Exchange Rates and Prices in General Equilibrium: Theory, Evidence and Policy Implications
May 29-30, 2000
The conference was sponsored jointly with the CEPR. The program was prepared by Jordi Galí and Andrew Rose (University of California, Berkeley). Financial support was obtained from the Spanish Ministerio de Educación y Cultura and from the Generalitat de Catalunya.
The main objective of the conference was to revisit the new developments in the international macroeconomic literature both from a theoretical and an empirical point of view. The conference was organized in three sessions, and covered recent research on topics like currency unions, monetary policy in the open economy, Euro area modeling, financial crises, and others of significant policy relevance and current interest.
A CEPR/CREI conference on ‘Exchange Rates and Prices in General Equilibrium: Theory, Evidence and Policy Implications’ was held in Barcelona on 29/30 May 2000. Organized by Jordi Galí (Universitat Pompeu Fabra, Barcelona, and CEPR) and Andrew Rose (University of California, Berkeley, and CEPR), the conference reviewed the new developments in the international macroeconomic literature both from a theoretical and an empirical perspective. Topics covered included currency unions, monetary policy in the open economy, Euro area modelling and financial crises.
Harald Hau (ESSEC and CEPR) began the conference with his paper ‘Real Exchange Rate Volatility and Economic Openness: Theory and Evidence’. Hau employed a theoretical model to study exchange rate volatility issues by relating the volatility of the effective real exchange rate to the degree of trade openness in an economy. He presented an international monetary model with monopolistic competition and rigid wages, which predicts that both monetary and aggregate supply shocks imply an inverse relationship between the degree of openness of an economy (the import share) and the volatility of its real exchange rate. The empirical evidence presented, on a cross-section of 54 countries (and in particular the OECD subsample), is supportive of the conjectured openness-volatility linkage for low frequencies. This relationship is robust to the inclusion of various control measures. Hau’s results predict large real exchange rate volatility for the future Euro/Dollar or the Euro/Yen rate if the level of intercontinental trade remains at its presently modest level.
Tommaso Monacelli (Boston College) pointed out that, in the model, the increase of the volatility of the real exchange rate was mainly due to the existence of non-traded goods, which decreases the expenditure switching effect of changes in the relative price of goods in domestic demand. He suggested that since the expenditure switching effect is empirically important, then Hau should not have tried to decrease its effect. The results can be equally well replicated by a model with non-traded goods, but endogenous monetary policy. And the stabilization role of monetary policy can explain the result of an inverse relationship between the degree of openness of an economy and its real exchange rate volatility.
Robert Kollman (University of Bonn), discussing the empirical part of the paper, noted that the theory is confirmed only in the long run. He also highlighted that although the model captures the sign of the cross-sectional correlation well, the level of the standard deviation of the real exchange rate is small compared with the data. Finally, he suggested that Hau should include in his analysis the impulse response of the real exchange rate to money and productivity shocks, in order to enforce the predictions of his theory. Harris Dellas (Universität Bern and CEPR) suggested that a less complicated model could reproduce the results of the present model, as long as it could produce real exchange rate effects.
Alberto Alesina (Harvard University and CEPR) presented his paper ‘Currency Unions’, which was co-authored by Robert Barro. The paper shows how the determination of optimal currency areas depends on a complex web of variables and interactions, such as the size of countries, the distance between countries, the size of the transaction costs of trade, the correlation between shocks, and institutional arrangements that determine how the seignorage is allocated and whether transfers between members of a union are feasible. Alesina’s theoretical model implies that the country with the strongest incentive to give up its own currency is a small country with a history of high inflation that is close (in a variety of different ways) to a large monetarily stable country. As the number of countries increases, their average size decreases and the volume of international transactions rises. As a result more and more countries will find it profitable to give up their independent currency. Alesina showed that as the number of countries increases, the number of currencies may not only increase less than proportionally but may even fall.
In his discussion Giuseppe Bertola (European University Institute, Firenze, and CEPR) argued that the macroeconomic model Alesina used had weak microfoundations. He suggested that the assumption on seignorage payments by the country that dollarizes is unrealistic. Furthermore, he suggested that if the discussion of the paper would be introduced in a history environment, it would then add value to the work. Richard Portes (London Business School and CEPR) gave a very positive discussion on the paper. He thought the model allowed an elegant and parsimonious treatment of several key issues, such as the effect of the country size on the suitability of a monetary union, the role of trading costs and the importance of distance.
In the general discussion, Andrew Rose commented on the political implications of the paper for EMU, arguing that the main motive for the countries entering the Union was not the absence of commitment, as Alesina had argued. Rose argued that before entering the Union, the member-countries had to fulfill several criteria, which guaranteed their discipline. Thus, commitment for entering the currency union does not matter for the Euro Area. Alan Sutherland (University of St Andrews and CEPR) emphasized that the distortions in the theoretical model were taken as given. In reality, if distortions exist then countries have incentives to reform and these were not present in the paper. He suggested that endogenizing the distortions would add value to the work.
‘Optimal Monetary Policy in a Currency Area’ was presented by Pierpaolo Benigno (Princeton University). The paper investigates how monetary policy should be conducted in a two-region, general equilibrium model with monopolistic competition and price stickiness. The framework consists of a simple welfare criterion based on the utility of consumers that has the usual trade-off between stabilizing inflation and output. Monetary policy in a currency union depends on the degree of nominal rigidity in the different regions. If two regions share the same degree of nominal rigidity then optimal policy should target a weighted average of the regional inflation rates, where the weights equal the size of the regions. If the degrees of rigidity are different, then the optimal plan implies a high degree of inertia in the inflation rate. But an inflation targeting policy in which higher weights are given to the regions with higher degrees of nominal rigidity approximates well to the optimal policy.
David Lòpez Salido (Banco de España) discussed the empirical relevance of the theoretical model. He offered an econometric analysis based on the theoretical grounds of the paper. His findings for nine European countries (for an equation determining inflation that has only forward looking components) suggest that in Europe there are two areas with different degrees of price rigidity: one area includes Netherlands, Belgium and Germany where the prices adjust after four quarters and the second group is composed by Italy, Spain and France, where the prices adjust after two and six quarters. When Lòpez Salido introduced backward looking components in the determination of inflation, he found that the degree of price stickiness did not vary substantially across the two areas. His final empirical findings suggested that if monetary policy weights favour the regions with the highest degree of price stickiness then the variability of the harmonized price inflation is decreased, which confirms the theoretical predictions of Benigno’s model. In the general discussion Alberto Alesina (Harvard University and CEPR) argued that there might be incentives for the ‘sticky’ regions of a currency area to remain rigid because countries with a high degree of price rigidity received more weight in the objective of the policymaker. Jordi Galí added that the existence of persistent inflation differentials between European countries could be analysed in the theoretical framework presented by the author.
‘Optimal Monetary Policy in an Open Economy: An Application to the Euro Area’ was presented by Frank Smets (European Central Bank and CEPR) and co-authored by Raf Wouters. Focusing on the implications of openness for optimal monetary policy, Smets developed a general equilibrium model with staggered price setting and overlapping generations for an open economy. In particular, he examined whether there is a role for exchange rate stabilization and whether foreign shocks can be the source of a policy trade-off between inflation stabilization and other objectives, such as output stabilization. The addition of an overlapping generations model into the standard New-Keynesian model allowed Smets to derive a stationary steady state for consumption, the terms of trade and net foreign assets in an economy that takes the world’s real interest rate and world prices as given. Moreover, he assumed that international consumption smoothing takes place through investment in a foreign-currency-denominated bond. The combination of overlapping generations and imperfect integration of international capital markets implies that net foreign assets play an important role in the dynamics of the economy. The structural parameters of the model are calibrated so as to match the empirical impulse response function of a monetary policy shock in the euro area. This empirical calibration allows the authors to discuss alternative monetary policy regimes, as such regimes will typically depend on the processes driving the various shocks. In this theoretical framework, monetary policy is confronted with a trade-off between the stabilization of domestic inflation and the stabilization of output and consumption. The paper examines the empirical relevance of this trade off and uses the calibrated version of the model to analyse the difference between discretionary policies and policies under commitment and the extent to which simple policy rules can approximate the optimal outcome under commitment.
Andrew Rose (University of California, Berkeley, and CEPR) found the introduction of overlapping generations into the standard New-Keynesian model innovative. However, he questioned the empirical applicability of the model. The theoretical model was derived for a small open economy whereas in the empirical analysis the model was fitted with symmetric euro area data. He also found that the results of the model were subject to the ‘Lucas Critique’ because the paper examines monetary policy by a central bank that did not exist throughout the sample. Nevertheless, he found the model good for addressing different exchange rate regimes, debt and optimal monetary policy issues. In the general discussion, Jordi Galí added that in the theoretical model there was no institutional details for monetary policy. Issues such as different exchange rate regimes, different monetary policy preferences during the sample period and different transmission mechanisms were not analysed.
‘The Transfer Problem Revisited: Net Foreign Assets and Real Exchange Rates’ was presented by Philip Lane (Trinity College Dublin and CEPR) and Gian-Maria Milesi-Ferretti (International Monetary Fund and CEPR). The paper investigates the implications for the real exchange rate of the need for debtor countries to run trade surpluses in the long run so as to service their external liabilities. Using a newly assembled data set on the net external position of industrial and developing countries, the authors presented a simple theoretical framework that leads to empirically testable implications on the long-run co-movements of real exchange rates, net foreign assets, relative GDP and terms of trade, and cross-country and time-series evidence. It is shown that, on average, countries with net external liabilities have more depreciated real exchange rates. The main channel of transmission seems to work through the relative price of non-traded goods across countries, rather than through the relative price of traded goods across countries.
Elhanan Helpman (Tel Aviv University, Harvard University, and CEPR) argued that in the theoretical framework of the model the income changes should not be treated as exogenous as they are affected by changes in the real exchange rate. Also, the exogeneity of the terms of trade in the theoretical model is not consistent with the existence of large countries in the sample used in the empirical model. Fabio Canova (Universitat Pompeu Fabra, Barcelona, and CEPR) thought the theoretical model had too many normalizations and that the assumption that the non-traded goods are not produced is unrealistic. He also mentioned that the panel data analysis is irrelevant since the prediction of the model concerns only the steady state and not an evolution through time. In the general discussion David Backus (Stern School of Business, New York University) noted that a positive shock in productivity usually increases the level of net foreign assets in the economy, thus the assumption of exogenous income changes is not relevant, since output growth is connected positively with net foreign asset growth. This view was supported also by Giuseppe Bertola, who claimed that the relationship between output and net foreign assets growth is an empirical regularity. Jordi Gali said that the authors should use a metric to see the contribution of the transfer mechanism to the unit root in the real exchange rate.
‘Monetary Policy in the Open Economy Revisited: Price Setting and Exchange Rate Flexibility’ was presented by Michael Devereux (University of British Columbia and CEPR) and co-authored by Charles Engel. The paper develops a welfare-based model of monetary policy in an open economy, focusing on the extent to which monetary policy should be employed in maintaining the exchange rate. The traditional approach maintains that exchange rate flexibility is desirable in the presence of real country-specific shocks that require adjustment in relative prices. However, in the light of empirical evidence on nominal price responses to exchange rate changes, the expenditure-switching role played by nominal exchange rates may be exaggerated in the traditional literature. In the presence of local-currency pricing, Devereux found that optimal monetary policy in response to real shocks is fully consistent with fixed exchange rates. Conversely, when real country-specific shocks are not important, and when a country’s monetary sector is stable, the case for free-floating rates is strengthened in the presence of local currency pricing.
Philippe Bacchetta (Studienzentrum Gerzensee, Université de Lausanne, and CEPR) argued that the inclusion of covariance terms on the welfare criterion is important. He thought that the loglinearization of the utility of the representative consumer is more accurate than the calculation of a second order Taylor expansion around the steady state that has been used by many authors in this field. The second discussant, Harris Dellas (Universität Bern and CEPR) suggested that the paper would be more complete if it included quantitative together with the qualitative results. In the general discussion Fabio Canova noted that the monetary policy rule suggested by the authors was not feasible, since money reacts instantaneously to productivity shocks that are unobservable. He suggested that the authors should use a rule for the money supply that depends on variables that can be observed such as inflation, output and exchange rates.
‘On the Fundamentals of Self-Fulfilling Speculative Attacks’ was presented by Sérgio Rebelo(Kellogg Graduate School of Management, Northwestern University and CEPR) and co-authored byCraig Burnside (World Bank) and Martin Eickenbaum. The paper proposes a theory of twin-banking currency crises in which both fundamentals and self-fulfilling beliefs play crucial roles. Fundamentals determine whether crises will occur. The cause of ‘twin-crises’ is government guarantees to domestic banks’ foreign creditors. When these guarantees are in place ‘twin-crises’ inevitably occur, but their timing is a multiple equilibrium phenomenon that depends on agents’ beliefs. So while self-fulfilling beliefs have an important role to play, ‘twin-crises’ cannot occur everywhere. They occur only in countries where there are fundamental problems, such as government guarantees to the financial sector.
David Backus (Stern School of Business, New York University) commented on the well-defined financial infrastructure of the model and related bankruptcy issues. He noted that the amount of hedging, in contrast with the model, is not enough in reality. Alan Sutherland(University of St Andrews and CEPR) thought that the microfoundations of the model were innovative. He thought the model gave a good account of the mechanisms that create currency crises, but that an important factor in generating a currency crisis is bad monetary policy, which was not explicitly modelled in the paper. In the general discussion Andreas Fischer(Schweizerische Nationalbank and CEPR) commented that the theoretical framework is also applicable to flexible exchange rates and that the role of the exchange rate regime is not important in producing the results.
Call for papers
Working papers available
by Alberto Alesina and Robert J. Barro
Optimal Monetary Policy in Currency Area
by Pierpaolo Benigno
Monetary Policy in the Open Economy Revisited: Price Setting and Exchange Rate Flexibility
by Michael B. Devereux and Charles Engel
On the Fundamentals of Self-Fulfilling Speculative Attacks
by Craig Burnside, Martin Eichenbaum and Sérgio Rebelo