Knowledge that Transforms

This paper examines the impact of exchange rate volatility on the trade flows of the G-7 countries in the context of a multivariate error-correction model. The error-correction models do not show any sign of parameter instability. The results indicate that the exchange rate volatility has a significant negative impact on the volume of exports in each of the G-7 countries. Assuming market participants are risk averse, these results imply that exchange rate uncertainty causes them to reduce their activities, change prices, or shift sources of demand and supply in order to minimize their exposure to the effects of exchange rate volatility. This, in turn, can change the distribution of output across many sectors in these countries. It is quite possible that the surprisingly weak relationship between trade flows and exchange rate volatility reported in several previous studies are due to insufficient attention to the stochastic properties of the relevant time series.

, Shawna Grosskopf, C. A. Knox Lovell, Suthathip Yaisawarng, Derivation of Shadow Prices for Undesirable Outputs: A Distance Function Approach, The Review of Economics and Statistics, Vol. 75, No. 2 (May, 1993), pp. 374-380

In late 1990, the Federal Reserve eliminated reserve requirements on nonpersonal time deposits, and required reserves fell by about $10 billion, an almost 20-percent reduction. In early 1992, reserve requirements against transaction accounts were lowered from 12 percent to 10 percent, releasing an additional $3.5 billion of required reserves.1 These reductions, by lowering total reserve balances, potentially could increase reserve market volatility, impeding the implementation of monetary policy and possibly spilling over into other markets. This paper examines the effects of reserve requirements on market volatility and on the central bank's ability to achieve shortrun policy objectives. Although a number of earlier studies have examined the effects of reserve requirements on the effectiveness of monetary policy, our approach differs in two important respects. First, we focus on the ability to achieve short-run objectives. Second, we provide empirical estimates of the likely effects of lower reserve requirements. The central bank cannot directly achieve its long-run objectives of output and price stability, so it uses policy rules to set shortand intermediate-run targets for certain economic variables, such as interest rates or monetary aggregates, consistent with its long-term goals.2 The central bank cannot, however, perfectly control shortor intermediate-run targets, so it also relies on a set of operational rules. Operational rules are used to set instruments (such as reserve requirements, the discount rate, and openmarket operations) in order to achieve the shorter-run targets. Previous studies, such as Ira Kaminow (1977), Jeremy Siegel (1981), Ernst Baltensperger (1982), Richard T. Froyen and Kenneth J. Kopecky (1983), and Brian R. Horrigan (1988), focused exclusively on longer-term objectives of monetary policy. In contrast, we focus on the shortterm goals of monetary policy. In addition, we provide empirical estimates of the impact that changes in reserve requirements are likely to have on volatility in the money market. Previous studies were largely theoretical and, therefore, could only show that the impact of a change in policy depended on various unknown parameters of a particular model.