Exchange Rate Hysteresis from Trade Account Interaction

An explicitly specified macro model of exchange rate determination is integrated with a model of trade account hysteresis. In this macro model, flow imbalances in the trade account must be matched by equilibrating stocks of imperfectly substitutable assets, generating a stock-flow consistent determination of the exchange rate. In this paper, changes in the real exchange rate induce firms to enter particular markets for internationally traded goods, which in turn affects the trade balance. When there are sunk costs associated with this entry, returning the real exchange rate to its initial state may not induce those firms to exit the markets that they have entered. This causes trade account hysteresis. Since the real exchange rate is in part determined by the trade balance, trade account hysteresis feeds through to give exchange rate hysteresis. Copyright 2000 by Blackwell Publishers Ltd and The Victoria University of Manchester