Price adjustment and exchange rate pass-through

This paper develops a simple theoretical model that can be used to account for the determinants of exchange rate pass-through to consumer prices. While recent evidence has found low estimates of pass-through in many countries, there is little consensus on an explanation for this. Our paper argues that sticky prices represent a key determinant of exchange rate pass-through. We make this argument in two stages. First, holding the frequency of price change constant, we show that our model calibrated to data from low-inflation countries can reproduce the estimates of very low pass-through for these countries. The principal determinant of low pass-through in this case is the slow adjustment of prices. We then extend the model to allow the frequency of price change to be endogenous. Calibrating to a wider set of countries, including both low-inflation and high-inflation countries, we show that our model implies that exchange rate pass-through is increasing in average inflation, but at a declining rate. Performing the identical exercise on the data, we find a striking correspondence between the predictions of the model and those of the data.     

Oil price shocks and exchange rate movements

This study investigates the effects of oil price shocks on exchange rate movements in five major oil-exporting countries: Russia, Brazil, Mexico, Canada, and Norway. The R² of the fundamental model doubles in Russia and Brazil, but increases slightly in Canada and Norway when oil prices are added to it. The volatility of exchange rates associated with oil price shocks is significant in Russia, Brazil, and Mexico, but weak in Norway and Canada. It takes much longer for the exchange rate to reach the initial equilibrium level in Russia, Brazil, and Mexico than in Norway and Canada. The asymmetric behavior of exchange rate volatility among countries seems to be related to the efficiency of financial markets rather than to the importance of oil revenues in the economy.     

Option volume,strike distribution,and foreign exchange rate movements

Using Deutschmark currency option data from the Philadelphia Stock Exchange and British pound option data from the Chicago Mercantile Exchange, this article examines the signaling quality of option volume measures on movements in the underlying spot exchange rates. The concept of a volume-weighted strike distribution is proposed. It is demonstrated that measures using the strike distribution are inherently better predictors of both direction and volatility of the exchange rate movements as compared to their more traditional counterparts used in practice, such as the put-call ratio.      

A model of medium term exchange rate forecast in an open economy The case of the mexican peso

Keynes (1930) and Samuelson (1965) proposals open the possibility of matching predictability and efficiency, as evidenced by the seminal study by Fisher (1930). Recent findings suggest that the foreign exchange market gradually incorporates relevant information allowing the formation of prices in a rational manner but not randomly. Models of exchange rate by term based on asset valuation suggest that the inclusion of risk in the spot rate increases the degree of predictability. The results show that after incorporating an accurate measure of risk, predictability of medium term foreign exchange rate increases.     

Optimal exchange intervention for a small open economy

This paper investigates the optimal exchange intervension strategy for a small open economy in which both the domestic price level and domestic real GNP are endogenous, with the authority's objective being to stabilize a function involving both these variables. A special feature of the underlying macro model is that real balances are productive. Ultimately, this will mean that aggregate supply is sensitive to nominal interest rates. Additionally, both expectations and the intervention policy are designed to exploit the fact that financial market data, such as exchange and interest rates, are observable on a fairly current basis. Contrary to conventional wisdom, optimal intervention will usually require accentuating, not moderating, current exchange rate movements.     

Expectations of future income and real exchange rate movements

We show that changes in expectations of future income driven by exogenous factors (such as the discovery of oil and an increase in global demand for natural resources) can cause movements in the real exchange rate (RER) in excess of, and sometimes even in the opposite direction to, what one would expect given the changes in current income. We provide both a theoretical model and empirical evidence of this. In particular, we show that the signing of numerous production sharing agreements (PSAs) between the government of Azerbaijan and foreign oil companies in 1994–1998 fueled expectations of higher future incomes, resulting in a considerable appreciation of the RER. Some of these PSAs subsequently failed or ran into difficulties, which led to a downward revision of expected future income and a depreciation of the RER in 1999–2003, even though the current income started to rise, due to an increase in the current oil revenue.     

What explains global exchange rate movements during the financial crisis?

A striking and unexpected feature of the financial crisis has been the sharp appreciation of the US dollar against virtually all currencies globally. The paper finds that negative US-specific macroeconomic shocks during the crisis have triggered a significant strengthening of the US dollar, rather than a weakening. Macroeconomic fundamentals and financial exposure of individual countries are found to have played a key role in the transmission process of US shocks: in particular countries with low FX reserves, weak current account positions and high direct financial exposure vis-à-vis the United States have experienced substantially larger currency depreciations during the crisis overall, and to US shocks in particular.     

Unanticipated money,output, and prices in the small economy

Recent studies of the relationship between unanticipated monetary disturbances and the level of output and prices have focussed on the implications of monetary policy for the large, essentially closed, economy. This paper investigates the determination of output, the price level, and the money stock of a small open economy. In particular, primary interest is in delineating the channels of home and foreign monetary influence, and in discriminating between the effects of home-generated and foreign-generated unanticipated monetary disturbances under the alternative regimes of a fixed, managed, and flexible exchange rate.     

Identifying monetary policy in a small open economy under flexible exchange rates

Previous empirical study on the effects of monetary policy shocks in small open economies has generated puzzling dynamic responses in various macroeconomic variables. This paper argues that these puzzles derive from an identification of monetary policy that is inappropriate for such economies. To remedy this, it is proposed that a structural model be estimated to explicitly account for the features of the small open economy. Such a model is applied to Canada with tightly estimated results overall. The dynamic responses to the identified monetary policy shock are consistent with standard theory and highlight the exchange rate as a transmission mechanism.     

Nominal exchange rate volatility,relative price volatility,and the real exchange rate

We model real exchange rate, nominal exchange rate, and relative price volatility using real and nominal factors. We analyze these volatility measures across developing and industrialized countries. We find that the inclusion of nominal factors achieves a sizable reduction in the real exchange rate volatility spread between developing and industrialized countries. In addition, we find that nominal factors matter to real exchange rate volatility in the short run and the long run, and that for developing countries, a higher share of real exchange rate volatility stems from relative price volatility.     

Home bias,exchange rate disconnect,and optimal exchange rate policy

This paper examines how much the central bank should adjust the interest rate in response to real exchange rate fluctuations. The paper first demonstrates, in a two-country Dynamic Stochastic General Equilibrium (DSGE) model, that home bias in consumption is important to replicate the exchange rate volatility and exchange rate disconnect documented in the data. When home bias is high, the shock to Uncovered Interest rate Parity (UIP) can substantially drive up exchange rate volatility while leaving the volatility of real macroeconomic variables, such as GDP, almost untouched. The model predicts that the volatility of the real exchange rate relative to that of GDP increases with the extent of home bias. This relation is supported by the data. A second-order accurate solution method is employed to find the optimal operational monetary policy rule. Our model suggests that the monetary authority should not seek to vigorously stabilize exchange rate fluctuations. In particular, when the central bank does not take a strong stance against the inflation rate, exchange rate stabilization may induce substantial welfare loss. The model does not detect welfare gain from international monetary cooperation, which extends Obstfeld and Rogoff's [Obstfeld, M., Rogoff, K.,2002. Global implications of self-oriented national monetary rules, Quarterly Journal of Economics May, 503–535] findings to a DSGE model.     

A classical model of a small fixed exchange rate economy

This paper develops a monetary model of a small, fixed exchange rate economy. Prices are flexible and aggregate supply plays a key role. The model combines the Barro-Ricardo theorem that government bonds are not wealth to the residents of the country of issue with the ultra-rational view that the domestic component of the money supply is also not wealth. The short-run and long-run effects of monetary policy, fiscal policy and devaluations are examined. Monetary policy is neutral in both the short and long-runs. Devaluations and fiscal policy, however, are not necessarily neutral in either the short or long run.     

Real exchange rate fluctuations, endogenous tradability and exchange rate regimes

The real exchange rate is driven by fluctuations of the relative price of traded goods and the relative price of nontraded to traded goods. This study explains the variance decomposition of the real exchange rate using a stochastic dynamic general equilibrium model of comparative advantage with money. Given interest rate shocks, exchange rate stability reduces the covariance between the two relative prices and raises the contribution of the relative price of nontraded to traded goods. Productivity shocks do not alter the covariance across exchange rate regimes and let the relative price of traded goods drive the real exchange rate.     

Price and volatility spillovers between interest rate and exchange value of the US dollar

In this paper, the dynamic relationships between interest rate and exchange value of the US dollar are studied via a multivariate Exponential Generalised Autoregressive Conditional Heteroskedasticity (EGARCH) model. In terms of price changes, movements of interest rates have positive effects on movements of exchange rates. However, changes in exchange rates do not explain changes in interest rates. Nevertheless, there exists volatility spillovers between the two markets, indicating that their second moments are related. Overall evidence suggests that these two markets have short-term dynamic interactions. The existence of volatility spillovers also suggests that the relationships between these two economic variables are not necessarily linear.     

Do central banks respond to exchange rate movements? A structural investigation

We estimate a small-scale, structural general equilibrium model of a small open economy using Bayesian methods. Our main focus is the conduct of monetary policy in Australia, Canada, New Zealand and the UK. We consider generic Taylor-type rules, where the monetary authority reacts in response to output, inflation, and exchange-rate movements. We perform posterior odds tests to investigate the hypothesis whether central banks do target exchange rates. The main result of this paper is that the central banks of Australia and New Zealand do not, whereas the Bank of Canada and the Bank of England do include the nominal exchange rate in its policy rule. This result is robust for various specification of the policy rule. We also find that terms-of-trade movements do not contribute significantly to domestic business cycles.     

The influence of the forecast horizon on judgemental probability forecasts of exchange rate movements

An experiment is reported which compares directional forecasting performance of experts, novices and simple statistical models over three time horizons on a task involving probabilistic forecasts of exchange rate movements. Probability-judgement accuracy analyses illustrated no clear overall performance differences between experts and novices, but significant differences between the groups on various important components of judgement suggested that the groups obtained their similar overall scores using different cognitive strategies. Striking horizon effects and expertize–horizon interactions were also observed. The subjects performed better than a random walk forecaster, but worse than the random walk with constant drift and first-order autoregressive models. Composite human judgement, however, not only improved on individual judgement but, also, surpassed the simple statistical models in many instances. Possible explanations are offered for these results, suggestions are made for future research, and practical implications are emphasized.     

Some insights into the foreign exchange pricing puzzle: Evidence from a small open economy

One of the great puzzles of international finance research has been the surprising finding that firm value is only mildly sensitive, if at all, to exchange rate fluctuations. This runs against the conclusions of the standard net discounted cash flow theory. In this article we examine this puzzle, and provide some insights by looking at whether the result is peculiar to large economies like the US, using improved methodology including a residual regression model, the use of individual firm data, and looking at the effect of different exchange rates. We do find clear evidence that exchange rate movements affect the value of listed firms. We also find that the direction and degree of sensitivity is dependant on the currency used.     

Expectations,the exchange rate,and the current account

A critical examination is undertaken of the relationship between the exchange rate and the current account in a small open economy. Theoretically, the correlation between the exchange rate and the current account seems to be ambiguous. In particular, the association between movements in the exchange rate and the current account is likely to depend in an essential manner on the nature of exogenous disturbances affecting the two variables simultaneously. Lastly, the question of the role of an optimal monetary policy and the choice of an exchange rate regime in an uncertain environment is raised.     

Public sector layoffs, severance pay, and inflation in the small open economy

Because severance pay is worth 2–5 years of wages in many LDCs, public sector layoffs increase the fiscal deficit in the short run. Nevertheless, generous severance pay is not as serious a macroeconomic problem as generally thought. In the case where the fiscal deficit is financed by printing money, inflation is continuously lower under plausible conditions. When the government can borrow in world capital markets and layoffs reduce the present-value wage bill, there exists a sequence of bond sales and subsequent redemptions that guarantees continuously lower inflation. This result does not hold, however, if the reform lacks credibility.     

Asymmetric exchange rate pass-through in an emerging market economy: The case of Mexico

This paper applies a nonlinear Autoregressive Distribute Lag to examine the exchange rate pass-through into consumer price inflation in Mexico. Overall, the evidence confirmed that ignoring the asymmetric (sign) effect of exchange rate movements on inflation may lead to incorrect inferences and policy conclusions. Exchange rate fluctuation is transferred to prices level more during currency depreciation than appreciation. We compare the macroeconomic performances between pre- and post-inflation targeting, and our findings reaffirmed that the pass-through has weakened significantly after launching inflation targeting in 2001. This result implies that low inflation in the sample period examined is good for Mexico because exchange rate pass-through declines after 2001. Consumer prices have become less responsive to exchange rate movements. We further observe a revival (strengthening) of oil price pass-through to domestic inflation in the post- inflation targeting period.