The Fiscal Theory of the Exchange Rate: A Quantitative ...Fiscal theory of the exchange rate...
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The Fiscal Theory of the Exchange Rate:A Quantitative Assessment
Alexander Kriwoluzky (U Halle & IWH),Gernot Muller (U Tubingen & CEPR), Martin Wolf (U Bonn)
April 1, 2016
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Fiscal theory of the exchange rate (FTER)
FTER is implied by
I Fiscal theory of the price level (FTPL)
I Regime F: public debt/deficits determine Pt
I Purchasing power parity (PPP)
Pt = EtP∗t
Regime F: public debt/deficits determine the exchange rate.
FTER Model description Mechanism Outlook 1
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Fiscal theory of the exchange rate
Theoretical foundations
I Woodford (1996), Sims (1997, 1999), Dupor (2000),Daniels (2001, 2012), Bergin (2000)
Our contribution and research agenda
I Assess empirical relevance of FTER
Our research question for this project
I What is the contribution of US public debt to the Dollar-Markexchange rate at the end of the Bretton Woods era?
FTER Model description Mechanism Outlook 2
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Quantitative assessment of FTER
Ingredient 1: Regime F in one economy
I We consider the US as large open economy in the 60’s and70’s.
I Bianchi, Illut (2016), Davig, Leeper (2007), Chen, Leeper,Leith (2015), Sims (2010)
inflationary pressure in the U.S. due to fiscal policy
FTER Model description Mechanism Outlook 3
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Quantitative assessment of FTER
Ingredient 2: Dollar-Mark exchange rate
1. Until August 1971
fixed exchange rate regime and Gold standard
2. From December 1971 – March 1973
no Dollar convertibility into Gold, but Germany keeps peggingto the Dollar subject to realignments
3. After March 1973
flexible exchange rate
FX figure
FTER Model description Mechanism Outlook 4
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Model description
Mechanism
Outlook
FTER Model description Mechanism Outlook 5
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Two-country New-Keynesian model
I US influences smaller country, not vice versa
I Germany small open economy
I Standard household and firms problem
I Cost-push shocks in both countries
I Fiscal policy (deficit) shock in the US
I Exchange-rate realignment shock
FTER Model description Mechanism Outlook 6
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Model: policy regimes
Regime-switching DSGE model
I 3 regimes which correspond to the regimes at the end ofBretton Woods
FTER Model description Mechanism Outlook 7
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Regime 1: Gold standard and fixed exchange rate
Regime with Gold standard and fixed Dollar-Mark exchange rates(until 1971)
I U.S. – exogenous money supply
I U.S. – active fiscal policy
I Germany – no independent monetary policy
This regime features explosive dynamics.
I Under the assumption that the regime will change with apositive probability, we obtain a mean square stable solution(Farmer, Waggoner, Zha (2011))
FTER Model description Mechanism Outlook 8
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Regime 2: fixed Dollar-Mark exchange rates
Regime with fixed Dollar-Mark exchange rate, no dollarconvertibility into gold
I U.S. – Taylor-rule with passive monetary policy
I U.S. – active fiscal policy
I Germany – no independent monetary policy
Even with fixed exchange rates, FTER is at work:
Pt = EP∗t
FTER Model description Mechanism Outlook 9
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Effects of a US fiscal deficit shock
5 10 15 20Periods
5
10
15
Percent
US price level
5 10 15 20Periods
-1
-0.5
0
0.5
1
Percent
Exchange rate
5 10 15 20Periods
5
10
15
Percent
German price level
With fixed exchange rates: Pt → P∗t
FTER Model description Mechanism Outlook 10
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Regime 3: floating exchange rates
Floating exchange rates
I U.S. – Taylor-rule with passive monetary policy
I U.S. – active fiscal policy
I Germany – independent and active monetary policy
With floating exchange rates the exchange rate adjusts.
FTER Model description Mechanism Outlook 11
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Effects of a US fiscal deficit shock
5 10 15 20Periods
5
10
15
Percent
US price level
5 10 15 20Periods
0
5
10
15
Percent
Exchange rate
5 10 15 20Periods
0
5
10
15
Percent
German price level
With floating exchange rates: Pt → Et (red line)
FTER Model description Mechanism Outlook 12
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Model description
Mechanism
Outlook
FTER Model description Mechanism Outlook 13
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Effects of a US fiscal deficit shock
5 10 15 20Periods
5
10
15
Percent
US price level
5 10 15 20Periods
-1
-0.5
0
0.5
1
Percent
Exchange rate
5 10 15 20Periods
5
10
15
Percent
German price level
With fixed exchange rates: Pt → P∗t
FTER Model description Mechanism Outlook 14
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FTER and price-level spillovers
Krugman, Obstfeld, and Melitz (International Economics):
I “One interpretation of the Bretton Woods system’s collapse isthat foreign countries were forced to import unwelcome U.S.inflation... ”
I To stabilize their price levels and regain internal balance, theyhad to abandon fixed exchange rate and allow their currenciesto float.”
We capture expectations of regime change to a float while being inBretton Woods.
FTER Model description Mechanism Outlook 15
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Effects of a US fiscal deficit shock
0 10 200
5
10
15
20 US price level
0 10 20-1
-0.5
0
0.5
1 Exchange rate
5 10 15 20Periods
5
10
15
Percent
German price level
Figure: red line regime switching probability of 30%, blue line 0 %
FTER Model description Mechanism Outlook 16
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Anticipation effects of a regime change
I Key are expectations of change to a float and thecorresponding depreciation of the Dollar
I We can measure the expected depreciation using the UIPcondition:
it − i∗t = Et [∆et+1]
FTER Model description Mechanism Outlook 17
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Effects of a US fiscal deficit shock
0 10 200.6
0.7
0.8
0.9
1
1.1
1.2 US interest rates
0 10 20-1.5
-1
-0.5
0
0.5
1
1.5German interest rates
0 10 20Periods
0
0.5
1
1.5
2
2.5
Percent
Interest-rate differential
Figure: red line regime switching probability of 30%, blue line 0 %
FTER Model description Mechanism Outlook 18
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FTER operates under (imperfectly credible) peg
Fixed exchange rate, with possible switch to float (probability λ)
I UIP condition implies interest rate differential
it − i∗t = λEt [∆et+1|Float]
Expected depreciation depends on
I Probability of regime switch to float λ
I Size of the depreciation Et [∆et+1|Float]
Debt/deficit matter for expected exchange rate, even under peg
FTER Model description Mechanism Outlook 19
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Interest-rate differential: Eurocurrency rates in London
0
2
4
6
8
10
12
Mar Sep Mar Sep Mar Sep Mar Sep Mar Sep Mar Sep Mar Sep Mar Sep Jan MarMay Jul
1964 1965 1966 1967 1968 1969 1970 1971 1972
USDinLondon DMinLondon
FTER Model description Mechanism Outlook 20
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Model description
Mechanism
Outlook
FTER Model description Mechanism Outlook 21
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Outlook: Project
Estimate the DSGE model on:
I Interest rates (Germany, USA) – include model friction toallow for capital controls
I Inflation (Germany, USA)
I Exchange rate
I Market value US debt
Perform counterfactuals.
FTER Model description Mechanism Outlook 22
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Outlook: Agenda
Apply framework to further episodes
I EMS
I Argentina
I Mexico
Discriminate between two forces of currency devaluation
I unsustainable fiscal policy
I competitiveness of industry
FTER Model description Mechanism Outlook 23
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Open questions and discussion
I Convincing despite of short-time periods?
I Should we consider different variables and/or shocks?
I Suggestions for further episodes
FTER Model description Mechanism Outlook 24
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Mark - Dollar exchange rate
2
2.5
3
3.5
4
4.5
Back
FTER Model description Mechanism Outlook 25