The proposed work consists of four separate projects, though they are interrelated. The first project investigates the nature of optimal monetary policy in open economies, with a particular focus on the role of exchange-rate misalignment. Over the past two decades, theoretical macroeconomics has developed a better understanding of the costs of inflation and unemployment (or the "output gap" -the gap between actual output and the full-employment level of output) in Keynesian models based on optimizing microeconomic behavior of households and firms. This work has helped policymakers understand the factors that influence the tradeoffs involved in targeting inflation and the output gap. A recent paper, Engel (American Economic Review, 2011), used a simple Keynesian framework to show how currency misalignments can influence policy choices. In that paper, a currency is misaligned when the movements in nominal exchange rates lead consumer prices in one country relative to another to be out of line with the relative costs of producing and selling goods in those countries. That extension of the Keynesian model shows that reducing these currency misalignments can be an important target for monetary policy when economies are very integrated globally. A shortcoming of that analysis was that it examined policymaking from the cooperative standpoint - that is, assuming monetary policymakers cooperate globally to achieve the highest possible well-being of households in all countries. This project looks at the same question, but when policymakers do not cooperate. Under cooperation, any currency misalignment is detrimental to world welfare because it means that prices do not efficiently reflect costs. However, from a non-cooperative standpoint, these currency misalignments might improve one country's welfare. The exchange rate can influence the employment level and inflation, but the question is how the exchange rate might affect optimal policy goals beyond their effects on output and inflation. For example, when producers set prices in the importing consumer's currency, its revenue expressed in its own currency will be higher for any given level of foreign sales the weaker the domestic currency. Might the non-cooperative policymakers prefer some level of under- or over-valuation? Ultimately is there a significant cost to global welfare when policy is set non-cooperatively? The second project studies the behavior of real exchange rates (the relative consumer price levels in each country, when using the exchange rate to express prices in a common currency) in countries with fixed and floating nominal exchange rates. The study will use consumer price level data for 31 European countries to look at the determinants of real exchange rate adjustment for the countries with in the eurozone compared to adjustment in those countries that do not use the euro and have floating exchange rates. A common belief -not well supported by modern macroeconomic theory, but widely held in policymaking circles- is that floating exchange rates allow faster adjustment of relative price levels between any two given countries than if they have fixed exchange rates or share a common currency. In fact, when nominal exchange rates float but goods prices adjust slowly, the real exchange rate might not adjust efficiently because the nominal exchange rate is influenced by many financial market factors than can lead consumer prices to rise or fall for extended periods of time in one country relative to another. That is, drift in the euro/pound nominal exchange rate may cause real appreciation or depreciation that is unrelated to the supply and demand factors for goods that ought to determine this relative price. The behavior of actual prices and exchange rates are compared to predictions of efficient real exchange rate adjustment. The third project proposes a model of exchange rates and returns on short-term deposits or bonds. A country that can borrow in its own currency may debase its currency through depreciation in order to reduce the real value of its international debt. Such monetary policy behavior amounts to a partial default, because the lender is repaid with currency that has become devalued. In the model, the borrower is punished by international lenders for this behavior by being charged a penalty rate of interest on future loans. The aim here is to model the widely held view in the markets that some currencies, such as the U.S. dollar, are "safe havens". In times of economic uncertainty, the dollar tends to appreciate. From the standpoint of a risk averse investor, it might make sense to park assets in the U.S. during times of global turbulence, but standard models say that should drive up the dollar value of those assets (stocks, bonds, property) but not necessarily increase the value of the dollar. The idea here is that during times of turbulence, monetary policymakers in some countries may be more prone to devalue their currencies, while investors believe the Federal Reserve is less likely to do that. The model perhaps can also explain some puzzles regarding the behavior of exchange rates and interest rates in the short run and long run. The fourth project proposes a new model of exchange rates based on the marginal liquidity value of short-term assets. This is meant to explain the appreciation in the dollar in late 2008 and early 2009, but may also shed light on the determinants of returns during normal times as well. During the crisis, banks and other financial institutions found that they needed to hold greater volumes of short-term dollar denominated assets. Banks need to hold liquid assets to bridge mismatches between depositor demands and the maturity structure of loans, as well as a safety net against default risk on the loan portfolio. Normally the overnight loan market provides an important source of liquidity, but that market dried up during the crisis as lenders began to doubt the value of collateral that banks had to offer. So, a general demand for liquid dollar assets drove up the value of the dollar, even though the crisis originated in the U.S. The plan is to derive empirical measures of the determinants of this liquidity demand, and then test the effects of those determinants on currency values both during the crisis and during normal times.
