The Dynamic Interaction of Exchange Rates and Trade Flows

During the fifteen years since 1970, the theory of exchange-rate determination has been completely transformed. In the late 1960s, the standard model of the foreign exchange market had supply and demand as stable functions of exports and imports, with the expection that a floating rate would move gradually with relative price changes. However,the period of floating rates that began in the early 1970s has revealed that exchange rates exhibit the volatility of financial market prices.This experience, coupled with development of theory, led first to the"monetary" approach to exchange rate determination and then to the "asset market" approach. The monetary approach to exchange rate determination had essentially one-way causation from money to exchange rates, sometimes via purchasing power parity. The broader asset market approach assumes two-way causation.The exchange rate, in the asset-market view, is proximately determined by financial-market equilibrium conditions. It, in turn, influences the trade balance and the current account. The latter, in its turn, is the rate of accumulation of national claims on foreigners, and this feeds back into financial market equilibrium. Thus the asset market approach contains a dynamic feedback mechanism in foreign assets and exchange rates. This approach is called here a "fundamentals" model of exchange rate dynamics. Recent work on rational expectations adds a layer of expectations to the model. It is assumed that following an unexpected disturbance the market can anticipate where the fundamentals will move the system, and move the exchange rate in anticipation of that fundamentals path. This paper integrates the traditional elasticities and absorption approaches into the general equilibrium fundamentals model, and then add the expectations layer. The model is used to interpret recent shifts in U.S. fiscal policy and portfolio preferences for the dollar.

The Limits of Monetary Coordination As Exchange Rate Policy

macroeconomics, monetary coordination, exchange rate policy

U.S. Comparative Advantage: Some Further Results

macroeconomics, comparative advantage

A Model of Exchange-Rate Determination with Policy Reaction: Evidence from Monthly Data

During the 1970s an extensive theoretical literature has developed analyzing market determination of freely floating exchange rates. At the same time, there has been extensive and continuous intervention in the market by central banks. Exchange rates have not been floating freely;they have been managed, or manipulated, by central banks. However, most of the description of exchange rate policy, as actually practiced, has been informal, or "literary," not integrated with the formal theoretical literature. Recent examples are the surveys in Branson (l98la) and Mussa (1981). In this paper I integrate exchange-rate policy into a model of exchange-rate behavior, and examine the monthly data from the 1970s econometrically,to infer hypotheses about policy behavior. I focus on four major currencies, the U.S. dollar, the Deutschemark, Sterling, and the Japanese yen,and analyze movements in their effective (weighted) exchange rates as calculated by the IMF. In section II a model of market determination of a floating exchange-rateis laid out. It is a rational-expectations version of the model in Branson(1977), and it draws on the model of Kouri (1978). It is the same as the model in Branson (1983). The model shows how unanticipated movements in money, the current account, and relative price levels will cause first a jump in the exchange rate, and then a movement along a "saddle path" tothe new long run equilibrium. Here the role of "news" in moving the exchangerate, as recently emphasized by Dornbusch (1980) and Frenkel (1981), is clear.The model emphasizes imperfect substitutability between domestic and foreign bonds, in order to prepare for the analysis of intervention policy in section III.Exchange-rate policy is introduced in section III. We analyze the options available to the central bank that wants to reduce the jump in the exchangerate following a real or monetary disturbance-"news" about the current account, relative prices, or money. This is the policy characterized as"leaning against the wind" in Branson (1976). The distinction ismade between monetary policy and sterilized intervention.In section IV we turn to the monthly data. The quarterly data were analyzed in Branson (1983). Systems of vector autoregressions (VARs) are estimated for each of the countries, and the correlations among their residuals are studied. These represent the "innovations," or "news" in the time series. A clear pattern emerges in these correlations, in which policy inthe U.S. and Japan drives exchange rates, and policy in Germany and the U.K. reacts by moving interest rates, and by sterilized intervention. This is essentially the same result that appeared on the quarterly data in Branson (1983). Thus the analyses tend to reinforce each other; both datasets tell basically the same story.

Monetary Policy and the New View of International Capital Movements

macroeconomics, monetary policy, international capital

Monetary and Fiscal Policy with Flexible Exchange Rates

If price decisions are taken neither continuously nor in perfect synchronization, the process of adjustment of all prices to a new nominal level will imply temporary movements in relative prices. It might then well be that, to avoid these movements in relative prices, each price setter will want to move his own price slowly compared to others. The result will be a slow movement of all prices to their new nominal level, and substantial inertia of the price level. This paper formalizes this intuitive argument and reaches four main conclusions: (1) Even small departures from perfect synchronization can generate substantial price level inertia. (2) If price decisions are desynchronized, even anticipated movements in money will usually have an effect on economic activity. It is however possible to find paths of money deceleration which reduce inflation at no cost in output. (3) Price desynchronization has implications for relative price movements as well as for the price level. Goods early in the chain of production have more price and profit variability than goods further down the chain. (4) Price inertia, if it is due to price desynchronization, may be difficult to remove. It may well be that, given the timing decisions of others, no agent has an incentive to change his own timing decision: the time structure of price desynchronization may be stable.

On The Difference Between Tax And Spending Policies In Models With Finite Horizons

This paper uses the Blanchard (1985) finite horizon model to study how taxes and government spending can be managed to stabilize aggregate demand. It is shown that tax policy cannot stabilize demand in less time than it stabilizes the public debt, but that, if government spending is the instrument of policy, demand can be stabilized independently of the dynamics of the debt. These results imply that if the objective is to stabilize the debt while maintaining demand as close as possible to a pre-determined target path, and taxes are the instrument, taxes would have to be changed temporarily as much as feasible. On the other hand, if the instrument is government spending, it can be changed gradually to achieve the objectives. The dynamic effects of taxes are a straightforward implication of the intertemporal budget constraint, when it is assumed that agents cannot be surprised by government policies. More traditional dynamics can be obtained if it is assumed that the government succeeds in announcing a policy and implementing a different one. If however the announcement is no credible, discretion is inferior to a predetermined tax rule.