Academic journal article Economic Quarterly - Federal Reserve Bank of Richmond

Exchange Rates and Business Cycles across Countries

Academic journal article Economic Quarterly - Federal Reserve Bank of Richmond

Exchange Rates and Business Cycles across Countries

Article excerpt

(ProQuest-CSA LLC: ... denotes formulae omitted.)

Modern theories of exchange rate determination typically imply a close relationship between exchange rates and other macroeconomic variables such as output, consumption, and trade flows. The intuition behind this relationship is that, in most models, optimization of consumption between domestic and foreign goods implies conditions that equate the real exchange rate between two countries to marginal rates of substitution in consumption.1 Effectively, these conditions bind exchange rates to other contemporaneous macroeconomic aggregates, implying a close relationship between these variables.2

The relationship between exchange rates and macroeconomic variables implied by models of exchange rate determination is weakly supported by the data. For instance, Baxter and Stockman (1989) document that the exchange rate regime has little systematic effect on the business cycle properties of macroeconomic aggregates other than nominal and real exchange rates. Given that the magnitude of exchange rate volatility is substantially higher under a flexible exchange rate regime than under a fixed regime, this evidence suggests that the relationship between exchange rates and other macroeconomic variables is weak. Flood and Rose (1995) extend these findings and conclude that the exchange rate "appears to have a life of its own." 3 In their assessment of the major puzzles in international economics, Obstfeld and Rogoff (2000) term the weak relationship between nominal exchange rates and other macroeconomic aggregates found in the data as the "exchange rate disconnect puzzle." 4 In fact, the evidence on the relationship of exchange rates and macroeconomic aggregates is puzzling, not only from the point of view of modern theories, but also from a more intuitive point of view. For many economies, the nominal exchange rate is an important relative price, which affects a wide array of economic transactions. Hence, it is surprising that exchange rates are weakly correlated with real variables when they play an important role in determining relative prices in goods markets.

In this article, we present empirical evidence on the business cycle relationship between exchange rates and macroeconomic aggregates for a set of 36 countries. Our goal is to provide direct evidence on the relationship between exchange rates and other macroeconomic variables that potentially can be used to evaluate the implications of exchange rate models.5 Openeconomy models typically restrict the world economy to two large countries or to a small open economy which interacts with the rest of the world. In reality, however, countries interact with many other countries. As a result, it is not straightforward comparing the implications of models with data. We choose to study the relationship between a country's nominal and real effective exchange rates and its domestic macroeconomic variables. The effective exchange rates of a country are averages of the country's bilateral exchange rates against its trading partners.6 We use effective exchange rates rather than bilateral rates because, in our view, they provide a better indicator of their role in the economy. Hence, the evidence presented in this article can provide discipline to the implications of open-economy models that capture realistic interactions among countries.

We construct a data set with quarterly data on real macroeconomic aggregates and nominal and real effective exchange rates for 36 countries. We investigate the business cycle properties of effective exchange rates and macroeconomic aggregates for each country in our set. We find that in some developed economies, such as the United States, nominal effective exchange rates exhibit no correlation with macroeconomic aggregates such as output and consumption. However, we find that this behavior is not pervasive across our set of economies. In fact, we find that movements in the nominal effective exchange rate are correlated with movements in other macroeconomic variables in many economies, both developed and developing. …

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