Expectations and Exchange Rate Policy

Michael B. Devereux () and Charles Engel ()

No 5743, CEPR Discussion Papers from C.E.P.R. Discussion Papers

Abstract: 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.

Keywords: exchange rate; expectations; monetary policy (search for similar items in EconPapers)
JEL-codes: F3 F31 F33 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-cba, nep-ifn, nep-mac and nep-mon
Date: 2006-07
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Working Paper: Expectations and Exchange Rate Policy (2006)
Working Paper: Expectations and Exchange Rate Policy (2007)
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