Expectations and Exchange Rate Policy
Michael B. Devereux
University of British Columbia - Department of Economics; Centre for Economic Policy Research (CEPR)
Charles M. Engel
University of Wisconsin - Madison - Department of Economics; National Bureau of Economic Research (NBER); University of Washington - Department of Economics
NBER Working Paper No. w12213
Both empirical evidence and theoretical discussion have long emphasized the impact of %u201Cnews%u201D on exchange rates. In most exchange rate models, the exchange rate acts as an asset price, and as such responds to news about future returns on assets. But the exchange rate also plays a role in determining the relative price of non-durable goods when nominal goods prices are sticky. In this paper we argue that these two roles may conflict with one another. If news about future asset returns causes movements in current exchange rates, then when nominal prices are slow to adjust, this may cause changes in current relative goods prices that have no efficiency rationale. In this sense, anticipations of future shocks to fundamentals can cause current exchange rate misalignments. Friedman%u2019s (1953) case for unfettered flexible exchange rates is overturned when exchange rates are asset prices. We outline a series of models in which an optimal policy eliminates the effects of news on exchange rates.
Number of Pages in PDF File: 34working papers series
Date posted: May 25, 2006
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