Posted by: Dirk | May 8, 2008

Exchange rate bubbles and macro shocks

Rudi Dornbusch in his 1985 classic Dollars, Debts, and Deficits reminds us why exchange rate bubbles are bad (p. 43):

The analysis has shown the possibility of temporary deviations of the exchange rate from the fundamental rate warranted by “the” model or fundamentals. Why should we be concerned about such deviations? The obvious reason is that given the path of policy variables, an exchange rate bubble will have real effects on competitiveness, inflation, and employment. It represents a macro-shock that, if possible, we would want to offset. The possibility of rational bubbles is important to recognize because it represents a fundamental departure from the view that markets do things right, all the time.

Commentators have compared the financial crisis (that started as a sub-prime mess) with the Asian crisis, which was exactly of the kind described by Rudi Dornbusch. Probably, the dollar was overvalued for a long time, especially against the euro. But if these kind of bubbles always appear with flexible exchange rates, why have policy makers worldwide been so unprepared for the challenge that now arises with the depreciating dollar?

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