Abstract
The paper summarizes the current theory of how a floating exchange rate is determined, dividing the subject into what determines the steady state and what determines the transition to steady state. The inadequacies of this model are examined, and an alternative “behavioral” model, which recognizes that the foreign exchange market is populated by both fundamentalists and chartists is presented. It is argued that the main importance of understanding the foreign exchange market for development strategy is to permit a correct appraisal of the dangers of Dutch disease. Empirically it seems that from the standpoint of promoting development it is preferable to have a mildly undervalued rate. The paper concludes by examining implications for exchange rate regimes.
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Notes
The corollary, assuming continuity, is that a government of a developing country should take advantage of its good fortune and revalue, which would improve both the balance of payments and the terms of trade. This corollary was seldom recognized and never turned into a policy recommendation.
Does not the burgeoning literature on order flows (see, for example, Evans and Lyons 2004) talk in flow terms? Yes, but it does not get us far in explaining the determination of exchange rates. This literature traces the flow of orders into the market and aims to explain exchange rate changes on the basis of variations in the flow of orders. It is presumably true, indeed it is surely almost tautologically true, that exchange rate changes follow order flows, but if the orders are not exogenous then it is what determines the willingness to place orders that are the real determinants of exchange rates. This is what is analyzed in the standard literature.
This is a necessary condition for present values to be finite in a model where there is a unique interest rate that applies to lenders and borrowers. It is possible for the pure rate of time preference to be lower, but this needs to be supplemented so that gross interest rates exceed the growth rate. The classic approach adds the rate of growth of consumption multiplied by the marginal utility of income (Ramsey 1928). An alternative is to add a probability of death for lenders and a risk premium for borrowers (Meredith 2007).
If transport costs and trade impediments for all goods were zero and the composition of consumption was the same everywhere, PPP would be a consequence of perfect arbitrage. Conversely, the existence of transport costs (which are practically infinite in the case of nontraded goods) and differences in consumption patterns mean that absolute PPP (equality of the price levels in different countries, after multiplying by the exchange rate) is a nontrivial hypothesis, which holds only if the purchasing power of a unit of money converted by the prevailing exchange rate is the same everywhere. Empirically, the hypothesis has not fared well. Relative PPP (equality of inflation rates, so leaving initial relative prices unchanged) has fared much better, at least as an equilibrium condition (Rogoff 1996).
A good source for standard exchange rate economics is Isard (1995).
It is sometimes referred to simply as the interest parity condition, though this usage runs the risk of confusion with covered interest parity, which is always true in a well-functioning financial system. Covered interest parity is the proposition that the interest differential is equal to the forward premium or discount. Failure of covered interest parity would allow riskless profits to be made by arbitraging between two currencies. In contrast, engaging in arbitrage that is not covered involves taking a speculative risk and yields a profit only if expectations are basically correct.
A transversality condition requires convergence in the long run, so as to rule out Ponzi games being chosen in the optimal solution. (If one assumes that players will always play by the rules of the game, the outcome of a Ponzi game always dominates over any finite time horizon, though one knows that it must eventually blow up. A transversality condition excludes “solutions” that are not indefinitely feasible.)
Alan Walters is reputed to have stated an obvious fact: that the pound was overvalued. But hearing this stated by someone with a strong monetarist reputation and Margaret Thatcher’s ear was enough to persuade “the market” to start ending the overvaluation.
In Shleifer and Summers (1990) chartists are replaced by “noise traders,” whose modus operandi is less well specified, but the model also depends on their interaction with arbitrageurs, who are similar to “fundamentalists” though they are limited in their operations because these involve incurring risks.
And we are right, in a sufficiently long run, but that turns out not to imply that we will make more money.
The financial crisis of 2007 has caused much more distress to hedge fund managers than it would have done in the absence of fat tails to many financial variables.
Dutch disease can also be caused by excessive capital inflows, or too much aid.
Note that the proposition refers to “most” countries, the exceptions being those with small populations relative to the value of their natural resources. For example, forecasts suggest that the citizens of Kuwait and Abu Dhabi will be able to live very comfortably for all future time from their oil and the rents they will earn from investing a large part of the proceeds.
This issue is discussed inter alia in Barry Eichengreen’s (2007) paper written for the Growth Commission.
A good exposition of the standard view is provided by Corden (2002).
There are two definitions of the real exchange rate in the literature (in addition to the trivial Latin American versus Anglo-Saxon issue of which way one expresses an exchange rate). One definition, stemming from the analysis of industrial countries and used in IMF publications, refers to the relative price of two national outputs, qA/pA ÷ qB/pB. The alternative definition, which stems for the analysis of primary producing countries and is widely used in particular in Latin America, is the relative price of tradables to the price of nontradables, pT/pNT. Empirically the two move sufficiently closely together that the choice between them is not a big issue in the short run, although different trends in the productivity of tradable versus nontradable industries can lead to important divergences in the longer term.
Some domestic resident has to be indebted to a foreigner when money has been lent internationally. It would be his responsibility to pay the tax surcharge.
In this context BBC stands for basket (the parity is expressed in terms of a basket of currencies rather than a single currency), band (the exchange rate is allowed to fluctuate in some band around parity), and crawl (parity changes are effected in a series of small steps rather than occasional discrete jumps).
The second B—band—is fundamental, or else the regime becomes one of managed floating.
See Krugman (1991) for the canonical paper that developed the argument.
Inflation targeting is now pursued by the overwhelming majority of countries that have adopted free floats and by an important minority of those with intermediate regimes. It has been adopted so widely because it seems to work. Critics who interpret it as prioritizing inflation control over output growth have made an analytical error, unless at least they still believe in a non-vertical Phillips curve even in the long run. A policy of inflation targeting in fact implies seeking to stimulate employment whenever unemployment rises above the non-accelerating inflation rate of unemployment (NAIRU). Inflation targeting may thus be regarded as a contemporary version of seeking to secure “internal balance.”
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An earlier draft of this paper was prepared for the Growth Commission sponsored by the World Bank in association with the William and Flora Hewlett Foundation and the governments of the Netherlands, Sweden, and United Kingdom. The author is indebted to participants in a meeting of the commission in New York in April 2007, Roberto Zagha, Heiko Hesse, Edmar Bacha, and the participants in a conference at the Instituto de Estudos de Política Econòmica in Rio de Janeiro, particularly discussant Luis Servén, for useful comments on previous drafts.
Copyright © 2008 by the Peterson Institute for International Economics. All rights reserved. No part of this working paper may be reproduced or utilized in any form or by any means, electronic or mechanical, including photocopying, recording, or by information storage or retrieval system, without permission from the Institute.
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Williamson, J. Exchange Rate Economics. Open Econ Rev 20, 123–146 (2009). https://doi.org/10.1007/s11079-008-9091-7
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DOI: https://doi.org/10.1007/s11079-008-9091-7