This paper studies exchange rate behavior in models with moving long-run equilibria incorporating alternative price-adjustment mechanisms.The paper demonstrates that price-adjustment rules proposed by Mussa andby Barro and Grossman yield models that are empirically indistinguishable from each other. For speeds of goods-market adjustment that are "too fast," the Barro-Grossman rule appears to induce instability; but we argue that when the ruleis interpreted properly, models incorporating it are dynamically stable regardless of the speed at which disequilibriumis eliminated. The Barro-Grossman pricing scheme is shown to be a natural generalization, to a setting of moving long-run equilibria, of less versatile schemes proposed in earlier literature on exchange rate dynamics.
The central claim in this paper is that by explicitly introducing costs of international trade (narrowly, transport costs but more broadly, tariffs, nontariff barriers and other trade costs), one can go far toward explaining a great number of the main empirical puzzles that international macroeconomists have struggled with over twenty-five years. Our approach elucidates J. McCallum's home bias in trade puzzle, the Feldstein-Horioka saving-investment puzzle, the French-Poterba equity home bias puzzle, and the Backus-Kehoe- Kydland consumption correlations puzzle. That one simple alteration to an otherwise canonical international macroeconomic model can help substantially to explain such a broad arrange of empirical puzzles, including some that previously seemed intractable, suggests a rich area for future research. We also address a variety of international pricing puzzles, including the purchasing power parity puzzle emphasized by Rogoff, and what we term the exchange-rate disconnect puzzle.' The latter category of riddles includes both the Meese-Rogoff exchange rate forecasting puzzle and the Baxter-Stockman neutrality of exchange rate regime puzzle. Here although many elements need to be added to our extremely simple model, we can still show that trade costs play an essential role.
Negative net foreign asset and positions have been associated with a troublesome stability problem in flexible exchange rate regimes. In this paper, a symmetrically-specified, two-country, portfolio balance model is employed to provide some perspective on this problem. It is concluded that negative negative net foreign asset positions do not constitute an independent source of instability. Instability can arise only under nonrational expectations or because of destabilizing speculation.
There are three great challenges facing researchers in modern macroeconomics today, all brought into sharp relief by the recent financial crisis. The first is to find more realistic, and yet tractable, ways to incorporate financial market frictions into our canonical models for analyzing monetary policy. The second is to rethink the role of countercyclical fiscal policy, particularly in the response to a financial crisis where credit markets seize. A third great challenge is to achieve a better cost‐benefit analysis of financial market regulation.