The Economics of Exchange Rates (Collected Works of Harry Johnson)

Selected Studies

Jacob Frenkel, Harry Johnson

• Publisher: Routledge
• Year: 2013
• ISBN:
  9781135039462
• Edition: 1
• Topic: Economics
• Subtopic: Monetary Policy
• Index: Economics

The studies in this book deal with the determination of foreign exchange rates and the characteristics of the foreign exchange market. Analysis is made of flexible exchange rates through an approach developed by the authors, called the 'asset-market approach'. Theory is combined with practical application in a clear concise way that will be understood by readers with a basic understanding of economics.

CHAPTER 1

A MONETARY APPROACH TO THE EXCHANGE RATE: DOCTRINAL ASPECTS AND EMPIRICAL EVIDENCE

JACOB A. FRENKEL

University of Chicago, Illinois,
USA and Tel-Aviv University, Tel-Aviv, Israel

What, then, has determined and will determine the value of the Franc? First, the quantity, present and prospective, of the francs in circulation. Second, the amount of purchasing power which it suits the public to hold in that shape.
Keynes (Introduction to French edition, 1924, xviii).

ABSTRACT

This paper deals with the determinants of the exchange rate and develops a monetary view (or more generally, an asset view) of exchange rate determination. The first part traces some of the doctrinal origins of approaches to the analysis of equilibrium exchange rates. The second part examines some of the empirical hypotheses of the monetary approach as well as some features of the efficiency of the foreign exchange markets. Special emphasis is given to the role of expectations in exchange rate determination and a direct observable measure of expectations is proposed. The direct measure of expectations builds on the information that is contained in data from the forward market for foreign exchange. The empirical results are shown to be consistent with the hypotheses of the monetary approach.

INTRODUCTION

This paper deals with the determinants of the exchange rate. The approach that is taken reflects the current revival of a monetary view, or more generally an asset view, of the role of the rates of exchange.¹ Basically, the monetary approach to the exchange rate may be viewed as a dual relationship to the monetary approach to the balance of payments. These approaches emphasize the role of money and other assets in determining the balance of payments when the exchange rate is pegged, and in determining the exchange rate when it is flexible.

Being a relative price of two assets (moneys), the equilibrium exchange rate is attained when the existing stocks of the two moneys are willingly held. It is reasonable, therefore, that a theory of the determination of the relative price of two moneys could be stated conveniently in terms of the supply of and the demand for these moneys.

The renewed emphasis on the role of the supply of and the demand for moneys and assets as stocks in contrast with the circular flow approach to the determination of the exchange rate (that gained popularity with the domination of the Keynesian revolution), revives the basic discussion of the Bullionist controversy which culminated in the early 1800’s and led to the developments of the “Balance of Trade Theory” and the “Inflation Theory” of the determination of the exchange rate (Ricardo, 1811; Haberler, 1936; Viner, 1937). Reminiscence of that controversy can be traced to present times in the various discussions and interpretation of the purchasing power parity doctrine. It may be argued that the long experience with the gold standard and with the gold exchange standard may have led to the retrogression of the theory of flexible exchange rates (Wicksell, 1919, p. 231; Gregory, 1922, p. 80).²

The first part of the paper traces some of the doctrinal origins of approaches to exchange rate determination. Its purpose is to provide some perspective into the evolution of the theory.³ The main emphasis of the paper lies in its second part where we examine some of the empirical hypotheses of the monetary approach. In that part we analyze the role of expectations, we describe a direct measure thereof, examine the efficiency of the foreign exchange market during the German hyperinflation; and provide some evidence which supports the asset view of exchange rate determination.

I. A DOCTRINAL PERSPECTIVE TO EXCHANGE RATE DETERMINATION

1.1. The Purchasing Power Parity Doctrine:
The Nature of Equilibrium

The purchasing power parity doctrine (in its absolute version) states that the equilibrium exchange rate equals the ratio of domestic to foreign prices. The relative version of the theory relates changes in the exchange rate to changes in price ratios. Many of the controversies around that doctrine relate to the question of choice of proper indices to be used in computing the parity.¹ One extreme view argues that the proper price index should pertain to traded goods only (Angell, 1922; Bunting, 1939; Heckscher, 1930; Pigou, 1920; Viner, 1937), while according to the other extreme view the proper price index should cover the broadest range of commodities (Hawtrey, 1919, p. 109;Cassel, 1928, p. 33).²

Those who advocate the use of traded goods index emphasize the role of commodity arbitrage while those who advocate the broader price index emphasize the role of asset equilibrium as determining the rate of exchange. If the role of the exchange rate is to clear the money market by equating the purchasing power of the various currencies, then the relevant measure should be a consumer price index.³ Proponents of this view reject the use of the wholesale price index since it gives an excessive weight to traded goods (Ellis, 1936, pp. 28–9; Haberler, 1945, p. 312 and 1961, pp. 49–50).

The two views differ fundamentally in the interpretation of the equilibrium exchange rate. The commodity arbitrage view goes even further in arguing that no aggregate price index is relevant and only individual commodity prices should be analyzed:

Foreign exchange rates have nothing to do with the wholesale commodity price level as such but only with individual prices (Ohlin, 1967, p. 290).

The equilibrium exchange rate reflects spatial arbitrage from which non-traded goods are excluded:

Patently, I cannot import cheap Italian haircuts nor can Niagara-Falls honeymoons be exported (Samuelson, 1964, p. 148).

The asset view takes it for granted that the operation of commodity arbitrage equates the prices of traded goods and emphasizes that if the doctrine only applies to traded goods, then:

the purchasing power parity doctrine presents but little interest … (it) simply states that prices in terms of any given currency, of same commodity must be the same everywhere … Whereas its essence is the statement that exchange rates are the index of the monetary conditions in the countries concerned (Bresciani-Turroni, 1934, p. 121).

In fact since the exchange rate links the purchasing power values of moneys in terms of the broad definition of the price level, one may imagine a situation in which all traded goods possess the same price, when expressed in common currency, but the exchange rate is in disequilibrium:

The equilibrium to which the foreign exchange market tends is an equilibrium of the price level … If the currency units of two countries be considered in terms of foreign trade products only, then the rate of exchange between the two currency units will approximate closely to the ratio of their purchasing power so calculated … But that is not the condition of equilibrium … It is to the price level in general, of home trade products as well as foreign trade products, that the rate of exchange must adjust (Hawtrey, 1919, p. 109).

To completely divorce the determination of exchange rates from considerations of commodity arbitrage, one could even go further in developing an argument for using price indices of non-traded goods only. Such an argument was advanced by Graham:

Strictly interpreted then, prices of non-internationally traded commodities only should be included in the indices on which purchasing power pars are based (Graham, 1930, p. 126, n. 44).

Further pursuit of that idea leads to the use of the price of the least traded commodity–the wage rate parity–advocated by Rueff in 1926 (reproduced in Rueff, 1967), and similar views can also be found in Hawtrey (1919, p. 123) and Cassel (1930, p. 144). The wage rate approach was extended to the concept of production cost parities advocated by Hansen (1944, p. 182), Houthakker (1962, pp. 293–4) and Friedman and Schwartz (1963, p. 62).

Whatever the price index used for computations of parities, the question remains of distinguishing between an equilibrium relationship and a causal relationship. Most authors recognized that prices and exchange rates are determined simultaneously. A minority, however, argued that there exists a causal relationship between prices and exchange rates. While Cassel (1921) claimed that the causality goes from prices to the exchange rate, Einzig (1935, p. 40) claimed the opposite.

1.2. The Asset View

Since in general both prices and exchange rates are endogenous variables that are determined simultaneously, discussions of the link between them provide little insights into the analysis of the determinants of the exchange rate. The original formulation of Cassel (1916) was stated in terms of the relative quantities of money. The formulation was then translated into a relationship between prices via an application of the quantity theory of money. Conceptually, however, it seems clear that the role of prices in Cassel’s computation of the equilibrium exchange rate serves only to proxy the underlying monetary conditions. The determination of exchange rates does not seem to rely, directly or indirectly, on the operation of arbitrage in goods.

In retrospect it seems that the translation of the theory from a relationship between moneys into a relationship between prices-via the quantity theory of money–was counterproductive and led to a lack of emphasis on the fundamental determinants of the exchange rate and to an unnecessary amount of ambiguity and confusion. It is noteworthy that the originators of the theory (although not in its present name)–Wheatley (1803) and Ricardo–stressed the monetary nature of the issues involved as well as the irrelevance of commodity arbitr...

Table of contents

• Cover
• Half Title
• Title Page
• Copyright Page
• PREFACE
• CONTENTS
• Chapter 1 A MONETARY APPROACH TO THE EXCHANGE RATE: DOCTRINAL ASPECTS AND EMPIRICAL EVIDENCE
• Chapter 2 THE THEORY OF FLEXIBLE EXCHANGE RATE REGIMES AND MACROECONOMIC POLICY
• Chapter 3 THE EXCHANGE RATE, THE BALANCE OF PAYMENTS, AND MONETARY AND FISCAL POLICY UNDER A REGIME OF CONTROLLED FLOATING
• Chapter 4 CONTRACTING AND SPURIOUS DEVIATIONS FROM PURCHASING-POWER PARITY
• Chapter 5 RATIONAL EXPECTATIONS AND THE EXCHANGE RATE
• Chapter 6 AN EMPIRICAL ANALYSIS OF THE MONETARY APPROACH TO THE DETERMINATION OF THE EXCHANGE RATE
• Chapter 7 EXCHANGE RESTRICTIONS AND THE MONETARY APPROACH TO THE EXCHANGE RATE
• Chapter 8 TESTS OF FORECASTING MODELS AND MARKET EFFICIENCY IN THE INTERNATIONAL MONEY MARKET
• Chapter 9 RISK, INFORMATION, AND FORWARD EXCHANGE RATES
• Chapter 10 A STOCK ADJUSTMENT APPROACH TO MONETARY POLICY AND THE BALANCE OF PAYMENTS
• Chapter 11 DEVALUATION IN AN EMPIRICAL GENERAL EQUILIBRIUM MODEL
• Author Index