DP5743 Expectations and Exchange Rate Policy

Author(s): Michael B Devereux , Charles M Engel

Publication Date: July 2006

Keyword(s): exchange rate , expectations , monetary policy

JEL(s): F3 , F31 , F33

Programme Areas: International Macroeconomics

Link to this Page: www.cepr.org/pubs/dps/DP5743.asp.asp

Both empirical evidence and theoretical discussion have long emphasized the impact of `news' on exchange rates. In most exchange rate models, the exchange rate acts as an asset price, and as such responds to news about future returns on assets. But the exchange rate also plays a role in determining the relative price of non-durable goods when nominal goods prices are sticky. In this paper we argue that these two roles may conflict with one another. If news about future asset returns causes movements in current exchange rates, then when nominal prices are slow to adjust, this may cause changes in current relative goods prices that have no efficiency rationale. In this sense, anticipations of future shocks to fundamentals can cause current exchange rate misalignments. Friedman's (1953) case for unfettered flexible exchange rates is overturned when exchange rates are asset prices. We outline a series of models in which an optimal policy eliminates the effects of news on exchange rates.