Floating Exchange Rates Versus a Monetary Union Under Rational Beliefs: The Role of Endogenous Uncertainty

Carsten Nielsen

No 97-22, Discussion Papers from University of Copenhagen. Department of Economics

Abstract: We study the consequences of substituting rational expectations with rational beliefs (beliefs consistent with observations) in an OLG model of exchange rate formation with stochastic endowments. We consider two types of monetary institutions, one with two currencies, one for each country, the other a monetary union. Under the first institution we in turn consider two policies, according to which the governments makes contingent transfers to its citizens, depending on the stochastic shocks to the two economies. The first policy implies devaluations in reaction to a negative shock while the other will ensure a fixed exchange rate. If agents have rational expectations these policies both lead to the same Pareto optimal allocation. However if they have rational beliefs these policies have very different consequences. The first may not be feasible (depending on beliefs) and even if it is, it will (generically in beliefs) not result in an ex-post optimal allocation. The second policy will on the other hand always be feasible and will result in the same allocation as under rational expectations (which is ex-post optimal). Also under a monetary union will this allocation be obtained. We argue that when evaluating the outcome of different policies the government should take into account that agents are likely to have incorrect albeit rational beliefs. The meaning of "endogenous uncertainty", as uncertainty which may be present under some institutions but not others is illustrated.

Keywords: OLG model; exchange rates; rational beliefs; rational expectations; monetary union (search for similar items in EconPapers)
JEL-codes: D51 D84 F31 F33 (search for similar items in EconPapers)
Pages: 53 pages
Date: 1997-12
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Citations: View citations in EconPapers (6)

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Journal Article: Floating exchange rates versus a monetary union under rational beliefs: the role of endogenous uncertainty (2003)
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