Working Paper: CEPR ID: DP221
Authors: David Currie; Simon Wren-Lewis
Abstract: This paper evaluates the extended target zone proposal of Williamson and Miller using the National Institute world economic model (GEM). Williamson and Miller's proposals envisage that real exchange rates will be controlled by movements in relative interest rates, that fiscal policy will be used to steer nominal demand towards a target which depends on capacity utilization, inflation and the current balance, and that the average level of world interest rates will be used to control global nominal demand. We evaluate the performance of these rules for the United States, Germany and Japan over the period 1975-84, using control methods to determine the best choice of parameters in the feedback rules. We then consider how history would have differed from actual events had such rules been in place. The results suggest that such rules would have led to a significant improvement in economic performance: exchange rate variability would have been reduced and the dramatic increase in United States interest rates which took place after 1980 would have been avoided.
Keywords: policy coordination; exchange rate targets; policy rules
JEL Codes: 430
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Extended target zone proposal (E61) | improved economic performance in G3 countries (F69) |
| Proposed feedback rules (E61) | reduced exchange rate variability (F31) |
| Dramatic increase in US interest rates post-1980 (E65) | avoided by proposed feedback rules (G18) |
| Fiscal policy (E62) | nominal demand (D12) |
| Interest rate differentials (E43) | stabilize real exchange rates (F31) |
| Large appreciation of US real exchange rate post-1980 (F31) | substantial deficit in US current account (F32) |
| Without large appreciation of US real exchange rate post-1980 (F31) | budget stability (H61) |