DP195 Exchange Rate Protection and Exchange Rate Conflict
The paper investigates a model of "exchange rate protection" by two countries. Either or both countries may protect their tradable sectors by maintaining undervalued exchange rates. The mechanism of protection considered involves a country increasing its national saving rate and exporting capital. The resulting depreciation of the real exchange rate boosts the tradable sector. The world equilibrium that will result if both countries pursue this policy is shown to be inefficient. In a more general case countries may wish to adopt "negative exchange rate protection". The simple model may throw light on the experiences of Germany and Japan during periods when their exchange rates have apparently been undervalued and the more general model may be relevant to the United States which until recently has had an overvalued exchange rate.