The proposal has three parts. The first examines real exchange rate behavior in sticky-price DSGE open-economy models. In particular, the research proposes to uncover the general attributes of models in which exchange rates react strongly to news about future fundamentals. In these models, the real exchange rate can be solved as a present value of current and expected future disturbances, real and monetary. In some standard models, however, when policy stabilizes inflation, the weight on future expected fundamentals is low. Models in which the real exchange rate is not the sole determinant of relative inflation rates across countries appear to allow scope for expected future fundamentals to influence exchange rates in a way that is consistent with empirical findings. The second part of the research will analyze optimal monetary policy when the exchange rate is forward looking. In particular, it will ask whether standard inflation-targeting prescriptions are optimal, or nearly so, in an environment in which real exchange rates react strongly to news. The third part of the proposal is to examine tariffs and trade policy under sticky nominal prices. It will address the positive effects of tariffs under different assumptions of how nominal prices are set. The proposed research will address the sense in which exchange-rate policy is analogous to protectionist trade policies. It will also examine optimal tariff policy under sticky prices. The three major areas of proposed work all involve applied general equilibrium modeling of open economies and are motivated by empirical work. Any work such as this will ultimately have broader impact in terms of promoting better understanding of the workings of the macroeconomy, and hence better policy making. The second and third parts of the proposal are directly related to policy questions, examining monetary policy and trade policy in economies with sticky nominal prices.
This research project aims at a deeper understanding of foreign exchange rates. Part of the project developed insights into the economic factors that help determine the movements in foreign exchange rates, such as the dollar per euro rate. The second part of the project developed the insights from recent macroeconomic models to assess the importance of misalignments of foreign exchange rates for monetary policy. The economics profession has had a great deal of difficulty understanding movements in exchange rates. There has been very little success in developing a model or statistical method to forecast exchange rate movements. I have developed one statistical tool that shows some promise for forecasting exchange rates. The idea is to look at a large collection of dollar exchange rates (the dollar price of euros, British pounds, Japanese yen, Swiss francs, Canadian dollars, etc.) and draw out a common movement in those exchange rates. Individual exchange rates will differ from this factor or trend that is common to all the exchange rates. We then can forecast the individual exchange rates using a forecast that projects the individual exchange rate will converge toward the common factor. While the common factor may not be forecastable, we have some success with this method in forecasting movements in individual currency prices. Another part of the research investigates the relationship between interest rates and exchange rates. It has been observed in a large number of empirical studies that when, for example, short-term U.S. interest rates (such as the interest rate on 30-day T-bills) rise, the dollar will subsequently appreciate over the next month. A foreign investor would find U.S. short term investments quite attractive because of both the increase in the interest rate and the gain in the value of the currency. A great deal of theoretical research in economics and finance has been devoted toward understanding why the returns on a U.S. asset would rise in such a way -- why the currency would appreciate, thus magnifying the returns. But my new empirical research finds that these currency gains are quite short-lived. A foreign investor that bought short-term U.S. Treasury bills but then continued to roll over those bills for as little as seven or eight months would, on average, find that the dollar actually loses value, and it loses value so much that it offsets the gains to the investor from a higher interest rate. This new empirical finding poses a challenge for our existing economic models, and may open the door to further research that deepens our understanding of exchange-rate movements. The next part of my research investigates the importance of exchange rates for monetary policy. Recent advances in macroeconomic research have helped economists to understand the costs of inflation, and also the economic factors that determine the tradeoff between reducing inflation and unemployment. Much of that research has been conducted using models of the economy that assume the economy is closed to the outside world. However, economies are becoming more globalized. The exchange rate is a direct measure of money's value (for example,the euro value of a dollar), so should monetary policymakers be concerned with the exchange rate? One answer is that even if ultimately policymakers are ultimately concerned about inflation and unemployment, the exchange rate matters because it influences those economic variables. A weaker dollar, for example, makes imported goods more expensive, so directly increases inflation. On the other hand, a weaker dollar makes U.S. goods cheaper for foreigners. That may lead to an increase in demand for U.S. goods, and reduce U.S. unemployment. In a sense, these channels of influence for the exchange rate were already fairly well known. What my research shows is that the exchange rate matters beyond its effects on unemployment and inflation. The reason is very straightforward, but perhaps the idea has not seeped through into policymaking circles because it previously had not been demonstrated in the type of formal economic model that guides policy analysis. To see the point, suppose somehow that inflation in the U.S. and Europe were exactly at the target that policymakers were aiming for, and there was full employment in both regions. Is there still a reason to be concerned about possible misalignment of the exchange rate? The answer is yes, because misalignment will change the relative wealth of Americans to Europeans. A "strong" dollar (an inexpensive euro in dollar terms) will reduce the dollar value of European investments for Americans, and reduce the dollar value of profits that American firms earn on European sales. This shift in wealth from Americans to Europeans reduces Americans' purchasing power and enhances Europeans'. Even if output is at full-employment levels, with a misaligned currency the benefits of that output are distorted. In this case, the European consumer has benefited at the expense of the American consumer.
