy, the elasticity of labour supply and the volatility of foreign producer prices. Welfare may be decreasing or increasing in the volatility of the exchange rate.     

Out-of-sample exchange rate predictability with Taylor rule fundamentals

An extensive literature that studied the performance of empirical exchange rate models following Meese and Rogoff's [Meese, R.A., Rogoff, K., 1983a. Empirical Exchange Rate Models of the Seventies: Do They Fit Out of Sample? Journal of International Economics 14, 3-24.] seminal paper has not convincingly found evidence of out-of-sample exchange rate predictability. This paper extends the conventional set of models of exchange rate determination by investigating predictability of models that incorporate Taylor rule fundamentals. We find evidence of short-term predictability for 11 out of 12 currencies vis-à-vis the U.S. dollar over the post-Bretton Woods float, with the strongest evidence coming from specifications that incorporate heterogeneous coefficients and interest rate smoothing. The evidence of predictability is much stronger with Taylor rule models than with conventional interest rate, purchasing power parity, or monetary models.     

Interpreting real exchange rate movements in transition countries

Real exchange rate movements in the transition economies during the initial transition period were unusually large by the standards of other economies and periods. Using cross-sectional evidence, this paper documents how real exchange rates were generally misaligned at the onset of the transition and how most of this misalignment was eliminated over a relatively short period. Turning to the time series dimension, the paper shows that estimates from a consensus-type single-equation model of the real exchange rate are well-behaved and provide a good fit for exchange rate movements in the early transition period. The results highlight the role of productivity-driven real exchange rate movements that can be interpreted as reflecting both the impact of the structural transformation process on productivity in the tradables sector per se and the effects of changes in tradables versus non-tradables productivity. Furthermore, the results show that the relationship between productivity and real exchange rates holds both when productivity is increasing and when it is falling.     

Exchange rate exposure: A nonparametric approach

The typical conclusion reached when researchers examine exchange rate exposure is that only a few firms are exposed. This finding is puzzling since institutional knowledge and theory suggests a larger effect. In this paper, we compare results obtained using a linear approach with those from nonlinear and nonparametric models. Among firms that don't have a linear exposure, we find that a considerable proportion of these are exposed when nonlinear or nonparametric models are used. This exposure is most striking when a nonparametric model is used. We also find that firms' hedging activities decrease linear exposure but don't affect nonparametric exposure.     

Twin dollarization and exchange rate policy

This paper develops a small open economy general equilibrium model with nominal rigidities to study twin dollarization in East Asian economies, a phenomenon where firms borrow in US dollars and also set export prices in US dollars. In this model, we endogenize both the currency of liability denomination and the currency of export pricing. We show that a key factor that affects firms' dollarization decisions is exchange rate policy. Twin dollarization is an optimal strategy for all firms when exchange rate flexibility is limited, which implies that a fixed exchange rate regime may lead to an equilibrium with twin dollarization. Furthermore, we find that twin dollarization can reduce the welfare loss caused by the fixed exchange rate regime, as it helps to cushion the economy against domestic nominal risk.     

Relative price volatility under Sudden Stops: The relevance of balance sheet effects

Sudden Stops are associated with increased volatility in relative prices. We introduce a model based on information acquisition to rationalize this increased volatility. An empirical analysis of the conditional variance of the wholesale price to consumer price ratio using panel ARCH techniques confirms the relevance of Sudden Stops and potential balance sheet effects as key determinants of relative price volatility, where balance sheet effects are captured by the interaction of a proxy for potential changes in the real exchange rate (linked to the degree of external leverage of the absorption of tradable goods) and a measure of domestic liability dollarization.     

Capital controls on inflows, exchange rate volatility and external vulnerability

We use high frequency data and a new econometric approach to evaluate the effectiveness of controls on capital inflows. We focus on Chile's experience during the 1990s, and investigate whether controls on capital inflows reduced Chile's vulnerability to external shocks. We recognize that changes in the controls will affect the way in which different macro variables relate to each other. In particular, we consider the case where controls co-exist with an exchange rate band aimed at managing the nominal exchange rate. We develop a methodology to deal explicitly with the interaction between these two policies. The main findings may be summarized as follows: (a) a tightening of capital controls on inflows depreciates the exchange rate and (b), we find that a tightening of capital controls increases the unconditional volatility of the exchange rate, but makes it less sensitive to external shocks.