Our Objective and the Contribution of Our Work

As summarized by Krugman (1989), there are two prominent puzzling facts since the collapse of the Bretton Woods system. First, why has the floating-rate regime led to an increase in the volatility of real exchange rates? The consensus expectation in the late 1960s and the early 1970s was that real rates would be more stable, but the experience has been quite to the contrary (see Frankel, 1993, chap. 10). Second, why has the impact of these enormous swings in the real exchange rate on national outputs and inflation rates been so limited? Baxter and Stockman (1989) and also Frankel and Rose (1995) provide empirical evidence that, except for an increase in real exchange rate volatility, other macroeconomic aggregates have not been affected by the change in the exchange rate system in the 1970s. Perhaps more controversially, Krugman also holds that the large fluctuations in the value of, in particular, the U.S. dollar relative to the deutsche mark and the Japanese yen, are irrational bubbles. Furthermore, international capital flows have not smoothed out fluctuations in outputs and investments as expected. Many academics and politicians also think that the volatility of the exchange rate hinders international trade and international investments and conclude that a return to a system of fixed exchange rates, if feasible, would be desirable. One illustration of such a system is the European Union's single-currency plan.

In light of these considerations, and given the widespread perception that an increase in exchange rate volatility leads to a reduction in the level of international trade, various questions arise.