Essays in International Economics: Exchange Rate Disconnect and the International Price System

Abstract

The dynamics of import and export prices is crucial for the transmission of shocks across countries and the optimal monetary policy in an open economy. This dissertation consists of three essays studying these issues.

In the first chapter, which is coauthored with Oleg Itskhoki, we propose a dynamic general equilibrium model of exchange rate determination, which simultaneously accounts for all major puzzles associated with nominal and real exchange rates (Meese-Rogoff disconnect puzzle, the PPP puzzle, the terms-of-trade puzzle, the Backus-Smith puzzle, and the UIP puzzle). We propose a small but persistent shock to international asset demand as a driving force and prove it is the only type of shock that can generate the exchange rate disconnect properties. We then show that a model with this financial shock alone is quantitatively consistent with the moments describing the dynamic comovement between exchange rates and macro variables.

The currency in which international prices are set is a factor of fundamental importance in international economics: it determines the benefits of floating versus pegged exchange rates and the spillover effects of national monetary policy on other economies. However, the standard assumption in existing models - that all prices are set in a currency of either the producer or the consumer - is inconsistent with the dominant status of the dollar in global trade and the radical transformation of the price system over history. In the second chapter, I develop a general equilibrium multi-country framework with endogenous currency choice that is consistent with these stylized facts.

The last chapter shows that despite small costs for exporters, the aggregate effects of currency choice are large. First, I identify a novel source of positive U.S. monetary spillovers on foreign output that outweighs the standard "currency war" effect. Second, I reexamine the optimal monetary policy in an open economy and show that local authorities "lean against the wind" in response to spillovers of U.S. monetary policy, which results in a partial peg to the dollar. The model prediction is consistent with the "fear of floating" and the widespread use of the dollar as an anchor currency seen in the data.