The development of a simple framework with optimizing agents and nominal rigidities is the point of departure for the analysis of three questions about fiscal and monetary policies in an open economy. The first question concerns the optimal monetary policy targets in a world with trade and financial links. In the baseline model, the optimal cooperative monetary policy is fully inward-looking and seeks to stabilize a combination of domestic inflation and output gap. The equivalence with the closed economy case, however, ends if countries do not cooperate, if firms price goods in the currency of the market of destination, and if international financial markets are incomplete. In these cases, external variables that capture international misalignments relative to the first best become relevant policy targets. The second question is about the empirical evidence on the international transmission of government spending shocks. In response to a positive innovation, the real exchange rate depreciates and the trade balance deteriorates. Standard open economy models struggle to match this evidence. Non-standard consumption preferences and a detailed fiscal adjustment process constitute two ways to address the puzzle. The third question deals with the trade-offs associated with an active use of fiscal policy for stabilization purposes in a currency union. The optimal policy assignment mandates the monetary authority to stabilize union-wide aggregates and the national fiscal authorities to respond to country-specific shocks. Permanent changes of government debt allow to smooth the distortionary effects of volatile taxes. Clear and credible fiscal rules may be able to strike the appropriate balance between stabilization objectives and moral hazard issues.
Martin D. D. Evans and Dagfinn Rime
An overview of research on the microstructure of foreign exchange (FX) markets is presented. We begin by summarizing the institutional features of FX trading and describe how they have evolved since the 1980s. We then explain how these features are represented in microstructure models of FX trading. Next, we describe the links between microstructure and traditional macro exchange-rate models and summarize how these links have been explored in recent empirical research. Finally, we provide a microstructure perspective on two recent areas of interest in exchange-rate economics: the behavior of returns on currency portfolios, and questions of competition and regulation.
While it is a long-standing idea in international macroeconomic theory that flexible nominal exchange rates have the potential to facilitate adjustment in international relative prices, a monetary union necessarily forgoes this mechanism for facilitating macroeconomic adjustment among its regions. Twenty years of experience in the eurozone monetary union, including the eurozone crisis, have spurred new macroeconomic research on the costs of giving up nominal exchange rates as a tool of adjustment, and the possibility of alternative policies to promote macroeconomic adjustment. Empirical evidence paints a mixed picture regarding the usefulness of nominal exchange rate flexibility: In many historical settings, flexible nominal exchanges rates tend to create more relative price distortions than they have helped resolve; yet, in some contexts exchange rate devaluations can serve as a useful correction to severe relative price misalignments. Theoretical advances in studying open economy models either support the usefulness of exchange rate movements or find them irrelevant, depending on the specific characteristics of the model economy, including the particular specification of nominal rigidities, international openness in goods markets, and international financial integration. Yet in models that embody certain key aspects of the countries suffering the brunt of the eurozone crisis, such as over-borrowing and persistently high wages, it is found that nominal devaluation can be useful to prevent the type of excessive rise in unemployment observed. This theoretical research also raises alternative polices and mechanisms to substitute for nominal exchange rate adjustment. These policies include the standard fiscal tools of optimal currency area theory but also extend to a broader set of tools including import tariffs, export subsidies, and prudential taxes on capital flows. Certain combinations of these policies, labeled a “fiscal devaluation,” have been found in theory to replicate the effects of a currency devaluation in the context of a monetary union such as the eurozone. These theoretical developments are helpful for understanding the history of experiences in the eurozone, such as the eurozone crisis. They are also helpful for thinking about options for preventing such crises in the future.
Menzie D. Chinn
The idea that prices and exchange rates adjust so as to equalize the common-currency price of identical bundles of goods—purchasing power parity (PPP)—is a topic of central importance in international finance. If PPP holds continuously, then nominal exchange rate changes do not influence trade flows. If PPP does not hold in the short run, but does in the long run, then monetary factors can affect the real exchange rate only temporarily. Substantial evidence has accumulated—with the advent of new statistical tests, alternative data sets, and longer spans of data—that purchasing power parity does not typically hold in the short run. One reason why PPP doesn’t hold in the short run might be due to sticky prices, in combination with other factors, such as trade barriers. The evidence is mixed for the longer run. Variations in the real exchange rate in the longer run can also be driven by shocks to demand, arising from changes in government spending, the terms of trade, as well as wealth and debt stocks. At time horizon of decades, trend movements in the real exchange rate—that is, systematically trending deviations in PPP—could be due to the presence of nontraded goods, combined with real factors such as differentials in productivity growth. The well-known positive association between the price level and income levels—also known as the “Penn Effect”—is consistent with this channel. Whether PPP holds then depends on the time period, the time horizon, and the currencies examined.
Ehsan U. Choudhri
Exchange rates often display sudden and large changes. There is considerable interest in examining how these changes affect prices, especially import and consumer prices. Exchange rate pass-through measures the responsiveness of the price of a basket of goods to changes in the exchange rate and is defined as the elasticity of the price of the basket (expressed in home currency) with respect to the exchange rate (defined as the price of foreign currency). The pass-through estimates vary across product groups, countries, and time periods, but a general finding is that pass-through tends to be significantly less than one, which implies that prices do not fully respond to a foreign currency appreciation. Pass-through to export prices tends to be smaller than pass-through to import prices. Pass-through to consumer prices is lower than both import and export price pass-through and is generally very small. One explanation of pass-through evidence focuses on the role of nominal rigidities (infrequent changes in prices set in home or foreign currency). Another explanation emphasizes the importance of markup variation in response to exchange rate changes. In models with nominal rigidities, one important issue is whether exporting firms set prices in their country’s currency (producer’s currency) or importing country’s currency (consumer’s currency). If prices are sticky in producer’s currency, flexible exchange rates are preferable as they allow for desirable relative price adjustment. On the other hand, if prices are sticky in consumer’s currency, exchange rate flexibility is not as helpful in adjusting prices and fixed exchange rates are superior. The standard model where markup is constant and all firms (at home and abroad) use either producer or consumer currency pricing is not consistent with typical estimates of pass-through to import and export prices. To explain this evidence, the standard model needs to be modified to allow for variable markup and/or a hybrid model of currency choice where some firms set prices in producer’s and others in consumer’s currency. In the case of the hybrid model, the welfare difference between fixed and flexible exchange rates is not as stark as in the pure cases of currency choice and is likely to be small. Another issue of much interest is whether inflationary environment can affect pass-through, especially to consumer prices. Inflationary environment can influence pass-through to import and consumer prices through several channels, such as persistence of costs and frequency of price change. Empirical evidence shows that pass-through to consumer prices is related to the level and variability of inflation across countries and time periods and is lower in an environment with low and stable inflation. This evidence suggests that a monetary policy regime that targets low inflation will produce a low pass-through environment, which would dampen the price effects of exchange rate changes.
Alessandro Rebucci and Chang Ma
This paper reviews selected post–Global Financial Crisis theoretical and empirical contributions on capital controls and identifies three theoretical motives for the use of capital controls: pecuniary externalities in models of financial crises, aggregate demand externalities in New Keynesian models of the business cycle, and terms of trade manipulation in open-economy models with pricing power. Pecuniary and demand externalities offer the most compelling case for the adoption of capital controls, but macroprudential policy can also address the same distortions. So capital controls generally are not the only instrument that can do the job. If evaluated through the lenses of the new theories, the empirical evidence reviewed suggests that capital controls can have the intended effects, even though the extant literature is inconclusive as to whether the effects documented amount to a net gain or loss in welfare terms. Terms of trade manipulation also provides a clear-cut theoretical case for the use of capital controls, but this motive is less compelling because of the spillover and coordination issues inherent in the use of control on capital flows for this purpose. Perhaps not surprisingly, only a handful of countries have used capital controls in a countercyclical manner, while many adopted macroprudential policies. This suggests that capital control policy might entail additional costs other than increased financing costs, such as signaling the bad quality of future policies, leakages, and spillovers.