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No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical or photocopying, recording, or otherwise without the prior permission of the publisher. Includes bibliographical references. Foreign exchange. Foreign exchange rates. V57 The superscript f denotes foreign value. A dot over a variable denotes a growth rate. Foreword This text, aimed at third-year undergraduate and first-year graduate students, is the fruit of quite a long period of teaching international monetary economics. It focuses on the economics behind exchange-rate models, leaving the econometrics of testing models to one side.

The former are known as monetary models and the latter as portfolio models. The monetary models are subdivided into flexprice monetary models, with fully flexible goods prices, and sticky-price monetary models, with sticky goods prices. We first apply the monetary model to the situation of fixed rates, where the balance of payments rather than the rate of exchange is the variable to be explained.

A common point of departure for asset models is the assumption that the foreign-exchange market is an efficient market. A market is efficient if asset prices fully reflect all available information. Consequently, no profits can be made by trading on the basis of the available information and new information is immediately reflected in prices. In the finance literature three forms of efficiency are usually distinguished: 1.

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The difference between semi-strong and strong efficiency does not seem very important in the case of exchange rates. Private information or insider information could only play a major role in the case of secret plans to change parities or to manipulate a floating exchange rate.

Efficiency in exchangerate models is generally of the semi- strong variety. Expectations about the future value of the exchange rate are formed using present information on the future values of the fundamental determinants or fundamentals of exchange rates, such as future money growth and future real income growth.

Two elements are involved in the concept of market efficiency. First, rational expectations are assumed, which means that economic agents make no systematic mistakes when making forecasts on the basis of the available information or, in other words, that they apply the correct model. Second, any differences between countries in risk-adjusted net returns on different assets are assumed to be swiftly arbitraged away, that is, capital mobility is high.

In other words, transaction costs are negligible. Note that high capital mobility is something different from high interest-elasticity of capital flows.

High mobility is a feature both of monetary and portfolio models. It should be recognised that the assumption of rational expectations is rather problematic. This is, however, dubious. Rational expectations imply that people will on average be right, but that is not of much help in the case of a negative shock. Bad luck can land you in bankruptcy as much as poor knowledge of the model and the dumb may fare better than the smart.

REH seems to imply that those observations are indeed made and that new information is immediately digested. Implicitly, REH Asset models 7 presumes an inductivist theory of learning, which is rather problematic cf. Boland , ch. If exchange rates are determined by expectations entertained by economic agents, those agents themselves create the model.

What we in fact do when applying REH is to assume that there is such a thing as a correct model and that people act circumventing the problem of the validity of inductive reasoning as if they know this model, following Friedman Rational expectations mean that economic agents act in conformity with the model of which they form part.

This is done in order to avoid ad-hocery in the modelling of expectations. Perhaps it can best be seen either as a kind of benchmark from which real-world situations will deviate to a greater or lesser extent or, following Gale , pp. If everybody applied the same model and used the same information, the commonly agreed fundamentals would determine exchange rates.

If there is no such homogeneity, we could distinguish between fundamentalists, who base their expectations on the fundamentals of exchange rates, and noise traders, who do not Shleifer and Summers It may be remarked in passing that without such heterogeneity there would be significantly less trade in financial markets. Noise traders may follow the advice of some guru or act on regularities they detect in exchange-rate time series; in the latter case they are called chartists on the technical analysis which chartists rely on, see Neely Chartists do not act on fundamentals; moreover, such regularities as they detect are at odds with the idea of efficient markets, as these imply that people pass up opportunities to earn a profit.

Monetary Economics-Institutions, Theory and Policy, 1/e

In such an approach exchange rates may easily take some time to adjust to a change in fundamentals van Hoek It does not come as a surprise that a simulation by Pilbeam a did not show any better performance by fundamentalists than by noise traders.

Noise traders were divided into chartists and so-called simpletons. The latter followed a very simple rule: they placed funds into the currency that provided the highest return in the previous period. They did not perform worse on average than the others.

Pilbeam b also found that in the short term extrapolative and adaptive expectations predict exchange-rate movements better than static, regressive or rational expectations. Whatever the way expectations are formed, it is a sobering exercise to compare expectations with outcomes. Wall Street Journal surveys among top US macroeconomic forecasters revealed for instance that from to the panellists predicted each year in December that next year the dollar would reverse its slide against the yen and every time they were proved wrong Greer Remember what we said in the Introduction: models are attempts to get a mental grip on reality.

For shorter terms, in particular, these attempts have not so far been too successful. All this does not mean that the idea of efficient markets is fully discredited. Students of stock-market prices and yields notice that professional investment fund managers, who spend most of their time collecting and assessing market information, are unable to systemically outperform the market. In line with this, it turns out that any predictable pattern in stock prices, the basis of chartism, disappears after it has been published in the finance literature Malkiel There is little reason to believe that things are different for exchange rates.

In a small country, any discrepancy Asset models 9 between the amount of money demanded and the amount of money supplied will be met through capital imports without production volume, interest rates or the price level being affected.

The price level is equal to the foreign price level at the going rate of exchange, that is, downloading Power Parity PPP prevails. As in the monetary models of exchange-rate behaviour, domestic and foreign interest rates are equal and international capital flows are infinitely interest-elastic. Any upward pressure on the rate of interest caused by money demand exceeding money supply thus will induce capital inflows and any downward pressure caused by money supply exceeding money demand triggers off capital outflows.

Domestic money is created through domestic credit granting, open-market downloads or a surplus in international payments. The surplus or deficit in international payments adjusts, through capital imports or exports, to the amount of money demanded. The monetary authorities are thus unable to control the money supply, nor can they influence the rate of interest or the price level, as these are fully determined by the foreign interest rate and the foreign price level respectively.

The only magnitude they can regulate is foreign-exchange reserves, by manipulating domestic credit creation or through open-market policy. If they wish to increase reserves, they resort to imposing a higher reserve ratio on commercial banks inducing the banks to slow down credit expansion or to open-market sales. Economic agents will then borrow abroad. They sell the foreign exchange which they borrowed to domestic banks and their accounts are credited in domestic currency.

A perhaps unexpected implication of the model is that economic growth may result in higher foreign-exchange reserves, that is, in a surplus on the balance of payments on the money account. Economic growth increases the volume of money demanded and if domestic credit creation does not meet this demand, the money supply will expand via the balance of payments. We first analyse the relationship between domestic and foreign interest rates on the one hand and exchange-rate movements on the other hand, without at this stage explaining the level of the exchange rate.

We postulate a fully free-floating exchange-rate system. The exchange rate, denoted by e and defined as the price of one unit of foreign exchange in terms of domestic currency, is determined by demand and supply. A fall in the exchange rate means that foreign exchange becomes cheaper. This is 10 A guide to international monetary economics equivalent to an appreciation of the domestic currency. Conversely, a rise in the exchange rate is synonymous with a depreciation of the domestic currency note that an appreciation of the domestic currency is sometimes called a rise in the rate of exchange and a depreciation a fall, especially in Britain; when reading the literature one must always first find out which definition is followed.

Movements in the rate of exchange ensure that the foreign-exchange market always clears. The banks, including the central bank, are assumed only to act as brokers in the foreign-exchange market and not as net downloaders or sellers of foreign exchange.

The domestic money supply consequently is not affected by international payments. In the monetary models it is furthermore assumed that domestic and foreign interest-bearing titles are perfect substitutes.

Monetary Economics-Institutions, Theory and Policy, 1/e

Economic agents are indifferent as to the shares of domestic and foreign titles in their portfolios, provided these yield the same return. The return on foreign titles is made up of the foreign interest rate plus any profit or loss on exchange-rate movements. Given competitive markets with negligible transaction costs that is, swift arbitrage and either exchangerate expectations that are held with certainty or risk-neutral investors, the foreign interest rate plus the expected profit from exchange-rate movements equals the domestic interest rate and uncovered interest parity UIP prevails.

This idea dates back at least to an article by Irving Fisher Levich , p. At the same time there will be covered interest parity CIP , which means that the yield on foreign investments which are covered in the forward market equals the yield on domestic investments. This relationship can be derived as follows. Given foreign and domestic assets that are identical as to default risk and time to maturity, deviations from CIP point to transaction costs including information costs , fear of capital controls or a finite elasticity of the supply of arbitrage funds.

Not surprisingly, the CIP assumption fares quite well in empirical tests involving Eurocurrency markets, where assets are comparable in all respects except currency of denomination, trade volume is high and information and other transaction costs are low from an extensive literature we mention Dufey and Giddy , pp.

It may be noted that forward cover is not usually available for periods longer than two years but currency swaps, involving the exchange of specific amounts of two different currencies for a specified period of time between two parties, can be negotiated for much longer periods; these will, however, have higher transaction costs and carry a higher default risk.

Apparently, banks do not have a very elastic supply of arbitrage funds for comparatively long periods see McKinnon , ch.

Possible reasons mentioned by Levich , p. What deviations from CIP there are for shorter periods, say up to one year, can to a great extent be explained by transaction costs, at least for the leading currencies Clinton ; Maasoumi and Pippenger UIP says that any difference between domestic and foreign interest rates equals the expected change in the rate of exchange.

This means that the current spot exchange rate depends on the expected future exchange rate 12 A guide to international monetary economics and on domestic and foreign interest rates. Any shock in one of these three variables will make the spot rate adjust.

We study two such shocks, starting from a situation in which domestic and foreign interest rates are equal and the exchange rate is not expected to change. They will download foreign exchange spot in the expectation of being able to sell it at a higher price in the future. They themselves thus bring about the rise in the exchange rate they expected, a case of a self-fulfilling prophecy. Instead of downloading foreign exchange spot, they could also download foreign exchange on the forward market, with a view to selling it upon delivery at a profit.

The arbitrageurs banks who offer forward exchange to the speculators cover their position by downloading foreign exchange on the current spot market, again pushing up the current spot exchange rate. The activities of the speculators thus see to it that both the current spot rate and the forward rate adjust to the expected future spot rate.

At the original exchange rate, investment in domestic securities promises higher returns than foreign investments. People want to invest in domestic rather than in foreign securities. They sell foreign exchange and download domestic currency. The exchange rate falls. The expected future exchange rate has not fallen, the exchange rate is, therefore, expected to rise again.

Foreign investments offer the prospect of a gain from an exchange-rate increase in addition to the interest yield. The fall in the exchange rate goes on until the expected future rise plus the foreign interest rate equals the domestic interest rate.

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