International Monetary Regimes and Incidence and Transmission of Macroeconomic Shocks: Evidence from the Bretton Woods and Modern Floating Periods.

• Author: Dibooglu, Selahattin

Selahattin Dibooglu [*]

This paper investigates the relationship between international monetary regimes and incidence and transmission of macroeconomic shocks within the context of an open-economy macro model. Empirical results confirm monetary interdependence and lower incidence of monetary discretion under fixed exchange rates. The average magnitude and dispersion of supply shocks in Bretton Woods and the subsequent float is comparable; however, the average magnitude and dispersion of real demand shocks under Bretton Woods seems higher. Overall, the international monetary regime may pose important constraints to policymakers in open economies.

1. Introduction

   Economists have long recognized the role of a flexible exchange rate regime in insulating economies and allowing independent pursuit of monetary policy. However, experience with floating rates in the post-Bretton Woods period led many to question the merits of flexible rates with increased volatility in nominal and real exchange rates and the implied effects of this volatility on international trade flows.

   Although fixed rates reduce uncertainty and transaction costs compared with flexible rates, these benefits may be outweighed by increased output volatility due to sticky prices and increased international interdependence. If countries face idiosyncratic shocks, independent monetary policy is needed to stabilize the domestic economy. Theoretical work on the effects of international monetary regimes has been inconclusive. Helpman (1981), Dornbusch (1983), Turnovsky (1983), and others provide evidence that exchange rate arrangements cannot be ranked unambiguously in terms of their impact on macroeconomic stability or domestic welfare. Instead, several studies have analyzed macroeconomic performance under different historical exchange rate arrangements. Using macroeconomic data from the Bretton Woods and the subsequent floating regime, Baxter and Stockman (1988) found no clear relationship between exchange rate flexibility and output stability or synchronization of the business cycle. Using bivariate vector auto regressions (VARs), Bayoumi and Eichengreen (1994) analyzed the standard deviations of supply and demand shocks under alternative monetary regimes and found little difference in the incidence of supply and demand shocks under the Bretton Woods and the subsequent float.

   It is known that the effects of the international monetary regime depend on some structural characteristics (e.g., openness, capital mobility, and the existence of rigidities), as well as the types and sources of shocks impinging on the domestic economy. Because fixed rate systems set limits to discretionary policy, one may expect a lower incidence of domestic demand shocks under fixed rate systems. Similarly, a fixed rate system can be viewed as a commitment mechanism that prevents the policymaker from pursuing expansionary policies. Thus, an interesting question is to disentangle the effects of policy shocks, which may be attributable to the monetary regime, from those of the macroeconomic environment and examine whether the switch to flexible rates was prompted by an unusual incidence of certain types of shocks.

   The objective of this paper is to reexamine the relationship between international monetary regimes and the incidence and coherence of macroeconomic shocks using a disaggregated framework. To that end, I present a simple macroeconomic model and try to identify a set of shocks using a combination of short-run and long-run restrictions. Using quarterly data from the G7 countries pertaining to Bretton Woods and Modern Floating periods, I distinguish between supply shocks, money supply shocks, real demand shocks, money demand shocks, and capital flows shocks. Examining the incidence and coherence of the shocks can shed some light on the effects of the exchange rate regime and conduct of macroeconomic policy under alternative exchange rate systems. It is also possible to examine the role of country-specific shocks in the collapse of the Bretton Woods system. Section 2 presents the theoretical framework and methodology. The model is illustrative in that it has a simple formulation while providing a reference for i dentifying a set of orthogonal shocks. Section 3 presents empirical results, and section 4 concludes.

2. Theoretical Framework and Methodology

   My starting point in identifying a set of orthogonal impulses is the familiar Aggregate Supply (AS)-Aggregate Demand (AD) framework, which is widely used in explaining macro-economic fluctuations. Consider an AS-AD model with a Lucas-type supply function, and a wedge between consumer and producer prices:

   [[y.sup.d].sub.t] = [[alpha].sub.0] - [[alpha].sub.1][[i.sub.t] - ([E.sub.t-1][[P.sup.c].sub.t+1] - [E.sub.t-1][[P.sup.c].sub.t])] + [[alpha].sub.2]([[P.sup.*].sub.t] + [s.sub.t] - [P.sub.t]) + [[epsilon].sub.ist] (1)

   [[y.sup.s].sub.t] = [[beta].sub.1]([P.sub.t] - [E.sub.t-1][P.sub.t]) - [[beta].sub.2]([[P.sup.*].sub.t] + [S.sub.t] - [P.sub.t]) + [P.sup.t] (2)

   [[P.sup.c].sub.t] = [gamma][P.sub.t] + (1 - [gamma])([[P.sup.*].sub.t] + [S.sub.t]), 0 [less than] [gamma] [less than] 1 (3)

   [m.sub.t] - [[P.sup.c].sub.t] = [ky.sub.t] - [lambda][i.sub.t] + [[epsilon].sub.mdt] (4)

   [E.sub.t-1][S.sub.t+1] - [S.sub.t] = [i.sub.t] - [[i.sup.*].sub.t] + [[epsilon].sub.cft], (5)

   where y is real output, i is the nominal interest rate, s is the exchange rate expressed as the domestic currency price of foreign currency, p is the domestic price level, [p.sup.c] is consumer prices, m is the money stock, [rho] is the exogenously given capacity output, asterisks denote foreign counterparts of domestic variables, [[epsilon].sub.i], are orthogonal stochastic disturbances, and all variables except interest rates are in logarithms. It is further assumed that [E.sub.t-1], the conditional expectation, is calculated using the model and all relevant information as of the end of period t-1.

   Equation 1 is an aggregate demand equation where aggregate demand for domestic goods and services depends on the expected domestic real interest rate and the real exchange rate (s + [p.sup.*] - p) defined as the relative price of foreign goods. Equation 2 is the aggregate supply schedule, which can be justified using a wage-price sector framework. An interesting feature of this specification of aggregate supply behavior is that changes in the real exchange rate may have nontrivial output effects. Exogenous improvements in the terms of trade affect the profitability of investment because import costs change relative to output costs, which may induce a supply-side response. Second, if labor supply is a function of the real wage defined relative to consumer prices (Eqn. 3), an exogenous decrease in the real exchange rate will reduce the wage pressure in the labor market. If domestic firms do not reduce their markup on costs to compensate for the wage pressure, equilibrium employment may be expected to increase. More importantly, the real exchange rate influences the import costs of raw materials and intermediate inputs, which implies that permanent changes in the real exchange rate may have significant supply-side effects. One may also expect increases in the real exchange rate to increase the domestic production of import substitutes.

   Equation 3 is the consumer price index, which is a geometric weighted average of domestic and foreign prices. Equation 4 is a conventional money demand equation with a disturbance term, which can capture a stochastic shift in, say, velocity. Equation 5 is the uncovered interest parity condition with a stochastic disturbance term and can be rewritten as

   [E.sub.t-1][q.sub.t+1] - [q.sub.t] = [r.sub.t] - [[r.sup.*].sub.t] + [[epsilon].sub.cft], (5a)

   where q is the real exchange rate and r is the ex ante real interest rate.

   It is assumed that [[p.sup.*].sub.t], [[i.sup.*].sub.t], [[rho].sub.t], and [m.sub.t] are exogenous processes. However, under a fixed exchange rate system, each country must accommodate fluctuations in money demand to keep the nominal interest rate compatible with foreign interest rates. In this case, the money stock is demand-determined (i.e., endogenous) and the nominal exchange rate, [s.sub.t], is exogenous. Moreover, it is assumed that the domestic country is small so that foreign variables are exogenously given. To facilitate the exposition, assume that [[p.sup.*].sub.t] = [[i.sup.*].sub.t] = 0. It is trivial to generalize the case to two large countries by assuming the behavioral parameters are equal across countries. In this case, domestic country variables can be reinterpreted as the difference between domestic and foreign variables.

   Consider the steady-state equilibrium under flexible exchange rates which can be derived by setting all disturbances in Equations 1-5 to zero and assuming expectations are realized. Denoting the steady-state values by bars, the solution for the endogenous variables are

   y = [[alpha].sub.2][rho] + [[beta].sub.2][[alpha].sub.0]/[[alpha].sub.2] + [[beta].sub.2] (6a)

   q = [rho] - [[alpha].sub.0]/[[alpha].sub.2] + [[beta].sub.2] (6b)

   s = m - k[rho] + ([gamma] + k[[beta].sub.2])([rho] - [[alpha].sub.0])/[[alpha].sub.2] + [[beta].sub.2] (6c)

   p = m - k[rho] + ([gamma] - 1 + k[[beta].sub.2])([rho] - [[alpha].sub.0])/[[alpha].sub.2] + [[beta].sub.2] (6d)

   As stressed by Turnovsky (1983), these equilibrium values relate to the means of the long-run distributions of the random variables [y.sub.1], [q.sub.1], [s.sub.1], [p.sub.t], not conditional on any knowledge of disturbances.

   Notice that the familiar neutrality properties are evident in Equations 6a-6d. Output and the real exchange rate are determined by the exogenous capacity output and are independent of the money supply process. Moreover, in the steady state, an increase in the money supply increases the price level and the nominal exchange rate by the same proportion.

   Following conventional practices, I derive the short-run behavior of...