A Laboratory Experiment about the Effects of Exchange Rate Uncertainty in a Two-Country Model

1. 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/Robin.Pope@uni-bonn.de **Experimental Economics Laboratory Bonn University ***Dept Economics, Karlsruhe University

2. Exchange Rate Risks: ??? Government & Central Bank: ? Are we managing the economy better • with a clean float, or • With dirty float, or • 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 2

3. 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 Pope, Selten, von Hagen, Kube Experiments 3

4. Conflicting design aims 1) Plausibility as an analogue to real problems 2) Playability • 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 Pope, Selten, von Hagen, Kube Experiments 4

5. Players in each land 2 currencies 1 government 1 central bank 1 union 1 employer's association 5 firms 9 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 union only 1 central bank, 2 governments — 17 players Focus on the two currency case Pope, Selten, von Hagen, Kube Experiments 5

6. Commodity Flows Pope, Selten, von Hagen, Kube Experiments 6

7. Decisions Government Central Bank expenditure interest factor exchange rate aim next period's target price Wage Bargaining After 10 minute chat nominal wage rate union proposal employer proposal Pope, Selten, von Hagen, Kube Experiments 7

8. 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 Pope, Selten, von Hagen, Kube Experiments 8

9. 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) Pope, Selten, von Hagen, Kube Experiments 9

10. Markets continued Currencyexchange 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 Pope, Selten, von Hagen, Kube Experiments 10

11. Goals - Payoffs(converted into EUROS) Joint Government & Central Bank: Penalties for deviations of 1 target price from prior target price 2 target price from actual price 3 actual interest rate from ideal interest rate 4 home materials cost from foreign materials cost 5 actual exchange rate from exchange rate target • employment from the ideal range, with underemployment more severely punished Pope, Selten, von Hagen, Kube Experiments 11

12. 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 Pope, Selten, von Hagen, Kube Experiments 12

13. Currency Influences Firms: • speculate on their currency appreciating • hedge against their currency depreciating before they pay for their imports bought on credit • interest differences Pope, Selten, von Hagen, Kube Experiments 13

14. Currency Influences Official Sector: • influences firms via interest rate, nominal demand, price and exchange rate targets • 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 Pope, Selten, von Hagen, Kube Experiments 14

15. Exchange Rate Fundamentals Unknown: extra sample predictions no better than a random walk. Why? • 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 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 Pope, Selten, von Hagen, Kube Experiments 15

16. 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 Pope, Selten, von Hagen, Kube Experiments 16

17. Time structure of a periodcontinued 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 Pope, Selten, von Hagen, Kube Experiments 17

18. 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 Pope, Selten, von Hagen, Kube Experiments 18

19. 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 Pope, Selten, von Hagen, Kube Experiments 19

20. 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 • In all 6 without a currency union, the exchange rate shifted contrary to GTB. Pope, Selten, von Hagen, Kube Experiments 20

21. First Results continued • 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 • too few countries to make central bank co-operation hard, or • Too much in-built co-operation • 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 Pope, Selten, von Hagen, Kube Experiments 21

22. First Results continued • 3 Nominalism: Central banks andgovernments 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

23. First Results continued • 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 4instruments, 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 Pope, Selten, von Hagen, Kube Experiments 23

24. 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 Pope, Selten, von Hagen, Kube Experiments 24

25. 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 Pope, Selten, von Hagen, Kube Experiments 25

26. 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. Pope, Selten, von Hagen, Kube Experiments 26

27. Uncertainties from: • before choosing, and then • 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. Pope, Selten, von Hagen, Kube Experiments 27

28. P1: 0≤t<K The pre-outcome period of risk P2: t≥K The post-outcome period of certainty Evaluation at t=0 t=0 choice xj Knowledge- ahead-independent sources of utility 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 • 1 possible outcomes U(x) utilities Risky act 10 or 20 in P2 X low U10 (10) 10 20 X high The Jump Through of the Period of Risk, Uncertainty Entailed under the Dominance Principle

29. First Results in Wage Bargaining • 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 Pope, Selten, von Hagen, Kube Experiments 28

30. First Results in Wage Bargainingcontinued Hunches on why wages are so low • No workers in the experiment, or • Cahuc et al (2004) that only get up to Nash if firms compete with each other for workers, or • Loss aversion, or • Aversion to dispersion of earnings, or Pope, Selten, von Hagen, Kube Experiments 29

31. First Results in Wage Bargainingcontinued • 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 Pope, Selten, von Hagen, Kube Experiments 30

32. First Results in Wage Bargainingcontinued 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) Pope, Selten, von Hagen, Kube Experiments 31

33. 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, 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), pp241-265 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. 32