Macroeconomic Uncertainty and Exchange Rate Policy

University dissertation from Uppsala : Acta Universitatis Upsaliensis

Abstract: Essay 1 (with Annika Alexius) uses a structural VAR model to study the role of floating exchange rates for five "small open economies" with inflation targets. We show that only in Sweden and Canada does the nominal exchange rate behave in a stabilizing way. Most exchange rate movements are responses to non-fundamental shocks. However, these exchange rate shocks have negligible effects on output and inflation. Thus, our findings indicate that exchange rates are neither stabilizing nor destabilizing but may be characterized as disconnected from the rest of the economy.Essay 2 uses a dynamic stochastic rational expectations model of a small open economy to shed some light on factors determining exits from a fixed to a flexible exchange rate regime. Exits are in the model determined by a concern for macroeconomic stabilization. If cost-push shocks are important relative to demand shocks exits should occur more likely in times of low consumption and output, high interest rates, negative asset holdings, current account deficits, high inflation and high domestic prices. If the policy maker is more sensitive to negative rather than positive output deviations the probability of exits increases overall and is tilted toward exits with accompanying depreciations.Essay 3 considers foreign exchange market interventions by central banks as an alternative monetary policy instrument. Under quadratic costs of interest rate variation and interventions the policy maker should use a combination of interest rate adjustment and interventions to stabilize output and inflation. Interventions should be negatively correlated with interest rate changes due to stabilization motives but positively with other motives or a binding zero lower bound, decreasing in inflation expectations and in the real exchange rate but increasing with expected interventions. Test of the model on data for Australia, Japan and Sweden supports these predictions in most dimensions.Essay 4 (with David Kjellberg) evaluates available proxies of macroeconomic uncertainty. Using correlations, some narrative evidence and a factor analysis we find that disagreement and volatility proxies seem to be valid measures of uncertainty whereas probability forecast proxies are not. This result is reinforced when we use our proxies in standard macroeconomic applications where uncertainty is supposed to matter. Derived measures of general macroeconomic uncertainty are found to be positively correlated with the absolute value of the GDP-gap.

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