Peter B. Clark

Exchange Rates and Economic Fundamentals: A Methodological Comparison of Beers and Feers

The analysis of exchange rate behavior has been a perennial topic in international monetary economics. One strand of this literature relates to the explanation of observed movements in nominal and real exchange rates in terms of relevant economic variables. A different strand focuses on assessing exchange rates relative to economic fundamentals and coming to a judgement as to whether a particular exchange rate is misaligned, i.e., over- or undervalued. One approach taken in this latter strand of research that has been developed by Williamson (1994) involves the calculation of what is called the Fundamental Equilibrium Exchange Rate (FEER). In this approach the equilibrium exchange rate is defined as the real effective exchange rate that is consistent with macroeconomic balance, which is generally interpreted as when the economy is operating at full employment and low inflation (internal balance) and a current account that is sustainable, i.e., that reflects underlying and desired net capital flows (external balance). This exchange rate concept is denoted as “fundamental” in that it abstracts from short-term factors and emphasizes instead determinants that are important over the medium term. An assessment of a country’s exchange rate can be made by comparing its current level with the calculated FEER

Robustness of Equilibrium Exchange Rate Calculations to Alternative Assumptions and Methodologies

This paper explores a number of methodological issues that arise in the calculation of equilibrium exchange rates, which are identified in this paper as those real effective exchange rates consistent with macroeconomic equilibrium, i.e., internal and external balance. A partial equilibrium, comparative static analysis is presented and the methodology is applied to the break-up of the Bretton Woods exchange rate system. Then the dynamic interaction between the current account and the stock of net foreign assets is examined. Finally, the analysis uses a more general equilibrium approach by relying on simulations using MULTIMOD, a multicountry econometric model. The paper demonstrates the extent to which the equilibrium exchange rate calculations depend upon alternative assumptions regarding factors that affect internal and external balance. In addition, results obtained using the comparative static and dynamic macroeconomic approaches are compared.

Asymmetry in the U.S. Output-Inflation Nexus

This paper presents empirical evidence supporting the proposition that there is a significant asymmetry in the U.S. output-inflation process. The important policy implication of this asymmetry is that it can be very costly if the economy overheats because this will necessitate a severe tightening in monetary conditions in order to re-establish inflation control. The empirical results presented in the paper show that the conclusions regarding asymmetry are robust to a number of tests for sensitivity to changes in the method used to estimate potential output and in the specification of the Phillips curve.

Exchange rates and economic fundamentals : a framework for analysis

This paper summarizes the methods and types of indicators that are often employed, both insid and outside the IMF, to assess whether exchange rates are broadly in line with economic fundamentals.

Optimal Monetary Policy Rules in a Rational Expectations Model of the Phillips Curve

In this paper we construct a rational expectations model based on a Phillips curve that embodies persistence in inflation. As we assume that the central bank targets the natural rate of output, there is no inflation bias. We derive optimal monetary policy rules that are state-contingent and shock-dependent both in the case where the central bank follows a commitment strategy and where it pursues a discretionary procedure. Numerical solutions show that in the state-contingent part there always exists a trade-off between these two optimal rules, in that the commitment rule involves smaller expected deviations of inflation from its target; in the shock-dependent part there can be situations in which the discretionary rule is more effective in reducing the impact of the random shock on inflation and less effective in reducing the random shock on output. Only in the latter case it is possible that one rule is superior; otherwise it is generally the case that a trade-off exists between these two rules.

Phillips Curves, Phillips Lines and the Unemployment Costs of Overheating

Most empirical work on the U.S. Phillips curve has had a strong tendency to impose global linearity on the data. The basic objective of this paper is to reconsider the issue of nonlinearity and to underscore its importance for policymaking. After briefly reviewing the history of the Phillips curve and the basis for convexity, we derive it explicitly using standard models of wage and price determination. We provide some empirical estimates of Phillips curves and Phillips lines for the United States and use some illustrative simulations to contrast the policy implications of the two models.

An Evaluation of Alternative Monetary Policy Rules in a Model with Capacity Constraints

A small model of the U.S. output-inflation nexus is used to examine the implications of two policy rules, one where the interest rate responds to contemporaneous inflation and one where the response is to predict future inflation. The model is asymmetric in that positive deviations of aggregate demand from potential are more inflationary than negative deviations are disinflationary. With asymmetry, following a myopic rule and allowing the economy to overheat requires deep or protracted recessions to control inflation, whereas following a forward-looking rule not only reduces volatility but also raises the equilibrium level of output.

Capacity Constraints, Inflation and the Transmission Mechanism: Forward-Looking Versus Myopic Policy Rules

This paper develops a small model of the output-inflation process in the United States in order to examine the implications of alternative monetary policy rules. In particular, two types of policy rules are considered; a myopic rule where interest rates respond contemporaneously to output and inflation and a forward-looking policy rule that exploits information about the nature of transmission mechanism in the setting of interest rates. The model has two key features. First, there are significant lags between interest rates and aggregate demand conditions. Second, the model is based on an asymmetric model of inflation where positive deviations of aggregate demand from potential are more inflationary than negative deviations are disinflationary. As a consequence of this asymmetry, a policymaker that follows a myopic policy rule and allows the economy to overheat periodically will be forced to impose large recessions on the economy to keep inflation under control. The paper shows that the estimated degree of asymmetry implies that myopic policies can result in significant permanent losses in output. By contrast, policymakers that follow a forward-looking policy rule that avoids overheating will not only reduce the variance of output but also raise the mean level of output.

International Liquidity and the Role of the SDR in the International Monetary System

This paper describes how the changed conditions in the international monetary system have undermined the role originally envisaged for the SDR. It argues that the concept of a global stock of international liquidity, which was fundamental to the creation of the SDR, is now no longer relevant. Nonetheless, there are good reasons to satisfy part of the growing demand for international reserves with SDR allocations: (i) there are efficiency gains, as SDRs can be created at zero resource cost, and thus obviate the need for countries to run current account surpluses or engage in expensive borrowing to obtain reserves, and (ii) there would be a reduction in systemic risk, as SDRs would substitute to some extent for borrowed reserves, which are a less reliable and predictable source of reserves, especially in times of crisis.

Asymmetry in the U.S. Output-Inflation Nexus: Issues and Evidence

This paper presents empirical evidence supporting the proposition that there is a significant asymmetry in the U.S. output-inflation process, which implies that excess demand conditions are much more inflationary than excess supply conditions are disinflationary. The important policy implication of this asymmetry is that it can be very costly if the economy overheats because this will necessitate a severe tightening in monetary conditions in order to reestablish inflation control. The small model of the U.S. output-inflation process developed in the paper shows that the seeds of large recessions, such as that in 1981-82, are planted by allowing the economy to overheat. This type of asymmetry implies that the measure of excess demand which is appropriate in estimating the Phillips curve cannot have a zero mean; instead, this mean must be negative if inflation is to be stationary. The paper also shows that a failure to account for this important implication of asymmetry can explain why some other researchers may have been misled into falsely accepting the linear model. The empirical results presented in the paper show that the conclusions regarding asymmetry are robust to a number of tests for sensitivity to changes in the method used to estimate potential output and in the specification of the Phillips curve.