Exchange Rate Determination: A Model of the Decisive Role of Central Bank Cooperation and Conflict
JÃ¼rgen von Hagen
The paper traces the dangers in the closed economy perspective of a Â monetary policy focused on a domestic inflation goal under a clean Â float. Â Field evidence of the damage wrought from this perspective is Â reinforced by that from a laboratory experiment. Â The laboratory Â experiment avoids measurement errors to which econometric estimation Â is subject concerning omitted or inadequately proxied determinants, Â non-normally distributed errors, inadequate degrees of freedom, false Â assumptions of temporal independence and false synchronicity in Â decision response lags to stimuli. Our laboratory experiment also Â embeds a new theory of exchange rate determination involving the Â uncontroversial power of fully cooperating central banks to totally Â fix the exchange rate. The new model is within a broader theory that Â includes risk effects normally excluded, SKAT, the Stages of Â Knowledge Ahead Theory. We use SKAT to analyse outliers in our Â experimental results, and indicate some new directions and foci for Â econometric work. Â Our laboratory results point to the superiority of Â dollarisation, currency unions, a single world money over even dirty Â floats that include the exchange rate as an objective in its own right.
outliers analysis, clean float, dirty float, IMF, exchange rate regime, exchange rate volatility, experiment, SKAT the Stages of Knowledge Ahead Theory, monetary policy, transparent policy, exchange rate shocks, central bank cooperation, central bank conflict; beggar thy neighbor.
Opinion is divided on whether it is better to have a single world Â money or variable exchange rates. Â Pope, Selten and von Hagen (2003) Â propose that fresh light would be shed via an analysis that allows Â for seven complexity impacts on the exchange rate that are Â underplayed (where not entirely absent) from current analyses: 1) the Â role of official sector, including its central bank; 2) the numerous Â official and private sector goals; 3) the disparate degrees of market Â power of different sorts of private agents; 4) the documentation that Â essentially all shocks to the exchange rate are generated by human Â decisions; 5) the non-maximising heuristics that in the complex Â economy agents use; 6) heterogenous beliefs. Â This paper analyses a Â closed form game theoretic solution of version 1 of a model that Â combines impacts 1 to 4 with the conventional finance assumption that Â all agents maximise their utility. Â Impact 1) precludes private Â agents being able to destabilise the exchange rate against the Â cooperation of the central banks required by the game theoretic Â solution. Â Impact 4) excludes random events and other exogenous Â shocks such as meteors falling from the sky. Â The rational maximising Â assumption in turn precludes all other sources of shocks and thus any Â need for a variable exchange rate to equilibrate after shocks. Â We Â then modify version 1 of our model substituting for the maximising Â assumption impacts 5 to 7, impacts that allow shocks from humans to Â be consistently incorporated. Â We do so by means of an experimental Â investigation which indicates that central bankers less than fully Â cooperate, leaving scope for private speculators to support their Â preferred currency. Â From the viewpoint of the game theoretic Â equilibrium, the resultant exchange rate changes render equilibrium Â unspecified. Â A single world money avoids disruptive exchange rate Â changes from less than fully cooperating central banks, exchange rate Â changes caused by central bank conflicts and that cannot be Â classified as equilibrating.
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