A Policy-Game Framework for the Dollar-Euro Exchange Rate

Most dollar-euro models are unstable in the sense that the influence of variables such as (short- or long-term) interest rate differentials, change through time from, statistically significant, positive to negative, and sometimes to being insignificant. This instability inherent in all currency models based on the small open paradigm or the two-country model is due to a policy-game framework, in which the equilibrium shifts from Stackelberg-leader to Stackelberg-follower.1 Once account is taken of this game framework, and the shift of the equilibrium between Stackelberg-leader and Stackelberg-follower, the resulting dollar-euro model is stable. The US has a clear preference for the Stackelberg-leader equilibrium when the economy is overheated or cools down, but inflation continues to rise because of inertia. The US has a clear preference for the Stackelberg-follower equilibrium when the economy is in recession or on the recovery phase of the business cycle. In each case markets impose the relevant equilibrium because it is stable for the world economy and global financial markets, based on the premise that ‘what is good for the US is also good for the rest of the world’. The question of stability/instability issue can only be answered when the business cycles of the US and euro area can be investigated in terms of them being synchronized or de-synchronized.