Real Exchange Rate And Output Variability

This paper investigates the relationships between the degree of price stickiness (inflexibility), the variability of output, and that of the real exchange rate in an open economy under flexible exchange rates and capital mobility. We show that there exists, in general, a critical degree of price inflexibility below which increased inflexibility of prices reduces the variability of output. We also show that, in general, as prices become more inflexible, the relationship between the variability of the real exchange rate and that of output will be nonmonotonic. That is, as the variability of the real exchange rate increases the variability of output will decline up to a point, and only then increase.

A central proposition regarding effects of different mechanisms of fi-nancing public expenditures is that, under specific circumstances, it makes no difference to the level of aggregate demand if the government finances its outlays by debt or taxation. This so-called Ricardian equivalence states that, for a given expenditure path, substitution of debt for taxes does not affect private sector wealth and consumption. This paper provides a model illustrating the implications of Ricardian equivalence, surveys the litera-ture, considers effects of relaxing the basic assumptions, provides a frame-work to study implications of various extensions, and critically reviews recent empirical work on Ricardian equivalence.

This paper investigates the consequences of exchange rate volatility on the variability of export prices and quantities in the presence of market segmentation and pricing to market. Firms stabilize destination prices through systematic price discrimination, limiting the degree of exchange rate pass-through. Consequently, the variability of exchange rates is not fully translated into prices and quantities at the point of destination. Empirical estimates using aggregate price data for the G-7 industrial countries show incomplete pass-through in variances, with considerable variation among these countries. U.S. industry specific data also indicate incomplete pass-through in most cases, with considerable variation across industries.

This paper studies dynamic-optimizing model of a semi-small open economy with sticky nominal prices and wages. The model exhibits exchange rate overshooting in response to money supply shocks. The predicted variability of nominal and real exchange rates is roughly consistent with that of G-7 effective exchange rates during the post-Bretton Woods era. The model predicts that a positive domestic money supply shock lowers the domestic nominal interest rate, that it raises output and that it leads to a nominal and real depreciation of the country’s currency. Increases in domestic labor productivity and in the world interest rate too are predicted to induce a nominal and real exchange rate depreciation.

This paper analyzes the relationship between the real exchange rate and the business cycle in Japan during the floating rate period. A structural vector autoregression is used to identify different types of macroeconomic shocks that determine fluctuations in aggregate output and the real exchange rate. Relative nominal and real demand shocks are found to be the main determinants of variation in real exchange rate changes, while relative output growth is driven primarily by supply shocks. Historical decompositions suggest that the sharp appreciations of the yen in 1993 and 1995 and its subsequent depreciation can be attributed primarily to relative nominal shocks.

This paper shows that exchange rate variability promotes agglomeration of economic activity. Under flexible rates, firms located in large markets have lower variability of sales, reinforcing concentration of firms there. Empirical evidence on OECD countries demonstrates (1) that the negative effect of country size on variability of industrial production is stronger after the 1973 collapse of fixed rates and (2) for small (large) countries, exchange rates variability has a long-run negative (positive) effect on net inward FDI flows. Two implications arise: creating a currency area fosters agglomeration in the area, and a two-stage EMU may exacerbate the current uneven regional development.

The paper uses MULTIMOD to examine the implications of uncertain exchange rate pass-through for the conduct of monetary policy. From the policymaker's perspective, uncertainty about exchange rate pass-through implies uncertainty about policy multipliers and the impact of state variables on stabilization objectives. When faced with uncertainty about the strength of exchange rate pass-through, policymakers will make less costly errors by overestimating the strength of pass-through rather than underestimating it. The analysis suggests that pass-through uncertainty of the magnitude considered does not result in efficient policy response coefficients that are smaller than those under certainty.

Variance decompositions of the Mexico-United States real exchange rate are examined using monthly data on consumer prices and the nominal exchange rate for the period January, 1969 to February, 2000. The results show that the robust result found in industrial-country data that most of the variation of the real exchange rate is due to fluctuations in prices of tradable goods and nominal exchange rates holds only in periods in which Mexico was not under a regime of exchange-rate management. In periods in the sample in which Mexico had a managed exchange-rate regime, the variability of prices of non-tradable goods relative to tradable goods accounts for up to 70 percent of the variability of the peso-dollar real exchange rate.