CHAPTER 2- THEORETICAL FRAMEWORK: EXCHANGE RATE
2.8 Summary 33
The exchange rate literature has gained substantially from the contribution imparted by approaches or models such as the purchasing power and interest rate parities, the balance of payments, the portfolio balance, the sticky prices, the RE and the ‘news’ models. PPP, which states that exchange rates between different currencies are in equilibrium when their purchasing power is the same in each of the two countries, owes its credibility to the role of arbitrageurs. However, monetary and real variables such as the existence of transaction cost and non-tradeables, variants of indices, the pattern of money and asset prices, simultaneity problem and productivity differentials weaken its validity and, hence, its empirical evidence.
As to IRP, which takes the interest rate differential as a predictor of exchange rate, states that interest rate differential driven speculators and arbitrageurs engagement in buying and selling assets higher for real returns force these returns to convergence for risky and risk-free profit respectively. The UIRP, unlike its variant, CIRP, is virtually impossible to test in isolation, given limited availability and questionable data quality. The consistency evidence on CIRP has been mixed and sometimes classified along the long and short-term currency swaps.
In the floating exchange rate BOP version that prohibits capital flow, an increase in the national income appears to dampen the current account and weaken the exchange rate.
Consequently, the lower currency rate ameliorates exports while depressing imports, thereby making current account improvement and currency strength imminent. In contrast, the version that permits capital flows worsens the current account in response to national income increases. In order to avoid official reserve movements, capital account improvement may be achieved via higher interest rates that dampens demand and, by implication, imports.
The Portfolio Balance Model that treats exchange rate as a function of the relative supply of domestic and foreign bonds considers home-currency securities or bonds, unlike the monetary approach of BOP, as imperfect substitutes, and considers the risk aversion as the overwhelming rationale for investment choice between domestic and foreign currency securities. Its wealth effect that regards saving as a flow of foreign currency via current account surplus assumes that, in floating exchange rate, the capital account surplus of a domestic economy must equate with the deficit on the current account of the rest of the world, and vice versa.
Table 2.1 Summary: Some Aspects of Exchange Rate (ER) Models
Variables Involved Exchange Rate
Model
Dependent Independent
Merit Demerit Focus Remark
The PPP Model (Absolute and Relative)
ER commodity prices
in respective countries
largely explains ER in the long- run
failure to address non- tradeables, transaction cost, money & asset prices, indexes’
variants, simultaneity &
productivity differentials
role of arbitrageurs
most influential and popular, results sometimes tend to vary along sample size, cross-section vs. time series, &
level of economic development lines The IRP
(Interest Rate Parity) Model
ER Interest rate
differential in domestic &
foreign assets
plausible given mobile international capital &
convertibility
heavily influenced by
‘news’
International capital mobility
The need for distinction b/n Covered Interest Rate & Uncovered Interest Rate Parities The Balance of
Payments (BOP) Model
ER Current & capital accounts
Covers inter- action of capital
& current a/c with the ROW
applies static rather than dynamic approach to national income analysis
sensitivity to imports and exports
-assumes domestic
& foreign bonds as perfect substitutes The Portfolio-
Balance Model
ER Domestic and
foreign bonds
Extends monetary approach by adding foreign money & bonds
Foreign denominated assets make demand for money more complex than in monetary approach
risk aversion as rationale for investment choice
-assumes foreign money bonds as perfect substitutes for domestic money and bonds
The Dornbusch (Sticky Prices) Model
ER Commodity price
in respective countries
Realistically reflects sluggish adjustment to price levels
-failure to account for current a/c role & its ad hoc specification of price determination process
menu costs and customer imperfect information on price
- sticky as opposed to flexible prices - affected by news on money supply The RE
(Rational Expectation) Model
ER (Future spot rate)
forward rate Enjoys fair empirical evidence
Lacks solid economic underpinnings
significance of expectation
prompts economists to consider feedback features in model building The News
‘Model’ or Approach
ER News regarding
fundamentals
Often affects ER greatly &
unpredictably
Difficulty in quantifying the news & isolating the white noise error
revising future fundamentals
unforeseen &
unforeseeable nature of news
The Dornbusch model, as opposed to previous models that presume either floating or fixed exchange rates, opts for sticky prices. The sticky prices act in response to new information about money supply. Thus, in response to slowly adjusting price levels, exchange rate overshoots – its tendency to jump in one direction precipitated by news, to be subsequently followed by its retreat to its original position. In parallel, the model has established the notion that such exchange rate movements are consistent with rational expectation formation.
Regarding expectations based on efficient and weakly efficient markets, the RE model refers to market participants enjoying complete information, form rational expectations, and to those incompletely informed who extract relevant information from the past exchange rate trading history per se respectively. Though the former lack economic underpinnings, its application by agents makes it difficult for economists to sideline it. The latter, fundamentals, highlights the importance of different structural models of exchange rates.
Finally, the ‘news’ model, more of an approach to estimating various theories, points to a random error that, in addition to forward rates and risk premium (discount) determines the spot rate. It indicates the unpredictable and unexpectational error written out explicitly in terms of ‘news’ regarding the fundamentals. Assuming RE and relying on the bootstrap feature; the information set incorporates all the previously available information including the latest news that arrives during the period. The next chapter looks into the productivity bias hypothesis that reflects the real variable in PPP determination. It discusses the importance of PPP in the context of productivity that falls under the category of real variables.