Charles M. Engel

Monetary Policy in the Open Economy Revisited: Price Setting and Exchange Rate Flexibility

This paper develops a welfare-based model of monetary policy in an open economy. We focus on the extent to which monetary policy should be employed in maintaining the exchange rate. The traditional approach maintains that exchange rate flexibility is desirable in the presence of real country-specific shocks that require adjustment in relative prices. However, in the light of empirical evidence on nominal price response to exchange-rate changes - specifically, that there appears to be a large degree of local-currency pricing in industrialized countries - the expenditure-switching role played by nominal exchange rates may be exaggerated in the traditional literature. In the presence of local-currency pricing, we find that optimal monetary policy in response to real shocks pricing is fully consistent with fixed exchange rates. On the other hand, when real country-specific shocks are not important, and when a countrys monetary sector is stable, the case for freely floating rates (a monetary policy in which exchange rates are not a consideration) is strengthened in the presence of local-currency pricing.

Accounting for U.S. Real Exchange Rate Changes

This study measures the proportion of U.S. real exchange rate movements that can be accounted for by movements in the relative prices of non-traded goods. The decomposition is done at all possible horizons that the data allow -- from one month up to thirty years. The accounting is performed with five different measures of non-traded goods prices and real exchange rates, for exchange rates of the U.S. relative to a number of other high income countries in each case. The outcome is surprising -- relative prices of non-traded goods appear to account for essentially none of the movement of U.S. real exchange rates at any horizon. Only for one crude measure, which uses the aggregate producer price index as an index of traded goods prices, do non-traded goods prices seem to account for more than a tiny portion of real exchange rate changes. This pattern appears to be true even during fixed nominal exchange rate episodes. Special attention is paid to the U.S. real exchange rate with Japan. The possibility of mismeasurement of traded goods prices is explored.

Can the Markov Switching Model Forecast Exchange Rates

A Markov-switching model is fit for eighteen exchange rates at quarterly and monthly frequencies. This model fits well in-sample at the quarterly frequency for many exchange rates. By the mean-squared-error or mean-absolute-error criterion. the Markov model does not generate superior forecasts at a random walk or at the forward rate. There appears to be some evidence that the forecast of the Markov model are superior at predicting the direction of change of the exchange rate.

Why interest rates react to money announcements: An explanation from the foreign exchange market☆

Abstract When the Fed announces a money supply greater than had been expected, interest rates rise. Why? One explanation is that the market raises its estimate of the future rates of money growth and inflation, and bids up nominal interest rates. We offer contrary evidence: on such days the dollar appreciates, not depreciates. An alternative explanation is that the market perceives the change in the money stock as a transitory fluctuation that the Fed will reverse in the future. The anticipated future tightening raises todays real interest rate, causes a capital inflow, and appreciates the dollar, the result in fact observed.

International trade in durable goods: Understanding volatility, cyclicality, and elasticities

Data for OECD countries document: 1. imports and exports are about three times as volatile as GDP; 2. imports and exports are pro-cyclical, and positively correlated with each other; 3. net exports are counter-cyclical. Standard models fail to replicate the behavior of imports and exports, though they can match net exports relatively well. Inspired by the fact that a large fraction of international trade is in durable goods, we propose a two-country two-sector model in which durable goods are traded across countries. Our model can match the business cycle statistics on the volatility and comovement of the imports and exports relatively well. The model is able to match many dimensions of the data, which suggests that trade in durable goods may be an important element in open-economy macro models.

A trial of prazosin for combat trauma PTSD with nightmares in active-duty soldiers returned from Iraq and Afghanistan

OBJECTIVE The authors conducted a 15-week randomized controlled trial of the alpha-1 adrenoreceptor antagonist prazosin for combat trauma nightmares, sleep quality, global function, and overall symptoms in active-duty soldiers with posttraumatic stress disorder (PTSD) returned from combat deployments to Iraq and Afghanistan. METHOD Sixty-seven soldiers were randomly assigned to treatment with prazosin or placebo for 15 weeks. Drug was titrated based on nightmare response over 6 weeks to a possible maximum dose of 5 mg midmorning and 20 mg at bedtime for men and 2 mg midmorning and 10 mg at bedtime for women. Mean achieved bedtime doses were 15.6 mg of prazosin (SD=6.0) and 18.8 mg of placebo (SD=3.3) for men and 7.0 mg of prazosin (SD=3.5) and 10.0 mg of placebo (SD=0.0) for women. Mean achieved midmorning doses were 4.0 mg of prazosin (SD=1.4) and 4.8 mg of placebo (SD=0.8) for men and 1.7 mg of prazosin (SD=0.5) and 2.0 mg of placebo (SD=0.0) mg for women. Primary outcome measures were the nightmare item of the Clinician-Administered PTSD Scale (CAPS), the Pittsburgh Sleep Quality Index, and the change item of the Clinical Global Impressions Scale anchored to functioning. Secondary outcome measures were the 17-item CAPS, the Hamilton Depression Rating Scale, the Patient Health Questionnaire-9, and the Quality of Life Index. Maintenance psychotropic medications and supportive psychotherapy were held constant. RESULTS Prazosin was effective for trauma nightmares, sleep quality, global function, CAPS score, and the CAPS hyperarousal symptom cluster. Prazosin was well tolerated, and blood pressure changes did not differ between groups. CONCLUSIONS Prazosin is effective for combat-related PTSD with trauma nightmares in active-duty soldiers, and benefits are clinically meaningful. Substantial residual symptoms suggest that studies combining prazosin with effective psychotherapies might demonstrate further benefit.

Violating the Law of One Price: Should We Make a Federal Case Out of it?

We use new disaggregated data on consumer prices to determine why there is variability in prices of similar goods across U.S. cities. We address questions similar to those that have arisen in the international context: is this variability purely a result of market segmentation or do sticky nominal prices play a role? We also examine how the degree of tradability of a good influences price variability. Surprisingly, we find that variability is larger for traded-goods. We attribute this finding to greater price stickiness for non-traded goods. Distance between cities accounts for a significant amount of the variation in prices between pairs of cities. But we also find that nominal price stickiness plays an even more significant role. We thank Dwight Bibbs, Gabriele Galati, Sharon Gibson and Dave Wilcox for assistance with the data, and Asim Husain for outstanding research assistance. The views expressed in this paper are those of the authors and do not necessarily reflect those of the Board of Governors of the Federal Reserve or the Federal Reserve System. Engel acknowledges assistance from a grant by the National Science Foundation to the National Bureau of Economic Research.

Long-run PPP may not hold after all

Recent tests using long data series find evidence in favor of long-run PPP (by rejecting either the null hypothesis of unit roots in real exchange rates or the null of no cointegration between nominal exchange rates and relative prices.) These tests may have reached the wrong conclusion. Monte Carlo experiments using artificial data calibrated to nominal exchange rates and disaggregated data on prices show that tests of long-run PPP have serious size biases. They may fail to detect a sizable and economically significant unit root component. For example, in the baseline case which is calibrated to actual price data, unit roots and cointegration tests with a nominal size of five percent have true sizes that range from .90 to .98 in artificial 100-year long data series, even though the unit root component accounts for 42% of the variance of the real exchange rate in sample. On the other hand, tests of stationarity are shown to have very low power in the same circumstances, so it is quite likely that a researcher would reject a unit root and fail to reject stationarity even when the series embodied a large unit root component.

Expenditure Switching vs. Real Exchange Rate Stabilization: Competing Objectives for Exchange Rate Policy

This paper develops a view of exchange rate policy as a trade-off between the desire to smooth fluctuations in real exchange rates so as to reduce distortions in consumption allocations, and the need to allow flexibility in the nominal exchange rate so as to facilitate terms of trade adjustment. We show that optimal nominal exchange rate volatility will reflect these competing objectives. The key determinants of how much the exchange rate should respond to shocks will depend on the extent and source of price stickiness, the elasticity of substitution between home and foreign goods, and the amount of home bias in production. Quantitatively, we find the optimal exchange rate volatility should be significantly less than would be inferred based solely on terms of trade considerations. Moreover, we find that the relationship between price stickiness and optimal exchange rate volatility may be non-monotonic.

On the foreign exchange risk premium in a general equilibrium model

Abstract The foreign exchange risk premium in a cash-in-advance model is investigated. Some weaknesses of the definition of the risk premium generally used are discussed. It is shown that the primary ultimate source of foreign exchange risk is the covariance of monetary shocks with real output shocks. Several studies have assumed this covariance is zero, and hence assumed away the major source of risk in the model. Finally, the risk premium generated from standard versions of this model is argued to be very small, because it is the same order of magnitudeas covariances of money and output growth rates.