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Expectations and Exchange Rate Policy

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Author Info
Michael B. Devereux
Charles Engel

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Abstract

Both empirical evidence and theoretical discussion have long emphasized the impact of %u201Cnews%u201D on exchange rates. In most exchange rate models, the exchange rate acts as an asset price, and as such responds to news about future returns on assets. But the exchange rate also plays a role in determining the relative price of non-durable goods when nominal goods prices are sticky. In this paper we argue that these two roles may conflict with one another. If news about future asset returns causes movements in current exchange rates, then when nominal prices are slow to adjust, this may cause changes in current relative goods prices that have no efficiency rationale. In this sense, anticipations of future shocks to fundamentals can cause current exchange rate misalignments. Friedman%u2019s (1953) case for unfettered flexible exchange rates is overturned when exchange rates are asset prices. We outline a series of models in which an optimal policy eliminates the effects of news on exchange rates.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 12213.

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Date of creation: May 2006
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Handle: RePEc:nbr:nberwo:12213

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Find related papers by JEL classification:
F3 - International Economics - - International Finance
F4 - International Economics - - Macroeconomic Aspects of International Trade and Finance
E5 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit

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References listed on IDEAS
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  1. Michael B. Devereux & Charles Engel, 2003. "Monetary Policy in the Open Economy Revisited: Price Setting and Exchange-Rate Flexibility," Review of Economic Studies, Blackwell Publishing, vol. 70(4), pages 765-783, October. [Downloadable!] (restricted)
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  2. Obstfeld, Maurice & Duarte, Margarida, 2005. "Monetary Policy in the Open Economy Revisited: The Case for Exchange-Rate Flexibility Restored," 2005 Meeting Papers 386, Society for Economic Dynamics.
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  3. Beaudry, Paul & Portier, Franck, 2003. "Stock Prices, News and Economic Fluctuations," CEPR Discussion Papers 3844, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
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  4. 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)
  5. Frenkel, Jacob A. & Mussa, Michael L., 1985. "Asset markets, exchange rates and the balance of payments," Handbook of International Economics, in: R. W. Jones & P. B. Kenen (ed.), Handbook of International Economics, edition 1, volume 2, chapter 14, pages 679-747 Elsevier. [Downloadable!] (restricted)
  6. Jacob A. Frenkel & Michael L. Mussa, 1985. "Asset Markets, Exchange Rates and the Balance of Payments," NBER Working Papers 1287, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  7. Charles Engel & Kenneth D. West, 2005. "Exchange Rates and Fundamentals," Journal of Political Economy, University of Chicago Press, vol. 113(3), pages 485-517, June.
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  8. Kenneth D. West, 1988. "Dividend Innovations and Stock Price Volatility," NBER Working Papers 1833, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  9. Andersen, Torben G. & Bollerslev, Tim & Diebold, Francis X. & Vega, Clara, 2002. "Micro Effects of Macro Announcements: Real-Time Price Discovery in Foreign Exchange," Working Papers 02-16, Duke University, Department of Economics. [Downloadable!]
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  10. Richard Clarida & Jordi Gali & Mark Gertler, 2002. "A Simple Framework for International Monetary Policy Analysis," NBER Working Papers 8870, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  11. Campbell, John Y & Shiller, Robert J, 1987. "Cointegration and Tests of Present Value Models," Journal of Political Economy, University of Chicago Press, vol. 95(5), pages 1062-88, October. [Downloadable!] (restricted)
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  12. Svensson, Lars E O & Woodford, Michael, 2004. "Implementing Optimal Policy Through Inflation-Forecast Targeting," CEPR Discussion Papers 4229, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
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  13. Robert J. Barro & Robert G. King, 1985. "Time-Separable Preference and Intertemporal-Substitution Models of Business Cycles," NBER Working Papers 0888, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  14. Maurice Obstfeld & Kenneth Rogoff, 1998. "Risk and Exchange Rates," NBER Working Papers 6694, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  15. Charles Engel & Kenneth D. West, 2004. "Accounting for Exchange Rate Variability in Present-Value Models When the Discount Factor is Near One," NBER Working Papers 10267, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  16. Jon Faust & John H. Rogers & Shing-Yi B. Wang & Jonathan H. Wright, 2003. "The high-frequency response of exchange rates and interest rates to macroeconomic announcements," International Finance Discussion Papers 784, Board of Governors of the Federal Reserve System (U.S.). [Downloadable!]
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Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Frankel, Jeffrey, 2007. "On the Rand: Determinants of the South African Exchange Rate," Working Paper Series rwp07-015, Harvard University, John F. Kennedy School of Government. [Downloadable!]
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  2. Cédric Tille & Eric van Wincoop, 2008. "International Capital Flows under Dispersed Information: Theory and Evidence," NBER Working Papers 14390, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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