Expectations and Exchange Rate Policy

Abstract

Empirical evidence and theoretical discussion have long emphasized the impact of "news" on exchange rates. In most exchange rate models, the exchange rate acts as an asset price and, as such, responds to news about future returns on assets. But the exchange rate also plays a role in determining the relative price of non-durable goods. This paper argues that these two roles may conflict with one another when nominal goods prices are sticky. If news about future asset returns causes movements in current exchange rates, then when nominal prices are slow to adjust, this may prompt changes in current relative goods prices that have no efficiency rationale. In this sense, anticipations of future shocks to fundamentals can cause current exchange rate misalignments. The paper outlines a series of models in which an optimal policy eliminates news shocks on exchange rates.