Exchange Rates and Prices (1998)

In the early 1970s, when the industrialized countries abandoned the fixed exchange rates of the Bretton Woods system, many economists were surprised by the high volatility of exchange rates under the new regime of more flexible rates. Dornbusch provided a new paradigm, based on the Mundell-Fleming model of the 1960s, but granting a prominent role to expectations in the determination of exchange rates.(1) His model assumed that nominal goods prices adjusted sluggishly, but that exchange rates resembled asset prices more closely. In that model, expectations generated the short-run of exchange rates in response to monetary and other demand shocks. The Dornbusch model dominated academic discussions of exchange rates for at least a decade, but gradually began to lose favor. There were two reasons for the decline of the overshooting model. First was evidence that the model was not very useful in forecasting exchange rates. Meese and Rogoff showed that forecasts of the exchange rate based on the Dornbusch model could not beat the simplest forecast of no-change-in-the-exchange-rate.(2) Still, not all of the empirical evidence on the Dornbusch model was negative. For example, Frankel and I used the Dornbusch model to explain the famous money supply announcements puzzle of the early 1980s.(3) The model was successful in explaining the simultaneous jump in short-term interest rates and appreciation of the dollar at the moment the Federal Reserve announced money supply totals that were greater than anticipated by markets. However, many of the movements of exchange rates appeared to be completely unrelated to the economic fundamentals - money supplies and government budgets - stressed by Dornbusch. Even after dozens of variants of the model were introduced, nobody was able to tweak the model to produce consistently successful forecasts of exchange rates. The second cause for the decline in popularity of the Dornbusch model was the movement in macroeconomics in the 1980s toward models based explicitly on utility maximization. Dornbusch developed a rational expectations version of the Mundell-Fleming model, which was based on descriptive equations for asset markets and goods markets. Although the new Keynesian theory of the 1980s established a formal basis for slow adjustment of prices by optimizing firms, the new international macroeconomics of the 1980s was based primarily on neoclassical models with flexible prices. One assumption that characterized all of these models was the law of one price: that any traded good would sell for the same price (corrected for currency of denomination) in every country. Law of One Price The data clearly show that there are large fluctuations in real exchange rates (that is, the price of a consumption basket in one country relative to another). Since the neoclassical models did not allow for the failure of the law of one price, there had to be some other mechanism for explaining these movements in real exchange rates. Probably the most popular type of model assumed that there was a group of goods that were not traded, so that the law of one price did not need to hold for these goods. Fluctuations in the prices of nontraded goods relative to traded goods explained the movements in real exchange rates. For example, services generally were nontraded. A country experiencing rapid inflation in services relative to traded manufactured goods would experience a greater increase in its price level than a country without inflation in services prices. Another class of models assumed that countries weighted goods differently in their consumption bundles. For example, wine might receive a high weight in the French consumption bundle and beer a high weight in the U.S. consumption bundle. Even though Frenchmen and Americans pay the same prices for each good, an increase in the price of wine relative to beer would drive the overall French price index up relative to the U. …