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Long-run consequences of finite exchange rate bubbles

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Alessandra Pelloni

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Abstract

This paper draws on the literature on exchange rate instability and on sunk-cost hysteresis to analyze the long-run effects of exchange rate bubbles. To address the issue, after discussing the implications of sunk-cost hysteresis for aggregate supply, we propose two versions of the Dornbusch (1976) model of exchange rate determination. We modify it so as to allow for endogenous adjustment in productive capacity, with the aggregate investment function being linear with respect to the exchange rate in one version and non-linear in the other. For both versions, we provide solutions for a Blanchard-type bubble developing on the foreign exchange market. We find that, if capacity adjusts non-linearly, such a bubble will affect the steady state of the economy. Copyright Kluwer Academic Publishers 1993

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File URL: http://hdl.handle.net/10.1007/BF00999551
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Publisher Info
Article provided by Springer in its journal Open Economies Review.

Volume (Year): 4 (1993)
Issue (Month): 1 (March)
Pages: 5-26
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Handle: RePEc:kap:openec:v:4:y:1993:i:1:p:5-26

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Related research
Keywords: exchange-rate bubbles; sunk-cost hysteresis;

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  1. Wilson, Charles A, 1979. "Anticipated Shocks and Exchange Rate Dynamics," Journal of Political Economy, University of Chicago Press, vol. 87(3), pages 639-47, June. [Downloadable!] (restricted)
  2. Baldwin, Richard & Krugman, Paul, 1989. "Persistent Trade Effects of Large Exchange Rate Shocks," The Quarterly Journal of Economics, MIT Press, vol. 104(4), pages 635-54, November. [Downloadable!] (restricted)
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  3. Dornbusch, Rudiger, 1976. "Expectations and Exchange Rate Dynamics," Journal of Political Economy, University of Chicago Press, vol. 84(6), pages 1161-76, December. [Downloadable!] (restricted)
  4. Diba, Behzad T. & Grossman, Herschel I., 1988. "Rational inflationary bubbles," Journal of Monetary Economics, Elsevier, vol. 21(1), pages 35-46, January. [Downloadable!] (restricted)
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  5. Miller, Marcus H & Weller, Paul, 1990. "Currency Bubbles Which Affect Fundamentals: A Qualitative Treatment," Economic Journal, Royal Economic Society, vol. 100(400), pages 170-79, Supplemen. [Downloadable!] (restricted)
  6. Klemperer, Paul D, 1987. "Entry Deterrence in Markets with Consumer Switching Costs," Economic Journal, Royal Economic Society, vol. 97(388a), pages 99-117, Supplemen. [Downloadable!] (restricted)
  7. Dixit, Avinash K, 1989. "Entry and Exit Decisions under Uncertainty," Journal of Political Economy, University of Chicago Press, vol. 97(3), pages 620-38, June. [Downloadable!] (restricted)
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  8. Obstfeld, Maurice & Rogoff, Kenneth, 1983. "Speculative Hyperinflations in Maximizing Models: Can We Rule Them Out?," Journal of Political Economy, University of Chicago Press, vol. 91(4), pages 675-87, August. [Downloadable!] (restricted)
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  9. Giavazzi, Francesco & Wyplosz, Charles, 1985. "The Zero Root Problem: A Note on the Dynamic Determination of the Stationary Equilibrium in Linear Models," Review of Economic Studies, Blackwell Publishing, vol. 52(2), pages 353-57, April. [Downloadable!] (restricted)
  10. Richard Baldwin, 1989. "Sunk-Cost Hysteresis," NBER Working Papers 2911, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  11. Camerer, Colin, 1989. " Bubbles and Fads in Asset Prices," Journal of Economic Surveys, Blackwell Publishing, vol. 3(1), pages 3-41.
  12. Baldwin, Richard, 1990. "Hysteresis in Trade," Empirical Economics, Springer, vol. 15(2), pages 127-42.
  13. Corbae, Dean & Ouliaris, Sam, 1988. "Cointegration and Tests of Purchasing Power Parity," The Review of Economics and Statistics, MIT Press, vol. 70(3), pages 508-11, August. [Downloadable!] (restricted)
  14. Richard Baldwin & Richard Lyons, 1989. "Exchange Rate Hysteresis: The Real Effects of Large vs Small Policy Misalignments," NBER Working Papers 2828, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  15. Schmalensee, Richard, 1982. "Product Differentiation Advantages of Pioneering Brands," American Economic Review, American Economic Association, vol. 72(3), pages 349-65, June. [Downloadable!] (restricted)
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  16. Mark, Nelson C., 1990. "Real and nominal exchange rates in the long run: An empirical investigation," Journal of International Economics, Elsevier, vol. 28(1-2), pages 115-136, February. [Downloadable!] (restricted)
  17. Pindyck, Robert S, 1988. "Irreversible Investment, Capacity Choice, and the Value of the Firm," American Economic Review, American Economic Association, vol. 78(5), pages 969-85, December. [Downloadable!] (restricted)
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