exchange rates and prices - nber.org.docVIP

[research summary] Exchange Rates and Prices Charles M. Engel* * Engel is a Research Associate in the NBER’s International Finance and Macroeconomics Program and a Professor of Economics at the University of Washington. His “Profile” appears later in this issue. In the early 1970s, when the industrialized countries abandoned the fixed exchange rates of the Bretton Woods system, many economists were surprised by the high volatility of exchange rates under the new regime of more flexible rates. Dornbusch provided a new paradigm, based on the Mundell–Fleming model of the 1960s, but granting a prominent role to expectations in the determination of exchange rates.1 His model assumed that nominal goods prices adjusted sluggishly, but that exchange rates resembled asset prices more closely. In that model, expectations generated the short-run “overshooting” of exchange rates in response to monetary and other demand shocks. The Dornbusch model dominated academic discussions of exchange rates for at least a decade, but gradually began to lose favor. There were two reasons for the decline of the overshooting model. First was evidence that the model was not very useful in forecasting exchange rates. Meese and Rogoff showed that forecasts of the exchange rate based on the Dornbusch model could not beat the simplest forecast of no-change-in-the-exchange-rate.2 Still, not all of the empirical evidence on the Dornbusch model was negative. For example, Frankel and I used the Dornbusch model to explain the famous money supply announcements puzzle of the early 1980s.3 The model was successful in explaining the simultaneous jump in short-term interest rates and appreciation of the dollar at the moment the Federal Reserve announced money supply totals that were greater than anticipated by markets. However, many of the movements of exchange rates appeared to be completely unrelated to the economic fundamentals — money supplies and government budgets — stressed by Dornbusch. Even after