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The NATREX is a model of the equilibrium real exchange rate, which is where the real exchange rate is heading. The NATREX model has two components: the long-run equilibrium real exchange rate and the dynamics of adjustment of the medium-run equilibrium to the long-run equilibrium. In the medium-run equilibrium, the ratio of the external debt/GDP is predetermined, and the real exchange rate is associated with both internal and external balance. The real exchange rate and debt ratio are endogenous variables. In full stock-flow equilibrium, the long run equilibrium real exchange rate and external debt ratio depend upon the vector of time varying fundamentals, which are productivity and thrift in the country relative to the rest of the world.

This overview chapter explains the relevance and the contributions of this book to economic theory and policy. The economic theory and mathematics developed in chapters 2 and 3 derive benchmarks for the optimal debt in an environment where both the return on capital and the real rate of interest are stochastic variables. The equilibrium real exchange rate, the subject of chapter 4, is where the real exchange rate is heading. These benchmarks are applied in chapters 5-9 to the euro, the real exchange rate of the transition economies in Eastern Europe, default risks in emerging market countries, the Asian crises, and the United States current account deficits.

On the basis of the NATREX model, several key studies are evaluated to answer the questions: How can the trends in the real exchange rates of the transition economies of Eastern Europe be explained? What are sustainable and equilibrium real exchange rates, current account deficits, and net investment positions in the medium and in the long-run? What are the policy implications for the transition economies planning to join the Euro area? Neither the PPP nor the Balassa-Samuelson hypotheses can explain the data. Both the reduced form and structural equations of the NATREX model are consistent with the data for Hungary and the Czech Republic. The exchange rate behavior for Poland and Bulgaria also are explained by the NATREX model.

This chapter looks at exchange rate management and other policy options for an open economy. It begins with an introductory discussion of overall macroeconomic management for open economies, including the issues of internal and external balance and inflation targeting. It then examines how countries can attempt to manage the exchange rate. Topics covered in this section include the benefits of maintaining an undervalued exchange rate in some developing countries, government interventions to smooth out exchange rate fluctuations, and the trade-off between stability and flexibility when choosing an exchange rate regime. The chapter concludes with an analysis of other policy options in open economies, including heterodox microeconomic interventions, public sector liability management, and debt restructuring.

Based on the NATREX model in chapter 4, this chapter answers the question: How can one explain the medium to longer run movements in the Synthetic-Euro, which is a basket of currencies of the member countries, from 1973-2000? Based upon the answer to this question, the expected value of the Euro/$US exchange rate in the future is analyzed, conditional upon policies followed in the two areas. The NATREX model, whose fundamentals are relative productivity and thrift, is consistent with the evidence. Both the PPP and Balassa-Samuelson hypotheses are rejected.

This chapter extends the analysis of the previous chapter to an open economy by introducing exchange rate policy; analyzing the complex relationships between exchange rate, fiscal, and monetary policies; and examining the ways in which capital flows complicate traditional analyses. Despite the greater complexities associated with open economy macroeconomics, the policy conclusions for a closed economy remain remarkably unaffected. While Keynesians and heterodox economists believe that government should actively intervene, conservatives remain skeptical about the desirability of such interventions. The objective of this chapter is to shed some light on how economists can come to such diverse views on economic policy. The first section examines the macroeconomic effects of exchange rates on employment, trade, inflation, aggregate demand, growth, and balance sheets. The second section examines the complex interactions between fiscal, monetary, and exchange rate policies in open economies with either fixed or flexible exchange rate regimes. This section also examines the effects of interest rates and exchange rates on capital flows in both crisis and non-crisis situations.

The Asian financial crises were unexpected by the market and many countries in the region experienced it at about the same time. Drawing upon the theoretical analyses in chapters 2-4, an operational theory is provided to answer the following questions for the Asian countries: Was a currency crisis produced by an overvalued real exchange rate? Was a debt crisis produced by an “excessive/unsustainable” external debt? What was the interaction between the two? The models imply a set of objective, theoretically-based warning signals and empirical analysis allows the assessment of which countries were or were not highly vulnerable to shocks.

Seeks to understand why some member‐states of the European Community attempted, with eventual success, to extend supranational authority in the domain of monetary and exchange‐rate policy and to anticipate some of the probable consequences of such extension. It begins by analysing the beliefs that originally underpinned the attempt, concerning the perceived need to resolve the community tensions inherent in independent economic policy‐making. It then considers the economic, political and institutional dilemmas, and uncertainties likely to confront member‐states as economic integration proceeds. Concentrating on the issues of low growth and high unemployment, it assesses how far European Monetary Union is likely to provide a remedy, and whether it will be necessary or desirable to create a counterweight to the authority of the European Central Bank, and to create new supranational organizations in the domain of European macroeconomic governance.

For nearly a quarter of a century, the US has persistently run significant current account deficits that transformed it from the world’s largest net creditor to its largest debtor. The stochastic optimal control/dynamic programming approach provides a framework to derive the optimal debt ratio, based upon both objective variables and preferences. The following set of questions are answered: What is a sustainable ratio of external debt/GDP? What are the consequences of an “excessive” debt? By how much does the dollar need to decline in order to achieve a sustainable current account position for the US and rest of world? The deviation of the actual debt ratio from the derived optimum increases the vulnerability of the economy to external shocks.

This chapter discusses the basic analytical framework of “first-generation” models of currency crises and their extensions to deal with important features of balance-of-payments crises such as alternative post-collapse regimes, capital control and borrowing constraints, interest rate defence policies, the interaction between bank solvency and currency stability, uncertainty about government policies, real effects of crises. The key implication of this approach is that a fixed exchange rate regime cannot survive the long-run inconsistency between monetary, fiscal, and exchange rate policies. Unnecessary domestic money growth leads to a persistent loss of reserves and ultimately to a speculative attack against the home currency that forces the government to switch out of the peg once reserves approach a minimum level. It also predicts that the attack will take place at the point where the shadow exchange rate (i.e., the rate that would prevail if the government diverted into a floating rate) equals the fixed peg.

This chapter presents a highly stylized model, based on limited access to credit that can explain why an economy that is carrying a large amount of foreign currency debt might be vulnerable to currency crises, leaving it with a depreciated currency and GDP that remains lower than the pre-crisis trend for some time into the future. It is argued that in a monetary economy with standard price rigidities, credit constraints together with pecuniary externalities working through the nominal exchange rate are sufficient to generate currency crises.

In order to describe the path followed by major macroeconomic variable around the time of crises, this chapter examines some dynamic models. It thus shows how the dynamic adjustment path of the economy associated with exchange rate based stabilization plan can be linked to currency crisis. How expected changes in future government's policies can affect the timing of attacks. How a run on central bank's foreign reserves can emerge in a context of consistent and flexible policy rules. How policymakers can elude speculative attacks by introducing uncertainty into the speculators' decisions. That the domestic currency often stays overvalued for a long period. That large discrete devaluations occur after the peg is abandoned. That the domestic interest rates tend to rise in the run up to the crisis. That speculative runs often occur in a multi-period context giving rise to alternating phases of “tranquillity” and “distress”. That asset price dynamics plays a critical role in triggering a full-blown financial crisis.

This chapter analyses policy responses to the instability of the international monetary system during the 1970s and how these policies affected the City of London. First, the collapse of the international monetary system through the 1960s and then the increased risk to the financial market in the 1970s accelerated the pace of financial innovation. Second, as currency speculation grew, policymakers were reluctant to relax controls on the flow of capital, and this had important implications for London's competitiveness. The debate between the state, academics, and bankers over the desirability of floating exchange rates is surveyed in this chapter. The era of floating exchange rates and inflation prompted an international and domestic banking crisis in 1974 that drew the Bank of England into more active attempts at prudential supervision.