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Exchange Rate Hysteresis: The Real Effects of Large vs Small Policy Misalignments

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Author Info
Richard Baldwin
Richard Lyons

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Abstract

Using the sticky price monetary model of exchange rate determination and the sunk cost model of trade hysteresis, we show that a sufficiently large policy misalignment can induce hysteresis in the trade balance and thereby alter the steady?state real exchange rate. Thus in our model exchange rate dynamics are path dependent, PPP need not hold and money need not be neutral even in the very long run. We present only positive analysis but conjecture that the results have strong welfare, policy, and econometric implications. Since hysteresis in our model can entail industrial dislocation and the scrappage of sunk assets, we suggest that these factors may constitute a welfare cost of large policy misalignments that have not been formally considered. On the policy side, one could sensibly argue against the dollar volatility of the 1980s without at the same time arguing for a return to a formal exchange rate regime (because 1980s-size swings may involve welfare costs that 1970s-size swings do not). Lastly, since the long-run exchange rate is path dependent, standard empirical tests of exchange rate models may be misspecified.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 2828.

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Date of creation: Jan 1989
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Handle: RePEc:nbr:nberwo:2828

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References listed on IDEAS
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. Jeffrey A. Frankel and Richard Meese., 1987. "Are Exchange Rates Excessively Variable," Economics Working Papers 8738, University of California at Berkeley.
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  2. Richard Baldwin & Richard K. Lyons, 1988. "The Mutual Amplification Effect of Exchange Rate Volatility and Unresponsive Trade Prices," NBER Working Papers 2677, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  3. 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, vol. 18(1-2), pages 17-41, February. [Downloadable!] (restricted)
  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. Kenneth A. Froot & Takatoshi Ito, 1990. "On the Consistency of Short-run and Long-run Exchange Rate Expectations," NBER Working Papers 2577, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  6. 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. [Downloadable!] (restricted)
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  1. Alessandra Pelloni, 1993. "Long-run consequences of finite exchange rate bubbles," Open Economies Review, Springer, vol. 4(1), pages 5-26, March. [Downloadable!] (restricted)
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