EXCHANGE-RATE HYSTERESIS - LARGE VERSUS SMALL POLICY MISALIGNMENTS

Using a monetary model in the spirit of Dornbusch (1976) and a 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. Hence, exchange rate dynamics are path dependent. Since hysteresis in our model can entail industrial dislocation and the scrapping of sunk assets, we suggest that these factors constitute a welfare cost of large policy misalignments that have not been considered formally. Additionally, since the long-run exchange rate is path dependent, standard empirical tests of exchange rate models may involve a misspecification.