The Role of the Exchange Rate

Abstract

All of the models used in this book contain forward expectations, but of differing sets of macroeconomic variables. There is just one common thread — they all take the forward expectation of the Sterling effective exchange rate. Not only is this the only common expectation term in all the models, it is by far the most important in each. This chapter begins by sketching the role of the exchange rate in the structure of the models, the underlying “exchange rate equation” and the implications for model stability. The second section presents a method for analyzing these issues by a process of linearization and reduction. This section also presents a case study using the NIESR model. In Section 3 we use the results to assess the sensitivity of the model to different forms of exchange rate equation. In Section 4 we consider some of the wider implications of our results for the development of macroeconomic models.