a laboratory experiment about the effects of exchange rate uncertainty in a two-country model robin...

A Laboratory Experiment about the Effects of Exchange

Rate Uncertainty in a Two-Country Model

Robin Pope,* Reinhard Selten,** Jürgen von Hagen,* Sebastian

Kube***

* ZEIb Center European Integration Studies Bonn University•http://www.zei.de/ [email protected]

* * Experimental Economics Laboratory Bonn University

* * * Dept Economics, Karlsruhe University

http://www.zei.de/

http://www.zei.de/

mailto:[email protected]

Exchange Rate Risks: ???

Pope, Selten, von Hagen, Kube Experiments 2

Government & Central Bank: ? Are we managing the economy better1. with a clean float, or 2. With dirty float, or 3. without exchange rate

uncertainty?Is EURO a mistake for Italy,

worsenign employment, competitiveness, inflation, interest rates?

Or is EURO great for Italy, removing exchange rate risks achieves all these goals especially competitiveness better?

GoalNew insights about the effects on firms, on unions and on government and central bank management of the macroeconomy when two countries eliminate some exchange rate uncertainties by adopting a single currency like the EURO

Pope, Selten, von Hagen, Kube Experiments3

Conflicting design aims1) Plausibility as an analogue to real

problems2) Playability 3) Analysability — our experimental set-up

may lack a standard game theoretic solution: Reinhard Selten's new incomplete equilibrium concept, more plausible for players to implement than the normal one, is our game theoretic benchmark

ModelTwo countries "home" and "foreign"SymmetricalFocus on the home country


Players in each land2 currencies1 government1 central bank1 union1 employer's association5 firms9 total per country, 18 players in the two

countries

One Session: 18 players who have not participatedbefore, so 1 independent observation. In one session same participants play 20 rounds: rounds are not

independent observations

Currency uniononly 1 central bank, 2 governments — 17 players

Focus on the two currency case



Commodity Flows

home materials

competitive

home labourhome labour

home

consumption

good

Cournot

home

consumption

foreign

consumption

foreign

consumption

good

Cournot

home labour

foreign labour

foreign materials

competitive

Commodity Flows

DecisionsGovernment Central Bankexpenditure interest factor

exchange rate aim

next period's target price

Wage Bargaining

After 10 minute chat

nominal wage rate union proposal

employer proposal


Firmsproduction quantity amount of home currency borrowedamount of foreign currency borrowed

Participants in ExperimentsBonn University economics students who had completed at least two years


Decisions continued

Markets

Wages from union and employer representative bargaining or a strike with government set wages

Materials competitive, price equals interest plus wage cost

Consumption Cournot market, price equals expenditure (set by government) divided by the total quantity (the sum of each firm's individual quantity decision)


Currency exchange rate balances demand and supply of home and foreign currencies by firms and central banks, but constrained to the interval between the exchange rate aims of the 2 central banksPope, Selten, von Hagen, Kube Experiments10

Markets continued

Goals - Payoffs(converted into EUROS)

Joint Government & Central Bank:

Penalties for deviations of

1 target price from prior target price2 target price from actual price3 actual interest rate from ideal interest

rate4 home materials cost from foreign

materials cost5 actual exchange rate from exchange rate

target• employment from the ideal range, with

underemployment more severely punishedPope, Selten, von Hagen, Kube Experiments11

Wage Bargainers:union representative gets target pricedeflated wage; employer representative gets expendituredeflated average firm profits Strike: both zero

Firm i: gets expenditure deflated own profits


Goals - Payoffs continued (converted into EUROS)

Currency Influences

Firms:1. speculate on their currency

appreciating2. hedge against their currency

depreciating before they pay for their imports bought on credit

3. interest differences


Currency InfluencesOfficial Sector: 1 influences firms via interest rate,

nominal demand, price and exchange rate targets

2 intervenes on foreign exchange marketdirectly to try to attain its target exchange rate

3 co-operates with other central bank if firms would otherwise push exchange rate outside the target of either central bank


Exchange Rate Fundamentals Unknown: extra sample predictions no

better than a random walk. Why?1 Need to estimate from yearly not monthly data

for trade / investment – but not so many years since Bretton Woods

2 Illusions of “clean” floats, homogenous capital – but connections of exchange rates and public sector goals make all floats dirty, capital is country specific

3 Shocks, unpredictability of:• fiscal / monetary policy and when central banks do

/ do not agree to co-operate• decisions of the private sector (eg firms, unions)

Our experiment: largely free of problems 1-3


Time structure of a period

Step 1: Government total expenditure

Step 2: Central bank — interest rate, exchange rate aim, next period's target price

Step 3: Wage bargainingStep 4: Firm decisions on production

quantities and currency offers, wage payments

Step 5: Currency market


Step 6: Interest payments — interest paid or received in step 5 account balances

Step 7: Sales— revenues flow to home accounts

Step 8: Payment of materialsStep 9: Account balance outflow —

positive or negative firm account balances taken over by owners


Time structure of a periodcontinued

Shocks in Mundell 1961

Exchange rate changes countervail shocks

Mundell sees his 1961 model as

misapplied

Mundell’s 1961 Model excludes:•capital flows•the risk of future exchange rate changes


All shocks arise from behaviour! No need to try to model firm and official sector reaction functions or substitute random generated shocks for them

Demand Shocks Level: changes in foreign expenditure Switches

a. exchange rate: actions of firms and foreign central bank

b. foreign interest rate: foreign central bank

Supply shockswage: union and the firms’ representatives bargaininginterest rate: foreign central bank

output: firms


Shocks in Our Model

Game Theoretic Benchmark GTB

Initial values at start are equilibrium. None change if all played equilibrium in all 20 sequel rounds: zero exchange rate risk, all earn 5 EURO/round


6 experiments with, 6 without currency union1. In all 6 without a currency union, the exchange rate shifted contrary to GTB.

First Results

First Results continued2 Exchange rates shift but between 1/10 and

1/100 post Bretton Woods exchange rate variability: closer to the modest variations of the gold standard, Bretton Woods and EMS eras for members. Hunches on why

a) too few countries to make central bank co-operation hard, or

b) Too much in-built co-operationc) Too explicit an exchange rate targetd) equal concern when cheap as when too

dear misses the beggar thy neighbour reality of national pressures on central bankers


First Results continued

• 3 Nominalism: Central banks and governments diverge from IGT equilibrium toward a 1:1 target and actual exchange rate (6/6 sessions, significant at 10% level), identical target an actual consumer prices (5/6 sessions) and identical expenditures (4/6 sessions)

• Pope, Selten, von Hagen, Kube Experiments 22

4 Currency union helps central bank and government goal achievement significant at 10% level for central bank

5 The more variable the actual exchange rate, theworse central banks achieve their goals significant at 5% level

• Gradualism in all 4 instruments, not sharp shocks (variability), helps central bank and government goal achievement significant at 1% level for expenditure (government), at 10% level for exchange rate goal & target prices, (for central banks)

• Lower prices and wages under currency union:contrary to fears of union indiscipline


First Results continued

Conclusion

Euro has advantages:Without exchange rate shocks, and with fewer decisions to make, the governments and central bank grapple better with demand and supply shocks


Better macro management:Without those 3 branchings of the exchange up, down or steady, governments and the central bank are down to a level of complexity they can better handle!


Conclusion continued

We need to analyse more and more experiments to understand more of the EURO’s effects

Why Expected Utility Theory helps us miss exchange rate uncertainty

costs • It, like all standard rank dependent theories is atemporal, imposes a preference for first order stochastically dominating distributions of outputs – ie ignores changing stages of knowledge ahead, ie ignores uncertainties from:

• 1 before choosing, Janis Manne 1977, and then

• 2 before learning which outcome of the chosen act has occurred, Keynesian uncertainty, Keynes 1921

• Instead its choosers parachute from a problem to having decided what to do, and then parachute

again to the certainty of the outcome of our chosen act. There are no costs of uncertainty, only a focus on the utility expectation functional, with each possible utility evaluated “as if certain”Friedman and Savage 1948. Thereby these theories ignore findings of Omodei et al 2006 and others on information overload and planning costs on the part of firms, the official sector and we scientific analysts / advisers of the firms and official sector.


Uncertainties from: 1 before choosing, and then2 before learning which outcome of the chosen act has occurredFailure to discover robust (out of sample) exchange rate fundamentals despite 35 post Bretton Woods years establishes uncertainty 1. Our experimental results in a setting with some of the real world complexities, suggest uncertainties 1 and 2 are costly, that our theorizing should include uncertainty as a separate influence. To include uncertainty consistently, we need a stages of knowledge ahead framework, Pope 1983, 2005.


• 1

The Jump Through of the Period of Risk, Uncertainty Entailed under the Dominance

Principle

t=0 choic

e

possible outcomes

Evaluation at t=0

P1: 0≤t<KThe pre-

outcome period of risk

This risky period does not exist so

no planning problems on what other government, other central bank will do, whatg unions and employers

negotiate on wages, on what firms produce

Risky act 10 or 20 in P2

P2: t≥KThe post-outcome period of certainty

10

20

xj

Knowledge-ahead-

independent sources of utility

X high

X low

U(x) utilities

U10 (10)

First Results in Wage Bargaining

8 Nash bargaining overpredicts Wages if firms are anticipated to play Cournot: in fact firms on average produced lower quantities than wages struck imply (attempts at collusion?) so firm profits were even higher than our IGT benchmark:

union representatives, government and central banks got barely half of firms and their representative


Hunches on why wages are so lowa)No workers in the experiment, orb)Cahuc et al (2004) that only get

up to Nash if firms competewith each other for workers, or

c)Loss aversion, ord)Aversion to dispersion of

earnings, or



continued


continued

e) Aversion to ignorance of earnings (once the wage is struck, the union representative know his pay, but the employer representative must wait to see how profitable his firm’s are, or

f) Diminishing marginal utility from earnings, or



continued

g) Some union representatives were from former communist countries

and China where the union representative is appointed directly or indirectly by the government and has the task of helping the firm (in part by attending to safety and like needs of workers)


ReferencesFriedman, M., and L.J. Savage, 1948, ‘Utility Analysis of Choices Involving Risk’, Journal of Political Economy, 56 (4) 279-304.Janis, Irving L. and Leon Mann, 1977, Decision Making: A Psychological Analysis of Conflict, Choice, and Commitment, Free Press, New York.Keynes, John Maynard, 1921 and 1948, A Treatise on Probability, Macmillan and Co., Ltd, London.Mundell, R. (1961): “A Theory of Optimum Currency Areas”, American Economics Review 51, 657-665. Omodei Mary, Alexander Wearing, Jim McLennan, Glenn Elliott, Julia Clancy, “More is Better? ”: A Bias Towards Overuse off Resources in Problems of Self-regulation in Naturalistic Decision Making Settings,Working paper, LaTrobe University 2006.Pope, R, 1983, 'The Pre-Outcome Period and the Utility of Gambling', in B. Stigum and F. Wenstøp (eds), Foundations of Utility and Risk Theory with Applications, Reidel, Dordrecht, 137-177.Pope, R.E., 1995, "Towards a More Precise Decision Framework, A Separation of the Negative Utility of Chance from Diminishing Marginal Utility and the Preference for Safety", Theory and Decision 39, (3), pp241-265Pope, R.E., 2005, ‘The Riskless Mapping of Expected Utility and all Theories Imposing the Dominance Principle: its inability to include loans, commitments even with fully described decision trees’, in Ulrich Schmidt and Stefan Traub eds, Advances in Public Economics: Utility, Choice & welfare, Springer, 289-327. 32

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