Persistent real exchange rates

Over the past decades, product market deregulation has typically preceded labor market reforms in OECD countries. This paper incorporates labor market rigidities in a model of footloose capital in order to study how globalization might affect the trade-offs generated by labor market regulation and put pressure on labor market institutions. In this two-sector model, globalization ultimately reduces labor market rigidities through either one of two channels: capital mobility triggers a re-allocation of resources, which trade integration amplifies, away from the high-rent / highly-unionized sector; the threat of costly relocations encourages labor market deregulation. The latter channel is more efficient because it avoids sub-optimal sectoral specialization.     

Persistent real exchange rates

Three well known facts that characterize exchange rate data are: (a) the high correlation between bilateral nominal and real exchange rates; (b) the high degree of persistence in real exchange rate movements; and (c) the high volatility of real exchange rates. This paper attempts a joint, albeit partial, rationalization of these facts in an environment with no staggered contracts and where prices are preset for only one quarter. There are two key innovations in the paper. First, we augment a standard two-country open economy model with learning-by-doing in production at the firm level. This induces monopolistically competitive firms to endogeneize the productivity effect of their price setting behavior. Specifically, firms endogenously choose not to adjust prices by the full proportion of a positive monetary shock in order to take advantage of the productivity benefits of higher production. Second, we introduce habits in leisure. This makes the labor supply decision dynamic and adds an additional source of propagation. We show that the calibrated model can quantitatively reproduce significant fractions of the aforementioned facts. Moreover, as in the data, the model also produces a positive correlation between the terms of trade and the nominal exchange rate.     

Long-run real exchange rates in the Four Little Dragons

This paper analyses changes in the exchange rate arrangements and policy and their impact on the long-run real exchange rates of the Asian Four Little Dragons. It is found that purchasing power parity is a basic guide in formulating the exchange rate policy of the Four Little Dragons and that exchange rate regimes are very responsive to the effect of major external disturbances on prices. Thus, the exchange rate policy and arrangements are important factors in shaping the behaviour of the real exchange rates of the FLDs, which tend to return to the long-run average value. To test the null hypothesis that purchasing power parity does not hold between the Four Little Dragons and the United States, two cointegration tests, the augmented Dickey-Fuller (ADF) test and the Johansen test, are applied. As the symmetry and proportionality conditions are not supported by the data, the tests are conducted in a trivariate system. While the ADF test does not support PPP, evidence of cointegration is found by the Johansen test.     

On cross-country differences in the persistence of real exchange rates

Previous findings of long-run purchasing power parity come mainly from data for industrial countries, raising the issue of whether the results suffer sample-selection bias and exaggerate the general relevance of parity reversion. This study uncovers substantial cross-country heterogeneity in the persistence of deviations from parity. The results show that it is more likely, rather than less likely, to find parity reversion for developing countries than industrial countries. Although some persistence variations may partly reflect country differences in structural characteristics such as inflation experience and government spending, a considerable portion of those variations seems unaccounted for.     

Asymmetric real exchange rates and poverty: The role of remittances

This paper explores the asymmetric effect of real exchange rate changes on poverty through the remittance channel for a panel of 99 countries, spanning the period 1980–2015. Considering a threshold partial adjustment modelling approach, the results document that real exchange rate depreciations exert a stronger positive effect on poverty through remittances. The results are expected to be of substantial importance in the case of emerging and developing countries in designing exchange rate and inflation policies that affect the poverty levels of their population through the mechanism of remittances.     

Inflation forecasts,the expected real rate and information efficiency

This paper examines the inflation forecast accuracy and rationality of a time series predictor, an expected inflation series constructed from surveys undertaken by the University of Michigan's Institute for Social Research, and the yield on U.S. Treasury bills. A quadratic loss function is assumed, and Theil's inequality ratios are used to decompose the mean squared foreast error (MSE). Although it is the only unbiased forecast, the time series predictor does not appear to be optimal during the recent period of turbulent inflation. As for bias in the other series, the surveys are inconsistent with weak-form rational expectations and the Treasury bill is reflecting variations in more than one factor. In an examination of the latter under the assumption of no liquidity premium, the results suggest that the forecast error is in part attribute to moderate variation in the expected real rate. Given the minimal cost of observing the Treasury bill yield, the findings of this study suggest that the market, although imperfect, has performed reasonably well in forecasting inflation.     

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.     

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.     

Unstable exchange rates and trade policy

Floating exchange rates affect two basic principles of GATT, namely: stability of trade policy conditions and reciprocity of trade concessions. What is the relevance of the changes to foreign trade? What possibilities for surmounting the new problems exist in the realm of external economic relations?     

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.     

The causes of real exchange rate movements

Increasing exchange rate fluctuations, such as those that have occurred in the US dollar, have recently revived the discussion about the causes of such movements and the criteria for calculating the long-term over- or undervaluation of a currency. This article stresses some aspects that have attracted little attention hitherto.     

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.     

Manufacturing restructuring and the role of real exchange rate shocks

Using a new and extensive micro data set we investigate the impact of a change in international competitive pressure on industrial performance and restructuring. Unlike previous studies we are able to account for the heterogeneity across firms in their exposure to foreign competition. We focus on a situation akin to a natural experiment, and examine the impact of a sharp real appreciation of the Norwegian Krone in the early 2000s on Norwegian manufacturing firms which differ substantially in their trade orientation. A change in the real exchange rate (RER) affects a firm through three different channels: (i) firm's export sales, (ii) firm's purchases of imported inputs, and (iii) import competition faced in the domestic market. Unlike previous studies, we are able to examine all three channels. Both net exporters and import-competing firms were exposed to increased competition due to the real appreciation. Both groups reacted by shedding labor, but only the first group experienced increasing labor productivity. Partly, the productivity improvements came from measured TFP gains, while capital deepening does not appear to have been affected by the shock.     

Lending booms, sharp reversals and real exchange rate dynamics

Emerging markets in the 1990s experienced periods of booms followed by collapses in gross domestic product, consumption, traded and non-traded sector output and real exchange rate movements alongside unprecedented movements in foreign investor participation in these economies. An important feature of these episodes is the asymmetry in the pattern of booms and collapses. We introduce a natural search friction into the foreign investment decision in a small open economy and demonstrate that this can generate the asymmetry observed in the data. The magnitude of the reversals predicted by the model can be quantitatively large and empirically relevant.