Working Paper: CEPR ID: DP5743
Authors: Michael B. Devereux; Charles M. Engel
Abstract: Both empirical evidence and theoretical discussion have long emphasized the impact of `news' 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's (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.
Keywords: exchange rate; expectations; monetary policy
JEL Codes: F3; F31; F33
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| news about future asset returns (G17) | current exchange rate misalignments (F31) |
| current exchange rate misalignments (F31) | inefficiencies in relative prices of goods (D61) |
| movements in exchange rates driven by expectations (F31) | undesirable allocational effects (D61) |
| optimal monetary policy (E63) | eliminate the impact of news on exchange rates (F31) |
| exchange rates driven primarily by expectations (F31) | misalignment of terms of trade (F14) |
| misalignment of terms of trade (F14) | impact on resource allocation (F69) |
| optimal policy (C61) | dampen the response of exchange rates to news shocks (F31) |