According to the classical model in international macro constructed by Robert Mundell and Marcus Fleming in the sixties, the central bank can pursue an active monetary policy under a floating exchange rate regime, in such a way that the exchange rate and the interest rate have a stabilizing effect on the economy. This principal argument is generally accepted, but the judgment of how important it in reality is, still remains an open question.
While it is obvious that the central bank can stabilize the economy under a floating exchange rate in the simple textbook model, the situation is more complex in practice (see e.g. Obstfeld and Rogoff (1996)). First, the central bank takes its decisions under imperfect information and monetary policy affects the economy with a lag. According to traditional macroeconomic theory, price and wage adjustments tend to stabilize the economy. This implies that the significance of the fact that the central bank can pursue an active monetary policy under a floating exchange rate regime depends on how quickly it can react, and how quickly the monetary policy affects the economy, as compared to how quickly wages and prices adapt. Second, stabilizing output is not the only target of the central bank; in fact an inflation target is often assigned as its most important target. Third, there may be some uncertainty about the monetary policy of the central bank, which in itself generates destabilizing exchange rate movements (overshooting).
According to neoclassical growth theory, the capital stock is one of the main determinants of the long-run standard of living. In some versions of endogenous growth theory, the capital stock plays an even more important role by influencing the rate of economic growth.
Recent surveys of major thrifts and mortgage bankers (see, for example, Inside Mortgage Finance) indicate that, while there are many different indices underlying adjustable rate mortgages in the U.S., four indices dominate the market:
The results of the Ott [18] ARM duration study, and numerous recent studies of the time series properties of EDCOFI, suggest that only the first of these indices adjusts instantaneously to changes in contemporaneous Treasury rates. The others adjust with a lag. Ott [18] uses a classical duration approach to show that this lag can have a significant impact on the interest rate sensitivity of ARMs. However, without explicitly modeling term structure dynamics, he cannot address the impact of mortgage prepayment, or additional common contract features such as interest rate caps. On the other hand, most recent ARM valuation models, using a contingent claims approach with a richer specification of interest rate dynamics, can analyze the impact of interest rate caps and prepayment, but they ignore the lag in the adjustment of the ARM coupon to the contemporaneous term structure (see, for example, Kau et al. [10], Schwartz and Torous [23], and McConnell and Singh [13]). No previous study simultaneously analyzes the interacting effects of both the time series properties of the index and prepayment/interest rate caps on the interest rate risk of ARMs.
