Working Paper: CEPR ID: DP16517
Authors: Marcus Hagedorn
Abstract: This paper proposes an equilibrium theory of nominal exchange rates, which offers a new perspectiveon various issues in open economy macroeconomics.The nominal exchange rate and portfolio choices are jointly determined in equilibrium,thus providing a new approach to overcoming the indeterminacy results in Kareken and Wallace (1981).The distinctive features of this theory are that the nominal exchange rate is determined in international financial markets,that the risk premium and UIP deviations are fully endogenous equilibrium objects and that the real exchange rate inherits its properties from the nominal exchange rate.In terms of policy, this novel theory implies that a country with an exchange rate peg and free asset mobility faces a tetralemma and not a trilemma, because it loses not only monetary policy independence but also fiscal policy independence.
Keywords: exchange rate determinacy; incomplete markets; monetary and fiscal policy; international asset flows
JEL Codes: D52; E31; E43; E52; E62; E63
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Nominal Exchange Rate (F31) | Real Exchange Rate (F31) |
| Market Conditions (D49) | Nominal Exchange Rate (F31) |
| Nominal Exchange Rate (F31) | Risk Premium (G19) |
| Nominal Exchange Rate (F31) | UIP Deviations (L15) |
| Fundamental Risk (D81) | Nominal Exchange Rate (F31) |
| Fundamental Risk (D81) | Real Exchange Rate (F31) |
| Exchange Rate Peg + Free Capital Mobility (F31) | Loss of Monetary Policy Independence (E49) |
| Exchange Rate Peg + Free Capital Mobility (F31) | Loss of Fiscal Policy Independence (H69) |