Econbrowser

Thanks Mr Chinn for the link to Mr Engel's paper (and more broadly for you blog). I agree with Mr Engel's conclusions but for very different reasons. It surely is difficult to assess what is an equilibrium exchange rate as I have stated several times before (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1103427 for example for the China US exchange rate), and the task is even harder for developing economies. But I wouldn't oppose the 60's models of exchange rate based on trade balance to the 90's models of Obstfeld-Rogoff et al. Mr Engel seems to underline that equilibrium models have (at least) two problems: data limitations (this issue is well-established in my view and very accurate) and are based on "old fashioned economic modelling", this issue is more debatable for the following reasons:
1. Even in old-fashioned models the exchange rate can be described as an asset price and you can model bubbles as well. See articles in the Dornbusch tradition for example.
2. In my opinion, equilibrium exchange rate models (FEER and BEERs) have flaws that depend:
a) on the lack of modelling of the internal equilibrium (unemployement, output-gap and prices in general) and economic policies
b) the lack of empirical content for "sustainable trade balance" or "desired net foreign asset position, as evinced by Mr Engel

It is true that floating exchange rate have not been able to reach external equilibrium or what I called "macroeconomic efficiency" (see "Through the Looking-Glass: Reconsidering FX Market Efficiency" http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1483493) and analysing micro factors such as currency pricing are a very promising route for addressing this issue

Regarding Mr Engel point 3 (Target for Exchange rate for emerging economies), a way to assess this value could rely on modelling authorities objectives (for example China wants high foreign demand for goods to decrease unemployment)...

"If the nominal exchange rate regime matters for the determination of relative prices such as the real exchange rate or the terms of trade, it must matter because there is some kind of nominal price stickiness."

The myriad factors that prevent Chinese factory workers from coming to the US to get the higher wages they could get here create more a little stickiness.

There is an enormous amount of stickiness out there. A theory that assumes stickiness is insignificant is for most practical purposes worthless.

Since I'm not an economist, and actually have a marginal propensity for playing golf and tennis, I've simply employed Occam's Razor and concluded that there is no such thing as "equilibrium exchange rate". It is a total myth.

It is mythical because of the time lags(ok, call it stickiness) for the economies and bilateral exchange rates to sync up and achieve "equilibrium". Because of the time lags the swings needed in either exchange rates or the economy are too large to handle, by one party or the other, so they resist. Also, the exchange rate policy works unevenly on the economy(ie strong oil-ruble was bad for Russian automakers). The other problem in today's world is that financial flows may even dominate trade flows, making exchange rate policy or meaningful floating rates difficult to implement.

This all makes me think they are targeting the wrong variable. If you want trade balance, target trade balance directly. One idea along these lines that made sense was where Warren Buffett proposed a trade voucher system. Trading partners must earn vouchers by importing things, then they are allowed to export(I guess this is managed at government level). For instance, China would have had to buy Boeing aircraft rather than Airbus in order to sell toaster ovens to Wal-Mart. Of course the interesting question here is what would China claim the exchange rate is under these new rules? And do floating rates in general take care of the price question?

It seems to be an implication of the premises of this paper that one could use relative levels of purchasing power to explain at least long term price fluctuations of the Japanese Yen vs. other currencies. Is there any empirical validity to that idea?

I've come with a question, which is not overtly associated with this exchange rate article.

Please forgive that and consider giving an answer?

I'm wondering of wealth generation within the context of the U.S. Govt. Specifically can it be determined conclusively there is no wealth generated by the U.S. Govt.? My expectation of the answer is to include such variables as infrastructure, subsidies to myriad public and private businesses, and in a way it seems that being the largest employer there is huge demand created by all the income of federal employees?

The argument I've seen and disagree is that the Fed Govt. in no way can be equated to creating wealth. This doesn't seem logical, but if you could give insight...?

It would be interesting to plot on the same time us euro areas business cycles to probe test ME. I notice as well Keynes is given no word on the interest rates differential,inflation, balance of payment.
Markets do as usual give no chance to anyone but their own (please see the OOCC derivatives report)
As an aside statistics would show that many banks on a 10 years pure speculative Forex activities show zero profit (after separation of the profits derived from commercial,customers orders)

The paper doesn't say much about the overriding issue - should China be allowed to continue to accumulate foreign reserves in the face of the dirth of global aggregate demand. It might go some way to justifying the policies of oil exporters to prevent large short-run currency realignments that would come from large oil price changes.
Overall, I don't think there is much substance to the paper.

He's got it right that real exchange rates are what matter, not nominal exchange rates. The real exchange rate is identical to the relative value of (all kinds of) labor in two different currency zones.

Where he's wrong is in stating that managed or fixed exchange rate policies shoudn't effect real exchange rates in "perfect markets". This is thoughtless nonsense: if you have a managed or fixed exchange rate, you obviously don't have a perfect goods market. The mechanisms by which governments manipulate nominal exchange rates inevitably distort goods markets and real exchange rates.

I think Tom must be right. When a government holds its currency artificially low, it sends its own (non-market) price signal. I think this type of policy forces domestic consumers of imported products to subsidize exporters.

Chapter 16 of Peter Montiel's "Macroeconomics in Emerging Markets" serves as a great primer on exchange rate misalignment for those who want a cursory overview on the subject.

You can read excerpts here:
http://books.google.com/books?id=ShobukedfBwC

"If the nominal exchange rate regime matters for the determination of relative prices such as the real exchange rate or the terms of trade, it must matter because there is some kind of nominal price stickiness."

The myriad factors that prevent Chinese factory workers from coming to the US to get the higher wages they could get here create more a little stickiness.

There is an enormous amount of stickiness out there. A theory that assumes stickiness is insignificant is for most practical purposes worthless.

"If the nominal exchange rate regime matters for the determination of relative prices such as the real exchange rate or the terms of trade, it must matter because there is some kind of nominal price stickiness."

The myriad factors that prevent Chinese factory workers from coming to the US to get the higher wages they could get here create more a little stickiness.

There is an enormous amount of stickiness out there. A theory that assumes stickiness is insignificant is for most practical purposes worthless.