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Resurrecting the Weak Credibility Hypothesis in Models of Exchange-Rate-Based Stabilization

  • Edward F. Buffie

    ()

    (Department of Economics, Indiana University)

  • Manoj Atolia

    ()

    (Department of Economics, Florida State University)

We analyze how weak credibility affects the volatility of consumption spending in a model of exchange-rate-based stabilization that allows for both durable and nondurable goods. The inclusion of durables greatly improves the explanatory power of the weak credibility hypothesis. The hypothesis can account for the main qualitative properties of the boom-bust cycle provided the elasticity of durables expenditure with respect to Tobin’s q is greater than the intertemporal elasticity of substitution. Moreover, the quantitative effects are very large. In numerical simulations based on conservative assumptions about the expenditure share of durables (20%) and wealth effects (none), aggregate consumption increases 12-28% during the low-crawl phase and the real exchange rate appreciates 24-26%. In variants of the model that incorporate supply effects, the consumption boom is equally strong but appreciation of the real exchange rate rises to 30-40%.

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File URL: ftp://econpapers.fsu.edu/RePEc/fsu/wpaper/wp2009_01_03.pdf
File Function: First version, 2007-08
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Paper provided by Department of Economics, Florida State University in its series Working Papers with number wp2009_01_03.

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Length: 57
Date of creation: Jun 2006
Date of revision: Aug 2007
Handle: RePEc:fsu:wpaper:wp2009_01_03
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