Date of this Version

September 1991

Document Type

Discussion Paper

Publication Details

Christopher M. Adam (1991) Exchange Rate Volatility, Monetary Policy Adjustment & Price Hysteresis

I am grateful to Doug McTaggart, Jeff Carmichael and Richard Tweedie for informal discussions about the topic. None is responsible for the present text.

School of Business Discussion Paper ; No. 13, Sep. 1991

© Copyright Christopher M. Adam and the School of Business, Bond University

Abstract

Nominal exchange rate volatility has been greater than that of "fundamentals" supposed to establish the exchange rates. A major contribution to our understanding of this volatility was given by Rudiger Dornbusch in his 1976 paper "Expectations and Exchange Rate Dynamics", where stickiness of goods prices forced exchange rates to carryall the shortrun adjustment of the economy in response to unanticipated monetary shocks. The price stickiness was assumed, not explained. Some recent authors, especially Baldwin and Krugman in the US and Bean in the UK, have linked modern industrial organisation theory to exchange rate behaviour to conjecture that the very volatility of exchange rate movements induces firms to have sluggish price adjustments. The concept that prices may respond differently to changes in other variables depending on the size of movement of those other variables as well as on their levels is called hysteresis or path dependence. All immediate implication of price hysteresis is a renewed importance for economic policy to reduce exchange rate volatility if policy authorities expect exchange rate movements to redress severe current account imbalances. The size of exchange rate changes affects prices, which are normally the principal influences on current account adjustment. This paper explores the linkage of exchange rate volatility and price movements within an exchange rate model incorporating monetary policy reactions. The model has already been used by the author to trace how policy reactions can themselves give rise to exchange rate overshooting. With the insights of the industrial organisation literature, we gain a better understanding of how closely monetary policy can affect exchange rate movements. In particular, we show how the parameters of the model providing the channel for monetary policy to cause "overshooting" of the exchange rate depend on perceived uncertainty about exchange rate movements, but in turn can change the level of the conditional variance of the exchange rate.

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