Exchange Rate Economics: Theories and Evidence

286 The new open economy macroeconomics part 2
that this correlation can be made consistent with the data when there is incomplete
pass-through of exchange rate changes.
A further attempt to explain the excess volatility of exchange rates using a variant
of the NOEM is made by Devereux and Engel (2001). They attempt to shed
light on a conjecture of Krugman (1989) that exchange rate volatility is so great
because fluctuations in the exchange rate matter so little for the economy. They
use a variant of the NOEM in which there is a combination of local currency
pricing,heterogeneity in international price setting and in the distribution of goods
(e.g. some firms market their products directly in the foreign market and charge
a foreign price while some exporters use foreign distributors,charging a price
set in the exporter’s currency) and,crucially,the existence of noise traders who
impart expectational biases into international financial markets. They derive an
expression for the unanticipated change in the exchange rate of the following form:
ŝ t = (1 + σ/r)( ˆm t −ˆm t ∗ ) + (σ/r)v t
[σ/r + ρ(θ − (1 − θ ∗ ,(11.30)
))]
where θ is the fraction of home firms that sell directly to households in the foreign
country at a foreign price (with 1−θ selling their product to home-based distributors
at a home price), θ ∗ is the fraction of foreign firms that sell directly to households
in the home country at a home currency price (with 1 − θ ∗ selling their product
to home-based distributors at a foreign currency price), v is the biasedness in
foreign exchange dealers’ prediction of the exchange rate due to the existence of
noise traders, ρ is the elasticity of inter-temporal substitution, σ is a function of the
elasticity of inter-temporal substitution,the intra-temporal elasticity of substitution
and a leisure–work parameter. How volatile the exchange rate is with respect to
the fundamentals can be gauged by calculating the conditional variance of the
exchange rate:
Var t−1 (ŝ t ) = (1 + σ/r)Var t−1( ˆm t −ˆm ∗ t )
2 [ 1 − [λσ /(r)] 2] , = [ σ/r + ρ(θ − (1 − θ ∗ )) ] ,
(11.31)
where,of terms not previously defined,λ >0 and Var t−1 (v t ) = λVar t−1 (s t );
that is,the volatility of the bias in noise traders’ expectations is determined by
exchange rate volatility. Given this expression,(11.31) says that the conditional
volatility in the exchange rate depends only on fundamentals which in this case
are the volatility in relative money supply terms. Given (11.31) it turns out that as
θ + θ ∗ → 1 and with λ = 1,the conditional volatility of the exchange rate rises
without bound. This is because in this model the combination of local currency
pricing,along with asymmetric distribution of goods and noise trading implies a
degree of exchange rate volatility which is far in excess of the underlying shocks.
The basic intuition for this result is that the presence of local currency pricing
and domestic distributors tends to remove both the substitution and wealth effects
of exchange rate movements at any point in time. In the absence of noise traders