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

57 Pages Posted: 16 Oct 2008

See all articles by Edward F. Buffie

Edward F. Buffie

Indiana University Bloomington - Department of Economics

Manoj Atolia

Florida State University - Department of Economics

Date Written: August 1, 2007

Abstract

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%.

Keywords: credibility, exchange-rate-based-stabilization, durables

JEL Classification: E31, E63, F41

Suggested Citation

Buffie, Edward F. and Atolia, Manoj, Resurrecting the Weak Credibility Hypothesis in Models of Exchange-Rate-Based Stabilization (August 1, 2007). Available at SSRN: https://ssrn.com/abstract=1285057 or http://dx.doi.org/10.2139/ssrn.1285057

Edward F. Buffie (Contact Author)

Indiana University Bloomington - Department of Economics ( email )

Wylie Hall 105
107 S. Indiana Avenue
Bloomington, IN 47405-7000
United States
812-855-4848 (Phone)

Manoj Atolia

Florida State University - Department of Economics ( email )

Tallahassee, FL 30306-2180
United States
+1.850.644.7088 (Phone)
+1.850.644.4535 (Fax)

HOME PAGE: http://mailer.fsu.edu/~matolia/

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