Exchange Rate Policy Rules: A Note
Introduction
Exchange rate policy has been one of the most lively discussed issues in the Finnish debate on economic policy. The discussion of exchange rate policy rules or norms which define the criteria according to which exchange rate policies could be pursued has become one important part of the debate.
The main contributions to this discussion have been given by Korkman, who provides a theoretical analysis of three alternative rules for exchange rate policy: the fixed exchange rate rule, the inflation norm and the competitiveness norm. The fixed exchange rate rule means that an index of prices of foreign exchange is stabilized; the inflation norm means that the domestic currency value of a price index of foreign goods is stabilized and the competitiveness norm means that the real exchange rate is stabilized. (See Korkman (1980) pp. 79–80.) In his study, Korkman discusses the usefulness of these rules in neutralizing various exogenous shocks.
Contributions which are based on the use of an econometric model have been presented e.g. in Halttunen (1981) and Halttunen-Korkman (1983). In these works, the authors examine the merits and drawbacks of the alternative rules (above all the fixed exchange rate norm and the inflation norm) by performing simulation experiments i.e. by calculating dynamic multipliers.
On the other hand, when Korkman conducts his theoretical analysis in Korkman (1980) he proceeds in a way, which has become standard: First, he develops an dynamic macro model which is expressed in levels. Thereafter, he studies some short run comparative statics properties of the model. Having performed these considerations, he investigates the dynamics of the model – stability etc.
We see that the way of conducting the theoretical analysis differs from the way which is used when the empirically oriented studies have been carried out.
We now pose the following question: can we use a way similar to calculating dynamic multipliers with the help of an econometric model when conducting a theoretical analysis by a (non-linear) dynamic macro model? The answer we give in this note is: yes.
The positive answer is given by variational dynamic analysis introduced into economics by Aoki. ( See e.g. Aoki, 1981.) The technique of variational dynamic analysis is based on comparing time paths of the economy which lie near some reference paths or states. Variational dynamics thus describe how models behave near their “control” solution time paths. Consequences of changes of macroeconomic policy instruments as well as changes in exogenous circumstances can be evaluated by this method. A very important merit in the use of variational analysis is that besides short-run and long-run effects of e.g. policy instruments also inter-run effects of these instruments can be studied when variational analysis is used. Therefore, e.g. the time patterns of the effects af policy instruments can be analysed.
In this note, we illustrate how one can apply variational dynamic analysis to examining the merits and drawbacks of the three alternative exchange rate policy rules. Thus this note concerns mainly the method of analysing; it adds very little to the economics of exchange rate policy rules. The main objective of this note is to demonstrate that by using variational analysis one can conduct perhaps a more detailed investigation of the exchange rate policy rules than by using the traditional approach.
We performe all considerations by using a rather simple dynamic nonlinear macroeconomic model, which is presented in chapter 2. In chapter 3 we utilize this model in analysing the consequences of the policies corresponding to the three alternative rules.
- ISSN: 0357-9603
- ISBN: 951-9281-37-1
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