International Economics Update Jul/Aug 2002 Copyright (C) 2002 The International Economics Network http://www.internationaleconomics.net Marginal Notes. Algorithmic Exchange Rate Behavior As has been noted by many authors (see, for example Rogoff 1998 and Mussa 1996), the persistence of both nominal and real exchange rate volatility in the era of floating exchange rates has been a puzzle that has not been easily explained within the conventional rational expectations framework. Attempts to do so have often resorted to assumptions of exogenous stochastic real shocks (Baxter & Stockman 1989) or of some form of nominal price rigidity (Monacelli 1998). However, another approach to modeling such exchange rate volatility has been shown by Arifovic (1996, 2001), where boundedly rational agents apply a genetic algorithm to make portfolio allocation decisions. The key results of these papers has been largely in accord with empirical regularities: under the genetic algorithm, the nominal exchange rate displays persistent volatility over time. Using a 2-country, overlapping generations model, Arifovic shows that the application of a genetic algorithm to boundedly rational agents in these economies can explain volatile exchange rates, without necessarily resorting to imperfections such as nominal or real rigidities. The results fall out naturally from the fact that since there is perfect currency substitution, there is only a single currency market equilibrium condition from which to define the price levels in both countries. As a consequence of this extra degree of freedom, if there exists any monetary equilibrium in which both currencies are valued at some exchange rate, e, it is possible to find an alternate sequence of prices to support a different exchange rate e' which is not equal to e under the same investment decisions. This is the celebrated result of Karaken and Wallace (1981) concerning the indeterminacy of the exchange rate. This suggests that there is a rich agenda available for researchers seeking to apply genetic methodologies to model economies, in an attempt to explain observed phenomena in international economics. References Arifovich, J. (1996). "The Behavior of Exchange Rate in the Genetic Algorithm and Experimental Economies", Journal of Political Economy 104: 510-41. Arifovich, J. (2001). "Performance of Rational and Boundedly Rational Agents in a Model with Persistent Exchange Rate Volatility", Macroeconomic Dynamics 5(2) . Baxter, M. & A. Stockman (1989). "Business Cycles and the Exchange Rate Regime: Some International Evidence," Journal of Monetary Economics 23 (May): 377-400. Karaken, J. & N. Wallace (1981). "On the Indeterminancy of Equilibrium Exchange Rates", Quarterly Journal of Economics 96: 207-22. Monacelli, T. (1998). "Into the Mussa Puzzle: Monetary Policy Regimes and the Real Exchange Rate in a Small Open Economy". Mimeograph: NYU. Mussa, M. (1996). "Nominal Exchange Rate Regimes and the Behavior of Real Exchange Rate: Evidence and Implications", Carnegie-Rochester Series on Public Policy 25: 117-214. Rogoff, K. (1998). "Perspectives on Exchange Rate Volatility", in M. Feldstein (ed.), International Capital Flows. Chicago: NBER and University of Chicago Press. Website Additions. No major new additions this month, unfortunately, although updates continue to be made on the news and research papers section. Interesting Readings. 1. F&D: The June/August issue of finance and development is now available. Articles include: Point of View by Professor Angus Deaton of Princeton University on reliability of poverty counts, Overview on new approaches to poverty reduction followed by articles covering recent reviews of the IMF/World Bank Poverty Reduction Strategy Paper approach and the IMF's Poverty Reduction and Growth Facility, as well as an article on the preparation of Bolivia's Poverty Reduction Strategy Paper bringing together the views of five participants. Other articles on how financial crises affect income distribution and the poor, the need for automatic safety nets, the streamlining of IMF conditionality in new loans, the impact of external debt on growth, the issue of whether countries should be obligated to repay "odious" debt incurred by their leaders, and the challenges of expanding aid flows to poor countries with small economies. On other subjects, articles on the popular value-added-tax and the lessons from a decade of transition in Eastern Europe and the former Soviet Union. In his regular column, Straight Talk, Kenneth Rogoff, IMF Economic Counsellor and Director of the IMF's Research Department explores the volatility of G-3 exchange rates (http://www.imf.org/external/pubs/ft/fandd/2002/06/index.htm). 2. Poverty Rocks: Bono, the lead singer of the rock band U2, has been the most recent high profile rock star to be involved in the Third World. An assessment, courtesy of the WSJ ('Bononomics Rocks', http://online.wsj.com/article/0,,SB10233236193689840,00.html?mod=opinion) (subscription required). 3. Idiosyncratic Risk: Steve Roach from MSDW clarifies the concept, and why it might writ large in today's global economy ('Global: Idiosyncratic Risk', (http://www.morganstanley.com/GEFdata/digests/20020610-mon.html#anchor0). 4. A Little Bicker: Ken Rogoff, the mild-mannered former Harvard professor and current head of research at the IMF, has written a sharp open letter ('An Open Letter', http://www.imf.org/external/np/vc/2002/070202.htm) to Joe Stiglitz, former chief economist of the World Bank and current Columbia professor. A flavor of Stiglitz's critique can be found in this FEER book review ('InReview: Books - Defying The Fundamentalists', http://www.feer.com/articles/2002/0207_18/p052current.html). 5. Banishing Orwellian Nightmares: Richard A. Muller writes a refreshing article in the MIT Tech Review about the opportunities ('Who's Afraid of 1984?', http://www.technologyreview.com/articles/wo_muller071202.asp). 6. Parity at Long Last: The euro finally breaks parity with the U.S. dollar ('The dollar', http://www.economist.com/agenda/displaystory.cfm?story_id=1223006), and now fluctuates around parity - and it appears to be staying that way for some time to come. This was, arguably, in the brewing ('Investors look beyond U.S.', http://tm0.com/IHT/sbct.cgi?s=131847734&i=558585&m=1&d=2731532). 7. Remembering Rudiger Dornbusch: With great sadness, another excellent economist has passed on. Rudi Dornbusch, possibly best known for his open economy work and the exchange rate overshooting model, passed on late July, 2002. Krugman writes two short memoirs, available on his personal website ('Rudi Dornbusch', http://www.wws.princeton.edu/~pkrugman/rudi.html; 'Remembering Rudi Dornbusch', http://www.wws.princeton.edu/~pkrugman/rudimem.html). Endnotes. This update is sent by request to subscribers. If you wish to join the mailing list, please click on: http://www.internationaleconomics.net/contact.html And enter your email address on the form there. You will receive a verification message confirming your subscription to the International Economics Update mailing list. 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