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Expectations and Exchange Rate Policy

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  • Michael B. Devereux
  • Charles Engel

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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  1. Anderson, Torben G. & Bollerslev, Tim & Diebold, Francis X. & Vega, Clara, 2002. "Micro Effects of Macro Announcements: Real-Time Price Discovery in Foreign Exchange," Working Papers, University of Pennsylvania, Wharton School, Weiss Center 02-1, University of Pennsylvania, Wharton School, Weiss Center.
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  3. Duarte, Margarida & Obstfeld, Maurice, 2008. "Monetary policy in the open economy revisited: The case for exchange-rate flexibility restored," Journal of International Money and Finance, Elsevier, Elsevier, vol. 27(6), pages 949-957, October.
  4. John Y. Campbell & Robert J. Shiller, 1986. "Cointegration and Tests of Present Value Models," NBER Working Papers 1885, National Bureau of Economic Research, Inc.
  5. Charles Engel & Kenneth D. West, 2005. "Exchange Rates and Fundamentals," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 113(3), pages 485-517, June.
  6. Robert J. Barro & Robert G. King, 1982. "Time-Separable Preference and Intertemporal-Substitution Models of Business Cycles," NBER Working Papers 0888, National Bureau of Economic Research, Inc.
  7. 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, Board of Governors of the Federal Reserve System (U.S.) 784, Board of Governors of the Federal Reserve System (U.S.).
  8. Michael B. Devereux & Charles Engel, 2003. "Monetary Policy in the Open Economy Revisited: Price Setting and Exchange-Rate Flexibility," Review of Economic Studies, Wiley Blackwell, Wiley Blackwell, vol. 70(4), pages 765-783, October.
  9. Paul Beaudry & Franck Portier, 2004. "Stock Prices, News and Economic Fluctuations," NBER Working Papers 10548, National Bureau of Economic Research, Inc.
  10. West, Kenneth D, 1988. "Dividend Innovations and Stock Price Volatility," Econometrica, Econometric Society, Econometric Society, vol. 56(1), pages 37-61, January.
  11. Lars E. O. Svensson & Michael Woodford, 2003. "Implementing Optimal Policy through Inflation-Forecast Targeting," NBER Working Papers 9747, National Bureau of Economic Research, Inc.
  12. 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.
  13. Frenkel, Jacob A. & Mussa, Michael L., 1985. "Asset markets, exchange rates and the balance of payments," Handbook of International Economics, Elsevier, in: R. W. Jones & P. B. Kenen (ed.), Handbook of International Economics, edition 1, volume 2, chapter 14, pages 679-747 Elsevier.
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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.
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Cited by:
  1. Tille, Cédric & van Wincoop, Eric, 2008. "International Capital Flows under Dispersed Information: Theory and Evidence," CEPR Discussion Papers, C.E.P.R. Discussion Papers 6989, C.E.P.R. Discussion Papers.
  2. Filardo, Andrew & Genberg, Hans, 2010. "Monetary Policy Strategies in the Asia and Pacific Region: What Way Forward?," ADBI Working Papers, Asian Development Bank Institute 195, Asian Development Bank Institute.
  3. Alessandro Rebucci & Akito Matsumoto & Pietro Cova & Massimiliano Pisani, 2011. "New Shocks and Asset Price Volatility in General Equilibrium," IMF Working Papers 11/110, International Monetary Fund.
  4. Jeffrey Frankel, 2007. "On The Rand: Determinants Of The South African Exchange Rate," South African Journal of Economics, Economic Society of South Africa, Economic Society of South Africa, vol. 75(3), pages 425-441, 09.
  5. Pierpaolo Benigno, 2006. "Are Valuation Effects Desirable from a Global Perspective?," NBER Working Papers 12219, National Bureau of Economic Research, Inc.
  6. Beetsma, Roel & Giuliodori, Massimo, 2009. "The Macroeconomic Costs and Benefits of the EMU and other Monetary Unions: An Overview of Recent Research," CEPR Discussion Papers, C.E.P.R. Discussion Papers 7500, C.E.P.R. Discussion Papers.
  7. Philippe Bacchetta & Eric van Wincoop, 2011. "Modeling Exchange Rates with Incomplete Information," Cahiers de Recherches Economiques du Département d'Econométrie et d'Economie politique (DEEP), Université de Lausanne, Faculté des HEC, DEEP 11.03, Université de Lausanne, Faculté des HEC, DEEP.

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