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The Mutual Amplification Effect of Exchange Rate Volatility and Unresponsive Trade Prices

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  • Richard Baldwin
  • Richard K. Lyons

Abstract

The volatility of flexible exchange rates greatly exceeds what most analysts anticipated at the advent of generalized floating. The Dornbusch overshooting model accounts for the fact that exchange rates fluctuate more than the underlying fundamentals. This paper presents a model which may help account for why exchange rates have been even more volatile than the overshooting model would suggest, and why trade prices have been so unresponsive in recent years. The paper employs an extended version of the sticky-price monetary model of exchange rates and a simple industrial organization model of import pricing. The combined macro-JO. model shows that exchange rate volatility and unresponsive trade prices can be mutually amplifying.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 2677.

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Date of creation: Aug 1988
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Publication status: published as "The Mutual Amplification Effect of Unresponsive Trade Prices and Exchange Rate Volatility." Journal of International Financial Markets, Institutions & Money, Vol. 1, No. 2, pp. 1-20, Spring 1991
Handle: RePEc:nbr:nberwo:2677

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  1. Feinberg, Robert M, 1989. "The Effects of Foreign Exchange Movements on U.S. Domestic Prices," The Review of Economics and Statistics, MIT Press, vol. 71(3), pages 505-11, August.
  2. Rothschild, Michael & Stiglitz, Joseph E., 1970. "Increasing risk: I. A definition," Journal of Economic Theory, Elsevier, Elsevier, vol. 2(3), pages 225-243, September.
  3. Arthur M. Okun, 1975. "Inflation: Its Mechanics and Welfare Costs," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 6(2), pages 351-402.
  4. Stulz, Rene M, 1984. "Currency Preferences, Purchasing Power Risks, and the Determination of Exchange Rates in an Optimizing Model," Journal of Money, Credit and Banking, Blackwell Publishing, Blackwell Publishing, vol. 16(3), pages 302-16, August.
  5. Kenneth A. Froot & Paul Klemperer, 1989. "Exchange Rate Pass-Through When Market Share Matters," NBER Working Papers 2542, National Bureau of Economic Research, Inc.
  6. Jeffrey A. Frankel and Richard Meese., 1987. "Are Exchange Rates Excessively Variable," Economics Working Papers, University of California at Berkeley 8738, University of California at Berkeley.
  7. Catherine L. Mann, 1986. "Prices, profit margins, and exchange rates," Federal Reserve Bulletin, Board of Governors of the Federal Reserve System (U.S.), Board of Governors of the Federal Reserve System (U.S.), issue Jun, pages 366-379.
  8. Richard Baldwin, 1988. "Hysteresis In Import Prices: The Beachhead Effect," NBER Working Papers 2545, National Bureau of Economic Research, Inc.
  9. Meese, Richard A. & Rogoff, Kenneth, 1983. "Empirical exchange rate models of the seventies : Do they fit out of sample?," Journal of International Economics, Elsevier, Elsevier, vol. 14(1-2), pages 3-24, February.
  10. Kenneth A. Froot & Takatoshi Ito, 1988. "On the Consistency of Short-run and Long-run Exchange Rate Expectations," NBER Working Papers 2577, National Bureau of Economic Research, Inc.
  11. Lucas, Robert Jr., 1982. "Interest rates and currency prices in a two-country world," Journal of Monetary Economics, Elsevier, Elsevier, vol. 10(3), pages 335-359.
  12. Klemperer, Paul, 1987. "Markets with Consumer Switching Costs," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 102(2), pages 375-94, May.
  13. Svensson, Lars E. O., 1985. "Currency prices, terms of trade, and interest rates: A general equilibrium asset-pricing cash-in-advance approach," Journal of International Economics, Elsevier, Elsevier, vol. 18(1-2), pages 17-41, February.
  14. Katz, Michael L & Shapiro, Carl, 1985. "Network Externalities, Competition, and Compatibility," American Economic Review, American Economic Association, American Economic Association, vol. 75(3), pages 424-40, June.
  15. Paul R. Krugman & Richard E. Baldwin, 1987. "The Persistence of the U.S. Trade Deficit," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 18(1), pages 1-56.
  16. Richard Baldwin, 1988. "Some Empirical Evidence on Hysteresis in Aggregate US Import Prices," NBER Working Papers 2483, National Bureau of Economic Research, Inc.
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Cited by:
  1. Barkoulas, John T. & Baum, Christopher F. & Onochie, Joseph, 1997. "A nonparametric investigation of the 90-day t-bill rate," Review of Financial Economics, Elsevier, Elsevier, vol. 6(2), pages 187-198.
  2. Bernard Dumas, 1989. "Perishable Investment and Hysteresis in Capital Formation," NBER Working Papers 2930, National Bureau of Economic Research, Inc.
  3. John Barkoulas & Christopher F. Baum & Joseph Onochie, 1996. "Nonlinear Nonparametric Prediction of the 90-Day T-Bill Rate," Boston College Working Papers in Economics, Boston College Department of Economics 320., Boston College Department of Economics.
  4. Richard A. Meese & Andrew K. Rose, 1989. "An empirical assessment of non-linearities in models of exchange rate determination," International Finance Discussion Papers, Board of Governors of the Federal Reserve System (U.S.) 367, Board of Governors of the Federal Reserve System (U.S.).
  5. 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.

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