Download - A Laboratory Experiment about the Effects of Exchange Rate Uncertainty in a Two-Country Model
A Laboratory Experiment about the Effects of Exchange
Rate Uncertainty in a Two-Country Model
Robin Pope,* Reinhard Selten,** Jürgen von Hagen,* Sebastian
Kube***
* ZEIb Center European Integration Studies Bonn University•http://www.zei.de/ [email protected]
* * Experimental Economics Laboratory Bonn University
* * * Dept Economics, Karlsruhe University
Exchange Rate Risks: ???
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Government & Central Bank: ? Are we managing the economy better1. with a clean float, or 2. With dirty float, or 3. without exchange rate
uncertainty?Is EURO a mistake for Italy,
worsenign employment, competitiveness, inflation, interest rates?
Or is EURO great for Italy, removing exchange rate risks achieves all these goals especially competitiveness better?
GoalNew insights about the effects on firms, on unions and on government and central bank management of the macroeconomy when two countries eliminate some exchange rate uncertainties by adopting a single currency like the EURO
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Conflicting design aims1) Plausibility as an analogue to real
problems2) Playability 3) Analysability — our experimental set-up
may lack a standard game theoretic solution: Reinhard Selten's new incomplete equilibrium concept, more plausible for players to implement than the normal one, is our game theoretic benchmark
ModelTwo countries "home" and "foreign"SymmetricalFocus on the home country
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Players in each land2 currencies1 government1 central bank1 union1 employer's association5 firms9 total per country, 18 players in the two
countries
One Session: 18 players who have not participatedbefore, so 1 independent observation. In one session same participants play 20 rounds: rounds are not
independent observations
Currency uniononly 1 central bank, 2 governments — 17 players
Focus on the two currency case
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Commodity Flows
home materials
competitive
home labourhome labour
home
consumption
good
Cournot
home
consumption
foreign
consumption
foreign
consumption
good
Cournot
home labour
foreign labour
foreign materials
competitive
Commodity Flows
DecisionsGovernment Central Bankexpenditure interest factor
exchange rate aim
next period's target price
Wage Bargaining
After 10 minute chat
nominal wage rate union proposal
employer proposal
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Firmsproduction quantity amount of home currency borrowedamount of foreign currency borrowed
Participants in ExperimentsBonn University economics students who had completed at least two years
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Decisions continued
Markets
Wages from union and employer representative bargaining or a strike with government set wages
Materials competitive, price equals interest plus wage cost
Consumption Cournot market, price equals expenditure (set by government) divided by the total quantity (the sum of each firm's individual quantity decision)
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Currency exchange rate balances demand and supply of home and foreign currencies by firms and central banks, but constrained to the interval between the exchange rate aims of the 2 central banksPope, Selten, von Hagen, Kube Experiments10
Markets continued
Goals - Payoffs(converted into EUROS)
Joint Government & Central Bank:
Penalties for deviations of
1 target price from prior target price2 target price from actual price3 actual interest rate from ideal interest
rate4 home materials cost from foreign
materials cost5 actual exchange rate from exchange rate
target• employment from the ideal range, with
underemployment more severely punishedPope, Selten, von Hagen, Kube Experiments11
Wage Bargainers:union representative gets target pricedeflated wage; employer representative gets expendituredeflated average firm profits Strike: both zero
Firm i: gets expenditure deflated own profits
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Goals - Payoffs continued (converted into EUROS)
Currency Influences
Firms:1. speculate on their currency
appreciating2. hedge against their currency
depreciating before they pay for their imports bought on credit
3. interest differences
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Currency InfluencesOfficial Sector: 1 influences firms via interest rate,
nominal demand, price and exchange rate targets
2 intervenes on foreign exchange marketdirectly to try to attain its target exchange rate
3 co-operates with other central bank if firms would otherwise push exchange rate outside the target of either central bank
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Exchange Rate Fundamentals Unknown: extra sample predictions no
better than a random walk. Why?1 Need to estimate from yearly not monthly data
for trade / investment – but not so many years since Bretton Woods
2 Illusions of “clean” floats, homogenous capital – but connections of exchange rates and public sector goals make all floats dirty, capital is country specific
3 Shocks, unpredictability of:• fiscal / monetary policy and when central banks do
/ do not agree to co-operate• decisions of the private sector (eg firms, unions)
Our experiment: largely free of problems 1-3
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Time structure of a period
Step 1: Government total expenditure
Step 2: Central bank — interest rate, exchange rate aim, next period's target price
Step 3: Wage bargainingStep 4: Firm decisions on production
quantities and currency offers, wage payments
Step 5: Currency market
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Step 6: Interest payments — interest paid or received in step 5 account balances
Step 7: Sales— revenues flow to home accounts
Step 8: Payment of materialsStep 9: Account balance outflow —
positive or negative firm account balances taken over by owners
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Time structure of a periodcontinued
Shocks in Mundell 1961
Exchange rate changes countervail shocks
Mundell sees his 1961 model as
misapplied
Mundell’s 1961 Model excludes:•capital flows•the risk of future exchange rate changes
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All shocks arise from behaviour! No need to try to model firm and official sector reaction functions or substitute random generated shocks for them
Demand Shocks Level: changes in foreign expenditure Switches
a. exchange rate: actions of firms and foreign central bank
b. foreign interest rate: foreign central bank
Supply shockswage: union and the firms’ representatives bargaininginterest rate: foreign central bank
output: firms
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Shocks in Our Model
Game Theoretic Benchmark GTB
Initial values at start are equilibrium. None change if all played equilibrium in all 20 sequel rounds: zero exchange rate risk, all earn 5 EURO/round
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6 experiments with, 6 without currency union1. In all 6 without a currency union, the exchange rate shifted contrary to GTB.
First Results
First Results continued2 Exchange rates shift but between 1/10 and
1/100 post Bretton Woods exchange rate variability: closer to the modest variations of the gold standard, Bretton Woods and EMS eras for members. Hunches on why
a) too few countries to make central bank co-operation hard, or
b) Too much in-built co-operationc) Too explicit an exchange rate targetd) equal concern when cheap as when too
dear misses the beggar thy neighbour reality of national pressures on central bankers
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First Results continued
• 3 Nominalism: Central banks and governments diverge from IGT equilibrium toward a 1:1 target and actual exchange rate (6/6 sessions, significant at 10% level), identical target an actual consumer prices (5/6 sessions) and identical expenditures (4/6 sessions)
• Pope, Selten, von Hagen, Kube Experiments 22
4 Currency union helps central bank and government goal achievement significant at 10% level for central bank
5 The more variable the actual exchange rate, theworse central banks achieve their goals significant at 5% level
• Gradualism in all 4 instruments, not sharp shocks (variability), helps central bank and government goal achievement significant at 1% level for expenditure (government), at 10% level for exchange rate goal & target prices, (for central banks)
• Lower prices and wages under currency union:contrary to fears of union indiscipline
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First Results continued
Conclusion
Euro has advantages:Without exchange rate shocks, and with fewer decisions to make, the governments and central bank grapple better with demand and supply shocks
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Better macro management:Without those 3 branchings of the exchange up, down or steady, governments and the central bank are down to a level of complexity they can better handle!
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Conclusion continued
We need to analyse more and more experiments to understand more of the EURO’s effects
Why Expected Utility Theory helps us miss exchange rate uncertainty
costs • It, like all standard rank dependent theories is atemporal, imposes a preference for first order stochastically dominating distributions of outputs – ie ignores changing stages of knowledge ahead, ie ignores uncertainties from:
• 1 before choosing, Janis Manne 1977, and then
• 2 before learning which outcome of the chosen act has occurred, Keynesian uncertainty, Keynes 1921
• Instead its choosers parachute from a problem to having decided what to do, and then parachute
again to the certainty of the outcome of our chosen act. There are no costs of uncertainty, only a focus on the utility expectation functional, with each possible utility evaluated “as if certain”Friedman and Savage 1948. Thereby these theories ignore findings of Omodei et al 2006 and others on information overload and planning costs on the part of firms, the official sector and we scientific analysts / advisers of the firms and official sector.
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Uncertainties from: 1 before choosing, and then2 before learning which outcome of the chosen act has occurredFailure to discover robust (out of sample) exchange rate fundamentals despite 35 post Bretton Woods years establishes uncertainty 1. Our experimental results in a setting with some of the real world complexities, suggest uncertainties 1 and 2 are costly, that our theorizing should include uncertainty as a separate influence. To include uncertainty consistently, we need a stages of knowledge ahead framework, Pope 1983, 2005.
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• 1
The Jump Through of the Period of Risk, Uncertainty Entailed under the Dominance
Principle
t=0 choic
e
possible outcomes
Evaluation at t=0
P1: 0≤t<KThe pre-
outcome period of risk
This risky period does not exist so
no planning problems on what other government, other central bank will do, whatg unions and employers
negotiate on wages, on what firms produce
Risky act 10 or 20 in P2
P2: t≥KThe post-outcome period of certainty
10
20
xj
Knowledge-ahead-
independent sources of utility
X high
X low
U(x) utilities
U10 (10)
First Results in Wage Bargaining
8 Nash bargaining overpredicts Wages if firms are anticipated to play Cournot: in fact firms on average produced lower quantities than wages struck imply (attempts at collusion?) so firm profits were even higher than our IGT benchmark:
union representatives, government and central banks got barely half of firms and their representative
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Hunches on why wages are so lowa)No workers in the experiment, orb)Cahuc et al (2004) that only get
up to Nash if firms competewith each other for workers, or
c)Loss aversion, ord)Aversion to dispersion of
earnings, or
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First Results in Wage Bargaining
continued
First Results in Wage Bargaining
continued
e) Aversion to ignorance of earnings (once the wage is struck, the union representative know his pay, but the employer representative must wait to see how profitable his firm’s are, or
f) Diminishing marginal utility from earnings, or
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First Results in Wage Bargaining
continued
g) Some union representatives were from former communist countries
and China where the union representative is appointed directly or indirectly by the government and has the task of helping the firm (in part by attending to safety and like needs of workers)
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ReferencesFriedman, M., and L.J. Savage, 1948, ‘Utility Analysis of Choices Involving Risk’, Journal of Political Economy, 56 (4) 279-304.Janis, Irving L. and Leon Mann, 1977, Decision Making: A Psychological Analysis of Conflict, Choice, and Commitment, Free Press, New York.Keynes, John Maynard, 1921 and 1948, A Treatise on Probability, Macmillan and Co., Ltd, London.Mundell, R. (1961): “A Theory of Optimum Currency Areas”, American Economics Review 51, 657-665. Omodei Mary, Alexander Wearing, Jim McLennan, Glenn Elliott, Julia Clancy, “More is Better? ”: A Bias Towards Overuse off Resources in Problems of Self-regulation in Naturalistic Decision Making Settings,Working paper, LaTrobe University 2006.Pope, R, 1983, 'The Pre-Outcome Period and the Utility of Gambling', in B. Stigum and F. Wenstøp (eds), Foundations of Utility and Risk Theory with Applications, Reidel, Dordrecht, 137-177.Pope, R.E., 1995, "Towards a More Precise Decision Framework, A Separation of the Negative Utility of Chance from Diminishing Marginal Utility and the Preference for Safety", Theory and Decision 39, (3), pp241-265Pope, R.E., 2005, ‘The Riskless Mapping of Expected Utility and all Theories Imposing the Dominance Principle: its inability to include loans, commitments even with fully described decision trees’, in Ulrich Schmidt and Stefan Traub eds, Advances in Public Economics: Utility, Choice & welfare, Springer, 289-327. 32