me Theory ami Empirics of Exchange Rates

340 064 me Theory ami Empirics of Exchange Rates Imad A Moosa Monash University, Australia Razzaque H Bhatti Gulf University for Science and Technology, Kuwait World Scientific NEW JERSEY LONDON SINGAPORE BEIJING SHANGHAI HONG KONG TAIPEI CHENNAI

Contents Preface List of Tables List of Figures List of Acronyms Currency Abbreviations vii xix xxi xxv xxvii 1. Why Do We Study Exchange Rates? 1 1.1. Introduction 1 1.2. The Importance of Exchange Rates 3 1.2.1. The Exchange Rate and Business Operations 3 1.2.2. The Exchange Rate and Macroeconomic Policy 5 1.2.3. Macroeconomic Linkages Through Exchange Rates 5 1.3. Stylized Facts and Figures 7 1.3.1. Stylized Facts: Exchange Rates Only... 7 1.3.2. Stylized Facts: Spot Rates, Forward Rates, and Macroeconomic Variables 12 1.4. Exchange Rates and Other Financial Prices: The Subprime Crisis as an Example 16 1.5. Exchange Rate Regimes 19 1.5.1. Exchange Rate Regime Classification... 19 1.5.2. Exchange Rate Regime Verification 22 1.6. What Is to Come 22 IX

x The Theory and Empirics of Exchange Rates 2. Exchange Rate Determination in the Mundell-Fleming Model 26 2.1. Introduction 26 2.2. Disequilibrium Systems and Alternative Adjustment Mechanisms 29 2.3. Efficacy of Fixed and Flexible Exchange Rates 37 2.4. Dynamic Adjustment Under Fixed and Flexible Exchange Rates.. _ 40 2.5. Dynamic Adjustment and the Role of Capital Mobility 42 2.6. The Appropriate Use of Monetary and Fiscal Policies 46 2.7. Stabilization Policies Under Fixed and Flexible Exchange Rates 49 2.8. The Standard Mundell-Fleming Model 54 2.8.1. Fundamental Propositions of the Mundell- Fleming Model 55 2.8.2. The Structure of the Mundell-Fleming Model 57 2.9. The Reduced Form Equation of the Equilibrium Exchange Rate 59 2.9.1. The Current Account 60 2.9.2. The Capital Account 61 2.10. Stabilization Policies Under Alternative Exchange Rate Regimes 65 2.10.1. Fixed Exchange Rates, Capital Mobility and Stabilization Policies 66 2.10.2. Flexible Exchange Rates, Capital Mobility, and Stabilization Policies 70 2.11. A Critique of Mundell's Results About Stabilization Policies 74 2.11.1. McLeod's Critique of Mundell's Results... 74 2.11.2. Niehans's Doubts About the Efficacy of Monetary Policy..., 78 2.12. Recapitulation 80

Contents xi 3. The Flexible-Price Monetary Model of Exchange Rates 82 3.1. Introduction 82 3.2. Key Propositions of the Flexible-Price Monetary Model 85 3.3. The Specification of the Flexible-Price Monetary Model 87 3.4. A Digrammatic Representation of the Flexible-Price Monetary Model ; 89 3.5. Some Variants of the Flexible-Price' s Monetary Model. 95 3.5.1. The Rational Expectations Monetary Model. 95 3.5.2. Frankel's Flexible-Price Monetary Model with a Wealth Effect 98 3.5.3. A General Monetary Model of Exchange Rates 99 3.6. Policy Implications of the Flexible-Price Monetary Model 101 3.7. Recapitulation 102 4. The Theory of the Balance of Payments 104 4.1. The Price-Specie Flow Mechanism 104 4.2. The Elasticities Approach and the J-Curve Effect... 108 4.3. The Keynesian Multiplier Approach 114 4.4. The Income Absorption Approach 115 4.5. The Monetary Approach to the Balance of Payments. 124 4.5.1. Fundamental Propositions of the Monetary Approach 127 4.5.2. A Simple Monetary Model of the Balance of Payments 132 4.5.3. A Diagrammatic Representation of the Monetary Approach 134 4.5.4. An Expanded Monetary Model of the Balance of Payments 140 4.5.5. Policy Implications of the Monetary Approach 141 4.6. A Comparison of the Monetary and Keynesian Models 143

xii The Theory and Empirics of Exchange Rates 4.7. A Synthesis of Monetary and Keynesian Approaches 144 4.8. Recapitulation 147 5. Exchange Rate Determination in the Dornbusch Model 149 5.1. Introduction 149 5.2. Fundamental Propositions of the Dornbusch Model.. 151 5.3. In Defense of the Mundell-Fleming Model 153 5.3.1. A Restatement of the Mundell-Fleming Model :.. - 153 5.3.2. Exchange Rate Expectations and Adjustment to Monetary Expansion 155 5.3.3. Failure of the Marshall-Lerner Condition.. 159 5.3.4. Exchange Rate Overshooting and Aggregate Spending 159 5.4. Short- and Long-Run Views of Exchange Rates... 162 5.4.1. Exchange Rate Determination in the Short Run 162 5.4.2. Exchange Rate Determination in the Long Run 164 5.4.3. Interaction Between Goods and Asset Markets 166 5.5. The Overshooting Model of Exchange Rates 169 5.5.1. The Structure of the Dornbusch Model... 170 5.5.2. Adjustment to Monetary Expansion 179 5.6. The Reduced Form Equation of the Equilibrium Exchange Rate 183 5.7. Recapitulation 184 6. Other Sticky-Price Monetary Models of Exchange Rates 186 6.1. Introduction 186 6.2. The Real Interest Differential Monetary Model... 190 6.2.1. Moderate Inflation and the Exchange Rate Expectations Scheme 190 6.2.2. A More General Model of Exchange Rate Determination 191 6.3. Driskell's Generalized Stock-Flow Sticky-Price Model 193 6.3.1. The Dornbusch Model in Discrete Time... 193 6.3.2. The Stock-Flow Model 195

Contents xiii 6.4. The Equilibrium Real Exchange Rate Monetary Model 196 6.4.1. The Expectation Mechanism and Exchange Rate Determination 196 6.4.2. The Equilibrium Real Exchange Rate /and Current Account 198 6.4.3. The Reduced-Form Equation of Exchange Rate Determination 200 6.4.4. The Impact of the Risk Premium on the Exchange Rate 202 6.5. The Buiter-Miller Model with Core Inflation Rate... 203 6.6. Frankel's Sticky-Price Model with a Wealth Effect.. 204 6.7. Recapitulation 205 7. The Monetary Model of Exchange Market Pressure 206 7.1. Introduction 206 7.2. The Exchange Market Pressure Model of Exchange Rates 208 7.3. Exchange Market Pressure and Monetary Independence 211 7.4. A Simple Version of the Girton-Roper Market Pressure Model 213 7.5. An Expanded Version of the Girton-Roper Market Pressure Model 216 7.6. Recapitulation 218 8. The Portfolio Balance Model of Exchange Rates 220 8.1. Introduction 220 8.2. The Portfolio Balance Effect of Wealth and the Exchange Rate 222 8.3. The Current Account in the Portfolio Balance Model 225 8.4. The Structure of the Portfolio Balance Model 226 8.5. Short-Run Properties of the Portfolio Balance Model. 230 8.6. Stable Portfolio Balance and Short-Run Exchange Rate Determination 231 8.7. Monetary Policy Effects on Exchange and Interest Rates 235 8.7.1. Monetary Expansion via Open Market Purchases of Domestic Bonds 235

xiv The Theory and Empirics of Exchange Rates 8.7.2. Monetary Expansion via Open Market Purchases of Foreign Bonds 237 8.7.3. Sterilized Open Market Foreign Exchange Operations 238 8.7.4. A Rise in Wealth via Accumulation * of Foreign Assets 239 8.8. Fiscal Policy Effects on Exchange and Interest Rates 241 8.8.1. Money-Financed Government Budget Deficit.' 241 8.8.2. Bond-Financed Government Budget Deficit 242 8.9. Alternative Specifications of the Portfolio Balance Model 243 8.10. A Synthesis of the Monetary and Portfolio Balance Models 248 8.11. The Portfolio Balance Model with a Banking Sector.. 251 8.11.1. The Model 251 8.11.2. The Impact of Monetary Policy on Exchange and Lending Rates 253 8.12. The Portfolio Balance Model with Bank Lending... 256 8.13. Recapitulation 258 9. The Currency Substitution Model of Exchange Rates 260 9.1. Introduction 260 9.2. Currency Substitution and Dollarization 261 9.3. Implications of Currency Substitution 264 9.4. Determinants of Currency Substitution 266 9.5. Exchange Rate Determination Under Currency Substitution 270 9.6. The Calvo-Rodriguez Overshooting Currency Substitution Model 271 9.6.1. Assumptions of the Model 272 9.6.2. The Asset Market 273 9.6.3. The Goods Market 274 9.6.4. A Diagrammatic Illustration of the Currency Substitution Model 277 9.7. The Importance of Currency Substitution in a Regional Setting 281

Contents xv 9.8. Some Policy and Analytical Issues Related to Currency Substitution 282 9.8.1. Should Currency Substitution be Encouraged? 282 9.8.2. Discouraging the Use of Foreign ' Currencies 284 9.8.3. Currency Substitution and Nominal Anchors 284 9.8.4. Monetary Expansion and the_real Exchange Rate 286 9.8.5. Inflationary Finance under Currency Substitution 287 9.9. Recapitulation ; 290 10. The Microstructure Approach to Exchange Rates 292 10.1. Macroeconomic Models: Failure and Alternatives... 292 10.2. The Microstructure Models of Exchange Rates... 295 10.2.1. Assumptions of Microstructure Models... 296 10.2.2. Exchange Rate Determination in Microstructure Models 297 10.2.3. Information Models versus Inventory Models 301 10.3. Factors Affecting Exchange Rates in Microstructure Models 302 10.3.1. Order Flow 302 10.3.2. The Bid-Offer Spread 305 10.4. The Microstructure Solution to the Determination Puzzle 307 10.5. The Microstructure Solution to the Excess Volatility Puzzle 313 10.6. The Microstructure Solution to the Forward Bias Puzzle 316 10.6.1. The Statistician's Perspective on Forward Bias 317 10.6.2. The Economist's Perspective on Forward Bias 318 10.6.3. The Practitioner's Perspective: Limits to Speculation 318

xvi The Theory and Empirics of Exchange Rates 10.6.4. A Simple Explanation: Model Misspecification 321 10.7. Recapitulation 322 11. The News Model of Exchange Rates 324 11.1. Intrqduction 324 11.2. The Role of News in Macroeconomic Models of Exchange Rates 325 11.2.1. The News Framework of the Flow Model.. 328 11.2.2. The News Framework of the Monetary Models 329 11.2.3. The News Framework of the Portfolio Balance Models 331 11.3. The Role of News in the Microstructure Models of Exchange Rates 333 11.3.1. The Link Between Macroeconomic Fundamentals and Exchange Rates 336 11.3.2. The Link Between Order Flow and Macroeconomic News 337 11.4. Recapitulation 338 12. Empirical Evidence on the Macroeconomic Models of Exchange Rates 340 12.1. Evidence on the Mundell-Fleming Model 340 12.2. Evidence on the Monetary Model of Exchange Rates 342 12.2.1. Evidence Based on Conventional Econometric Methods 342 12.2.2. Out-of-Sample Forecasting 346 12.2.3. Cointegration-Based Dynamic Models... 354 12.2.4. Simultaneous Equation Models 359 12.3. Evidence on the Monetary Model Under Rational Expectations 359 12.4. Evidence on the Monetary Model Allowing for Currency Substitution 362 12.5. Evidence on the Portfolio Balance Model 365 12.6. Evidence on the Role of News 369 12.7. Evidence on the Exchange Market Pressure Model.. 373 12.8. Recapitulation 377

Contents xvii 13. Empirical Evidence on the Microstructure Models of Exchange Rates 379 13.1. Introduction 379 13.2. The Explanatory Power of Order Flow 380 13.3. Order Flow and Other Characteristics of Exchange Rates 393 13.4. The Forecasting Power of Order Flow 395 13.5. The Micro Impact of Macroeconomic News on Exchange Rates >....- 398 13.5.1. Macroeconomic Fundamentals-Related News and Exchange Rate Changes 398 13.5.2. Macroeconomic Announcements and Exchange Rates 399 13.5.3. Macroeconomic News and Exchange Rate Mean and Variance 402 13.5.4. Macroeconomic Announcements, Order Flow, and Exchange Rates 409 13.6. A Microstructure Test of International Financial Integration 417 13.7. Recapitulation 420 14. Concluding Thoughts and Remarks 422 14.1. Where Do We Stand? 422 14.2. Rational Expectations in the Foreign Exchange Market 426 14.3. Exchange Rate Peculiarities 427 14.4. Pitfalls in Exchange Rate Economics 431 14.5. Alternative Approaches to Exchange Rates 433 14.5.1. The Post-Keynesian Approach 433 14.5.2. The Behavioral Finance Approach to Exchange Rates 435 14.5.3. Chaos Theory 436 14.6. Do Macroeconomic Fundamentals Matter? 438 14.7. Concluding Remarks 442 References 443 Index 477