Exchange Rate Volatility

Abstract

In chapter 2 we have considered a monetary model with completely flexible prices and in chapter 3 contrasted this model type with a fixed price model where quantities rather than prices adjusted in order to clear the markets for the domestically produced and the foreign good. The flexprice approach may be considered the earliest in the study of international trade and balance of payments adjustments, while the Keynesian international multiplier analysis was of course only developed after the appearance of Keynes ‘General Theory’ in 1936 and in particular after World War II. The monetary model had a brief renaissance in the early 1970s when the Bretton Woods system came to an end. It was supposed to provide an alternative to the prevailing fixprice macrotheory of Mundell-Fleming type and proposed the establishment of a system of flexible exchange rates. Yet, exchange rates proved to be much more volatile after the breakdown of the Bretton Woods system in 1973 than was predicted by the monetary model. Confronted with such findings the immediate success of another model type, the Dornbusch (1976) model of sticky, but not fixed prices and flexible, in fact too volatile exchange rates in an environment of high capital mobility, can easily be understood.¹ The seminal Dornbusch (1976) model² combines stock and flow equilibria on the asset markets (money, domestic and foreign bonds respectively) with sluggishly adjusting prices on the market for goods and in later extensions also on the market for labor. Money supply shocks thereby enforce overreaction of the domestic interest rate and as a consequence also of the exchange rate, with respect to their new steady state values, and only after some time are eliminated by subsequent convergence to their (new) steady state values. In appropriately revised form the Dornbusch approach can be viewed to be composed of short-run Mundell-Fleming elements, a new type of exchange rate dynamics, and long-run Classical features (neutrality of money and the relative form of the PPP). It therefore synthesizes to some extent the three preceding chapters of this part of the book by providing an IS-LM-PC approach to the dynamics of exchange rates and expectations of exchange rate depreciation or appreciation with a Classical long-run outlook.