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Nick, it's been a long time since I was lucky enough to play with forward looking is lm models. Something is sitting uncomfortably with me. But it seems to me that the new equilibrium must involve expectations of a further depreciation, say once Brexit actually occurs. IS shifts right due to new exports from the 10 per cent depreciation, pushed up the interest rate above i*, which can only be sustained if the market believes that the pound will fall even further in the future. That seems to make sense to me (and given the pound's behaviour today). The size of the expected future depreciation (additional to the 10 percent we already got) would seem to define how big the boom is. If the exchange rate has fully adjusted and i=i*, then we're done. No?
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Good point. Guess the counter point would be that Brexit is an uncertainty shock hitting investment (firms have the option of waiting). Shift IS left. Could also be some j curve effects, no? Just thinking aloud.
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Nick an interesting post. The key issue is that you identify is uncertainty. Everyone realises that the current situation is unsustainable and that disorderly exits and defaults will be a nightmare. But no one knows what the rules for an orderly euro exit or default are; and whatever rules there are are subject to change almost randomly. So the problem is one of Knightian uncertainty. What is needed is a clear policy statement that explains the rules for exit and makes Mario Draghi’s vision for a sustainable euro area possible. I don’t think that an orderly euro exit is impossible. Consider this. Theauthorities issue a parallel currency (scrip) while leaving the economy (Greece, Spain, Ireland) euroised. The scrip would initially (on day one be pegged to the euro at one to one (or any other rate, but that would be simplest). The central bank would pre-announce tha the currency would depreciate over time – a Gesselian type currency. To avoid an immediate one off depreciation, the central bank would stand ready to convert euros into scrip, but scrip would not be convertible into euro. This is essentially what mints chose to do under the bi-metallic standard. It is possible that the scrip would immediately depreciate by x percent if firms and workers simply added a premium of x % to the (euro prices and wages that they charge). But since the economy is still euroised, the government could chose to accept the scrip at the official exchange rate for payment of taxes and utilities and any other euro liability that citizens have with the government. This would create an incentive for firms and workers to accept payment at the official exchange rate. Most of the arguments made here have been more fully developed at
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Jun 4, 2012