Exchange Rate Dynamics: A New Open Economy

Are exchange rates determined by economic fundamentals or are they a prey to random speculative forces? Some economists assert that economic theory has so far performed poorly in explaining the dramatic increase in exchange rate volatility in the recent floating rate period. This book argues that modern macroeconomics theory does provide guidelines for understanding exchange rate fluctuations. Since the mid-1990s, there has been an outpouring of research that aims at laying new foundations for open-macroeconomic theory. The so-called "New Open Economy Macroeconomics" (NOEM) approach embeds micro-founded behavior into dynamic general equilibrium models. This provides a rich framework for thinking about exchange rate behavior and lays the groundwork for credible policy evaluation. This book shows how the most recent analytical tools proposed in this literature improve our understanding of exchange rate fluctuations. With contributions from an international array of thinkers, this impressive bookshall interest both students and researchers involved with Macroeconomics, Money and Banking as well as all those interested in International Finance, including financial institutions.

List of figures

xi

List of tables

xiii

List of contributors

xiv

Preface

xv

Acknowledgments

xxi

PART I Exchange rate volatility and persistence

1

(178)

1 Net foreign assets and exchange rate dynamics: the monetary model revisited

3

(52)

MICHELE CAVALLO AND FABIO GHIRONI

1.1 Introduction

3

(4)

1.2 The model

7

(12)

1.3 The log-linear model

19

(8)

1.4 The exchange rate and net foreign assets with exogenous money supplies

27

(8)

1.5 Net foreign assets and exchange rate dynamics with endogenous interest rate setting

35

(11)

1.6 Conclusion

46

(1)

Appendix A: aggregate per capita net foreign assets in the initial period

47

(1)

Appendix B: determinacy of the exchange rate under endogenous interest rate setting

48

(4)

Notes

52

(3)

2 Dornbusch revisited

55

(29)

JEAN-OLIVIER HAIRAULT, LISE PATUREAU AND THEPTHIDA SOPRASEUTH

2.1 Introduction

55

(3)

2.2 The model

58

(11)

2.3 What drives exchange rate fluctuations?

69

(9)

2.4 Conclusion

78

(1)

Appendix A: stationarizing the model

79

(2)

Appendix B: steady-state equilibrium

81

(1)

Notes

82

(2)

3 Nominal wage rigidities in an optimizing model of an open economy

84

(22)

STEVE AMBLER AND EMMANUEL HAKIZIMANA

3.1 Introduction

84

(1)

3.2 The model

85

(8)

3.3 Model solution

93

(1)

3.4 Model calibration and parameter values

94

(1)

3.5 Numerical simulation results

95

(8)

3.6 Conclusion

103

(1)

Notes

104

(2)

4 Sources of exchange rate fluctuations: pricing-to-market versus non-tradables

106

(16)

JEAN-OLIVIER HAIRAULT AND THEPTHIDA SOPRASEUTH

4.1 Introduction

106

(1)

4.2 The model

107

(3)

4.3 Exchange rate determination

110

(9)

4.4 A quantitative evaluation

119

(1)

4.5 Conclusion

120

(1)

Notes

121

(1)

5 Sources of non-stationary real exchange rate fluctuations: elements of theory and some empirical evidence

122

(28)

PHILIPPE ANDRADE

5.1 Introduction

122

(2)

5.2 An open economy with translog preferences

124

(12)

5.3 Statistical approach

136

(3)

5.4 Empirical results

139

(9)

5.5 Conclusion

148

(1)

Notes

148

(2)

6 Beliefs-based exchange rate dynamics

150

(29)

FABRICE COLLARD AND PATRICK FÈVE

6.1 Introduction

150

(1)

6.2 The model economy

151

(5)

6.3 Dynamic properties

156

(6)

6.4 Exchange rate dynamics

162

(10)

6.5 Concluding remarks

172

(1)

Appendix A: equilibrium conditions

172

(1)

Appendix B: log-linear representation

173

(2)

Appendix C: proof of propositions

175

(1)

Notes

176

(3)

PART II Exchange rate regimes and monetary policy

179

7 Exchange rate regimes and international business cycles: some stylized facts

181

(23)

THEPTHIDA SOPRASEUTH

7.1 Introduction

181

(1)

7.2 Methodology

182

(3)

7.3 Impact of exchange rate regimes on volatility

185

(8)

7.4 Cross-country correlations

193

(8)

7.5 Conclusion

201

(1)

Appendix A: data

202

(1)

Appendix B: countries

203

(1)

Notes

203

(1)

8 A quantitative analysis of currency regimes

204

(20)

LUCA DEDOLA AND SYLVAIN LEDUC

8.1 Introduction

204

(2)

8.2 The model

206

(4)

8.3 Calibration

210

(3)

8.4 Findings

213

(7)

8.5 Conclusion

220

(1)

Appendix

221

(1)

Notes

222

(2)

9 Commitment, discretion and fixed exchange rates in an open economy

224

(24)

TOMMASO MONACELLI

9.1 Introduction

224

(2)

9.2 A small open economy model

226

(8)

9.3 Monetary policy, interest rate and the exchange rate

234

(4)

9.4 Monetary regimes and equilibrium dynamics

238

(7)

9.5 Conclusion

245

(1)

Notes

246

(2)

10 Price setting and optimal monetary cooperation: a New Keynesian perspective

248

MATTHIEU DARRACQ-PARIÈS

10.1 Introduction

248

(2)

10.2 The core model

250

(7)

10.3 Equilibrium

257

(8)

10.4 Optimal monetary cooperation

265

(10)

10.5 Cooperation gains and implementation of the optimal policy

275

(1)

10.6 Conclusion

276

(1)

Appendix A: approximation of the welfare function

277

(4)

Appendix B: derivation of the optimal policy under commitment

281

(2)

Notes

283

(1)

Bibliography

284

(11)

Index

295

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Exchange Rate Dynamics: A New Open Economy Macroeconomics Perspectives

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