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Introduction to special issue on ‘real and nominal exchange rates’
Journal of Banking and Finance 14 (1990) 839-843. North-Holland
INTRODUCTION
TO SPECIAL ISSUE ON ‘REAL EXCHANGE RATES’
AND
NOMINAL
Jerome L. STEIN Brown University, Providence, RI
02912, USA
There is no shortage of theories concerning the nominal exchange rate. Since the 196Os, there has been a succession of popular theories. The MundellFleming theory was the open economy version of the Hicks IS-LM model. It emphasized the real exchange rate, by assuming that prices were sticky. It was succeeded by portfolio models, based upon the theory of optimal portfolio selection of Tobin and Markowitz. The monetary approach to the balance of payments, associated with Johnson, which was popular in the 197Os, was the antithesis of the Mundell-Fleming model. The monetary models were predicated upon the assumption that the exchange rate is the relative price of two monies. Thus, the real exchange rate was assumed to be constant; and nominal exchange rates just depend upon relative prices. The monetary approach models were replaced by models of exchange rate and monetary dynamics with rational expectations, stemming from Dornbusch’s 1976 paper, which characterized the state of the art in 1988. Recently, intertemporal optimization models have been devised. These models are quite similar to the monetary approach. Both are based upon purchasing power parity theory, and a simple demand for money. It is not surprising that the optimization models alsc end up claiming that the nominal exchange rate is proportional to relative prices which are proportional to relative money supplies per unit of output. Each theory is logical within its own set of assumptions and constraints, but none has general validity. Since the beginning of the recent period of floating rates in 1973, the nominal values of currencies have fluctuated considerably. On a trade weighted basis (March 1973= loo), the U.S. dollar fell from 99 in 1973 to 87 in 1980, it rose to 143 in 1985, and then fell to 97 at the end of 1989. These movements have profound macroeconomic and welfare implications. The large variations in the nominal value of the dollar were almost identical to the variations in the real value of the dollar. These exchange rate 03784266/90/%03.500 1990-Elsevier Science Publishers B.V. (North-Holland)
840
.l.L
Stein, Introduction
movements and shorter period fluctuations, in both the trade weighted value of the dollar and the bilateral exchange rates, have led many economists to re-examine the explanatory power of the theories mentioned above: particularly, the dominant theory based upon monetary dynamics with rational expectations. Empirical researchers have not been able to explain movements in nominal exchange rates by movements in relative price levels or by relative money supplies per unit of output. Non-linearities, peso problems and nontautological risk premia have not been able to account for the rejection of the monetary theories with rational expectations, or of the variants with intertemporal optimization. Meese concluded that ‘[. . .] economists do not yet understand the determinants of short- to medium-run movements in exchange rates’. This state of affairs induced me to direct my research towards explaining the movements in the real exchange rate. In a discussion of the unsatisfactory state of the theory, Giorgio Szegii suggested that I edit a special issue of the Journal of Banking and Finance devoted to explaining nominal and real exchange rate movements. We decided to re-examine several major issues, from two points of view: topics and methodology. Our point of view is that of positive economics: What theories can explain the phenomena that have been observed? We were not inclined towards ‘beautiful’ theories per se: for example, normative economics where rational expectations and optimization occur over infinite horizons. The major problem is that the models over which agents are assumed to optimize are misspecifled: they are inconsistent with the evidence. Along with several other economists, looking at the post 1973 experience, we found that beauty is not necessarily truth. We were searching for the truth, ‘warts and all’. I wrote to a broad set of economists, located in the U.S.A., Europe, Australia and Japan, who were not committed to the popular theories, and asked if they would like to write a paper on one of the following subjects. (1) Exchange rates were supposed to be as stable as the macroeconomic fundamentals. Was this expectation confirmed? If not, why not? (2) Were exchange rate expectations rational? If not, how can they be explained? (3) Under the theory of free exchange rates, countries were likely to have divergent macroeconomic policies. Was the covariation of monetary or fiscal policies among countries greater or less under free rates compared to the pre-1971 period? (4) Was there more or less international mobility of non-speculative capital under the free rates than before 1971? (5) It was assumed that there would be less transmission of international
.l.L Stein, Introduction
841
disturbances under floating rates than under the fixed rates. Was the theory correct? What kind of insulation can be expected from an exchange rate regime? (6) Was the Purchasing Power Parity theory (Law of One Price) more or less valid under floating rates than under fixed rates? (7) What determines the real exchange rate? (8) Were real, or nominal, interest rates more closely linked under fixed rates than under free rates? (9) Monetary and fiscal policy were supposed to have certain effects upon the exchange rate, output and the price level under floating rates, and different effects under fixed rates. Were these predictions borne out by the evidence? (10) To what extent is the overshooting hypothesis correct? (11) Can the same theories which explained the rise of the dollar from 1980 to 1985 explain its decline from 1985 to 1988, and from 1973 to 1979? (12) Have speculative capital flows been stabilizing or destabilizing? Have they been welfare improving? (13) To what extent will changes in government saving, or social saving, be financed by capital flows .and to what extent will they be offset by domestic investment? (14) Does a structural government budget deficit tend to appreciate a currency, as implied by almost all of the models? Does it have the same effect as a rise in the marginal efficiency of investment? (15) Is the portfolio theory of capital flows consistent with the evidence? (16) Evaluate the costs and benefits accruing to a country (e.g. U.K.) contemplating joining the European Monetary System. (17) What are likely to be the effects of capital market integration upon a large economy with an endogenous capital stock and real GNP? What are the likely consequences of ‘Europe after 1992’? The papers received fall into several overlapping categories. The first set concerns capital market and monetary integration, and is relevant for thinking about Europe after 1992. Polly R. Allen analyzes the role of the ECU in international capital markets. The private ECU has moved beyond a currency basket to function fully as a currency in the financial markets, with market determined ECU interest rates and a market determined exchange rate that banks peg to the basket. A utility maximizing model of demand for private ECU instruments is developed. Risk aversion and acquisition costs are shown to be necessary for the existence of private ECU markets, and are the primary basis for demand. Charles uan Marrewijk and Casper de Vries analyze the logic of monetary union. They argue that, if the real exchange rate follows a random walk, and there are non-traded goods, then a monetary union may generate a Pareto improvement. By the
842
J.L Stein, Introduction
end of 1992, there should be free movement of goods, persons and capital in the EC. Christian de Bossieu studies some implications of the financial liberalization which takes place in the EC. He discusses the features of the EMS which must be considered when assessing the process of financial liberalization. Polly R. Allen and Jerome L. Stein develop a tractable growth model of two large interacting countries to answer the following questions. What will be the short-run and long-run effects of capital market liberalization upon GNP, GDP, capital accumulation and the rate of return on capital? The second set of papers concerns the transmission mechanism under alternative exchange rate regimes. Victor Argy considers the transmission mechanism of foreign impulses, when there are various degrees of wage indexation. This is a generalization of the older Mundell-Fleming literature which contains both supply and demand constraints. The insulating properties of the exchange rate regime depend upon the degree of wage indexation. James Boughton examines the relationship between exchange rates and current account balances in a model of two large cooperating countries. He shows that the two countries aiming to reduce an external imbalance can shift their monetary-fiscal mix in the same direction. The third set of papers focuses upon the exchange rate experience of the several countries. Georg Rich analyzes the Swiss approach to exchange rate management. He shows how the objective of price stability conflicts with the desire to stabilize the exchange rate in the case of Switzerland. He also examines the explanatory power of the exchange rate models with monetary dynamics and rational expectations for Switzerland. Giancarlo Gandolfo, Pietro Padoan and Giovanna Paladin0 evaluate the explanatory powers of a wide variety of the existing state of the art theories, mentioned at the beginning of this introduction, in the context of Italian lira exchange rate. They show that the evidence is inconsistent with these theories, and that their continuous time macroeconometric model performs better than the hypothesis that the lira follows a random walk. Kazuo Ueda analyzes the determinants of Japanese long-term capital movements, especially the large capital outflows in the 1980s. Expectations of the net uncovered yield on foreign assets were important, but do not explain a large part of the capital movements. One must also consider the changing set of government regulations. The fourth category concerns the real exchange rate. Richard Marston studies the validity of the law of one price on both macro and micro levels. To what extent are external prices of manufactured goods tightly linked, i.e., is the real exchange rate a constant? He shows that internal prices of different goods are much more closely linked than are external prices of the same category of good. Jerome L. Stein presents a theory to explain the quarterly movements in the real exchange rate from 1973 to 1988. He
.l.L Stein, Introduction
843
examines to what extent the observed movements are due to fundamentals. It is shown that the real exchage rate responds differently to changes in the cyclically adjusted government budget deficit which finances social consumption than it does to changes in aggregate demand due to changes in the marginal efficiency of investment. The papers are closely related to each other, and the authors obtain mutually consistent results. If this special issue is successful, it will elicit criticism and stimulate research in new directions. References Dornbusch, R., 1976, Expectations and exchange rate dynamics, Journal of Political Economy 84, 1161-l 176. Meese, R., 1990, Currency fluctuations in the post Bretton Woods era, Journal of Economic Perspectives 4, no. 1, 117-134.
INTRODUCTION
TO SPECIAL ISSUE ON ‘REAL EXCHANGE RATES’
AND
NOMINAL
Jerome L. STEIN Brown University, Providence, RI
02912, USA
There is no shortage of theories concerning the nominal exchange rate. Since the 196Os, there has been a succession of popular theories. The MundellFleming theory was the open economy version of the Hicks IS-LM model. It emphasized the real exchange rate, by assuming that prices were sticky. It was succeeded by portfolio models, based upon the theory of optimal portfolio selection of Tobin and Markowitz. The monetary approach to the balance of payments, associated with Johnson, which was popular in the 197Os, was the antithesis of the Mundell-Fleming model. The monetary models were predicated upon the assumption that the exchange rate is the relative price of two monies. Thus, the real exchange rate was assumed to be constant; and nominal exchange rates just depend upon relative prices. The monetary approach models were replaced by models of exchange rate and monetary dynamics with rational expectations, stemming from Dornbusch’s 1976 paper, which characterized the state of the art in 1988. Recently, intertemporal optimization models have been devised. These models are quite similar to the monetary approach. Both are based upon purchasing power parity theory, and a simple demand for money. It is not surprising that the optimization models alsc end up claiming that the nominal exchange rate is proportional to relative prices which are proportional to relative money supplies per unit of output. Each theory is logical within its own set of assumptions and constraints, but none has general validity. Since the beginning of the recent period of floating rates in 1973, the nominal values of currencies have fluctuated considerably. On a trade weighted basis (March 1973= loo), the U.S. dollar fell from 99 in 1973 to 87 in 1980, it rose to 143 in 1985, and then fell to 97 at the end of 1989. These movements have profound macroeconomic and welfare implications. The large variations in the nominal value of the dollar were almost identical to the variations in the real value of the dollar. These exchange rate 03784266/90/%03.500 1990-Elsevier Science Publishers B.V. (North-Holland)
840
.l.L
Stein, Introduction
movements and shorter period fluctuations, in both the trade weighted value of the dollar and the bilateral exchange rates, have led many economists to re-examine the explanatory power of the theories mentioned above: particularly, the dominant theory based upon monetary dynamics with rational expectations. Empirical researchers have not been able to explain movements in nominal exchange rates by movements in relative price levels or by relative money supplies per unit of output. Non-linearities, peso problems and nontautological risk premia have not been able to account for the rejection of the monetary theories with rational expectations, or of the variants with intertemporal optimization. Meese concluded that ‘[. . .] economists do not yet understand the determinants of short- to medium-run movements in exchange rates’. This state of affairs induced me to direct my research towards explaining the movements in the real exchange rate. In a discussion of the unsatisfactory state of the theory, Giorgio Szegii suggested that I edit a special issue of the Journal of Banking and Finance devoted to explaining nominal and real exchange rate movements. We decided to re-examine several major issues, from two points of view: topics and methodology. Our point of view is that of positive economics: What theories can explain the phenomena that have been observed? We were not inclined towards ‘beautiful’ theories per se: for example, normative economics where rational expectations and optimization occur over infinite horizons. The major problem is that the models over which agents are assumed to optimize are misspecifled: they are inconsistent with the evidence. Along with several other economists, looking at the post 1973 experience, we found that beauty is not necessarily truth. We were searching for the truth, ‘warts and all’. I wrote to a broad set of economists, located in the U.S.A., Europe, Australia and Japan, who were not committed to the popular theories, and asked if they would like to write a paper on one of the following subjects. (1) Exchange rates were supposed to be as stable as the macroeconomic fundamentals. Was this expectation confirmed? If not, why not? (2) Were exchange rate expectations rational? If not, how can they be explained? (3) Under the theory of free exchange rates, countries were likely to have divergent macroeconomic policies. Was the covariation of monetary or fiscal policies among countries greater or less under free rates compared to the pre-1971 period? (4) Was there more or less international mobility of non-speculative capital under the free rates than before 1971? (5) It was assumed that there would be less transmission of international
.l.L Stein, Introduction
841
disturbances under floating rates than under the fixed rates. Was the theory correct? What kind of insulation can be expected from an exchange rate regime? (6) Was the Purchasing Power Parity theory (Law of One Price) more or less valid under floating rates than under fixed rates? (7) What determines the real exchange rate? (8) Were real, or nominal, interest rates more closely linked under fixed rates than under free rates? (9) Monetary and fiscal policy were supposed to have certain effects upon the exchange rate, output and the price level under floating rates, and different effects under fixed rates. Were these predictions borne out by the evidence? (10) To what extent is the overshooting hypothesis correct? (11) Can the same theories which explained the rise of the dollar from 1980 to 1985 explain its decline from 1985 to 1988, and from 1973 to 1979? (12) Have speculative capital flows been stabilizing or destabilizing? Have they been welfare improving? (13) To what extent will changes in government saving, or social saving, be financed by capital flows .and to what extent will they be offset by domestic investment? (14) Does a structural government budget deficit tend to appreciate a currency, as implied by almost all of the models? Does it have the same effect as a rise in the marginal efficiency of investment? (15) Is the portfolio theory of capital flows consistent with the evidence? (16) Evaluate the costs and benefits accruing to a country (e.g. U.K.) contemplating joining the European Monetary System. (17) What are likely to be the effects of capital market integration upon a large economy with an endogenous capital stock and real GNP? What are the likely consequences of ‘Europe after 1992’? The papers received fall into several overlapping categories. The first set concerns capital market and monetary integration, and is relevant for thinking about Europe after 1992. Polly R. Allen analyzes the role of the ECU in international capital markets. The private ECU has moved beyond a currency basket to function fully as a currency in the financial markets, with market determined ECU interest rates and a market determined exchange rate that banks peg to the basket. A utility maximizing model of demand for private ECU instruments is developed. Risk aversion and acquisition costs are shown to be necessary for the existence of private ECU markets, and are the primary basis for demand. Charles uan Marrewijk and Casper de Vries analyze the logic of monetary union. They argue that, if the real exchange rate follows a random walk, and there are non-traded goods, then a monetary union may generate a Pareto improvement. By the
842
J.L Stein, Introduction
end of 1992, there should be free movement of goods, persons and capital in the EC. Christian de Bossieu studies some implications of the financial liberalization which takes place in the EC. He discusses the features of the EMS which must be considered when assessing the process of financial liberalization. Polly R. Allen and Jerome L. Stein develop a tractable growth model of two large interacting countries to answer the following questions. What will be the short-run and long-run effects of capital market liberalization upon GNP, GDP, capital accumulation and the rate of return on capital? The second set of papers concerns the transmission mechanism under alternative exchange rate regimes. Victor Argy considers the transmission mechanism of foreign impulses, when there are various degrees of wage indexation. This is a generalization of the older Mundell-Fleming literature which contains both supply and demand constraints. The insulating properties of the exchange rate regime depend upon the degree of wage indexation. James Boughton examines the relationship between exchange rates and current account balances in a model of two large cooperating countries. He shows that the two countries aiming to reduce an external imbalance can shift their monetary-fiscal mix in the same direction. The third set of papers focuses upon the exchange rate experience of the several countries. Georg Rich analyzes the Swiss approach to exchange rate management. He shows how the objective of price stability conflicts with the desire to stabilize the exchange rate in the case of Switzerland. He also examines the explanatory power of the exchange rate models with monetary dynamics and rational expectations for Switzerland. Giancarlo Gandolfo, Pietro Padoan and Giovanna Paladin0 evaluate the explanatory powers of a wide variety of the existing state of the art theories, mentioned at the beginning of this introduction, in the context of Italian lira exchange rate. They show that the evidence is inconsistent with these theories, and that their continuous time macroeconometric model performs better than the hypothesis that the lira follows a random walk. Kazuo Ueda analyzes the determinants of Japanese long-term capital movements, especially the large capital outflows in the 1980s. Expectations of the net uncovered yield on foreign assets were important, but do not explain a large part of the capital movements. One must also consider the changing set of government regulations. The fourth category concerns the real exchange rate. Richard Marston studies the validity of the law of one price on both macro and micro levels. To what extent are external prices of manufactured goods tightly linked, i.e., is the real exchange rate a constant? He shows that internal prices of different goods are much more closely linked than are external prices of the same category of good. Jerome L. Stein presents a theory to explain the quarterly movements in the real exchange rate from 1973 to 1988. He
.l.L Stein, Introduction
843
examines to what extent the observed movements are due to fundamentals. It is shown that the real exchage rate responds differently to changes in the cyclically adjusted government budget deficit which finances social consumption than it does to changes in aggregate demand due to changes in the marginal efficiency of investment. The papers are closely related to each other, and the authors obtain mutually consistent results. If this special issue is successful, it will elicit criticism and stimulate research in new directions. References Dornbusch, R., 1976, Expectations and exchange rate dynamics, Journal of Political Economy 84, 1161-l 176. Meese, R., 1990, Currency fluctuations in the post Bretton Woods era, Journal of Economic Perspectives 4, no. 1, 117-134.