An Equilibrium Theory of Determinate Nominal Exchange Rates, Current Accounts and Asset Flows

Marcus Hagedorn

No 1310, 2017 Meeting Papers from Society for Economic Dynamics

Abstract: In standard open economy macro-models, where monetary policy in each country works through setting nominal interest rates, only the expected change but not the level of the nominal exchange rates is determinate. In contrast to this standard result (Kareken+Wallace (1981), in this paper I show determinacy of the level in a large class of heterogenous agents incomplete markets models with aggregate risk. I then characterize the determinants of the nominal exchange rate: assets held by a country, the net foreign asset position, the nominal interest rate and productivity. I also show whether a change in one of the determinants leads to a depreciation or an appreciation. The incompleteness of markets implies that temporary shocks affect the long-run world distribution of assets and exchange rates with interesting feedback effects on the current exchange rate. The determinacy result also enables the researcher to answer many question in open economy macroeconomics within a coherent equilibrium model. I discuss some of these questions, such as how international asset flows affect exchange rates, how a country can divorce itself from these flows and how a country can manage its exchange rate. The model also implies that a country with an exchange rate peg and free asset mobility faces a tetralemma and not a trilemma as it not only loses monetary but also fiscal policy independence. This suggest a new way to think about fiscal coordination in a monetary union as a response to within union asset flows. I also provide some empirical evidence consistent with the theoretical predictions.

Date: 2017
New Economics Papers: this item is included in nep-dge, nep-mac and nep-opm
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