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Exchange rate determination: a theory of the decisive role of central bank cooperation and conflict

Abstract

Economists’ faith that variable exchange rates benevolently equilibrate has been empirically disconfirmed. That faith is here tackled at its theoretical core with an exchange rate model that although ultra abstract, includes the undeniable fundamentals of market power and differential goals of central bankers and large-scale private players. It permits a game theoretic analysis under the assumption that all agents maximize their payoffs. The paper then relaxes the assumption of maximising agents, allowing for a more complex and thus realistic second version of the model that is interpretable within SKAT, the Stages of Knowledge Ahead Theory of risk and uncertainty. In an experimental setting, this second version of the model points to: a) the inability of agents in central banks, governments and the private real and financial sectors to operate in maximising ways; b) destructive central bank conflict; and c) the widely discrepant outcomes arising from the dynamics of individual personality differences. The paper’s theoretical and empirical findings thus both point to the merits of a single world currency.

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Fig. 1

Notes

  1. 1.

    Richardson (1993, 2000, 2002), Richardson and McKie (2007b), Richardson et al. (2010).

  2. 2.

    We are indebted to Paul Welfens for drawing our attention to the asymmetric attention of economists and lawyers to modelling market power in stocks and commodities price setting where individuals whilst nearly all ignore central bank market power despite central bank power being so much more decisive in setting exchange rates than is the market power of those influencing prices in stock markets and commodities exchanges.

  3. 3.

    An important exception is Hausken and Pluemper (2002).

  4. 4.

    An important exception in allowing for official sector market power by offering a game theoretic treatment in a model comprising international agencies as well as central banks is the model of Hausken and Pluemper (2002).

  5. 5.

    Observations of Robert Merton on the Reasons for Long Term Capital Management’s problems, made at the beginning of his presentation to the American Economic Association Meetings, New Orleans, 2001 dissenting with the view that this hedge fund’s demise had “nothing to do with science”.

  6. 6.

    See Telser (2007a and b) on the Federal Reserve Board’s decision to ignore “sweeping” that effectively eliminated some bank reserve requirements that reduced bank profits but also beneficially reduced excessive competition among banks, excessive in that it leads to unwise lending as in each recurrent housing crisis in many a country.

  7. 7.

    Hendry, On the Mathematical Basis of Inter-temporal Optimization, Oxford University Economics Department Working Paper 497, http://www.economics.ox.ac.uk/Research/wp/pdf/paper497.pdf.

  8. 8.

    Field and empirical studies reveal that Cournot oligopolies with five or more participants have difficulty attaining systematic collusion, the lack of which, broadly speaking, characterises corporatist EURO bloc production. The European Economic Commission has been helpful in reducing the corporatist, collusive character of Europe over the past decades.

  9. 9.

    To constitute an equilibrium not only the exchange rate and fiscal policy choice, but also the selected interest rates, exchange rate aims, wage rates, production quantities and currency offers must also be at their equilibrium values.

  10. 10.

    This allows for the complexities of a reserve currency that enter naturally once the number of currencies exceeds two.

  11. 11.

    These could include studies of how regulatory changes alter capital market imperfections influencing foreign investment, as in Froot and Stein (1991) and Dunning (1998).

  12. 12.

    Shifting to a more full-fledged modelling of currencies as assets (rather than having the equilibrium exchange rate dependent only on interest rates in two currencies), and the inclusion of non-currency assets would permit more elements of the portfolio approach to exchange rate determination. But within the umbrella of this paper’s central bank conflict-cooperation theory of exchange rates, these multiple asset influences would enter in a radically different manner from that in neoclassical growth exchange rate models such as that of Welfens (2008).

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The text is written by Robin Pope, with valued improvements on successive drafts from comments of Johannes Kaiser and Reinhard Selten. The participants’ instructions here reported are based on those written by Sebastian Kube and translated into English by Reinhard Selten, with minor improvements on these from Robin Pope. The calculations requested by Robin Pope were kindly furnished by Johannes Kaiser. The particular model within the central bank conflict co-operation theory of exchange rate determination is that of Robin Pope and Reinhard Selten, with valued input from Juergen von Hagen on allowing for the distinct input of the government sector. The operationalisation of the model into a computer-programmed set-up is that of Sebastian Kube and Johannes Kaiser. We thank for comments Paul Welfens; for background information Richard Cooper and Herbert Grubel; for editorial assistance Pulikesh Naidu; for research assistance Corinna Wassermann, Daniel Lederer, Andreas Orland, and Laura Frank; and for funding the Center for European Integration Studies and the German National Science Foundation. The paper does not reflect the opinion of the Deutsche Bundesbank.

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Pope, R., Selten, R., Kaiser, J. et al. Exchange rate determination: a theory of the decisive role of central bank cooperation and conflict. Int Econ Econ Policy 9, 13–51 (2012). https://doi.org/10.1007/s10368-011-0203-2

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Keywords

  • Central bank
  • Cooperation
  • Conflict
  • Exchange rate
  • Experiment
  • Market power

JEL

  • F310
  • F330
  • B400
  • B590
  • C790
  • C900
  • C910
  • C920