Rudiger Dornbusch

Expectations and Exchange Rate Dynamics

The paper develops a theory of exchange rate movements under perfect capital mobility, a slow adjustment of goods markets relative to asset markets, and consistent expectations. The perfect foresight path is derived and it is shown that along that along that path a monetary expansion causes the exchange rate to depreciate. An initial overshooting of exchange rates is shown to derive from differential adjustment speed of markets. The magnitude and persistence of the overshooting is developed in terms of the structural parameters of the model. To the extent that output responds to a monetary expansion in the short run, this acts a a dampening effect on exchange depreciation and may, in fact, lead to an increase in interest rates.

Exchange Rate Economics: Where Do We Stand?

Publisher Summary This chapter discusses the exchange rate economics. There are basically three views of the exchange rate. The first takes the exchange rate as the relative price of monies, and the second as the relative price of goods. An increase in the money supply at home leads to an equiproportionate depreciation. As an increase in domestic real income raises the demand for real balances and thus leads to a fall in domestic prices, it induces an offsetting exchange appreciation. Relatively higher domestic interest rates, by contrast, reduce the demand for real balances, raise prices, and therefore bring about exchange depreciation. There are two ways to test the monetary approach. Instantaneous purchasing power parity (PPP) is an essential part of the monetary approach and directly tests whether PPP prevails. The alternative approach to testing the monetary theory relies on evidence from regression equations. The empirical evidence tests the explanatory power of theory using the dollar-mark exchange rate. The explanatory variables are relative nominal money supplies, relative real income levels, and nominal long-term and short-term interest differentials.

Reform in Eastern Europe

How can the new governments of Eastern Europe succeed in moving from centrally planned to freemarket economies? This incisive report identifies and describes the major policy choices to be made and discusses what will work and what will not.Reform in Eastern Europe provides a comprehensive, easily read statement of reform policy that stands in the mainstream of modern Western economics. Based on their experience with stabilization policies in other countries, the authors show how Eastern Europe can reduce unemployment during the painful adjustment process, create effective and socially acceptable mechanisms to subject enterprises to market discipline, and replace barter trade under CMEA with market-based international trade.

Mexico: Stabilization, Reform, and No Growth

IN THE SECOND HALF of the 1980s, after strenuous efforts, Mexico was coming to be viewed as a showcase of successful stabilization and economic reform, institutional stability, and financial predictability. Mexico was becoming what Chile already had become and what all of Latin America hoped to be. But the Chiapas uprising, the assassination of presidential candidate Luis Donaldo Colosio, the ensuing muddle about his succession, and the sheer fact of an election year have raised doubts about Mexicos ability to achieve lasting stability. By April 1994, the sharp upturn in interest rates, arising from speculative attacks on the peso, suggested that a far too optimistic view may have been taken of Mexicos future. The Mexican economy had come to a virtual standstill. Per capita income is now far below what it was in 1980, as shown in figure 1, and from 1992 to 1993 it fell by 1.2 percent. Moreover, any positive growth that may occur, in 1994, will have been fueled by fiscal expansion not by strength in the real economy. This paper argues that Mexico suffers from a failure to accompany the stabilization of inflation, shown in figure 2, and the impressive array of economic reforms with not only true political reform but also true economic progress. The stabilization strategy has led to an overvaluation of the exchange rate, a precarious financial situation, and a lack of growth. Real interest rates paid by firms continue to be very high, nonperforming loans have been increasing, and the current account deficit stands at more than

Immediate challenges for the European Central Bank

20 billion. Arguably, the lack of growth may reflect the costs of transition, as the massive restructuring causes expansion in some industries and contrac-

The Theory of Flexible Exchange Rate Regimes and Macroeconomic Policy

This paper discusses a number of issues that the newly constituted Board of the ECB will face early on. We show how conducting a European monetary policy is very different from living under the protective umbrella of the Bundesbank. We discuss voting on the ECB Board and argue that the ability to communicate to the public will be a critical factor for the success of the new institution. We also ask how a single monetary policy -- a common change in the interest rate controlled by the ECB -- is transmitted to the economy of the member countries. We show that the monetary process differs significantly inside EMU: initially disinflation episode could thus fall very unequally on a few member countries because they have a combination of financial structure that spreads a monetary contraction widely structure that is relatively inflexible. This process, moreover, is sure to evolve of the financial industry restructuring that is already underway and will be accentuated by the common money. Furthermore, as the Lucas principle suggests, the wage-price process itself will adapt to the changing focus of European monetary policy.

Extreme Inflation: Dynamics and Stabilization

This paper develops three perspectives on the determination of exchange rates and their interaction with macroeconomic equilibrium and aggregate policies. A long- run view characterizes exchange rate determination in terms of monetary and real factors where the real aspects include an explicit consideration of relative price structures. A short-run or “liquidity” view of the exchange rate emphasizes the role of asset market equilibrium and expectations. A policy view, finally, analyses the effectiveness of aggregate policies and points out that in the short-run nominal disturbances will tend to be transmitted internationally. The paper concludes with an analysis of dual exchange rate systems as a stabilizing policy in the presence of speculative disturbances.

Heckscher-Ohlin Trade Theory with a Continuum of Goods

No abstract is available for this paper.

The Black Market for Dollars in Brazil

This paper studies trade theory for the case of a continuum of goods, two factors, two countries, and Cobb-Douglas demand functions. If factor endowments are similar, factor price equalization obtains and geographic patterns of production are indeterminate; nonetheless the effects of changes in factor endowments on prices and welfare in each country are well defined. Factor price equalization does not obtain if factor endowments are far apart, and the geographic pattern of specialization is then determinate. The effects of changes in endowments on the range of goods produced in each country and on prices of goods and factors are analyzed for this case, and the elasticity of substitution in production is shown to play an important role in determining comparative static outcomes.

Economic Interdependence and Flexible Exchange Rates

The model of the black market for dollars focuses on the interaction of portfolio decisions relevant to the holding of asset stocks and the determinants of net flows of dollars associated with tourism and smuggling. A partial-equilibrium model of the black market shows that the level of the premium is determined by the official real exchange rate and the official, depreciation-adjusted interest differential, as well as seasonal factors associated with tourism. Expectations of future exchange rate changes, under rational expectations, are shown to affect the current level of the black market premium. The empirical evidence provides ample support for the role of the key determinants of the premium as well as for an important seasonal pattern. The magnitude of the seasonal variation is evidence of the imperfect substitutability between black dollars and cruzeiro assets in portfolios.