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

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  • Richard Baldwin
  • Richard Lyons

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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Bibliographic Info

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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Publication status: published as "Exchange Rate Hyteresis: Large nersus Small Policy Misalignments" European Economic Review, Jan 1994, vol 38, pp 1-22
Handle: RePEc:nbr:nberwo:2828

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  1. Jeffrey A. Frankel & Richard Meese, 1987. "Are Exchange Rates Excessively Variable?," NBER Chapters, in: NBER Macroeconomics Annual 1987, Volume 2, pages 117-162 National Bureau of Economic Research, Inc.
  2. Dornbusch, Rudiger, 1976. "Expectations and Exchange Rate Dynamics," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 84(6), pages 1161-76, December.
  3. 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.
  4. 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.
  5. 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.
  6. Froot, Kenneth A. & Ito, Takatoshi, 1989. "On the consistency of short-run and long-run exchange rate expectations," Journal of International Money and Finance, Elsevier, vol. 8(4), pages 487-510, December.
  7. Kenneth A. Froot & Paul Klemperer, 1989. "Exchange Rate Pass-Through When Market Share Matters," NBER Working Papers 2542, National Bureau of Economic Research, Inc.
  8. 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.
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Cited by:
  1. Mougoué, Mbodja & Aggarwal, Raj, 2011. "Trading volume and exchange rate volatility: Evidence for the sequential arrival of information hypothesis," Journal of Banking & Finance, Elsevier, vol. 35(10), pages 2690-2703, October.
  2. Richard E. Baldwin, 1990. "Re-Interpreting the Failure of Foreign Exchange Market Efficiency Tests:Small Transaction Costs, Big Hysteresis Bands," NBER Working Papers 3319, National Bureau of Economic Research, Inc.
  3. Alessandra Pelloni, 1993. "Long-run consequences of finite exchange rate bubbles," Open Economies Review, Springer, vol. 4(1), pages 5-26, March.
  4. Ansgar Belke & Matthias Göcke & Laura Werner, 2014. "Hysteresis Effects in Economics – Different Methods for Describing Economic Path-dependence," Ruhr Economic Papers, Rheinisch-Westfälisches Institut für Wirtschaftsforschung, Ruhr-Universität Bochum, Universität Dortmund, Universität Duisburg-Essen 0468, Rheinisch-Westfälisches Institut für Wirtschaftsforschung, Ruhr-Universität Bochum, Universität Dortmund, Universität Duisburg-Essen.
  5. Marc W. Simpson & Sanjay Ramchander, 2004. "The Informational Content of Consumer Expectations on the Direction of Exchange Rate Movements," American Journal of Business, Emerald Group Publishing, Emerald Group Publishing, vol. 19(1), pages 31-36.

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