Exchange rate overvaluation under hyperinflation: The case of Peru

This dissertation examines the behavior of the exchange rate under two different scenarios. The first one is characterized by, relatively, low inflation or a situation where prices adjust sluggishly. The second is a high inflation economy where prices respond very rapidly even to unanticipated shocks. In the first one, following a monetary expansion, the exchange rate overshoots, i.e. the nominal exchange rate depreciates at a faster pace than the price level. Under high levels of inflation, prices change faster than the exchange rate so the exchange rate undershoots its long run equilibrium value.^ The standard work in this area, Dornbusch (1976), explains the overshooting process in the context of perfect capital mobility and sluggish adjustment in the goods market. A monetary expansion will make the exchange rate increase beyond its long run equilibrium value. This dissertation expands on Dornbusch's model and provides an analysis of the exchange rate under conditions of currency substitution and price flexibility, characteristics of the Peruvian economy during the hyper inflation process that took place at the end of the 1980's. The results of the modified Dornbusch model reveal that, given a monetary expansion, the change in the price level will be larger than the change in the exchange rate if prices react more than proportionally to the monetary shock.^ We will expect this over-reaction in circumstances of high inflation when the velocity of money is increasing very rapidly. Increasing velocity of money, gives rise to a higher relative price variability which in turn contributes to the appearance of new financial (and also non-financial) instruments that report a higher return than the exchange rate, causing people to switch their demand for foreign exchange to this new assets. In the context of currency substitution, economic agents hoard and use foreign exchange as a store of value. The big decline in output originated by hyper inflation induces people to sell this hoarded money to finance current expenses, increasing the supply of foreign exchange in the market. Both, the decrease in demand and the increase in supply reduce the price of foreign exchange i.e. the real exchange rate. The findings mentioned above are tested using Peruvian data for the period January 1985-July 1990, the results of the econometric estimation confirm our findings in the theoretical model. ^

Neutralizing the tendency to the overvaluation of the exchange rate or assuming a foreign constraint and asking for foreign savings

The objectives of these notes are two. The first objective is to analyze whether the strategy of growth with absorption of foreign savings leads to a trajectory of the economy that is sustainable in the long run. The second one is to evaluate the possibility of success of a policy of administered devaluation of the exchange rate in Brazil.

Exchange rate policies, patterns of specialization and economic development: theory and evidence in developing countries

The objectives of this paper are twofold. First, it intends to provide theoretical elements to analyze the relation between real exchange rates and economic development. Our main hypothesis is very much in line with the Dutch disease literature, and states that competitive currencies contribute to the existence and maintenance of the anufacturing sector in the economy. This, in turn, brings about higher growth rates in the long run, given the existence of increasing returns in the industrial sector, and its importance in generating echnological change and increasing productivity in the overall economy. The second objective of this paper is empirical. It intends to analyze examples of successful exchange rate policies, such as Chile and Indonesia in the eighties, as a benchmark for comparison with countries where currency overvaluation has taken place, such as Brazil. In the latter case, the local currency is being inflated by large capital inflows, due to high domestic interest rates and to a boom in demand and prices of commodities in the international markets. It will be argued that the industrial sector bears most of the burden when the currency appreciates, and that Brazil risks at deindustrialization if there are no changes in the exchange rate regime

The impacts of exchange rate volatility on vegetable trade flows

Trade flows of commodities are generally affected by the principles of comparative advantage in a free trade. However, trade flows might be enhanced or distorted not only by various government interventions, but also by exchange rate fluctuations among others. This study applies a commodity-specific gravity model to selected vegetable trade flows among Organization for Economic Co-operation and Development (OECD) countries to determine the effects of exchange rate uncertainty on the trade flows. Using the data from 1996 to 2002, the results show that, while the exchange rate uncertainty significantly reduces trade in the majority of commodity flows, there is evidence that both short- and long-term volatility have positive effect on trade flows of specific commodities. This study also tests the regional preferential trade agreements such as the North American Free Trade Agreement (NAFTA), the Asia-Pacific Economic Cooperation (APEC) and the EU, and their different effects on commodities.

The Macroeconomic Effects of Fiscal Policy in a Small Open Economy under a Flexible Exchange Rate Regime

This licentiate's thesis analyzes the macroeconomic effects of fiscal policy in a small open economy under a flexible exchange rate regime, assuming that the government spends exclusively on domestically produced goods. The motivation for this research comes from the observation that the literature on the new open economy macroeconomics (NOEM) has focused almost exclusively on two-country global models and the analyses of the effects of fiscal policy on small economies are almost completely ignored. This thesis aims at filling in the gap in the NOEM literature and illustrates how the macroeconomic effects of fiscal policy in a small open economy depend on the specification of preferences. The research method is to present two theoretical model that are extensions to the model contained in the Appendix to Obstfeld and Rogoff (1995). The first model analyzes the macroeconomic effects of fiscal policy, making use of a model that exploits the idea of modelling private and government consumption as substitutes in private utility. The model offers intuitive predictions on how the effects of fiscal policy depend on the marginal rate of substitution between private and government consumption. The findings illustrate that the higher the substitutability between private and government consumption, (i) the bigger is the crowding out effect on private consumption (ii) and the smaller is the positive effect on output. The welfare analysis shows that the less fiscal policy decreases welfare the higher is the marginal rate of substitution between private and government consumption. The second model of this thesis studies how the macroeconomic effects of fiscal policy depend on the elasticity of substitution between traded and nontraded goods. This model reveals that this elasticity a key variable to explain the exchange rate, current account and output response to a permanent rise in government spending. Finally, the model demonstrates that temporary changes in government spending are an effective stabilization tool when used wisely and timely in response to undesired fluctuations in output. Undesired fluctuations in output can be perfectly offset by an opposite change in government spending without causing any side-effects.

Prices and the Real Exchange Rate in Hong Kong: 1985-2006

This paper has been presented at the XIII Encuentros de Economía Aplicada, Sevilla, Spain, 2010.

Going Multinational under Exchange Rate Uncertainty

Published as an article in: Journal of International Money and Finance, 2010, vol. 29, issue 6, pages 1171-1191.

A multivariate generalized ARCH approach to modeling risk premia in forward foreign exchange rate markets

Assuming that daily spot exchange rates follow a martingale process, we derive the implied time series process for the vector of 30-day forward rate forecast errors from using weekly data. The conditional second moment matrix of this vector is modelled as a multivariate generalized ARCH process. The estimated model is used to test the hypothesis that the risk premium is a linear function of the conditional variances and covariances as suggested by the standard asset pricing theory literature. Little supportt is found for this theory; instead lagged changes in the forward rate appear to be correlated with the 'risk premium.'. © 1990.

International order flows: Explaining equity and exchange rate returns

Macroeconomic models of equity and exchange rate returns perform poorly at high frequencies. The proportion of daily returns that these models explain is essentially zero. Instead of relying on macroeconomic determinants, we model equity price and exchange rate behavior based on a concept from microstructure – order flow. The international order flows are derived from belief changes of different investor groups in a two-country setting. We obtain a structural relationship between equity returns, exchange rate returns and their relationship to home and foreign equity market order flow. To test the model we construct daily aggregate order flow data from 800 million equity trades in the U.S. and France from 1999 to 2003. Almost 60% of the daily returns in the S&P100 index are explained jointly by exchange rate returns and aggregate order flows in both markets. As predicted by the model, daily exchange rate returns and order flow into the French market have significant incremental explanatory power for the daily S&P returns. The model implications are also validated for intraday returns.

Solving exchange rate puzzles with neither sticky prices nor trade costs

We present a simple framework in which both the exchange rate disconnect and forward bias puzzles are simultaneously resolved. The flexible-price two-country monetary model is extended to include a consumption externality with habit persistence. Habitpersistence is modeled using Campbell Cochrane preferences with ‘deep’ habits along the lines of the work of Ravn, Schmitt-Grohe and Uribe. By deep habits, we mean habits defined over goods rather than countries. The model is simulated using the artificial economy methodology. It offers a neo-classical explanation of the Meese–Rogoff puzzle and mimics the failure of fundamentals to explain nominal exchange rates in a linear setting. Finally, the model naturally generates the negative slope in the standard forward market regression.