A General Equilibrium Theory of Exchange Rates and Managed Floating

Abstract

The notion of exchange rate equilibria which are unstable or are strongly expectationally dependent finds little support in the theoretical literature. This is surprising since casual observation suggests incorporating the idea of rapidly fluctuating exchange rates and prices is appropriate for modelling developing country monetary phenomena. Nevertheless, the incorporation of rapid fluctuations in exchange rates is quite difficult except as an unexplained exogenous variation since generally endogenously arising fluctuations give rise to exploitable profit opportunities. In this chapter we present, following Kareken and Wallace (1977, 1981), Helpman and Razin (1979) and Nickelsburg (1980, 1984) a general equilibrium framework for the analysis of exchange rate fluctuations. We begin with an analysis of the indeterminacy of foreign exchange rate equilibria in a stochastic model. The third section of this chapter discusses the resolution of the indeterminacy problem and the fourth section presents welfare results for the “dirty” of managed floating exchange rate regimes.