Exchange Rate Hysteresis: The Real Effects of Large vs Small Policy Misalignments

Using the sticky price monetary model of exchange rate determination and the sunk cost model of trade hysteresis, we show that a sufficiently large policy misalignment can induce hysteresis in the trade balance and thereby alter the steady?state real exchange rate. Thus in our model exchange rate dynamics are path dependent, PPP need not hold and money need not be neutral even in the very long run. We present only positive analysis but conjecture that the results have strong welfare, policy, and econometric implications. Since hysteresis in our model can entail industrial dislocation and the scrappage of sunk assets, we suggest that these factors may constitute a welfare cost of large policy misalignments that have not been formally considered. On the policy side, one could sensibly argue against the dollar volatility of the 1980s without at the same time arguing for a return to a formal exchange rate regime (because 1980s-size swings may involve welfare costs that 1970s-size swings do not). Lastly, since the long-run exchange rate is path dependent, standard empirical tests of exchange rate models may be misspecified.