Working Paper: NBER ID: w1138
Authors: Jonathan Eaton; Stephen J. Turnovsky
Abstract: This paper develops a stochastic equilibrium model of an open economy incorporating speculation in the forward exchange market. The model is used to examine two issues. The first is the role of speculation in stabilizing the economy against stochastic disturbances. Much risk averse speculation stabilizes domestic income against disturbances in the domestic bond market and forward exchange marketbut exacerbates the effect of foreign disturbances. Speculation may dampen or augment the effect of money market and output supply disturbances depending upon the share of foreign bonds in total wealthand the interest elasticity of bond demand. The second issue that the model addresses is the role of the forward market in stabilization policy. Forward market intervention (or its equivalent in this model,sterilized spot market intervention) does not provide monetary authorities additional leverage in stabilizing income beyond unsterilized spot market intervention. Intervention rules based on reactions to both the forward and the spot exchange rates, however, can outper-form intervention policies responding to the spot rate alone,regardless of the market in which intervention occurs.
Keywords: forward exchange market; speculation; exchange market intervention; stochastic equilibrium model; domestic income stability
JEL Codes: F31; F33; F41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| speculation (D84) | domestic income stability (E25) |
| domestic disturbances (J12) | domestic income stability (E25) |
| foreign disturbances (F55) | domestic income stability (E25) |
| speculation (D84) | effects of money market and output supply disturbances (E44) |
| intervention rules based on forward and spot rates (E43) | economic stability (E63) |
| speculation can dampen or augment effects of disturbances (D84) | economic stability (E63) |