Prospects for Exchange Rate Stabilization

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This project is part of an effort to rigorously model and empirically study the performance of the global economy. The project examines three subjects: (1) the likely behavior of exchange rates under a system of reference rates and target zones; (2) the long-term effects of large exchange rate movements on trade flows; and (3) the possible existence of sustained secular trends in equilibrium real exchange rates. Some aspects of movements in exchange rates during the eighties puzzle policy makers and challenge the large body of theory on international finance and trade. Why were there wild fluctations in the value of the dollar during this period? More generally, why were exchange rates so volatile under a regime of floating exchange rates? Why have trade flows been so slow to respond to exchange rate movements? Specifically, why has the sharp decline in the dollar from 1985 to the present not had more of an impact on U.S. trade flows? Finally, why do the terms of trade of the U.S. towards Japan keep deteriorating year after year? This project takes international economics in new directions that could answer these questions and suggest new policy tools for dealing with U.S. problems in international trade and finance. Exchange rate volatility is explained by modelling the way changes in the beliefs of market participants can increase the volatility of international financial markets. The project develops and extends theoretically a framework in which the belief by market participants that authorities may intervene to prevent the exchange rate from drifting outside a target zone exerts a strong stabilizing influence on exchange rates within the band. This framework is the basis for an examination of the experience with the European Monetary System (EMS), the nearest thing to a target zone system. Preliminary work suggests that the EMS has been unexpectedly successful at stabilizing European exchange rates. An "hysterisis" model, a model in which short-run shocks cause long-run effects, is used to explain why the U.S. economy did not rebound as rapidly as predicted when the dollar started to decline in 1985. The U.S. economy is not as competitive as expected now because of quasi-permanent damage suffered when the dollar was overvalued in the early eighties. Finally, supply side differences in the industrial structures among countries could explain apparent strong secular trends in the terms-of- trade.