Exogenous Shocks and Exchange Rate Regimes

Wai-Mun Chia School of Humanities and Social Sciences Nanyang Technological University Singapore 637332 E-mail: [email protected]

and

Tianyin Cheng London School of Economics and Political Science Houghton Street, London WC2A 2AE United Kingdom E-mail: [email protected]

and

Mengling Li School of Physical and Mathematical Sciences Nanyang Technological University Singapore 637332 E-mail: [email protected]

 

1 

ABSTRACT We examine the impact of terms-of-trade and foreign interest rate shocks on key macroeconomic variables by numerically solving a dynamic stochastic general equilibrium (DSGE) model of a small open economy. The model considers nominal price rigidity and imperfect competition under different exchange rate regimes. The numerical solutions obtained are consistent with the empirical regularities documented using data from 62 non-oil exporting developing countries for the period of 1981-2009. We find that (1) output responses to terms-of-trade and foreign interest rate shocks are smoother in floats than in pegs, (2) in moving from pegs to floats, the rise in nominal exchange rate volatility is coupled by the rise in real exchange rate volatility, and (3) in both exchange rate regimes, net foreign assets is the most volatile variable.

Keywords: Dynamic stochastic general equilibrium, exchange rate regimes, external shocks, net foreign assets, economic fluctuation

JEL Classification: F3, F4

 

2 

1.

INTRODUCTION

The merit that is often attributed to flexible exchange rate regimes over fixed exchange rate regimes is their ability to insulate the economy more effectively against real shocks. This hypothesis was first proposed by Friedman (1953). The reason why the exchange rate may matter is the presence of price stickiness. When an economy is hit by real shocks, the economy that can change relative prices more quickly will have smaller and smoother adjustment in output. This is particularly true in an economy with price stickiness where the speed at which relative prices adjust depends crucially on the exchange rate regime. Flexible exchange rate allows relative prices to adjust instantly through changes in the nominal exchange rate. However fixed exchange rate restricts the relative prices to adjust only at the much slower speed that is permitted by price stickiness. Therefore, flexible regimes allow smoother adjustment in output than fixed regimes. The theoretical proposition made by Friedman has subsequently prompted international economists to examine the effects of shocks on economic variables with different exchange rate regimes. Although some focused on theoretical models (Dornbusch, 1980; Poole, 1970), some focused on empirics (Baxter and Stockman, 1989; Bleaney and Fielding, 2002; Broda, 2004; Devereux, 1999; Taylor, 1993). This paper is a synthesis of theoretical and empirical work. We examine the effects of two different types of exogenous shocks, namely terms-of-trade and foreign interest rate shocks, on a set of key macroeconomic variables for a small open economy using a dynamic stochastic general equilibrium model with nominal price rigidity and imperfect competition. The analysis is made by simulating the responses of this key set of macroeconomic variables to the shocks under two different exchange rate regimes. The model is designed based on a two-sector model for a small open economy developed by Obstfeld and Rogoff (1995). Similar but modified models are used by (Chia and Alba, 2006; Lane and Milesi-Ferretti, 2004; Soto, 2003). In this model, households are infinitely-lived and consume a bundle of traded and non-traded goods. The non-traded sector is the locus of monopoly and sticky-price problems, and the traded sector has a single homogenous output  

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that is priced in competitive world market. Households can borrow in the world market to finance their excess demand for traded goods. However, domestic households have to pay a risk premium over the world interest rate, which is assumed to be an increasing function of the stock of debt held by the domestic agents. In this way, one is able to endogenize the effective interest rate and thereby pins down a stationary steady state for the foreign liability. The model-based impulse responses are compared with empirical panel VAR of 62 developing countries from 1981 to 2009. The empirical study follows the framework of Broda (2004). The analysis focuses on the response of real GDP, real exchange rate and consumer price index to terms-of-trade and foreign interest rate shocks. Both the model-based and empirical documentation show that real GDP responses to the shocks are smoother in floats than in pegs. The paper is organized as follows: Section 2 lays out a dynamic stochastic general equilibrium model of a small open economy; Section 3 provides the numerical solutions of the theoretical model; and Section 4 describes the structural model used in the empirical study and reports our empirical findings. Section 5 concludes.

2.

METHODOLOGY

We derive an intertemporal dynamic stochastic general equilibrium model of a small open economy. We make four main assumptions. First, the importable is consumed but not produced, and the exportable is produced but not consumed. Second, investment is held constant and the capital stock is an endowment that is not affected by the terms-of-trade or nominal foreign interest rate shocks. Third, the economy is small in the sense that it cannot influence the terms of trade of the economy. Fourth, the output of the traded goods sector is an endowment of the tradable goods which is sold in the world markets at the export price of

,

. The foreign price level is assumed to be

given and the foreign price denominated in price of the imported goods (to H from F) is normalized to be one. Then,  

by definition is the term of trade and exogenous. 4 

2.1. The Households We consider two asymmetric countries,

(Home) and

represented by a small open economy and country

(Foreign), where country

is

by the rest of the world economy. The world

economy is populated with a continuum of infinitely-lived consumer-producer agents, whose total is normalized to one. The population in the segment 0, country . There are

belongs to country

and the rest belongs to

0,1  imperfect substitute goods, each one being produced by a different

producer in a monopolistic basis. The utility function of an agent in country ∑ 0,1 ,

where

,

0.

,

(1)

is the subjective discount or time-preference factor,

intertemporal elasticity of substitution, and operator.

is:

is the marginal disutility of work.

is the

is the expectation

is the production of -th variety of the non-traded goods. The second term in the

objective function captures the disutility the individual experiences in having to produce more output. Suppose, for example, that the disutility from effort production function is

is given by –

. Inverting the production function yields

and that the

⁄ . Then if

we have the output term that appears in (1). Note that a rise in productivity

2 /

,

is captured in this

model by a fall in . is a composite of the consumption of traded (imported) goods ( (

) and non-traded goods

) and is given by CES aggregators according to Dixit and Stiglitz (1977):

1 where

,

1 is the intratemporal elasticity of substitution between the traded and non-traded goods.

The parameter determining home consumers’ preferences for traded goods, 1 function of the relative size of the foreign economy 1

 

(2)

5 

0,1 , is a

and of the degree of openness of the

small open economy ; 1

1

. The sub-indices

and

are the consumption of

traded and non-traded goods and are defined as:

where

,

(3)

,

(4)

1 is the elasticity of substitution across differentiated products. The consumption-based

price indices corresponding to these specifications are: 1 where

,

is the price sub-index for imported goods and

(5)

is the price sub-index for non-traded

goods, both expressed in the domestic currency: ,

(6)

,

(7)

From consumers’ preference, we can derive the total demand function for a generic good , produced in country : ,

(8)

Finally, to portray our small open economy, we use the definition of ω and take the limit for n

0.

Then, conditions (Eq. 2) and (Eq. 8) can be rewritten as: 1 1

,

(9)

,

(10)

Each domestic agent holds only on type of asset, namely an internationally traded bond. We assume that

 

is the number of real bonds that is denominated in traded goods and 6 

is the return of the

international bond. The agent also produces a single non-traded good, price of

and receives a constant endowment of traded goods,

, sold domestically at a , exported at a price of

.

Hence the flow of budget constraint faced by agent is given by: 1

,

(11)

Maximization of (1) subject to (9) and (11) generates the first-order conditions: ⁄

1

,

⁄

(12)

,

(13)

1

.

(14)

2.2. The domestic firm Domestic firm , operates a constant return to scale technology the only factor of production and /

, where labour is

is the total factor productivity shifter. The real marginal cost

is: ,

(15)

The price of goods produced by domestic firms follow a partial adjustment rule as in Calvo (1983) and Yun (1996). As monopolies in the good market, firms know the form of their demand functions, and maximize profit, taking overall market prices and products as given. In each period

0,1 of

randomly chosen producers is not allowed to reset the nominal price of the goods they produce. The remaining 1

firms choose prices optimally by maximizing the expected discounted value of

profits. Hence firm chooses: max 

∑

Λ

,

,

(16)

subject to the demand schedule: 1

 

7 

,

(17)

where Λ

,

is the time-varying portion of the firm’s discount factor. The necessary first-order

condition of this problem gives: µ µ

E ∑

,

E ∑

,

,

(18) 0), it will choose a

Note that if a firm was able to freely adjust its price each period (i.e. constant mark-up over marginal cost: µ

,

µ

(19)

Given the Calvo-type setup, the price index evolves according to the following law of motion: 1

.

(20)

2.3. International capital market Under the assumption of perfect international capital markets, the problem of steady state definition is typically solved by assuming the relationship between the intertemporal discount factor and the exogenous interest rate charged in the international market

1

(Obstfeld and

Rogoff, 1995a). To relax this constraint, we assume that the interest rate faced by domestic agents depends on net foreign debt of the economy as in Oganes (1998) and Soto (2003): 1 where 1

1

.

(21)

is the risk-free international interest rate and

0 is a parameter that measures the

premium the domestic economy must pay. Basically this expression captures the fact that countries with a high stock of debt pay a premium over the interest rate that prevails in the international capital market. In this particular case there is a stock of minimum debt

above which the country starts

paying the premium. For levels below this threshold the country receives a discount.

 

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2.4. Price and the real exchange rate The nominal exchange rate

is the price of one unit of foreign currency expressed in unit of

domestic currency. The real exchange rate is defined as: P ⁄ .

(22)

As the foreign price denominated in price of the tradable good is normalized to be one, when the law 1

of one price holds for traded goods, we have

⁄ .

1, and

,

2.5. Monetary policy and exchange rate regimes The formulation of monetary policy by the domestic authority follows a generalized rule in which deviations of inflation, non-traded output and the nominal exchange rate from their long-run targets have a feedback effect on short-run movements of the nominal interest rate. As in Clarida et al. (1999), Monacelli (2004), Rotemberg and Woodford (1998), and Taylor (1993), the following equation describes the target for the nominal interest rate: 1

̃

, , 

where it is the target for the nominal interest rate,

(23) and

are weights assigned to the

movements of the nominal exchange rate, inflation and non-tradable output, respectively. From eq. (23), the monetary authority reacts to the contemporaneous level of inflation, non-traded output and the nominal exchange rate. The determination of the actual short-run interest rate that accounts for the desire of the monetary authority to smooth changes in the interest rate is: 1

1

̃

1

.

(24)

2.6. Steady-state equilibrium To solve for the steady-state equilibrium, we assume that all exogenous variables are constant and the relative price of non-traded goods in terms of traded goods is unity at the steady state

 

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(

). The terms of trade is also assumed to be one. The steady state value for the real 1. If

domestic interest rate is derived from Eq. (12) to be . In the symmetric equilibrium

, Eq. (21) gives

, so the equilibrium can be solved: 1

,

(25)

,

(26)

,

(27) ,

(28) 1

.

(29)

2.7. The log-linear approximation The model is solved by taking a log-linear approximation around the steady state. Firstly, firms are assumed to set price according to the Calvo (1983) framework. The firm’s optimal price setting strategy (described by eq. (18), (19) and (20)) implies the following path for the PPI inflation: , where

is the real marginal cost under fully flexible price and

(30) 1

1

/ .

Define the output gap in the non-traded sector as the difference between the stochastic component of current output and the stochastic component of the potential output:

̂ . Note that ̂ is

log-deviation of output under fully flexible prices and is assumed to follow a stationary stochastic process. Then using Eq. (15) and path of PPI inflation, one can derive the small open economy aggregate supply curve: ,

 

10 

(31)

Secondly, the aggregate demand curve is derived from the log-linearization of the household’s stochastic Euler Eq. (9) and the real exchange rate definition described by Eq. (22). It can be written as: ̂ ,

(32)

From the log-linear approximation of Eq. (5), (13) and (22), an expression that relates the output gap in the non-traded sector with the deviation of the real exchange rate traded goods from the steady states is derived as: ̂,

(33)

where we use the fact that the log deviation of consumption of non-traded goods from steady state is equivalent to deviation in output in this sector. Thirdly, the log-deviation of the real interest rate faced by domestic agents corresponds to: ̂ ̂

,

(34)

Using Eq. (11), the linear expression of the stock of foreign assets is: 1

̂

,

(35)

Fourthly, the uncovered interest parity defines a linear expression for the exchange rate expressed as: ̂

̂

̂

̂ ,

(36)

where ̂ and ̂ are the domestic and foreign nominal interest rates. The relation between the home nominal and real interest rate is: ̂

̂

,

(37)

As the foreign price level is held constant at 1, the real and nominal interest rate in foreign country is always equivalent, thus ̂

̂.

Fifthly, from Eqs. (23) and (24), one can obtain:

 

11 

̂ 1

where

̂ 1

,

̂

,

(38)

1

, and

/ 1

. As in Monacelli (2004),

this specification allows us to approximate the behavior of monetary policy under the flexible and the fixed exchange rate regimes as a function of the weight

assigned to the movements of the

nominal exchange rate around the parity: 0       0,1

flexible exchange rate regime;

(39)

managed-fixed exchange rate regime.

(40)

Finally, the stochastic process for the terms of trade, nominal foreign interest rate, and potential output are: exp 1

1

exp exp

where

,

(41) ,

(42)

.

are disturbance terms which are independently identically distributed with , where

,

,

(43) 0 and

  . 3.

RESULTS

We now discuss heterogeneity in dynamics after terms-of-trade and nominal foreign interest rate shocks using the impulse responses implied by a plausible parameterization (reported in Table 1) of the model. We conduct an experiment to investigate whether the model illustrated above can replicate the empirical evidence documented. To characterize a fixed/flexible exchange rate regime, we let approach one/zero. The benchmark calibration described above permits us to choose fixed exchange rate regime and

0.99 for a

0.25 for a more flexible exchange rate regime. We then

investigate the volatility in output, nominal and real exchange rate, and price levels generated by the model.  

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Figure 1 (a) and (b) illustrate the effect of a positive shock to the terms of trade under fixed and flexible regimes, respectively. Suppose there is an increase in export demand that leads to improving terms of trade. This results in a nominal appreciation of the domestic currency. As traded and nontraded goods are assumed to be close substitutes, the appreciation of the domestic currency induces a switch in consumption from the consumption of non-tradable goods to the consumption of tradable goods. This substitution effect causes a decrease in the price of non-tradables. The degree of change in the price of non-tradables during the period of shock depends on two factors. First, with the same degree of nominal price rigidity, under a fixed exchange rate regime, as the nominal exchange rate is not allowed to respond much, the price of non-tradables jumps by more compared with one under flexible exchange rate regime. Second, under both exchange rate regimes, the jump in the price of non-traded goods is larger if the degree of nominal rigidity is low and prices are allowed to adjust more freely. Additionally, from the figures, overshooting in the nominal and real exchange rates is observed as the substitution effect takes place before the income effect. The size of the nominal appreciation during the period of shock is larger under a flexible than a fixed exchange rate regime. Over time, when income effect starts to dominate (as a result of lower purchasing power), the nominal exchange rate depreciates, so does the real exchange rate. The speed of adjustment of the real exchange rate is much faster under a flexible exchange rate regime. Figure 2 (a) and (b) illustrate the effect of a positive shock foreign interest rate shock under fixed and flexible regimes. As a debtor, the home country has to pay more as the interest of lending from foreign country. With a shrunk income, the household has to reduce consumption. The demand curve for non-tradables is shifted to the left; the price of non-tradables drop; the non-tradable production is decreased too. It is reasonable to suppose that the export demand is unchanged. Under fixed exchange rate regime, the price of non-tradables drops more than the price of tradables, which is not significantly affected. This leads to a larger drop in import consumption than in non-tradable consumption. Under flexible exchange rate regime, however, the mixed effect of income and  

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substitution effects is unclear when the domestic currency depreciates. The intuition holds as follow. First, with the same degree of nominal price rigidity, under fixed exchange rate regimes, as the nominal exchange rate is not allowed to respond much, the price of non- tradables jumps by more compared with one under flexible exchange rate regime. Second, under both exchange rate regimes, the jump in the price of non-traded goods is larger if the degree of nominal rigidity is low and prices are allowed to adjust more freely. Additionally, from the figures, overshooting in the nominal and real exchange rates is observed as the substitution effect takes place before the income effect. The size of the nominal appreciation during the period of shock is larger under a flexible than a fixed exchange rate regime. Over time, when income effect starts to dominate (as a result of lower purchasing power), the nominal exchange rate depreciates, so does the real exchange rate. The speed of adjustment of the real exchange rate is much faster under flexible regimes. Figure 3 summarizes the standard deviations of key macroeconomic variables with different degree of rigidities in the nominal exchange rate when the model is driven by the term-of-trade shocks. One can see that when hit by shocks the fluctuation of the real non-tradable output increases as the small open economy changes from flexible rate to fixed rate. By contrast, the fluctuation of nominal exchange rate, real exchange rate, domestic price, and bonds decreases rapidly as the economy changes from flexible rate to fixed rate. These observations are consistent with Broda (2004), Monacelli (2004) and Mussa (1986) and have the following implications. First, countries do have smoother adjustment in terms of quantities (real non-tradable output) with flexible rates than with fixed rates. Second, the volatility of nominal and real exchange rates is strongly correlated. Countries, moving from fixed to floating exchange rate regime, will experience a dramatic rise in the volatility of the real exchange rate. Third, the volatility of the holding of net foreign assets is always the largest in all types of exchange rate regimes, but this fluctuation decreases rapidly when a more flexible exchange rate regime is adopted.

 

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4.

EMPIRICAL VAR

In this section we estimate impulse responses of key macroeconomic variables to a terms-oftrade shock and nominal foreign interest shock and compare them with those of the theoretical model derived in the previous section. Evidence suggests that terms-of-trade series can be treated as exogenous for the sample of developing countries examined. The exogeneity of the terms-of-trade and nominal foreign interest rate helps to identify the response of real GDP, real exchange rate, and consumer prices to these shocks across different exchange rate regimes, eliminating the need for complex identification strategies. The sample used data from 62 developing countries for the period of 1981 to 2009. 4.1. Data Description 4.1.1. Classifying exchange rate regime A primary input to test the above hypothesis is a classification of exchange rate regimes. Generally, the basic reference for classification of exchange rate regimes is the International Monetary Fund’s Annual Report on Exchange Arrangements and Exchange Restrictions (AREAER). However, this classification is a de jure classification that is based on the publicly stated commitment of the authorities in the country where it fails to capture whether the actual policies were consistent with the stated commitment. This paper uses Klein and Shambaugh (2008) which relies on de facto exchange rate behavior rather than de jure declarations to classify various exchange rate regimes. A country is considered as having a fixed exchange rate in a given calendar year, with its currency pegged to the currency of a base country, if its month-end official bilateral exchange rate stays within the same +/- 2% band of the entire year. Otherwise, the country is classified as having flexible exchange rate during the year. Figure 4 shows the evolution of exchange rate regimes for the 62 developing countries during the period of 1981-2009.

 

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4.1.2. Descriptive statistics To estimate the empirical model, we construct a yearly dataset for a group of non-oil exporting developing countries with population larger than one million over the period of 1981-2009. Table 2 reports the results of unit root test for the endogenous variable in VAR. These are terms-of-trade, real GDP, real exchange rate and price level. Since the data on nominal foreign interest rate are invariant from country to country, unit root is not tested. In approximately 65% of the countries, individual Augmented Dickey Fuller tests cannot reject the existence of a unit root in the four series examined. A panel unit root test (Levin et al., 2002) is also performed to improve on the power of the individual tests. The table shows that the panel tests cannot reject the existence of a unit root in the terms-oftrade and real GDP series. 4.1.3. Exogeneity of terms-of-trade and nominal foreign interest rate The assumption of exogeneity of the terms-of-trade and nominal foreign interest rate is the key for our identifying strategy used in the next subsection. For the nominal foreign interest rate, we use the nominal interest rate of the United States as a proxy and is hence reasonable to be treated as exogenous. For the terms-of-trade, the small open economy assumption is theoretically used as a rationale for these countries being price takers in the world markets. In practice, however, despite the 65 developing countries in the sample accounting for less than 27.3% of world trade in 2004, these countries can potentially influence the price of the goods they buy or sell. In this paper, the assumption of the exogeneity of the terms-of-trade is used directly as it has been carefully examined in various literature such as the work of Broda (2004), Kose (2002) and Mendoza (1995).

 

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4.2. Empirical methodology and results 4.2.1. Panel VAR Following Broda(2004), a structural VAR is used to model the empirical behavior of terms of trade ( ), nominal foreign interest rate ( ), real GDP ( ), real exchange rate ( ), and consumer price level ( ). The panel VAR is expressed as: ,  

where

,

 

,

  ,

endogenous variables, , ln 

, ,

  , ,

 

,

is a column vector of stationary is the vector of structural errors,

is the matrix of exogenous variables,

of order q

4, and var

(44)

is matrix polynomial in the lag operator

.

The assumption of the exogeneity of the terms of trade and nominal foreign interest rate implies a

that a (a

a

a a

a

0 and a

a

a

a

0 . Three additional assumptions

0) are required for A to be block diagonal in order to recover the structural

coefficients. The reduced form of Eq. (44) can be obtained and then estimated by changing the ordering of the remaining variables. In this paper, we also made additional assumptions that b

0

if i ≠ j for all q = 1,2,3,4.

To examine the difference in responses to shocks under the two regimes, two more setups are required. First, interacting

and and

should be allowed to differ across regimes. This can be achieved by

with a dummy variable for the exchange rate regime (

the regime is flexible and

, where

0 if

1 if the regime is fixed). Second, the observations during those years

where countries change regimes should be excluded from the sample. A restricted sample of observations with unchanged exchange rate regime in five consecutive years can be obtained by forcing all the observations to satisfy the following condition:  

17 

.

(45)

4.2.2. Empirical impulse responses Figure 5 shows the impulse responses of real GDP, real exchange rate and consumer price index to a positive one standard deviation terms-of-trade shock. As shown in the figure, the effect of a positive terms-of-trade shock on real GDP in countries with fixed exchange rate regimes is significantly positive for the period contemporaneous to the shock and 10 periods after the shock. The real exchange rate is generally unchanged at the first period after the shock. It appreciates gradually in the following periods. It should be noted that this real appreciation is realized through a rise in the price level and not from nominal depreciation from the fixed rate. The effect of a positive terms-of-trade on real GDP in countries with flexible exchange rate regimes is negligible. The real exchange rate depreciates by 2.8% and then appreciates slowly after the shock. Consumer price has smaller response under the fixed exchange rate regimes. Generally, these figures confirm that termsof-trade shocks have larger effects on real GDP in countries with fixed exchange rate regimes. Figure 6 shows the impulse responses of real GDP, real exchange rate and consumer price index to a positive one standard deviation nominal foreign interest shock. Again, these figures confirm that nominal foreign interest rate shocks have stronger effects on real GDP in countries with fixed exchange rate regimes. 5.

CONCLUSIONS

This paper examines the link between exogenous shocks, namely terms-of-trade and nominal foreign interest rate shocks, and some macroeconomic variables by numerically solving a dynamic stochastic general equilibrium model of a small open economy and then empirically estimating the coefficients in a panel VAR model. The numerical solutions are compared and found to be generally consistent with the empirical findings. The following conclusions are made. First, under a more flexible exchange rate regime, the real non-traded output has smaller fluctuations but the price and real exchange rate have larger fluctuations when countries are hit by external shocks. This result is in  

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line with Friedman's prediction that short run output responses to shocks are significantly smoother in floats than in pegs. Second, in moving from fixed to flexible, the proportional rise in volatility of the nominal exchange rate is coupled by a rise in volatility of the real exchange rate. This implies that countries, moving from fixed to floating exchange rate regime, will experience a dramatic rise in the volatility of the real exchange rate. Third, the volatility of the holding of net foreign assets is always the largest in all types of exchange rate regimes but this fluctuation tends to be smaller under a more flexible exchange rate regime. The appealing results obtained from the model suggest other topics for further investigation. The artificial economy and the numerical methods employed here can be used to explore quantitatively the effects of other economic policies implemented in small open economies.

6.

ACKNOWLEDGMENTS

We wish to acknowledge the funding support for this project from Nanyang Technological University under the Undergraduate Research Experience on Campus (URECA) programme.

 

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REFERENCES Baxter, Marianne, and Alan C. Stockman, 1989, Business cycles and the exchange-rate regime : Some international evidence, Journal of Monetary Economics, 23(3), pp 377-400. Bleaney, Michael, and David Fielding, 2002, Exchange rate regimes, inflation and output volatility in developing countries, Journal of Development Economics, 68(1), pp 233-245. Broda, Christian, 2004, Terms of trade and exchange rate regimes in developing countries, Journal of International Economics, 63(1), pp 31-58. Calvo, Guillermo A., 1983, Staggered prices in a utility-maximizing framework, Journal of Monetary Economics, 12(3), pp 383-398. Chia, W. M., and J. D. Alba, 2006, Terms-of-trade shocks and exchange rate regimes in a small open economy, The Economic Record, 82, SPEC. ISS. 1, pp S41-S53. Clarida, Richard, JordiGalí, and Mark Gertler, 1999, The science of monetary policy: a new Keynesian perspective, Journal of Economic Literature, 37(1), pp 661-707. Dixit, Avinash K., and Joseph E. Stiglitz, 1977, Monopolistic competition and optimum product diversity, American Economic Review, 67(3), pp 297-308. Devereux, Michael. B., 1999, A simple dynamic general equilibrium model of the trade-off between fixed and floating exchange rates, memio, University of British Columbia. Dornbusch, Rudi, 1980. Open Economy Macroeconomics, New York: Basic Book Inc. Friedman, Milton, 1953, The case for flexible exchange rates, Essays in Positive Economics. Chicago: University of Chicago Press, pp 157-203. Klein, Michael W., and Jay C. Shambaugh, 2008, The dynamics of exchange rate regimes: Fixes, floats, and flips, Journal of International Economics, 75(1), pp 70-92. Kose, Ayhan M., 2002, Explaining business cycles in small open economies, Journal of International Economics, 56(2), pp 274-299. Lane, Philip R., 1998, Money shocks and the current account, mimeo, Trinity College Dublin. Lane, Philip R., and Gian Maria Milesi-Ferretti, 2004. The transfer problem revisited: net foreign assets and real exchange rates, Review of Economics and Statistics, 86, pp 841-857. Levin, Andrew, Chien-Fu & James Lin, and Chia-Shang Chu, 2002, Unit root tests in panel data: asymptotic and finite-sample properties, Journal of Econometrics, 108(1), pp 1-24. Mendoza, Enrique G., 1995, The terms of trade, the real exchange rate, and economic fluctuations, International Economic Review, 36, pp 101-137.  

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Monacelli, Tommaso, 2004, Into the Mussa puzzle: monetary policy regimes and the real exchange rate in a small open economy, Journal of International Economics, 62(1), pp 191-217. Mussa, Michael, 1986, Nominal exchange rate regimes and the behavior of real exchange rates: evidence and implications, Carnegie-Rochester Conference Series on Public Policy, pp 117-214. Obstfeld, Maurice, and Kenneth Rogoff, 1995a, Exchange rate dynamics redux, Journal of Political Economy, 103(3), pp 624-660. Obstfeld, Maurice, and Kenneth Rogoff, 1995b, The mirage of fixed exchange rates, Journal of Economic Perspectives, 9, Fall, pp 73-96. Obstfeld, Maurice, and Kenneth Rogoff, 1999, New directions for stochastic open economy models, NBER Working Paper, 7313. Oganes, Luis, 1998, Capital inflows and optimal taxation, Mimeo, NYU. Poole, William, 1970. Optimal Choice of Monetary Policy Instruments in a Simple Stochastic Macro Model, The Quarterly Journal of Economics, 84(2), pp 197-216. Rotemberg, Julio J., and Michael D. Woodford, 1998, Interest rate rules in an estimated sticky price model, In: John B. Taylor, Ed., Monetary Policy Rules. Chicago: University of Chicago Press for NBER. Shambaugh, Jay C., 2004, The effects of fixed exchange rates on monetary policy, Quarterly Journal of Economics, 119, February, pp 301-352. Soto, Claudio, 2003, Monetary policy, real exchange rate, and the current account in a small open economy, Working Papers Central Bank of Chile 253. Taylor, John B., 1993, Discretion versus policy rules in practice, Carnegie-Rochester Conference Series on Public Policy, 39, pp 195-214. Yun, Tack, 1996, Nominal price rigidity, money supply endogeneity, and business cycles, Journal of Monetary Economics, 37(2), pp 345-370.

 

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TABLE 1 Calibration parameters Parameter θ σ γ φ β μ κ ψ χ ρTOT

Definition and description Intratemporal elasticity of substitution Intertemporal elasticity of substitution Degree of openness Probability of price non-adjustment Discount factor Elasticity of substitution between non-tradable goods Intertemporal elasticity of labor supply Elasticity of net foreign asset to interest differentials Interest smoothing parameter Autocorrelation of terms of trade

Value 1/4 1/6 0.35 0.75 0.99 1.2 3 0.015 0.5 0.414

Source Arbitrary from Soto [2003] Arbitrary from Soto [2003] Estimated by the author Common in Calvo pricing literature Business cycle literature [Monacelli, 2004] Business cycle literature [Soto, 2003] [Chia & Alba, 2006] [Mendoza, 1995]

σεTOT

Standard deviation of terms of trade (Unit: percent)

11.77

[Mendoza, 1995]

ρ

Autocorrelation of potential output

0.8

Arbitrary

σεz

Standard deviation of potential output (Unit: percent)

0.75

Arbitrary

ρ

Autocorrelation of foreign nominal interest rate

0.5

[Monacelli, 2004]

σεi_f

Standard deviation of foreign nominal interest rate (Unit: percent)

1

[Monacelli, 2004]

ωe

Responsiveness of monetary policy to exchange rate

0.25/0.99

ωπ

Responsiveness of monetary policy to inflation

1.5

[Monacelli, 2004]

ωy

Responsiveness of monetary policy to output

0.1

[Monacelli, 2004]

minimum stock of foreign asset to total output

-0.486

Estimated by the author

z

i_f

 

22 

0,1

TABLE 2 Common and individual unit root tests Series

ln tt t-star

ln y t-star

ln r t-star

ln p t-star

#ADF(j) #ADF(j) #ADF(j) #ADF(j) Reject Reject Reject Reject All 62 countries -1.138 14 1.133 3 -6.453*** 11 -7.646*** 23 Africa -2.664*** 5 0.245 0 -1.500* 3 -4.685*** 6 Asia 0.511 2 1.090 1 -3.921*** 2 -5.044*** 4 Latin America -0.826 6 0.157 1 -5.356*** 5 -1.394* 9 Notes: t-star is Levin, Lin and Chu test statistic for the unit root null hypothesis. t-star is distributed N(0,1). *, ** and *** mean significant at the 10, 5 and 1% level, respectively. Lag lengths are automatically selected based on Schwarz Information Criterion (SIC). #ADF(j) Reject stands for the number of countries for which Augmented Dickey Fuller test for the unit root null hypothesis is rejected at the 10% significant level. Lag lengths are also automatically selected based on Schwarz Information Criterion (SIC). The data on nominal foreign interest rate is invariant from country to country, hence not tested for unit root.

 

23 

(a)

(b)

FIG. 1 Terms-of-trade shock under (a) fixed regimes and (b) flexible regimes

 

24 

(a)

(b)

FIG. 2 Foreign interest rate shock under (a) fixed regimes and (b) flexible regimes

 

25 

FIG. 3 Volatility of macroeconomic variables  

26 

50

40

30

20

Fixed regime

10

Flexible regime 0 1981

1986

1991

1996

2001

2006

FIG. 4 Evolution of exchange rate regimes for 119 countries (1981-2009)

 

27 

.08

.08

.06

.06

.04

.04

.02

.02

.00

.00

-.02

-.02

-.04

-.04 1

2

3

4 5 6 RealGDP

7

8

9

10

.06

.06

.04

.04

.02

.02

.00

.00

-.02

-.02

-.04

-.04

-.06

-.06

-.08

1

2

3

1

2

3

1

2

3

4 5 6 RealGDP

7

8

9

10

4 5 6 7 RealExchange Rate

8

9

10

8

9

10

-.08 1

2

3

4 5 6 7 RealExchange Rate

8

9

10

.3

.3

.2

.2

.1

.1

.0

.0

-.1

-.1

-.2

-.2

-.3

-.3

-.4

-.4

-.5 1

2

3

4

5 CPI

6

7

8

9

-.5

10

       

(a)

4

5 6 CPI

7

 

(b)

FIG. 5 Impulse responses of a positive terms-of-trade shock under (a) fixed regimes and (b) flexible regimes  

 

28 

.02

.02

.01

.01

.00

.00

-.01

-.01

-.02

-.02

-.03

-.03

-.04

-.04 -.05

-.05 1

2

3

4 5 6 Re al GDP

7

8

9

10

.08

.08

.04

.04

.00

.00

-.04

-.04

-.08

1

2

3

1

2

3

1

2

3

4 5 6 Real GDP

7

8

9

10

4 5 6 7 Real Exchange Rate

8

9

10

8

9

10

-.08 1

2

3 4 5 6 7 Real Exchange Ra te

8

9

10

.2

.4 .2

.1 .0 .0

-.2 -.4

-.1 -.6 -.2 1

 

2

3

4

5 CPI

6

7

8

9

10

-.8

         

(a)

4

5 6 CPI

7

 

(b)

FIG. 6 Impulse responses of a positive foreign interest shock under (a) fixed regimes and (b) flexible regimes  

 

29