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Exchange rate dynamics revisited

Author

Listed:
  • Jorge Braga de Macedo
  • Urho Lempinen

Abstract

Many monetary and fiscal policy decision makers and economists hold the view that exchange rates are volatile even though nominal exchange rates vary less than many other financial market prices and yields. This paper seeks an explanation for this puzzle by contrasting exchange rate dynamics in a general equilibrium model to those presented in Dornbusch (1976) and Kouri (1978). Kouri introduced the "acceleration hypothesis'', according to which the rate of currency depreciation is given by the ratio of the current account deficit to the sum of holdings of foreign assets by domestic agents and holdings of domestic assets by foreign agents. In this paper, we derive the "generalized acceleration hypothesis'', assuming price flexibility but imperfect substitutability of assets. A Kouri type gradual adjustment of the current account induces stickiness in portfolio adjustments and exchange rate adjustment. Uncertainty in the model arises from monetary policy and supply side shocks. Due to general equilibrium constraints on wealth and investment behavior, the speed of adjustment is defined by the sum of speculative (expectations sensitive) demand for foreign (domestic) assets by domestic (foreign) agents, deducted by the stock of domestic assets traded out by domestic residents. The adjustment speed is then higher and the market correction mechanism through the current account stronger. The model developed in this paper includes the three key channels of external adjustment of an economy: the capital account or portfolio allocation channel as applied by Kouri (and also by Dornbusch, although under perfect substitutability of assets), the current account channel as applied by Kouri and the asset valuation channel as applied in Gourinchas & Rey (2007). In a linearized testing environment, we study three different cases of exchange rate dynamics. Sampling 10 000 continuous time paths of Monte Carlo simulations for 30 years, and using the 90% variation range as the metric, the Dornbusch formulation yields a 200% variation range about the mean, reduced to 100% in the Kouri case and to 20% in the general equilibrium case.

Suggested Citation

  • Jorge Braga de Macedo & Urho Lempinen, 2013. "Exchange rate dynamics revisited," NBER Working Papers 19718, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:19718
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    References listed on IDEAS

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    1. Maurice Obstfeld, 2012. "Does the Current Account Still Matter?," American Economic Review, American Economic Association, vol. 102(3), pages 1-23, May.
    2. Sercu,Piet & Uppal,Raman, 2006. "Exchange Rate Volatility, Trade, and Capital Flows under Alternative Exchange Rate Regimes," Cambridge Books, Cambridge University Press, number 9780521034234.
    3. Coeurdacier, Nicolas & Kollmann, Robert & Martin, Philippe, 2010. "International portfolios, capital accumulation and foreign assets dynamics," Journal of International Economics, Elsevier, vol. 80(1), pages 100-112, January.
    4. Pierre-Olivier Gourinchas & Hélène Rey, 2007. "International Financial Adjustment," Journal of Political Economy, University of Chicago Press, vol. 115(4), pages 665-703, August.
    5. Lucas, Robert Jr., 1982. "Interest rates and currency prices in a two-country world," Journal of Monetary Economics, Elsevier, vol. 10(3), pages 335-359.
    6. Devereux, Michael B. & Sutherland, Alan, 2010. "Valuation effects and the dynamics of net external assets," Journal of International Economics, Elsevier, vol. 80(1), pages 129-143, January.
    7. Giavazzi, Francesco & Blanchard, Olivier & Sá, Filipa, 2005. "The US Current Account and the Dollar," CEPR Discussion Papers 4888, C.E.P.R. Discussion Papers.
    8. Dornbusch, Rudiger, 1976. "Expectations and Exchange Rate Dynamics," Journal of Political Economy, University of Chicago Press, vol. 84(6), pages 1161-1176, December.
    9. Maurice Obstfeld & Kenneth Rogoff, 1995. "The Mirage of Fixed Exchange Rates," Journal of Economic Perspectives, American Economic Association, vol. 9(4), pages 73-96, Fall.
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    11. Michael Woodford, 2000. "Monetary Policy in a World Without Money," International Finance, Wiley Blackwell, vol. 3(2), pages 229-260, July.
    12. Pentti J.K. Kouri, 1978. "Balance of Payments and the Foreign Exchange Market: A Dynamic Partial Equilibrium Model," Cowles Foundation Discussion Papers 510, Cowles Foundation for Research in Economics, Yale University.
    13. Lucas, Robert E, Jr, 1978. "Asset Prices in an Exchange Economy," Econometrica, Econometric Society, vol. 46(6), pages 1429-1445, November.
    14. Mr. Kenneth Rogoff, 2002. "Dornbusch’s Overshooting Model After Twenty-Five Years," IMF Working Papers 2002/039, International Monetary Fund.
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    Cited by:

    1. Vesa Kanniainen, 2014. "The Future of the Euro: The Options for Finland," CESifo Forum, ifo Institute - Leibniz Institute for Economic Research at the University of Munich, vol. 15(03), pages 56-64, August.
    2. Vesa Kanniainen, 2014. "The Future of the Euro: The Options for Finland," CESifo Forum, ifo Institute - Leibniz Institute for Economic Research at the University of Munich, vol. 15(3), pages 56-64, August.
    3. David Alaminos & M. Belén Salas & Manuel Á. Fernández-Gámez, 2023. "Quantum Monte Carlo simulations for estimating FOREX markets: a speculative attacks experience," Palgrave Communications, Palgrave Macmillan, vol. 10(1), pages 1-21, December.
    4. Maggiori, Matteo, 2021. "International Macroeconomics With Imperfect Financial Markets," SocArXiv z8g6r, Center for Open Science.

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    More about this item

    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • F32 - International Economics - - International Finance - - - Current Account Adjustment; Short-term Capital Movements

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