Exchange Rate Economics: Theories and Evidence

The new open economy macroeconomics part 2 285
premium is too small to match the data and,as a result,the exchange rate changes
they produce are also too small. Duarte and Stockman suggest that further modifications
to the model,such as modelling the equity-premium and the introduction
of irrational speculation,may help to generate sufficient exchange rate variability.
Monacelli (2004) takes a stochastic small open economy version of the NOEM
model,in which there is an explicit role for capital accumulation (where capital is
assumed to be a function of Tobin’s q) and pricing to market,in order to examine
the issue of intra-regime volatility. The main novelty of this work is to introduce into
this class of model an open economy variant of a Taylor style interest rate monetary
rule which allows an analysis of the short-run dynamic effects of a change in the
nominal exchange rate regime. Specifically,the equation for the target for the
nominal interest rate is:
( ) ωπ PH ,t
(1 + ī t ) =
Y ω y
t S ω s/(1−ω s )
t . (11.27)
P H ,t−1
From this expression the monetary authority reacts to the contemporaneous level
of the nominal exchange rate (a forward-looking jump variable) and to contemporaneous
inflation and output. The use of this rule allows Monacelli to consider
fixed and floating exchange rate regimes in the context of the NOEM. If ω s = 0
this implies a flexible rate regime whereas if ω s ∈[0,1] this allows for a range of
managed to fixed exchange rates. It is then assumed that the monetary authority
smooth interest rates using the following rule:
(1 + i t ) = (1 + ī t ) 1−χ (1 + i t−1 ) χ ,(11.28)
and by taking a log-linear approximation of these two equations it is possible to
obtain:
i t =¯ω π π H ,t +¯ω y y t +¯ω s s t + χi t−1 ,(11.29)
where ¯ω π ≡ (1 − χ)ω π , ¯ω y = (1 − χ)ω y , ¯ω s = (1 − χ)(ω s /1 − ω s ), i t ≈
log(1 + i t /1 + i).
The model is then calibrated and solved numerically for the instances of complete
and incomplete pass-through. In the complete pass-through case,Monacelli (2004)
shows that in moving from fixed to flexible exchange rates there is a proportional
rise in the volatility of the nominal exchange rate which is coupled with a rise in
the real exchange rate which roughly mimics what we observe in the data. He
shows that the interest rate smoothing objective is crucial in generating this result.
Furthermore,the close correlation between real and nominal exchange rates in
a flexible rate regime is mimicked in this model and these results are robust with
respect to the sources of the underlying shocks. However,this version of the model
produces a correlation between nominal depreciation and inflation which is too
high relative to the actual correlation in the data. Nonetheless,it is demonstrated