Exchange Rate Economics

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Exchange Rate Economics

Exchange Rate Economics: Theories and Evidence is the second edition of Floating Exchange

Rates: Theories and Evidence,and builds on the successful content and structure

of the previous edition,but has been comprehensively updated and expanded

to include additional literature on the determination of both fixed and floating

exchange rates.

Core topics covered include:

• the purchasing power parity hypothesis and the PPP puzzle;

• the monetary and portfolio-balance approaches to exchange rates;

• the new open economy macroeconomics approach to exchange rates; and

• the determination of exchange rates in target zone models and speculative

attack models.

Exchange Rate Economics: Theories and Evidence also includes extensive discussion of

recent econometric work on exchange rates with a particular focus on equilibrium

exchange rates and measuring exchange rate misalignment,as well as discussion

on the non-fundamentals-based approaches to exchange rate behaviour,such as

the market microstructure approach.

The book will appeal to academics and postgraduate students with an interest

in all aspects of international finance and will also be of interest to practitioners

concerned with issues relating to equilibrium exchange rates and the forecastability

of currencies in terms of macroeconomic fundamentals.

Ronald MacDonald is the Adam Smith Professor of Political Economy,

University of Glasgow.

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Exchange Rate Economics

Theories and evidence

Ronald MacDonald

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First published 2007

by Routledge

2 Park Square, Milton Park, Abingdon, Oxon OX14 4RN

Simultaneously published in the USA and Canada

by Routledge

270 Madison Ave, New York, NY10016

Routledge is an imprint of the Taylor & Francis Group, an informa business

© 2007 Ronald MacDonald

All rights reserved. No part of this book may be reprinted or

reproduced or utilised in any form or by any electronic,

mechanical, or other means, now known or hereafter

invented, including photocopying and recording, or in any

information storage or retrieval system, without permission in

writing from the publishers.

British Library Cataloguing in Publication Data

A catalogue record for this book is available from the British Library

Library of Congress Cataloging in Publication Data

A catalog record for this book has been requested

ISBN13: 978–0–415–14878–8 (hbk)

ISBN13: 978–0–415–12551–2 (pbk)

ISBN13: 978–0–203–38018–5 (ebk)

This edition published in the Taylor & Francis e-Library, 2007.

“To purchase your own copy of this or any of Taylor & Francis or Routledge’s

collection of thousands of eBooks please go to www.eBookstore.tandf.co.uk.”

ISBN 0-203-38018-5 Master e-book ISBN

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To Catriona

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Contents

List of figures ix

List of tables xii

Preface xiii

1 Introduction: some basic concepts and stylised facts and the

case for (and against) floating exchange rates 1

2 Purchasing power parity and the PPP puzzle 39

3 The economics of the PPP puzzle 68

4 The flexible price monetary approach to the exchange rate 94

5 The sticky-price monetary model 106

6 The monetary approach to the exchange rate: an empirical

perspective 134

7 Currency substitution models and the portfolio balance

approach to the exchange rate 166

8 Real exchange rate determination: theory and evidence 199

9 Equilibrium exchange rates: measurement and

misalignment 227

10 The new open economy macroeconomics and exchange

rate behaviour 251

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viii Contents

11 The new open economy macroeconomic model: pricing to

market and exchange rate volatility redux 274

12 The economics of fixed exchange rates,part 1: target

zone models 289

13 The economics of fixed exchange rates,part 2: speculative

attack models and contagion 313

14 The market microstructure approach to the foreign

exchange market 339

15 Spot and forward exchange rates and the forward

premium puzzle 370

Notes 396

References 405

Index 440

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Figures

1.1 The balance of payments model of the determination of the

exchange rates 9

1.2 Exchange rate bands 10

1.3 Multiple equilibria in the foreign exchange markets 11

1.4 The joint determination of the spot and forward exchange rates 15

1.5 (a) UK pound sterling per US dollar,actual change and forward

premium. (b) Japanese yen per US dollar,actual change and

forward premium. (c) German Deutschemark per US dollar,

actual change and forward premium 22

1.6 Time series of traditional fundamentals,benchmark

flexible-price model 25

1.7 Time series of benchmark virtual fundamentals 26

1.8 (a) UK pound sterling per US dollar,nominal and real rates.

(b) Japanese yen per US dollar,nominal and real rates.

(c) German Deutschemark per US dollar,nominal and

real rates 27

2.1 PPP and the neutral band 42

4.1 An endowment change in the monetary model 104

5.1 The Mundell–Fleming model 108

5.2 Monetary expansion in the MF model 110

5.3 Fiscal policy and the MF model 111

5.4 The insulation properties of the MF model with respect to a

foreign interest rate shock 112

5.5 Monetary expansion and imperfect capital mobility 113

5.6 Fiscal expansion and imperfect capital mobility 114

5.7 The phase diagram representation of the SPMA model 117

5.8 Unanticipated and anticipated decreases in the money supply 118

5.9 The dynamic behaviour of the exchange rate and price level,

when the exchange rate is a deflator of real money balances 121

5.10 Goods market wealth effect dominates money market wealth

effect 122

5.11 Money market wealth effect dominates goods market wealth effect 122

5.12 Unanticipated reduction in the rate of monetary growth in the

Buiter–Miller model 126

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x Figures

5.13 Level and growth changes in the money supply 127

6.1 Actual and theoretical spread 162

7.1 Equilibrium in dynamic currency substitution model 1 172

7.2 Open market purchase of foreign money for domestic money 172

7.3 Currency substitution with perfect foresight and non-traded good 175

7.4 Increased monetary expansion in currency substitution model 2 176

7.5 Asset market equilibrium 182

7.6 Goods market equilibrium 183

7.7 Asset and goods market equilibrium in the portfolio balance

model 184

7.8 An open market purchase of bonds for money 185

7.9 The adjustment profiles of (a) the trade account,(b) the capital

account and (c) the exchange rate 187

7.10 An increase in the supply of bonds and currency depreciation 188

7.11 An increase in the supply of bonds which causes currency

appreciation 188

7.12 A shift in asset preferences 190

9.1 US BEER 234

9.2 US BEER,Counterfactual L,NFA at 1980 values (post-1980) 235

9.3 Sources of $/DM real exchange rate fluctuations 238

9.4 Effective exchange rate misalignments 239

10.1 Short-run equilibrium in NOEM 260

10.2 Unexpected relative rise in home money in NOEM 262

10.3 An unexpected temporary increase in home G 265

10.4 Unexpected relative rise in domestic productivity 267

12.1 The S function 291

12.2 Monetary policy and a family of S curves 293

12.3 The S schedule in S–f space 294

12.4 Smooth pasting in this sticky-price monetary model 296

12.5 Expected rate of devaluation (95% conf.i.): 3 months –

(a) BF/DM,(b) DK/DM,(c) FF/DM,(d) IL/DM,

(e) IP/DM and (f) NG/DM 299

12.6 Ninety-five confidence intervals for expected depreciation in

Bretton Woods: (a) of deutsche mark (b) of sterling 300

12.7 Expected realignment rate,95% CI,franc-sterling,Classical

Gold Standard 301

12.8 Expected realignment rate,95% CI,dollar-sterling,Classical

Gold Standard 301

12.9 Intra-marginal interventions 305

12.10 Components of the interest differential 309

12.11 Impulse response functions for system 2 311

13.1 First generation speculative attack model 316

13.2 The dynamics of the crisis 318

13.3 Second generation speculative attack model 320

13.4 Base line MF model 324

13.5 Third generation speculative attack model 325

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Figures xi

13.6 Fourth generation speculative attack model (sufficiently

responsive monetary authority) 327

13.7 Fourth generation speculative attack model (insufficiently

responsive monetary authority) 327

13.8 Fourth generation speculative attack model (no monetary

action case) 328

14.1 The two stages of information processing 360

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Tables

1.1 Global foreign exchange market turnover 5

1.2 Volumes and volatility of foreign exchange turnover 5

1.3 Currency distribution of reported foreign exchange market

turnover 6

1.4 Coefficients of variation of exchange rates and fundamentals 21

1.5 Exchange rate regime classifications 29

2.1 Engle–Granger two-step cointegration tests 54

2.2 Multivariate cointegration tests of PPP 55

6.1 Summary of different monetary models 137

6.2 Cointegration results for the monetary model 145

6.3 Cointegration results for the mark–dollar exchange rate 146

6.4 Dynamic forecast statistics 151

6.5 SEM equations: United Kingdom 154

6.6 Dynamic forecasting performance 155

6.7 Forecasting performance from a tripolar model 156

6.8 Root mean square error ratios for the monetary model of

La Cour and MacDonald 156

7.1 Some currency substitution evidence 192

8.1 Restricted cointegrating vectors for the Japanese yen effective

exchange rate 211

12.1 FIML estimation results 1890/02–1908/12 308

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Preface

This book is the second edition of Floating Exchange Rates: Theories and Evidence,first

published in 1988. That book was,I believe,the first to present a comprehensive

overview of both the theoretical and empirical strands of the exchange rate

literature and is still in print today despite much of the material being dated.

The changed name for the second edition reflects the changed nature of the subject

matter post-1988. Revising a book of this nature is a big undertaking and it certainly

would not have been possible were it not for the fact that I was invited to present

a course,entitled ‘The Economics of Exchange Rates’,at the IMF Institute in

1997,and subsequently asked to present revised versions of the course on seven

subsequent occasions. This is a five-day course which covers the core material

in this book. I am therefore indebted to Mohsin Khan for initially inviting me to

present this course and to Andrew Feltenstein for continuing the link sinceMohsin’s

departure from the Institute; without the discipline of preparing this course there

is no doubt that this book would never have been completed. I am also grateful to

the many IMF staff members and country officials who have indirectly commented

on the contents of this book and to the many other participants in central banks,

financial institutions and universities who have also commented on the Economics

of Exchange Rate course on the many other occasions it has been delivered.

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