Exchange Rate and Welfare in Small Open Economies

by Világi, Balázs

Abstract (Summary)
The thesis adapts the models of new open economy macroeconomics to the special problems of a certain group of emerging market economies, namely the economies of European post-communist countries. It studies the effects of asymmetric productivity growth for the CPI-based real exchange rate, the internal real exchange rate, i.e. the relative price of non-tradables to tradables, and the external real exchange rate, i.e. the relative price of domestic and foreign tradables. It is demonstrated that pricing to market is necessary to reproduce the empirically observable correlation of the nominal and real exchange rates, and the appreciation of the real exchange rate. It is also shown that the assumption of firm specific investments and investments adjustment costs helps explaining the slow adjustment of domestic relative prices to productivity differentials and the appreciation of the external real exchange rate. The thesis studies how to set optimally the Euro conversion rate of the new Member States of the European Union. Instead of ad-hoc objective functions it uses a model based social welfare function for the analysis. The thesis provides an algorithm to determine how to peg the nominal exchange rate optimally if the accession date values of state and exogenous variables are known. It is shown that the deviation from the equilibrium real exchange rate has a principal but not exclusive role in determining the optimal conversion rate. It is demonstrated that the past inflation rate and the level of real wages also influence the optimal choice. Furthermore, the foreign-business-cycle, exports demand and productivity shocks are the most important exogenous factors necessary for a proper policy decision. The thesis demonstrates the importance of a utility-based and that evaluations based on ad-hoc welfare criteria may result in misleading results. The thesis also considers the welfare implications of introducing unemployment in models of new open economy macroeconomics. The effects of an unexpected devaluation of the nominal exchange rate in a model with and without unemployment is compared. In models with Walrasian labor markets a devaluation decreases social welfare if the deterioration of the terms of trade offsets the rise in domestic consumption. However, in the presence of unemployment even such a situation can enhance social welfare, since the distribution of consumption becomes more even.
This document abstract is also available in Spanish.
Bibliographical Information:

Advisor:Rodríguez Mendizábal, Hugo

School:Universitat Autónoma de Barcelona

School Location:Spain

Source Type:Master's Thesis

Keywords:412 departament d economia i historia economica


Date of Publication:05/20/2005

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