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Floating Exchange Rates Versus a Monetary Union Under Rational Beliefs: The Role of Endogenous Uncertainty

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  • Carsten Krabbe Nielsen

    (Institute of Economics, University of Copenhagen)

Abstract

We study the consequences of substituting rational expectations with rational beliefs (beliefs consistent with observations) in an OLG model of exchange rate formation with stochastic endowments. We consider two types of monetary institutions, one with two currencies, one for each country, the other a monetary union. Under the first institution we in turn consider two policies, according to which the governments makes contingent transfers to its citizens, depending on the stochastic shocks to the two economies. The first policy implies devaluations in reaction to a negative shock while the other will ensure a fixed exchange rate. If agents have rational expectations these policies both lead to the same Pareto optimal allocation. However if they have rational beliefs these policies have very different consequences. The first may not be feasible (depending on beliefs) and even if it is, it will (generically in beliefs) not result in an ex-post optimal allocation. The second policy will on the other hand always be feasible and will result in the same allocation as under rational expectations (which is ex-post optimal). Also under a monetary union will this allocation be obtained. We argue that when evaluating the outcome of different policies the government should take into account that agents are likely to have incorrect albeit rational beliefs. The meaning of "endogenous uncertainty", as uncertainty which may be present under some institutions but not others is illustrated.

Suggested Citation

  • Carsten Krabbe Nielsen, 1997. "Floating Exchange Rates Versus a Monetary Union Under Rational Beliefs: The Role of Endogenous Uncertainty," Discussion Papers 97-22, University of Copenhagen. Department of Economics.
    • Handle: RePEc:kud:kuiedp:9722
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    Citations

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    Cited by:

    1. Kurz, Mordecai & Motolese, Maurizio, 2006. "Risk Premia, diverse belief and beauty contests," MPRA Paper 247, University Library of Munich, Germany.
    2. Carsten Nielsen, 2009. "Non-stationary, stable Markov processes on a continuous state space," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 40(3), pages 473-496, September.
    3. Hendrik Hakenes & Svetlana Katolnik, 2018. "Optimal Team Size and Overconfidence," Group Decision and Negotiation, Springer, vol. 27(4), pages 665-687, August.
    4. Kurz, Mordecai, 2008. "Beauty contests under private information and diverse beliefs: How different?," Journal of Mathematical Economics, Elsevier, vol. 44(7-8), pages 762-784, July.
    5. Kurz, Mordecai & Jin, Hehui & Motolese, Maurizio, 2005. "The role of expectations in economic fluctuations and the efficacy of monetary policy," Journal of Economic Dynamics and Control, Elsevier, vol. 29(11), pages 2017-2065, November.
    6. Carsten Nielsen, 2011. "Price stabilizing, Pareto improving policies," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 47(2), pages 459-500, June.
    7. Carsten Krabbe Nielsen, 2004. "Rational overconfidence and excess volatility in general equilibrium," Econometric Society 2004 Latin American Meetings 157, Econometric Society.
    8. Carsten K. Nielsen, 2009. "Optimal economic institutions under rational overconfidence, with applications to the choice of exchange rate regime," International Journal of Economic Theory, The International Society for Economic Theory, vol. 5(4), pages 375-407, December.
    9. Carsten Krabbe Nielsen, 2018. "Rational overconfidence and social security: subjective beliefs, objective welfare," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 65(2), pages 179-229, March.
    10. Carsten Krabbe Nielsen, 2009. "Rational Overconfidence and Social Security," Discussion Paper Series 0916, Institute of Economic Research, Korea University.
    11. Wang, Weijia, 2019. "A Pareto Criterion on Systemic Risk," MPRA Paper 93699, University Library of Munich, Germany.
    12. Mordecai Kurz & Maurizio Motolese, "undated". "Endogenous Uncertainty and Market Volatility," Working Papers 99005, Stanford University, Department of Economics.
    13. Mordecai Kurz, 2011. "Symposium: on the role of market belief in economic dynamics, an introduction," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 47(2), pages 189-204, June.
    14. Weijia Wang & Shaoan Huang, 2021. "Risk sharing and financial stability: a welfare analysis," Journal of Economic Interaction and Coordination, Springer;Society for Economic Science with Heterogeneous Interacting Agents, vol. 16(1), pages 211-228, January.
    15. Mordecai Kurz & Hehui Jin & Maurizio Motolese, 2005. "Determinants of stock market volatility and risk premia," Annals of Finance, Springer, vol. 1(2), pages 109-147, July.
    16. Mordecai Kurz, 2007. "Rational Diverse Beliefs and Economic Volatility," Discussion Papers 06-045, Stanford Institute for Economic Policy Research.
    17. Mordecai Kurz & Maurizio Motolese, 2011. "Diverse beliefs and time variability of risk premia," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 47(2), pages 293-335, June.
    18. Nielsen, Carsten Krabbe, 2008. "On rationally confident beliefs and rational overconfidence," Mathematical Social Sciences, Elsevier, vol. 55(3), pages 381-404, May.

    More about this item

    Keywords

    OLG model; exchange rates; rational beliefs; rational expectations; monetary union;
    All these keywords.

    JEL classification:

    • D51 - Microeconomics - - General Equilibrium and Disequilibrium - - - Exchange and Production Economies
    • D84 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Expectations; Speculations
    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • F33 - International Economics - - International Finance - - - International Monetary Arrangements and Institutions

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