Exchange rates and international finance 4e

Exchange rates and exchange rate fluctuation continue to play an increasingly important role in all our lives Exchange Rates and International Finance fourth edition provides a clear and concise guide to the causes and consequences of exchange rate fluctuations, enabling you to grasp the essentials of the theory and its relevance to major events in currency markets Fourth Edition Suitable for those following a course on international macroeconomics, international finance, or international money as a part of an economics or business programme at undergraduate, MBA or specialist Masters levels Laurence Copeland is Professor of Finance at Cardiff University, UK New to this Edition • Thoroughly updated to reflect recent events on the world monetary/financial scene • More included on recent empirical results • New chapter on general equilibrium models to cover the latest thinking on more advanced techniques • Expanded and up-to-date coverage of the Euro • Extended coverage of recent innovations on the Law of One Price and Purchasing Power Parity • New section on the relationship between PPP, UIRP and the Fisher equation An imprint of Additional student support at www.pearsoned.co.uk/copeland www.pearson-books.com EXCHANGE RATES and INTERNATIONAL FINANCE Key Features • A clear, non-technical explanation of the issues, emphasising intuitive understanding and interpretation of economic arguments rather than mathematical proofs • A balanced summary of the state of our knowledge in this area, including explanations of the problems faced by researchers in this field, and an indication of what questions remain open • Provides a sound overview of empirical evidence, without going into intricate detail: a springboard for those wishing to delve deeper into the published literature • Early chapters explain the basics of demand and supply, and basic macroeconomics, so those without prior study in economics will find the subject accessible • Covers leading edge material including the latest general equilibrium approaches LAURENCE COPELAND The orientation of the book is towards exchange rate determination with particular emphasis given to the contributions of modern finance theory Both fixed and floating exchange rate models and empirical results are explored and discussed ERA_A01.qxd 09/27/2004 02:57PM Page i Exchange Rates and International Finance ERA_A01.qxd 09/27/2004 02:57PM Page ii We work with leading authors to develop the strongest educational materials in International Finance, bringing cutting-edge thinking and best learning practice to a global market Under a range of well-known imprints, including Financial Times Prentice Hall, we craft high quality print and electronic publications which help readers to understand and apply their content, whether studying or at work To find out more about the complete range of our publishing, please visit us on the World Wide Web at: www.pearsoned.co.uk ERA_A01.qxd 09/27/2004 02:57PM Page iii Fourth Edition Exchange Rates and International Finance Laurence S Copeland ERA_A01.qxd 09/27/2004 02:57PM Page iv To the memory of Robert Copeland Pearson Education Limited Edinburgh Gate Harlow Essex CM20 2JE England and Associated Companies throughout the world Visit us on the World Wide Web at: www.pearsoned.co.uk First published in Great Britain 1989 Second edition published 1994 Third edition published 2000 Fourth edition published 2005 © Addison-Wesley Publishers Ltd 1989, 1994 © Pearson Education Limited 2000, 2005 The right of Laurence Copeland to be identified as author of this work has been asserted by him in accordance with the Copyright, Designs and Patents Act 1988 All rights reserved No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without either the prior written permission of the publisher or a licence permitting restricted copying in the United Kingdom issued by the Copyright Licensing Agency Ltd, 90 Tottenham Court Road, London W1T 4LP ISBN 0273-68306-3 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 is available from the Library of Congress 10 09 08 07 06 05 Typeset in 10/12.5pt Times by 35 Printed and bound by Bell & Bain Limited, Glasgow The publisher’s policy is to use paper manufactured from sustainable forests ERA_A01.qxd 09/27/2004 02:57PM Page v Contents Preface to the fourth edition Publishers’ acknowledgements Introduction Introduction 1.1 What is an exchange rate? 1.2 The market for foreign currency 1.3 Balance of payments 1.4 DIY model 1.5 Exchange rates since World War II: a brief history 1.6 Overview of the book Summary Reading guide Notes Part I THE INTERNATIONAL SETTING Prices in the open economy: purchasing power parity Introduction 2.1 The law of one price in the domestic economy 2.2 The law of one price in the open economy 2.3 A digression on price indices 2.4 Purchasing power parity 2.5 Purchasing power parity – the facts at a glance H 2.6 Purchasing power parity extensions H 2.7 Empirical research 2.8 Conclusions Summary Reading guide Notes Financial markets in the open economy Introduction 3.1 Uncovered interest rate parity 3.2 Covered interest rate parity 3.3 Borrowing and lending 3.4 Covered interest rate parity – the facts 3.5 Efficient markets – a first encounter H 3.6 PPP revisited x xii 1 11 18 22 23 33 34 35 36 41 43 43 44 51 56 59 65 68 73 74 76 77 78 81 81 82 90 92 96 97 100 ERA_A01.qxd 09/27/2004 02:57PM Page vi vi Contents Summary Reading guide Notes 104 105 105 Open economy macroeconomics 109 Introduction 4.1 IS–LM model of aggregate demand 4.2 Aggregate supply 4.3 Conclusions Summary Reading guide Notes 109 110 132 137 138 139 139 Part II EXCHANGE RATE DETERMINATION Flexible prices: the monetary model Introduction 5.1 The simple monetary model of a floating exchange rate 5.2 The simple monetary model of a fixed exchange rate 5.3 Interest rates in the monetary model 5.4 The monetary model as an explanation of the facts 5.5 Conclusions Summary Reading guide Notes Fixed prices: the Mundell–Fleming model Introduction 6.1 Setting 6.2 Equilibrium 6.3 Monetary expansion with a floating exchange rate 6.4 Fiscal expansion with a floating exchange rate 6.5 Monetary expansion with a fixed exchange rate 6.6 Fiscal expansion with a fixed exchange rate 6.7 The monetary model and the Mundell–Fleming model compared 6.8 Evidence 6.9 Conclusions Summary Reading guide Notes Sticky prices: the Dornbusch model Introduction 7.1 Outline of the model 7.2 Monetary expansion H 7.3 A formal explanation 7.4 Oil and the UK economy H 7.5 Empirical tests: the Frankel model 143 145 145 146 154 163 165 169 169 170 170 172 172 173 176 177 178 180 182 183 187 188 188 188 189 191 191 192 197 201 205 211 ERA_A01.qxd 09/27/2004 02:57PM Page vii Contents 7.6 Conclusions Summary Reading guide Notes Portfolio balance and the current account Introduction 8.1 Specification of asset markets 8.2 Short-run equilibrium 8.3 Long-run and current account equilibrium 8.4 Evidence on portfolio balance models 8.5 Conclusions Summary Reading guide Notes Currency substitution H10 vii 212 213 214 214 216 216 217 221 226 228 233 233 234 234 236 Introduction 9.1 The model 9.2 Evidence on currency substitution 9.3 Conclusions Summary Reading guide Notes 236 237 244 245 246 246 247 General equilibrium models 249 Introduction 10.1 The Redux model 10.2 Extensions of Redux 10.3 Evidence 10.4 Conclusions Summary Reading guide Notes Appendix 10.1: Derivation of price index (Equation 10.2) Appendix 10.2: Derivation of household demand (Equations 10.6 and 10.6′) Appendix 10.3: Log linearization of model solution (Equations L1–L4) Appendix 10.4: Sticky prices 249 251 269 272 273 274 275 275 277 279 279 281 11 Optimum currency areas and monetary union Introduction 11.1 Benefits of monetary union 11.2 Costs of monetary union 11.3 Other considerations 11.4 Currency boards 11.5 Conclusions Summary Reading guide Notes 282 282 285 290 293 303 305 306 307 307 ERA_A01.qxd 09/27/2004 02:57PM Page viii viii Contents Part III A WORLD OF UNCERTAINTY 12 Market efficiency and rational expectations Introduction 12.1 Mathematical expected value 12.2 Rational expectations 12.3 Market efficiency 12.4 Unbiasedness 12.5 The random walk model 12.6 Testing for efficiency: some basic problems 12.7 Spot and forward rates: background facts 12.8 Results 12.9 Conclusions Summary Reading guide Notes 13 The ‘news’ model and exchange rate volatility Introduction 13.1 The ‘news’ model: a simple example H 13.2 The monetary model revisited 13.3 Testing the ‘news’ 13.4 Results H 13.5 Volatility tests, bubbles and the peso problem 13.6 Conclusions Summary Reading guide Notes 14 The risk premium Introduction 14.1 Assumptions 14.2 A simple model of the risk premium: mean-variance analysis H 14.3 A general model of the risk premium 14.4 Evidence of the risk premium 14.5 Conclusions Summary Reading guide Notes Appendix 14.1 Part IV FIXED EXCHANGE RATES 15 A certain uncertainty: non-linearity, cycles and chaos Introduction 15.1 Deterministic versus stochastic models 15.2 A simple non-linear model 313 315 315 316 319 322 324 325 327 328 330 333 334 335 335 339 339 340 342 348 352 354 359 359 360 361 363 363 364 365 368 374 375 375 376 376 378 379 381 381 382 383 ERA_A01.qxd 09/27/2004 02:57PM Page ix Contents 15.3 Time path of the exchange rate 15.4 Chaos 15.5 Evidence 15.6 Conclusions Summary Reading guide Notes 16 Target zones Introduction 16.1 What is a target zone? 16.2 Effect of target zones 16.3 Smooth pasting H 16.4 An option interpretation 16.5 A honeymoon for policymakers? 16.6 Beauty and the beast: the target zone model meets the facts 16.7 Intramarginal interventions: leaning against the wind 16.8 Credibility and realignment prospects 16.9 Conclusions Summary Reading guide Notes Appendix 16.1 17 Crises and credibility Introduction 17.1 First generation model 17.2 Second generation crisis models 17.3 Third generation models 17.4 Conclusions Summary Reading guide Notes Part V CONCLUSIONS 18 Conclusions 18.1 Summary of the book 18.2 Where we go from here? Notes Appendix: list of symbols Bibliography Index ix 385 398 403 407 409 409 410 413 413 415 416 420 422 432 433 435 438 439 440 441 441 442 444 444 445 453 462 468 469 470 470 473 475 475 477 481 482 484 492 ERA_Z02.qxd 09/28/2004 10:01 AM Page 486 486 Bibliography Dooley M P (1997) A model of crises in emerging markets National Bureau of Economic Research Working Paper No 6300 Dooley M P and Shafer J R (1983) Analysis of short run exchange rate behavior: March 1973 to November 1981 In Bigman D and Taya T (eds) Exchange Rate and Trade Instability Cambridge, MA: Ballinger Dornbusch R (1973) Devaluation, money and non-traded goods American Economic Review, 63, 871– 80 Dornbusch R (1976a) Expectations and exchange rate dynamics Journal of Political Economy, 84, 1161–76 Dornbusch R (1976b) The theory of flexible exchange rate regimes and macroeconomic policy Scandinavian Journal of Economics, 78 (2), 255–76 Dornbusch R (1982) Equilibrium and disequilibrium exchange rates In Lessard D R (ed.) 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(1982) Crises in the Economic and Financial Structure Lexington: Lexington Books West K D (1987) A standard monetary model and the variability of the deutschemark– dollar exchange rate Journal of International Economics, 23 (1/2), 57–76 Williamson J (1983) The Open Economy and the World Economy New York: Basic Books Wilson C A (1979) Anticipated shocks and exchange rate dynamics Journal of Political Economy, 87 (3), 639 – 47 Wolff C C (1986) Exchange rate models and innovations: a derivation Economics Letters, 20, 373 –76 Wonnacott R J and Wonnacott T H (1977) Introductory Statistics 3rd edn Chichester: John Wiley & Sons ERA_Z03.qxd 09/27/2004 03:10PM Page 492 Index absolute purchasing power parity 60 ad valorem tax 55 Adler, M 78, 105 aggregate demand 11–13, 110 –14, 129–31 equilibrium price levels 148 IS curve 110–14 Redux model 257 aggregate supply 11–13, 132–7, 173 equilibrium price levels 148 fixed price curve 134–6 flexible price curve 132–4 sticky price curve 136–7 agricultural products 55 Aliber, R Z 105 Anderson, P W 409 announcements of news 350–1, 353 aperiodic paths 396, 402 appreciation of a currency 4, and income increases 150–1 arbitrage 45–8 interest costs 48 interest rate differential 90 – legal barriers to 47 risks involved 47 and transaction costs 45–6, 49–51, 69–71, 96–7 ARCH models 406–7, 479 Argentina 32 Arrow, K J 409 Artis, M J 35, 139 Asian crisis 32, 462, 463–7, 468 asset demand function 219 asset markets 217–21, 255–6 Azariadis, C 409 Bade, R 139 Baillie, R T 335 balance of payments 18–22 capital account 21–2, 75, 174 –5, 217 changes in reserves 126 current account 19–21, 75, 110 –12, 173– 4, 225, 226–31, 250 in disequilibrium 250 in equilibrium 175–6 and fixed exchange rates 156 –7, 294 and the Mundell-Fleming model 173– balance sheets of banks 122, 124 –5 balancing items 22 Baliño, T J T 307 Bank of England 123 banking system 121–7 commercial banks 124, 125 deposit guarantees 467– domestic credit 125 reserves requirements 124, 125 see also central banks Barnett, W A 409 barriers to trade 54 –5, 64 Barro, R J 189, 360 base periods 59 Baumol, W J 409 Begg, D K 35, 214, 335 behavioural finance 478 benchmark model 423– Benhabib, J 409 Bertola, G 438, 441 Betts, C 275 bid rates –11 bifurcation 395 bilateral exchange rates – 8, 232 Bilson, J O 170 binomial process 424 Black, F 478 Blanchard, O J 307 Branson, W H 234, 376 Brazil 32 Bretton Woods system 23– 6, 294, 416 Brock, W A 410 Bruno, M 139 bubbles 354 – collapsing 452 budget deficits 120 –1 budget line 58 buffer stocks 16 Buiter, W H 214 butterfly effect 400 buying rates –11 Caballero, R J 438, 441 Californian banknotes 283 Calvo, G 246 Cambridge quantity equation 118, 163 capital account 21–2, 75, 174 –5 and private sector savings 217 capital mobility 174 –5, 179– 80 capital services balance 19–20 Caribbean currency boards 304 cascade 395 ERA_Z03.qxd 09/27/2004 03:10PM Page 493 Index 493 Cassel, Gustav 43 central banks 122–3 European Central Bank 297 and monetary sovereignty 298 –300 open market transactions 123, 222 see also banking system Chance, D 441 chaotic behaviour 384, 398 – 403 butterfly effect 400 forecasting 400, 401, 402, 406 periodicity 402 sensitive dependence 398 – 400 testing for 403–7 tracking errors 401–2 volatility of 398, 402 see also time paths Cheung, Y W 79 China 463 Chrystal, A 247 classes of market agents 48 cobweb process 392 coefficient of relative risk aversion 372 collapses of bubbles 452 mechanism 448–51 post-collapse exchange rate 447– timing 451–2 commercial banks 124, 125 common markets 302–3 competitiveness 23, 62, 111 compound purchases 52 conditional expectations 318, 414 constant elasticity of substitution (CES) 252–3 consumption consumer price indices 56 –9, 60, 61–2, 277–9 consumer theory 58, 100 –1 current consumption premium 257– expected value 367 household allocations 254 variance 367 convergence criteria 300–1 Copeland, L S 139, 360 Copeland, T E 376 correlation dimension 404 costs of foreign exchange transactions 286 of foreign trade 285–6 of monetary unions 290 –3, 300 –2 of multiple currencies 285 of uncertainty 286–8 countercyclical fiscal policy 297 covered interest rate parity 90 –2, 96 –7 Cox, J 441 credibility and target zones 418, 438 –9 crises 32–3, 444–72 Asian crisis 32, 462, 463–7, 468 collapse mechanism 448 –51 collapse timing 451–2 collapsing bubbles 452 ERM crisis 453, 459– 62 first generation models 445–53 government loss function 454 –7 moral hazard problem 467 and multiple equilibria 454, 457 post-collapse exchange rate 447– second generation models 453– 62 speculative attacks 458 third generation models 462– cross-exchange rates 6, currency boards 303–5 currency quotations 3–10 currency substitution model 236 – 47 assumptions 237– and monetary policy 242– and money markets 240 –2 production sector 238 – 40 currency unions see monetary unions current account 19–21, 75, 110 –12, 173– 4, 225, 226 –31 in disequilibrium 250 invisibles account 19–20 visibles account 19 Cvitanovic, P 409 Daniel, B C 139 data snooping 272 Deardorff, A V 105 deflation 25, 150, 295 demand for assets 218 demand curves 11–13 for labour 132– for money 110, 113, 116 –20, 128 –9, 221–2 see also aggregate demand deposits borrowing and lending 92– domestic strategy 82–5 equilibrium of strategies foreign strategy 85– hedging in forward markets 90 –2, 94 –5, 98 insurance guarantees 467– depreciation of a currency 4, collapse mechanism 448 –51 deregulation 15–17, 236 derivative financial instruments 29 deterministic models 382–3 devaluations 23, 160 –3, 292–3, 455 Devaney, R L 409 Devereux, M B 275 Diba, B T 361 Diebold, F X 78 difference equations 346 direct investment 21 direct quotations dirty floating rates 17–18 diversification 216, 218, 370 –1 Dixit, A 441 ERA_Z03.qxd 09/27/2004 03:10PM Page 494 494 Index DIY model 22–3, 150–1 domestic credit 125 Dooley, M P 467, 470 Dornbusch model 191–214 and disequilibrium 203–4 equilibrium exchange rates 193–5 and expectations 193–5 goods markets 196–7, 206 –7 and interest rates 199 and monetary expansion 197–201 Dornbusch, R 35, 170, 246, 360 –1, 376 Dunn, R M 35 Eastwood, R K 214 econometrics economic activity 23, 117 Edison, H J 470 Edwards, S 360 effective exchange rates 7–8 efficient markets 97–100, 322–38 expected value 316–19 filter rules 332 and forward exchange rates 322–3, 328 –30 noise trading 478–9 random walk model 73, 325–7, 330 rational expectations 319–22, 328, 478 and the risk premium 332 testing for efficiency 327–33 and unbiasedness 324–5, 332 weakly efficient markets 324 elasticity of substitution 252–3, 273 electronic trading 75–6 employment see labour market EMS (European Monetary System) 29–30 EMU (European Monetary Union) 30 –1 convergence criteria 300–1 see also monetary unions endogenous variables 220 Engel, C 78 Enoch, C 307 equilibrium exchange rates and the Dornbusch model 193–5 long-run 196, 197, 198, 202–3, 226 – 8, 262– permanent disturbances 17 short-run 196–7, 221–6 temporary disturbances 17 ERM (Exchange Rate Mechanism) 294, 298–9, 416 crisis in 453, 459–62 euro 299–300 European Central Bank (ECB) 297 European Monetary System (EMS) 29–30 European Monetary Union see EMU Evans, G W 361 event studies 350–1 excess volatility 356–7 exchange rate controls 15–17, 236 exchange rates, definition 3, 53 exogenous variables 220 expectations 103, 165, 343 conditional 318, 414 Dornbusch model 193–5 irrational 333, 334 iterated expectation law 344 and the monetary model 184 –7 and the Mundell-Fleming model 184 –7 rational 319–22 subjective 319 survey data of 333 weakly rational 322 expected inflation rate 102 expected value 316 –19 exporters 12, 13 Fama, E F 335 Federal deficits 20, 27, 32, 187– Federal Reserve Bank 123 Feldstein, M 307 filter rules 332 financial markets bubbles 354 – classes of market agents 48 currency quotations 3–10 expectations of price changes 165 managed floating rates 17–18 overshooting phenomena 192, 205, 209–10 trading volumes 22 see also crises; efficient markets; money markets; volatility financial variables 351–2 first generation crisis models 445–53 fiscal policy countercyclical 297 expansionary 182–3 and floating exchange rates 178 – 80 sovereignty of 295– Fischer, S 35, 246 Fisher equation 255 Fisher, Irving 100 –2 fixed exchange rates 15–17, 33, 127, 444 and the balance of payments 156 –7, 294 Bretton Woods system 23– 6, 294, 416 compared to monetary unions 293–5 deflationary biases 295 devaluations 23, 160 –3, 455 EMS (European Monetary System) 29–30 and fiscal expansion 182–3 and foreign currency reserves 156 – and foreign price increases 159– 60 and income increases 158 –9 inflationary biases 295 monetary model 154 – 63, 445– and monetary policy 127, 154 – 8, 180 –2, 446 –7 Mundell-Fleming model 180 –3 and price shocks 290 see also monetary unions; target zones fixed prices supply curve 134 – ERA_Z03.qxd 09/27/2004 03:10PM Page 495 Index 495 flexible prices supply curve 132– floating exchange rates 13–15, 26 –9, 33, 126 –7 and fiscal expansion 178 – 80 and foreign price increases 151–2 and income increases 150 –1 and interest rate increases 163– and monetary expansion 177– monetary model 146–53 and the money supply 126 –7, 149, 152–3 Mundell-Fleming model 177– 80 and price shocks 290 two-country model 152–3 see also target zones Flood, R P 361, 470 forecasting 318, 320, 325, 334, 347, 382–3 and chaotic behaviour 400, 401, 402, 406 spot rates from forward rates 330 –1, 348 foreign investors 12 foreign price increases 151–2 forward exchange rates 8, 90 –2, 94 –5, 98, 287–8 forecasting spot rates 330 –1, 348 and market efficiency 322–3, 328 –30 turning points 329 unbiasedness of 99 France 29–30 franc fort policy 461 Frankel, J A 170, 211–12, 214, 234, 333, 335, 374–5, 376 freight costs 45–6, 49–51, 69–71, 96 –7 Frenkel, J A 77, 105, 170, 189, 246, 335, 360, 376 Friedman, M 26, 35, 119, 307 Froemmel, M 214 Froot, K A 333, 335 Garber, P M 361, 470 GARCH models 407 general equilibrium models 249–51 see also Redux model Germany 166–8 and Bretton Woods 24, 25 and the ERM crisis 460, 461 reunification 30, 299, 460 Geweke, J 409 Ghosh, A R 307 Gleick, J 409 globalization 479 gold reserves 16 Gold Standard 24, 304–5 Gold Window 24, 25 goods markets 196–7, 206 –7 governments behaviour and monetary unions 293–5 borrowing and spending 111, 113–14, 120–1, 123, 131 budget constraint 121, 186 exchange rate controls 15–17, 236 loss function 454–7 policy anticipation hypothesis 353 and the Redux model 256 transfer payments 295 see also fiscal policy; sovereignty Grabbe, J O 35 Graybill, F A 376 Green, H A 376 Grossman, H I 361 Grossman, S F 360 Grubel, H G 35 Gulde, A.-M 307 Halttunen, H 234 Hamburger, M J 247 Hansen, L P 335, 376 Hartley, P 360 Hau, H 307 hedging in forward markets 90 –2, 94 –5, 98 Henderson, D W 22, 234, 376 Hodrick, R J 335, 376 honeymoon effect 414, 432–3 Honohan, P 360 house prices 50 households allocation of consumption 254 budget constraints 255– consumer consumption theory 58, 100 –1 and currency of transactions 480 current consumption premium 257– expected value of consumption 367 indifference curves 365– and the Mundell-Fleming model 186 –7 Redux model 251–2 variance of consumption 367 see also savings Hsieh, D A 410 Hull, J C 441 Hume, David 145, 170 Husted, S 78 hyperinflation 68, 168, 298 Iannizzotto, M 441 iceberg model 70 –1 IMF (International Monetary Fund) 23– imported inflation 159 imports 12, 13 marginal propensity to import 112 incomes equilibrium 129 increases 150 –1, 158 –9 and the Mundell-Fleming model 184 national income 110, 117 inconvertible currencies 15 indices see price indices indifference map 365– Industrial Revolution 20 inflation expected inflation rate 102 and fixed exchange rates 25, 295 ERA_Z03.qxd 09/27/2004 03:10PM Page 496 496 Index inflation (continued) hyperinflation 68, 168, 298 imported inflation 159 and portfolio balance models 227 and purchasing power parity (PPP) 63, 68, 101–2 and the risk premium 373 world inflation and domestic economies 152 insurance schemes 467–8 interest rate parity covered 90–2, 96–7 transaction costs 96–7 uncovered 82–9, 98 interest rates 23, 28 costs of arbitrage 48 and the demand for money 110, 113, 128 –9, 221–2 determination of UK rates 89 differentials 90–6, 103 and the Dornbusch model 199 and floating exchange rates 163– liquidity effect 199 and the monetary model 163–5, 184 –7 and the Mundell-Fleming model 174, 184 –7 nominal interest rates 101–2 and product market equilibrium 112–13 real interest differentials 103 and savings 110, 113, 128–9 international unit of account 288 –9 Internet shopping 75–6 intramarginal interventions 417, 435– investment projects 287 investment spending 110 investors 12 invisibles account 19–20 irrational expectations 333, 334 IS curve 110–14 Isard, P 77 iterated expectation law 344 J-curve effect 163 jagged paths 414–15 Japan 29, 166–8, 463 Johnson, H G 170 Jurgens, H 409 Kahneman, D 478 Katseli-Papaefstratiou, L T 77 Katz, L F 307 Keynesian supply curve 134– Killeen, W 307 Kindleberger, C P 361 Kindleberger, R 35 Korea 463, 466 Kouri, P J 246 Krasker, W 360 Kravis, I B 77 Krugman, P 78, 302, 415, 437, 441, 442–3, 470 Kyle, A S 478 labour markets 132–7, 291–3 and devaluations 162 mobility of labour 291–2 lagged news terms 353 Lai, K S 78 Laidler, D E 139, 376 Lane, P 275 Latin America 32, 466 –7 law of one price 44 –56, 61, 74 in the domestic economy 44 –51 in the open economy 51– LeBaron, B 410 legal barriers to arbitrage 47 Lehmann, B 78, 105 leisure 132 Levich, R M 97, 105, 335 Lindert, P 35 Lippens, R E 335 Lipsey, R E 77 liquidity 116, 199 LM curve 127–9 local authority borrowing 296 log differentiation 242 log-linear approximation 260 –2, 279– 81 logistic function 384 Loisel, O 470 long positions 93– Luangaram, P 470 Lyons, R K 479 M0 115 M1 115 M3 115 Maastricht Treaty 30 MacDonald, R 214, 360 McKinnon, R I 35, 292–3, 302, 307 McMahon, P C 335 macroeconomics 109–39 aggregate demand 110 –14, 129–31 aggregate supply 132–7 IS curve 110 –14 LM curve 127–9 money market equilibrium 114 –29 national income 110, 117 quantity theory 118 –20 sovereignty of policy 152 see also money supply Magee, S P 77 Malaysia 463 managed floating rates 17–18 marginal propensity to import 112 markets see efficient markets; financial markets; money markets Markowitz, H M 376 Marston, R C 139 Martin, P 470 Masson, P 234 May, R M 409 Meade, J A 307 ERA_Z03.qxd 09/27/2004 03:10PM Page 497 Index 497 mean reversion 436 mean-variance analysis 365– 8, 371–2 Meese, R A 169, 170, 214, 272, 360, 361 Menkhoff, L 214 menu costs 72 Metzler, L A 234 Mexican Tequila crisis 462 mid-market rates 10 Miller, M 214, 470 mobility of labour 291–2 monetary model 61, 145–70 compared to Mundell-Fleming model 183–7 and expectations 184–7 of a fixed exchange rate 154 – 63, 445– of a floating exchange rate 146 –53 and incomes 184 and interest rates 163–5, 184 –7 and the news model 342– and price levels 184 and purchasing power parity (PPP) 146, 147, 165–6 monetary policy 16, 353 and the currency substitution model 242– and the Dornbusch model 197–201 and fixed exchange rates 127, 154 – 8, 180 –2, 446–7 and floating exchange rates 126 –7, 149, 152–3, 177–8 money supply 120–7 and portfolio balance models 222– 4, 227– sovereignty 152, 298–300 monetary shocks 265–6 monetary unions benefits 285–9 and common markets 302–3 compared to fixed exchange rates 293–5 costs 290–3 of foreign exchange transactions 286 of foreign trade 285–6 of multiple currencies 285 of transition 300–2 of uncertainty 286–8 and devaluations 292–3 fiscal sovereignty 295–8 and government behaviour 293–5 international unit of account 288 –9 and investment projects 287 and labour markets 291–3 and monetary sovereignty 298 –300 and national sovereignty 284 optimal currency areas 282, 292 and wages 292–3 money illusion 101 money markets 114–29 and the currency substitution model 240 –2 definition of money 114 –15 demand for money 110, 113, 116 –20, 128 –9, 221–2 equilibrium in 114 –29 history of 480 and liquidity 116, 199 LM curve 127–9 and oil 208 opportunity costs of money 117, 119 printing money 16, 17, 25, 125– 6, 283 quantity theory 118 –20 volume of transactions 117–18 see also financial markets money supply 120 –7 see also monetary policy monopolistic behaviour 265 Mood, A M 376 Moore, M 307 moral hazard 467 motor vehicles 289 multilateral exchange rates 7– 8, 232 multiple equilibria 454, 457 multivariate time series modelling 349–50 Mundell, R A 291–2, 294, 307 Mundell-Fleming model 172–214 and the balance of payments 173– and capital mobility 174 –5, 179– 80 compared to the monetary model 183–7 and the domestic economy 173 and expectations 184 –7 and fixed exchange rates 180 –3 and floating exchange rates 177– 80 and incomes 184 and interest rates 174, 184 –7 and price levels 184 Mussa, M 35, 77, 170 Muth, J F 335 NAFTA (North American Free Trade Association) 302 national income 110, 117 national sovereignty 284 news model 339– 62, 477– announcements of news 350 –1, 353 event studies 350 –1 financial variables 351–2 lagged news terms 353 and the monetary model 342– multivariate time series modelling 349–50 policy anticipation hypothesis 353 random errors 339 surprise element 339– 40 survey data 350 testing 348 –59 univariate time series modelling 349 vector autoregression 349–50 noise trading 478 –9 non-linear models 383– 4, 403, 406, 479 non-money assets 116 non-traded goods 51, 56, 64, 69, 271 North Sea oil see oil and the UK economy ERA_Z03.qxd 09/27/2004 03:10PM Page 498 498 Index Obstfeld, M 71, 78, 275, 441, 470 offer rates 8–11 Officer, L H 77 official reserves 16, 17–18, 22, 123, 125– 6, 126 and fixed exchange rates 156 – sterilization of reserve changes 157– oil shocks 27–8 oil and the UK economy 205–11, 228 and goods markets 206–7 and money markets 208 OPEC 27–8 open market transactions 123, 222 opportunity costs of money 117, 119 optimal currency areas 282, 292 see also monetary unions option-pricing theory 422–31 overall value of currencies 4–5 overshooting phenomena 192, 205, 209–10 Panama 283 parity values 17 Parkin, M P 139 pass-through of prices 71–3 Peel, D A 78 Peitgen, H.-O 409 period-doubling patterns 395 periodicity 402 permanent disturbances 17 Peruga, R 360 peso problem 358–9 phase curves 385 phase portraits 385–8 Pines, D 409 policy anticipation hypothesis 353 portfolio analysis 370–1 portfolio balance models 216 –34 asset market specification 217–21 data collection 232 demand for assets 218 domestic asset increases 222–3 foreign currency asset decrease 223– and inflation 227 long-run equilibrium 226– and monetary expansion 222– 4, 227– risk premium 372 and savings 224–6 short-run equilibrium 221– utility maximization 218 variables 220 wealth effects 224–6 portfolio investment 21 post-collapse exchange rate 447– PPP see purchasing power parity (PPP) price bubbles 354–8 collapses 452 price differentials see arbitrage; law of one price price discrimination 73, 250 price indices 56 –9, 60, 61–2, 277–9 base periods 59 price shocks 290 pricing to market (PTM) 71–3, 269–71, 272–3 printing money 16, 17, 25, 125– 6, 283 private sector 252– see also households probability theory 317–18 producer prices 68 product differentiation 111 product market equilibrium 112–13 production sector 238 – 40 purchasing power parity (PPP) 59–77, 100 – absolute purchasing power parity 60 and competitiveness 62 and electronic trading 75– empirical research on 73– in expectations 103 and freight costs 69–71 and inflation 63, 68, 101–2 and the law of one price 44 –56, 61, 74 in the domestic economy 44 –51 in the open economy 51– macroeconomic approach 61, 111 microeconomic approach 60 and the monetary model 146, 147, 165– pass-through of prices 71–3 price indices 56 –9, 60, 61–2 pricing to market (PTM) 71–3 and real exchange rates 62, 67, 102– and real interest rates 100 –2 relative purchasing power parity 63 and trade barriers 64 and traded/non-traded goods 51, 56, 64, 69 and volatility of exchange rates 68 Purvis, D D 214 quadratic utility function 371 quality of service 49–50 quantity theory 118 –20 quotas 55 quotations 3–10 random variables 357 random walk model 73, 325–7, 330 rate of time preference 257– rational bubbles 354 – rational expectations 319–22, 328, 478 Razin, A 189, 376 real exchange rates 62, 67, 102– real interest differentials 103 real interest rates 100 –2 realignment of target zones 438 –9 Redux model 251–75 aggregate demand 257 asset markets 255– extensions 269–72 government sector 256 ERA_Z03.qxd 09/27/2004 03:10PM Page 499 Index 499 Redux model (continued) graphic analysis 266–9 household budget constraints 255– initial steady state 259– 60 log-linear approximation 260 –2, 279– 81 long-run equilibrium 262– monetary shocks 265–6 non-tradable goods 271 pricing to market (PTM) 269–71, 272–3 private sector 252–4 solution 257–66 sticky prices 264–5, 281 relative purchasing power parity 63 relative value of currencies –5 research reserves see official reserves Retail Price Index (RPI) 59 return on assets 119–20 reunification of Germany 30, 299, 460 Ricardo, David 186 risk assessment 216, 218, 370 –1 risk aversion 87, 216, 218, 365 coefficient of relative risk aversion 372 risk neutrality 87, 324 risk premium 86, 185, 216, 232, 363–78 and efficient markets 332 equilibrium point 368 indifference map 365–6 and inflation 373 mean-variance analysis 365– 8, 371–2 model 368–73 and portfolio balance models 372 speculative opportunity line 367– zero-risk premium hypothesis 374 –5 risks involved in arbitrage 47 Rodriguez, C A 246 Rogoff, K 71, 78, 169, 170, 214, 272, 275, 441, 470 Roll, R 78, 105 Ross, S 441 Rubinstein, M 378, 441 Rush, M 78 Russian debt default 32 Sachs, J 139 Sarno, L 71, 78 Saupe, D 409 savings 20, 217 and the capital account and interest rates 110, 113, 128 –9 portfolio balance models 224 – Scottish banknotes 283 second generation crisis models 453– 62 seigniorage 256, 294 selling rates 8–11 sensitive dependence chaotic behaviour 398–400 services account 19–20 services sector 69 service quality 49–50 shadow exchange rate 446, 449–50 Sharpe, W F 376 Sheffrin, S S 335 Shell, K 409 Shiller, R J 360 short positions 93– single currency zones see monetary unions single markets 302–3 Singleton, K J 360 Smithsonian Agreement 25– smooth pasting 420 –2 Soros, George 459, 460 South Korea 463, 466 sovereign lending 28 sovereignty of fiscal policy 295– of monetary policy 152, 298 –300 national sovereignty and monetary unions 284 specialization 302 speculation 12–13, 48 –9, 54, 322 speculative attacks 458 utility maximization 369 speculative opportunity line 367– spot rates 8, 90, 328 –30 and expectations 343 forecasting from forward rates 330 –1, 348 turning points 329 weighting scheme 345– spreads 8, 10 Srivastava, S 376 Stability Pact 297 stable cycles 392 sterilization of reserve changes 157– Stewart, I 409 sticky prices 264 –5, 281 supply curve 136 –7 see also Dornbusch model stochastic models 382–3, 407– stocks of assets 185–7 subjective expectations 319 supply curves 11–13 see also aggregate supply survey data 333, 350 Svensson, L E O 441 swap transactions 96 Switzerland 297– target zones 17, 413– 43 barrier effects 426 –31 benchmark model 423– and credibility 418, 438 –9 definition 415–16 effect of 416 –20 honeymoon effect 414, 432–3 ERA_Z03.qxd 09/27/2004 03:10PM Page 500 500 Index target zones (continued) intramarginal interventions 417, 435– Krugman model 442–3 mean reversion 436 and option-pricing theory 422–31 random fundamentals 417 realignment 438–9 smooth pasting 420–2 symmetry 418 and volatility of markets 432–3 tariffs 54–5, 64 Taylor, M P 71, 78, 105, 360, 441 temporary disturbances 17 Tequila crisis 462 Thailand 463, 466, 468 third generation crisis models 462– time paths 385–98 aperiodic 396, 402 bifurcation 395 cascade 395 cobweb process 392 deterministic models 382–3 jagged paths 414–15 measure of an interval 396 non-linear models 383–4, 403, 406, 479 period-doubling patterns 395 phase portraits 385–8 stable cycles 392 stochastic models 382–3, 407– tuning parameter 384, 401 see also chaotic behaviour time series data 349–50 Tobin, J 234, 376 tracking errors 401–2 trade barriers 54–5, 64 trade costs 45–6, 49–51, 69–71, 96 –7 trade-weighted exchange rates 7– traded goods 51, 56, 64, 69 trading rules 332 trading volumes 22 transaction costs 45–6, 49–51, 69–71, 96 –7 transfer payments 295 transport costs see freight costs Tsiang, S C 105 tuning parameter 384, 401 turning points 329 Tversky, A 478 unbiasedness 99, 324 –5, 332 uncovered interest rate parity 82–9, 98 unilateral transfers 20 United States bank failures 28 and the Bretton Woods system 23– Californian banknotes 283 Federal deficits 20, 27, 32, 187– units of account 288 –9 univariate time series modelling 349 utility function 369–72 utility maximization 218, 369 variance bounds tests 356 –7 vector autoregression 349–50 Venables, A J 214 visibles account 19 volatility of chaotic behaviour 398, 402 volatility in financial markets 29, 68, 166, 353–9, 477– excess volatility 356 –7 peso problem 358 –9 rational bubbles 354 – and target zones 432–3 see also collapses Wachtel, P 361 wages 132–7, 292–3 weakly efficient markets 324 weakly rational expectations 322 wealth effects 206 –7, 224 – weighted price indices see price indices weighting scheme 345– West, K D 360 Weston, J F 376 Wholesale Price Index (WPI) 59 Williamson, J 35 Wilson, C A 214 Wolf, H C 307 Wonnacott, R J 376 Wonnacott, T H 376 zero-risk premium hypothesis 374 –5 ... 02:57PM Page i Exchange Rates and International Finance ERA_A01.qxd 09/27/2004 02:57PM Page ii We work with leading authors to develop the strongest educational materials in International Finance, ... 02:57PM Page iii Fourth Edition Exchange Rates and International Finance Laurence S Copeland ERA_A01.qxd 09/27/2004 02:57PM Page iv To the memory of Robert Copeland Pearson Education Limited Edinburgh... demand and the smaller the supply Conversely, when the dollar is expensive, there will be a smaller demand and greater supply At some exchange rate – $1 = £0.50 in the diagram – the demand and