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Motivated by the existence of time-varying volatility in exchange rates, the paper investigates the effects of exchange rate volatility shocks on a small open economy. First, we use a high-frequency dataset to generate a volatility measure for the period, instead of the traditional moving average standard deviation of exchange rates. The structural VAR impulse responses utilizing the volatility measure yield more significant and robust reactions of real variables to a volatility shock. Consumption, ouput, investment and net export exhibit non-trivial decrease upon impact of the shock. On the contrary, an exchange rate level shock and the traditional volatility measure fail to generate robust impulse responses under different Cholseky orderings. Second, we develop a theoretical model based on a standard New Keynesian small open economy, which can replicate the effects of a volatility shock observed in the VAR result. We solve the model up to a third order approximation so that the solution includes an explicit time-varying volatility term. The model impulse responses exhibit that real variables respond to a volatility shock and they are qualitatively consistent with the VAR result. The underlying mechanism is precautionary saving. The result is sensitive to various parameters such as the openness parameter and the elasticity of inter-temporal substitution. Finally, we make a welfare analysis regarding the optimal monetary policy. Two types of welfare measures are used: the unconditional mean of utility and the conditional welfare. The conditional welfare suggests that policy makers should raise the interest rate when volatility increases. The seemingly counter-intuitive result is due to the fact that the conditional welfare measure reflects dynamic response of the agent throughout her life-cycle. Under the optimal policy suggested by the conditional welfare, the initial consumption adjustment is severe but agents work less and eventually enjoy a higher level of consumption from savings carried over from earlier periods.
This dissertation revisits the literature on the role of exchange rate flexibility in smoothing the adjustments of the economy to different disturbances. Recently, the role of flexible exchange rates in stabilizing the economy against real shocks has been challenged by the new open economy models, which build on some empirical regularities, such as the low pass-through from nominal exchange rates to import prices. We take three approaches in an attempt to enrich this literature. Firstly, we incorporate factors of production into welfare analyses of fully-specified general equilibrium models. We find flexible exchange rate regimes reduce terms of trade and consumption volatility for primary commodity economies, particularly oil-exporting. Secondly, in an empirical investigation, using a panel Vector Autoregressive Regression of nine of the OECD's major oil-importing countries and the Reinhart and Rogoff's de facto classification of exchange rate regimes, we find support for the hypothesis that flexible exchange regimes better absorb oil-price shocks. We also document feedback from the real effective exchange rate and inflation rate to the domestic-currency real oil price shocks, supporting the growing notion that oil price shocks are not purely exogenous to developed economies. Thirdly, in a micro-level empirical investigation, we find a significant improvement in estimating the degree of nominal exchange rate pass-through to import prices when the adjustment costs and the equilibrium degree of pass-through assumptions are considered. More specifically, using a vector threshold cointegration model, we find increases in both the initial reaction and the long-run equilibrium response of import prices to nominal exchange rate changes for five industries in 16 OECD countries, especially for the manufacturing industry.
This paper examines the effect of overall and sector-specific productivity shocks on the real exchange rate in small open economies. A dynamic stochastic small open economy model shows that productivity shocks impact the real exchange rate mostly through changes in the relative price of non-traded goods and are unable to explain the large deviations from purchasing power parity for traded goods prices observed in the data. This paper also studies how the effect of productivity shocks on the real exchange rate changes when a country adopts a fixed exchange rate regime.
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Most trade is invoiced in very few currencies. Despite this, the Mundell-Fleming benchmark and its variants focus on pricing in the producer’s currency or in local currency. We model instead a ‘dominant currency paradigm’ for small open economies characterized by three features: pricing in a dominant currency; pricing complementarities, and imported input use in production. Under this paradigm: (a) the terms-of-trade is stable; (b) dominant currency exchange rate pass-through into export and import prices is high regardless of destination or origin of goods; (c) exchange rate pass-through of non-dominant currencies is small; (d) expenditure switching occurs mostly via imports, driven by the dollar exchange rate while exports respond weakly, if at all; (e) strengthening of the dominant currency relative to non-dominant ones can negatively impact global trade; (f) optimal monetary policy targets deviations from the law of one price arising from dominant currency fluctuations, in addition to the inflation and output gap. Using data from Colombia we document strong support for the dominant currency paradigm.
Both parts of Volume 44 of Advances in Econometrics pay tribute to Fabio Canova for his major contributions to economics over the last four decades.
''In summary, the book is valuable as a textbook both at the advanced undergraduate level and at the graduate level. It is also very useful for the economist who wants to be brought up-to-date on theoretical and empirical research on exchange rate behaviour.'' ""Journal of International Economics""
Discusses economic issues associated with exchange rates, commodity prices, the economic size of countries and alternatives to PPP exchange rates.