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
Exchange Rate Risks: ???
Government & Central Bank:
? Are we managing the economy better
1. 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?
Pope, Selten, von Hagen, Kube Experiments
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Goal
New 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
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Conflicting design aims
1) Plausibility as an analogue to real problems
2) 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
Model
Two countries "home" and "foreign"
Symmetrical
Focus on the home country
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Players in each land
2 currencies
1
1
1
1
5
9
government
central bank
union
employer's association
firms
total per country, 18 players in the two countries
One Session: 18 players who have not participated
before, so 1 independent observation. In one session
same participants play 20 rounds: rounds are not
independent observations
Currency union
only 1 central bank, 2 governments — 17 players
Focus on the two currency case
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Commodity
Flows
Commodity Flows
home
homelabour
labour
home materials
competitive
home
consumption
good
Cournot
home
consumption
foreign
consumption
foreign
consumption
good
Cournot
foreign materials
competitive
foreign labour
home labour
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Decisions
Government
expenditure
Central Bank
interest factor
exchange rate aim
next period's target price
Wage Bargaining
After 10 minute chat
nominal wage rate
union proposal
employer proposal
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Decisions continued
Firms
production quantity
amount of home currency borrowed
amount of foreign currency borrowed
Participants in Experiments
Bonn University economics students who
had completed at least two years
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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)
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Markets continued
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 banks
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Goals - Payoffs
(converted into EUROS)
Joint Government & Central Bank:
Penalties for deviations of
1
2
3
4
5
6
target price from prior target price
target price from actual price
actual interest rate from ideal interest rate
home materials cost from foreign materials cost
actual exchange rate from exchange rate target
employment from the ideal range, with
underemployment more severely punished
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Goals - Payoffs continued
(converted into EUROS)
Wage Bargainers:
union representative gets target price
deflated wage;
employer representative gets expenditure
deflated average firm profits
Strike: both zero
Firm i: gets expenditure deflated own
profits
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Currency Influences
Firms:
1. speculate on their currency appreciating
2. hedge against their currency
depreciating before they pay for their
imports bought on credit
3. interest differences
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Currency Influences
Official Sector:
1 influences firms via interest rate, nominal
demand, price and exchange rate targets
2 intervenes on foreign exchange market
directly 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
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Exchange Rate Fundamentals
Unknown: extra sample predictions no
better than a random walk. Why?
1
2
3
Need to estimate from yearly not monthly data for
trade / investment – but not so many years since
Bretton Woods
Illusions of “clean” floats, homogenous capital – but
connections of exchange rates and public sector
goals make all floats dirty, capital is country specific
Shocks, unpredictability of:
a) fiscal / monetary policy and when central banks do / do
not agree to co-operate
b) decisions of the private sector (eg firms, unions)
Our experiment: largely free of problems 1-3
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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 bargaining
Step 4: Firm decisions on production
quantities and currency offers,
wage payments
Step 5: Currency market
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Time structure of a period
continued
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 materials
Step 9: Account balance outflow — positive or
negative firm account balances taken
over by owners
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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
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Shocks in Our Model
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 shocks
wage: union and the firms’ representatives bargaining
interest rate: foreign central bank
output: firms
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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
First Results
6 experiments with, 6 without currency union
1. In all 6 without a currency union, the
exchange rate shifted contrary to GTB.
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First Results continued
2
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 cooperation hard, or
b) Too much in-built co-operation
c) Too explicit an exchange rate target
d) equal concern when cheap as when too
dear misses the beggar thy neighbour
reality of national pressures on central
bankers
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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
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First Results continued
4
5
6
7
Currency union helps central bank and
government goal achievement significant at 10%
level for central bank
The more variable the actual exchange rate, the
worse 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
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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
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Conclusion continued
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!
We need to analyse more and more
experiments to understand more of the
EURO’s effects
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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.
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Uncertainties from:
1 before choosing, and then
2 before learning which outcome of the
chosen act has occurred
Failure 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.
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• 1
t=0
choice
Risky act
10 or 20
in P2
P1: 0≤t<K
The 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
P2: t≥K
The post-outcome
period of certainty
Evaluatio
n at t=0
xj
Knowledgepossible
U(x)
outcomesahead-independent utilities
sources of
utility
10
X low
20
X high
U10 (10)
The Jump Through of the Period of Risk, Uncertainty Entailed
under the Dominance Principle
First Results in Wage Bargaining
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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
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First Results in Wage Bargaining
continued
Hunches on why wages are so low
a) No workers in the experiment, or
b) Cahuc et al (2004) that only get up
to Nash if firms compete
with each other for workers, or
c) Loss aversion, or
d) Aversion to dispersion of earnings,
or
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First Results in Wage Bargaining
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
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First Results in Wage Bargaining
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)
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References
Friedman, 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, 137177.
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), pp241-265
Pope, 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.
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