Exchange Rate Dynamics: A New Open Economy Macroeconomics Perspective

Exchange Rate Dynamics: A New Open Economy Macroeconomics Perspective

Exchange Rate Dynamics: A New Open Economy Macroeconomics Perspective

Exchange Rate Dynamics: A New Open Economy Macroeconomics Perspective

Synopsis

This book builds upon the seminal work by Obsfeld and Rogoff, Foundations of International Macroeconomics and provides a coherent and modern framework for thinking about exchange rate dynamics.

Excerpt

Following Obstfeld and Rogoff's (1995) seminal paper, the last decade has seen an outpouring of research aimed at laying new foundations for open-macroeconomic theory. This "New Open Economy Macroeconomics" (NOEM) addresses the core international issues within microfounded general equilibrium models. the intertemporal nature of this approach allows the dynamic effects to be tracked while the presentation of explicit utility and profit maximization problems lays the groundwork for credible policy evaluation.

The salient feature of Obstfeld and Rogoff's (1995) influential paper lies in the attempt to bridge the gap between two strands of the international macroeconomic theory: the agent optimizing framework developed by the "intertemporal approach to the current account" (Frenkel and Razin, 1987) and the Mundell (1963)- Fleming (1962)-Dornbusch (1976) sticky-price setting. Nesting nominal rigidities and imperfect competition within microfounded dynamic general equilibrium models echoes the emergence of the "neo-classical synthesis" (Goodfriend and King, 1997) or the "neo-monetarism" (Kimball, 1995a) in closed-economy macroeconomics. Moreover, the noem partakes of the International Real Business Cycle literature (Backus et al., 1994, 1995).

This theoretical framework has spurred a profusion of developments that allow us to revisit the major issues in international macroeconomics. Obstfeld and Rogoff (2000b) recall that the theory is challenged by six empirical puzzles. How can we rationalize the bias for home goods in households' preferences (the home bias in trade puzzle)? Can the high correlation between investment and saving be reconciled with capital mobility (Feldstein and Horioka, 1980)? Why do households not fully take advantage of the international portfolio diversification (the home bias portfolio puzzle and the low consumption correlations puzzle)? Why do deviations from purchasing power parity (PPP), captured by real exchange rate fluctuations, exhibit a very persistent behavior (the ppp puzzle)? Finally, the extreme exchange rate volatility has no corresponding counterpart in macroeconomic fundamentals (the exchange rate disconnect puzzle). the latter empirical observation leads Flood and Rose (1995) to assert that

There is remarkably little evidence that macroeconomic variables have consistent strong effects on floating rates […]. Such negative findings have led the profession to a certain degree of pessimism vis-à-vis the exchange rate research.

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