Alternative Views Of Exchange-Rate Determination
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Alternative Views
Of Exchange-Rate Determination
By Douglas K. Pearce
The foreign-exchange value of the U.S. While much research has been devoted to
dollar has fluctuated widely since fixed ex- providing an explanation for the fluctuations in
change rates were abandoned in the early 1970s. exchange rates, no single theoretical model has
The variation in exchange rates under the emerged predominate. In the beginning of
regime of flexible (floating) rates has been a the flexible-rate era, exchange-rate movements
matter of concern to policymakers because of were usually analyzed in terms of the demands
the fear that uncertainties could have for and supplies of currencies in the foreign-
deleterious effects on world trade. Large exchange market, with emphasis on the
changes in exchange rates are also thought to transactions originating from international
have significant impacts on the level and com- trade flows. The large short-run movements in
position of U.S. production by changing the exchange rates, however, cast considerable
relative prices of exports and importcompeting doubt on the adequacy of this approach and led
goods. Some analysts attribute a substantial to "asset models" that view the determination
part of the current U.S. recession to the impact of the exchange rate as the outcome of the port-
of the recent rise in the exchange value of the folio behavior of wealth holder^.^ One asset
dollar on the manufacturing sector, which ex- model, labeled the "monetary" model, ex-
ports 20 percent of its output. A stronger U.S. plains exchange-rate fluctuations largely in
dollar, on the other hand, has a beneficial ef-
fect on U.S. inflation in the short run by re-
ducing the domestic prices of imports.'
found by Richard K Abrarns, "International Trade Flows
Under Flexible Exchange Rates," Economic Review,
Federal Reserve Bank of Kansas City, March 1980, pp.
1 Empirical support for the view that exchange-rate volati- 3-10. For analyses of the economic impacts of the rise of the
lity has a significantly negative effect on trade flows was dollar, see C. Fred Bergsten, "The Villain is an Overvalued
Dollar," Challenge, March-April 1982, pp. 25-32, and
Robert A. Feldman, "Dollar Appreciation, Foreign Trade,
Douglas K. Pearce is an associate professor of economics at and the U.S. Economy," Quarterly Review, Federal
the University of Missouri-Columbia and a visiting scholar Reserve Bank of New York, Summer 1982, pp. 1-9.
at the Federal Reserve Bank of Kansas City. The author 2 For a critique of the flow model, see Michael Mussa.,
would like to thank Dan Vrabac for research assistance and "Empirical Regularities in the Behavior of Exchange Rates
Don Schilling for helpful comments. The views expressed and Theories of the Foreign Exchange Market," in Policies
here are those of the author and d o not necessarily reflect for Employment, Prices, and Exchange Rates, Carnegie-
the views of the Federal Reserve Bank of Kansas City or the Rochester Conference Series on Public Policy, Volume 11,
Federal Reserve System. ed. by Karl Brunner and Allan H. Meltzer, pp. 9-57.
16 Federal Reserve Bank of Kansas Cityterms of changes in the supplies of or demands rate since the adoption of floating rates. The
for respective money stocks. According to this second section discusses the influences of such
model, a fall in a country's exchange rate variables as inflation, real income, and the in-
reflects excessive growth in its money stock. terest rate on the exchange rate. The third sec-
Another asset model, the "portfolio-balance" tion describes specific models of exchange-rate
model, extends the analysis to consider a wider determination. The fourth section reports how
range of financial assets. In this framework, in- well these models explain movements in the
terest rates and exchange rates are determined U.S.-Canadian exchange rate. The final section
simultaneously as wealthholders adjust their summarizes the findings of the article.
financial portfolios. Consequently, imbalances
in government budgets and current accounts af- EXCHANGE-RATE POLICIES AND
fect exchange rates by changing the size and RECENT DOLLAR MOVEMENTS
distribution of financial-asset stocks.The lack The choice of exchange-rate policy is an im-
of consensus on which analytical framework is portant decision for any country. This section
appropriate is an important problem for reviews the differences in policies, discusses
policymakers since the predicted effects of how policies affect a country's international
domestic economic policy on the exchange rate, balance of payments and its domestic money
and hence on the trade sector, differ across supply, and describes the recent behavior of the
these models. U.S. dollar under a flexible exchange-rate
This article reviews the factors considered policy.
important in determining exchange rates and
examines the integration of these factors into Alternative exchange rate policies
the exchange-rate models. The first section pro- A country has a choice of three major
vides background on the distinctions between exchange-rate policies-flexible, fixed, or
fixed and flexible exchange-rate policies along managed-which are distinguished. by the ex-
with a brief history of the U.S. dollar exchange tent to which the government, usually through
its central bank, intervenes in the foreign-
exchange market to affect the exchange rate of
3 One version of the flow model is given in Robert A. its currency.' If a country adopts a flexible
Mundell, "The Monetary Dynamics of International Ad- (floating) exchange-rate policy, its central bank
justment Under Fixed and Flexible Exchange Rates," does not participate in the foreign-exchange
Quarterly Journal of Economics, May 1960, pp. 227-57.
For a discussion of the origins of the monetary model, see market. Instead, the price of the country's cur-
Jacob A. Frenkel, "A Monetary Approach to the Exchange rency relative to foreign currencies is deter-
Rate: Doctrinal Aspects and Empirical Evidence," Scan- mined by supply and demand in the foreign-
dinavian Journal of Economics. May 1976, pp. 200-24.
Several studies employing this framework are collected in exchange market. The supply comes from
The Economics of Exchange Rates: Selected Studies, ed. by
Jacob A. Frenkel and Harry G. Johnson, Addison-Wesley,
1978. For analyses using the portfolio-balance model, see
William H. Branson, Hanna Halttunen, and Paul Masson,
"Exchange Rates in the Short Run," European Economic The foreign-exchange market is not in any one location,
Review, December 1977, pp. 303-24, and Joseph Bisignano as is, say, the New York Stock Exchange. Rather, it is a
and Kevin Hoover, "Some Suggested Improvements to a worldwide market connected by electronic communica-
Simple Portfolio Balance Model of Exchange Rate Deter- tions. This market is essentially never closed and has the
mination with Special Reference to the U.S. Dollar/Cana- largest trading volume of any financial market. See Robert
dian Dollar Rate," Weltwirschaftliches Archiv, Heft 1, Z. Aliber, The International Money Game. 3rd ed., New
1982, pp. 19-37. York: Basic Books, 1979, pp. 54-55.
Economic Review February 1983 17holders of domestic currency that need foreign domestic currency, or shifts in the private de-
currency to buy foreign goods and services (im- mand for the currency, cause fluctuations in the
ports) or assets denominated in foreign curren- central bank's holdings of foreign exchange
cies. The demand comes from foreigners that rather than fluctuations in the exchange rate.
want to buy domestic goods and services (ex- If a country adopts a managed exchange-rate
ports) or assets denominated in the domestic policy, its central bank participates in the
currency. Under this policy, the exchange rate foreign-exchange market when it decides a
moves to keep the amount of currency de- movement in its exchange rate is undesirable.
manded just equal to the amount supplied.' An There is no formal commitment to defend a
increase in the demand for (supply of) domestic specific exchange rate. Under a managed
currency, arising, say, from an increase in de- exchange-rate policy, the effect of a shift in the
mand for domestic (foreign) goods by for- supply of domestic currency, or the demand for
eigners (domestic residents), causes an im- it, is uncertain. If the central bank wants the ex-
mediate appreciation (depreciation) in the ex- change rate change that would result from the
change rate. The exchange rate, then, reflects shift, it takes no action and the exchange rate is
the activities of private economic agents or allowed to move to its new equilibrium value. If
foreign central banks but not the direct actions the central bank does not want the change, it
of the domestic central bank.6 enters the market to keep the rate constant. If
If a country adopts a fixed exchange-rate the central bank merely wants to smooth the
policy, its government or central bank is active movement in the exchange rate, as is often the
in the foreign-exchange market, buying or sell- case, it buys or sells just enough currency for
ing the country's currency when its exchange the exchange rate to adjust slowly to its new
rate starts to deviate from the fixed or pegged equilibrium value.
value.' If there is an excess demand for the
country's currency at the fixed rate, the central Exchange rate policy, the balance of
bank must satisfy the excess demand by buying payments, and the money supply
foreign exchange-that is, by supplying its own A country's transactions with the rest of the
currency-to keep the exchange rate from world are reported for specific periods as its
rising. If there is an excess supply of the coun- balance of payments statistics. Private transac-
try's currency, the central bank must purchase tions are classified either as current or capital
its own currency to prevent the exchange rate transactions. Included in the current account
from falling. This is done by supplying foreign are purchases or sales of goods and services and
exchange. Hence, shifts in the private supply of transactions involving interest payments.
Transactions involving the exchange of finan-
cial claims appear in the capital a c c ~ u n tThe
.~
5 The exchange rate discussed in this paper is the spot rate,
the price of foreign exchange for immediate delivery. The
forward exchange rate is the price of foreign currency that
8 The current account is essentially the sum of the trade
will be delivered at a specific date in the future. balance (the value of exports minus imports) and net in-
Domestic monetary policies that affect interest rates, in- terest income (interest earned from foreign assets less in-
flation, or real incomes may, of course, lead to exchange- terest paid to foreigners). For a description of alternative
rate changes. methods of reporting the international balance of
In practice, there is usually a narrow band in which the payments, see Leland B. Yeager, International Monetary
exchange rate can fluctuate without the central bank in- Relations: Theory, Hisrory, and Policy, 2nd ed., New
tervening. York: Harper & Row, 1976, chap. 3.
18 Federal Reserve Bank of Kansas Citynet private capital flow is the value of domestic 1 traces the bilateral exchange rates between the
financial assets purchased by foreigners minus dollar and the West German mark, the Japa-
foreign assets purchased by domestic private nese yen, the French franc, the Canadian
residents. If the current account plus the net dollar, and the English pound. The chart il-
private capital flow balance out, the country lustrates an important point: the dollar may
has a zero balance of payments. If the sum is simultaneously appreciate relative to one cur-
positive, the country has a balance of payments rency and depreciate relative to another.
surplus. If the sum is negative, the country has Generally, however, it fell against most curren-
a balance of payments deficit. cies immediately after the mid-1971 collapse of
Under a cleanly floating exchange-rate the fixed exchange-rate system and has ap-
policy, the balance of payments is always zero. preciated across the board since mid-1980.11Be-
This is because any surplus (deficit) implies an tween these two periods the dollar fell substan-
excess demand for (supply of) the domestic cur- tially relative to the "hard" currencies of West
rency in the foreign-exchange market that an Germany and Japan, despite considerable inter-
appreciation (depreciation) of the exchange rate vention by the central banks of these
would eliminate. There is no direct relation be- countries." Over the same period, the dollar
tween the foreign-exchange market and the rose relative to the Canadian dollar, stayed
domestic money supply. Under a fixed roughly constant relative to the French franc,
exchange-rate policy, a balance of payments rose and then fell back relative to the British
surplus (deficit) raises (lowers) the domestic pound. To give an overview of the exchange
money supply unless the central bank takes off- rate of the dollar, Chart 2 shows a weighted
setting action^.^ Hence, the choice of exchange- average of the dollar's value relative to 10 ma-
rate policy has important implications for the
control of the domestic money supply.
United States generally did not intervene in the foreign-ex-
U.S. dollar under flexible exchange rates change market, leaving defense of the pegged rates to the
countries involved, even though the United States typically
The foreign-exchange value of the dollar has ran balance of payments deficits. As a result of foreign cen-
varied considerably since the effective end of tral banks exchanging much of their dollar reserves for
the Bretton Woods regime in mid-1971.1° Chart gold-the U.S. gold stock fell about 50 percent from 1950
t o 1970-President Nixon eliminated the right of central
banks to convert U.S. dollars to gold in August 1971. This
led to the Smithsonian Agreement of December 1971 in
which exchange rates were realigned. This arrangement did
not last long, however, and the United States formally
9 Assume, for example, the country runs a $10 billion adopted a flexible-rate policy in March 1973. For a detailed
balance of payments surplus. To keep the exchange rate account of the Bretton Woods agreement, see Kenneth W.
from appreciating, the central bank has to supply the $10 Dam, The Rules of the Game, Chicago: University of
billion excess demand for the home currency so that the Chicago Press, 1982, chap. 4. For a review of the fined-rate
domestic monetary base (currency plus bank reserves) will period, see Richard K Abrams, "Federal Reserve Interven-
rise $10 billion. All else constant, this would lead to an in- tion Policy," Economic Review, Federal Reserve Bank of
crease in the domestic money supply. To offset or Kansas City, March 1979, pp. 15-23.
"sterilize" the balance of payments surplus, the central 11 Canada adopted a floating exchange rate in June 1970
bank would have to sell $10 billion of domestic government and the Canadian dollar immediately appreciated against
securities from its portfolio. the U.S. dollar.
10 The 1944 Bretton Woods conference of the Allies set up l 2 For a discussion of this intervention, see Victor Argy,
a system of fixed-exchange rates among most currencies. Exchange Rate Management in Theory and Practice,
Under this system, the U.S. dollar was fixed in terms of Princeton Studies in International Finance, No. 50, Oc-
gold and other currencies were pegged to the dollar. The tober 1982.
Economic Review February 1983Chart 1
EXCHANGE RATES- U.S. DOLLAR AND MAJOR CURRENCIES
Currency Per Dollar Currency Per Dollar
4.0
3 .O
2.0 2.0
'-L L :
.4
.3
1970 '71
British Pound
'72 '73 '74 '75 '76 '77 '78 '79 '80 '81 '82
.6
.5
.4
.3
Federal Reserve Bank of Kansas CityChart 2 Relative inflation
TRADE-WEIGHTED EXCHANGE RATE Because international trade in goods and ser-
OF U.S. DOLLAR vices underlies many of the transactions in the
(March 1973 = 100) foreign-exchange market, changes in domestic
prices relative to foreign prices are thought to
affect the exchange rate. If domestic inflation
exceeds that of a country's trading partners, the
demand for domestic goods falls, the demand
for foreign goods rises, and the exchange rate
of the home currency falls." However, the ex-
tent and speed of the adjustment of exchange
rates to different inflation rates are unresolved
issues. According to the theory of purchasing
power parity, the exchange rate moves quickly
to keep the effective prices of goods equal
across countries. In its strict form, this theory
asserts that the exchange rate always equals the
ratio of the foreign price level to the domestic
price level. For example, if a particular good
costs $3.00 in the United States and 15 francs in
France, the exchange rate must be 5 francs to
the dollar. The theory predicts that domestic in-
flation higher than world inflation results in an
immediate depreciation of the domestic ex-
change rate. Empirical evidence suggests,
however, that the relationship between infla-
jor currencies, with the weights based on the tion rates and exchanges rates is much looser
dollar-volume of trade with each country. This than this theory maintains."
composite measure indicates the dollar Relative real growth
depreciated generally over the 1970s but has re-
bounded in the last two years. Another factor affecting trade flows-and
thus supplies of and demands for the home cur-
FACTORS AFFECTING
EXCHANGE RATES
13 This assumes the sum of the absolute values of the price
Before discussing specific theories of elasticities for domestic exports and domestic imports ex-
exchange-rate determination, it is useful to ceeds one.
review factors generally thought to influence ex- 14 The literature on purchasing power parity is substantial.
change rates. The factors include a country's For a historical review, see Jacob A. Frenkel, "Purchasing
Power Parity: Doctrinal Perspective and Evidence From
inflation rate, real economic growth rate, in- the 1920s," Journal of International Economics, May
terest rates relative to the rest of the world, and 1976, pp. 169-91. A thorough review of the issues involved
private speculation. Theories of the exchange in this theory is given by Lawrence H. Officer, "The
Purchasing-Power-Parity Theory of Exchange Rates: A
rate differ because of the assumptions they Review Article," Staff Papers, International Monetary
make about the importance of these factors. Fund, March 1976, pp. 1-61.
Economic Review February 1983 21rency in the foreign-exchange market-is the change in the exchange rate. If, say, new one-
growth rate of domestic real income relative to year U.S. and West German Treasury notes are
the rest of the world. With all else held con- perfect substitutes and pay 10 percent and 5
stant, high domestic real growth is thought to percent, respectively, the expected appreciation
weaken a currency's exchange rate because in- of the mark over the year must be 5 percent.
creases in domestic real income raise the de- This suggests, however, that the interest-rate
mand for imports and hence the demand for differential will widen if investors come to
foreign currency relative to the available sup- believe for some reason that the mark will ap-
ply.I5 This line of reasoning assumes, however, preciate more than 5 percent. In that case, a
that higher domestic growth affects only the larger interest differential could occur without
current account. If investors at home and encouraging a capital flow from West Germany
abroad view the higher income growth as an to the United States. The interest differential
indication of higher retunis on capital, there could be just enough to compensate for a
could be a net capital inflow that would more higher expected appreciation of the mark.
than offset the current-account deficit. In that Thus, the source of the interest-rate differential
case, the home currency would appreciate determines whether a widening of the differen-
rather than depreciate. tial causes an exchange-rate appreciation.
Relative interest rates
Private speculation
A rise in interest rates that makes domestic
assets more attractive to investors (at home and Speculation-the purchase (sale) of foreign
abroad) can cause a capital inflow leading to an exchange for the sole purpose of profiting from
appreciation in the exchange rate. This an expected fall (rise) in the domestic exchange
result-that an increase in interest rates creates rate-is often said to account for much of the
a comparative advantage in the return on volatility of exchange rates. Volatility, then, is
domestic over foreign assets and tends to in- seen as stemming from the actions of specula-
crease the exchange rate-depends crucially on tors rather than from changes in the factors
the reason for the widening interest differential. determining the equilibrium exchange rate. One
Consider a case where iinvestors see foreign such view assumes that a fall (rise) in the ex-
and domestic assets as perfect substitutes. Their change rate leads speculators to think a further
portfolios will be in equilitlrium only when the decline (increase) is imminent and prompts
expected returns on alternative assets are equal. sales (purchases) of the domestic currency in
The expected return on (a foreign asset, as the foreign-exchange market that drive its price
viewed by a domestic resident, is the foreign in- down (up) further. According to this view,
terest rate plus the expecte:d change in the ex- speculation is a destabilizing force that
change rate. Perfect substitutability, then, im- magnifies fluctuations in flexible exchange
plies that in equilibrium the: interest differential rates and makes fixed rates preferable.
between two countries just equals the expected Some analysts, however, see speculation as a
stablizing force. Since, to make profits, specu-
lators must buy when the exchange rate is below
its equilibrium level and sell when it is above its
' 5 This result presumes that the rise in domestic income did
not originate from an increase in net exports caused, for ex-
equilibrium level, the action of profitable
ample, by an exogenous shift in the demand for domestic speculators (the only ones that can survive over
goods. time) push the exchange rate toward its
22 Federal Reserve Bank of Kansas Cityequilibrium rather than away from it.I6 In any plies in the foreign-exchange market. The ex-
case, to argue for government intervention to change rate is in equilibrium when supply just
counteract speculation is to argue that govern- equals demand-when any current-account
ment officials are better judges of the imbalance is just matched by a net capital flow
equilibrium exchange rate than private in the opposite direction. The current account is
speculators . I 7 assumed to be determined by relative prices and
relative real incomes. Increases in domestic
ALTERNATIVE EXCHANGE prices relative to foreign prices are predicted to
RATE MODELS have a negative effect on the current account
This section describes three models that have and hence, all else constant, to cause a
been proposed to explain movements in ex- depreciation. Goods prices, however, are
change rates. The first focuses on the demand presumed to move sluggishly so that purchasing
and supply flows in the foreign exchange power parity is not imposed. This allows
market and is referred to here as the "tradi- exchange-rate changes originating from other
tional flow" model. The other two models are sources to change the relative prices of domestic
asset models. In their analytical framework, the and foreign goods. An increase in domestic real
exchange rate is determined by the equilibrium income is thought, all else being equal, to cause
conditions in asset markets. One of these is the the exchange rate to fall. This is because an in-
"monetary" model, which looks solely at the crease in income tends to increase imports,
supply of and demand for money in each coun- reducing the current account, with no offsetting
try. The other is the "portfolio-balance" effect on capital flows.
model, which extends the analysis explicitly to
The model posits that foreign and domestic
include other assets. assets are imperfect substitutes in a portfolio.
Traditional flow model An increase in the domestic interest rate, with
no change in the foreign interest rate, is
The used in many predicted to cause a net capital inflop that
textbooks the flow demands and s u p results in an appreciation of the exchange rate.
Thus, according to this model, a country that
16 For arguments that speculation is likely to be destabi-
wants to strengthen the exchange value of its
lizing, see Paul Einzig, The Case Against Floating Ex- currency must adopt policies to lower prices,
changes, London: MacMillan, 1970, chap. 9. For raise interest rates, and reduce real growth.
arguments that speculation is likely to be stabilizing, see
Milton Friedman, "The Case for Flexible Exchange The main theoretical criticism of the tradi-
Rates," in Essays in Positive Economics, Chicago: Univer- tional flow model is directed at its implications
sity of Chicago Press, 1953. for the asset market. The model predicts that an
17 Political, as well as economic, instability also affects a exchange rate could be in equilibrium when a
country's exchange rate although its impact is difficult to
quantify. Political decisions that result in trade restrictions country is running a current-account deficit if
and capital controls create artificial barriers that interfere the domestic interest rate is high enough to
with the economic forces bearing on exchange rates. More maintain an offsetting net capital inflow. This
dramatic actions, such as the nationalization of banks in
Mexico or the election of the Socialist party in France, implies that at a constant interest differential,
make investments appear riskier and often lead to domestic there is a steady, potentially infinite, accumula-
capital outflows. The political stability of the United States tion of domestic assets by foreigners. No ac-
makes it the natural recipient of such capital flows. Conse-
quently, the dollar usually appreciates when international count is given of how the portfolios of for-
disruptions occur. eigners are brought into equilibrium.
Economic Review February 1983 23Monetary model mand that, with a fixed nominal money supply,
There are several variations of the monetary results in a reduction in domestic prices and,
model, but they all share the premise that through purchasing power parity, pulls the ex-
movements in the exchange rate between two change rate up. An increase in the domestic in-
currencies can be explained by changes in the terest rate, which is assumed to reflect higher
demand for or supply of money in the two expected inflation, lowers money demand,
countries. In contrast to the traditional model, raises prices, and lowers the exchange rate.
in which the exchange rate is determined by Changes in foreign variables have symmetric ef-
trade and capital flows, this model asserts that fects. The domestic exchange rate is increased
the equilibrium exchange rate depends on the by a rise in the foreign money supply, by a
stock-equilibrium conditio~lsin each country's reduction in foreign real income, and by an in-
money market. The model is derived from crease in the foreign interest rate.
several assumptions. First, purchasing power Like the traditional flow model, the
parity holds continuously so that the exchange monetary model predicts that changes in
rate always equals the ratio of price levels in the domestic real income and interest rates affect
two countries. Second, domestic and foreign the exchange rate. The effects are in the op-
bonds are perfect substitutes so that any dif- posite direction, however, since the monetary
ference in interest rates equals the expected rate model asserts that rapid economic growth and
of change in the exchange rate. These two low interest rates should cause the exchange
assumptions imply that interest differentials rate to appreciate rather than depreciate.
just equal differences in expected inflation Criticism of the monetary model centers on
rates. Third, the demand for money in each its assumptions. First, several investigators
country is a stable functiorl of the domestic in- have reported evidence that purchasing power
terest rate and real income. Fourth, if out of parity does not hold in the short run.19 In par-
equilibrium, the money market adjusts rapidly, ticular, it is argued that prices are "sticky" in
with domestic prices moving quickly to the short run and do not have the required flex-
eliminate any excess supply of & demand for ibility to keep the money market in equilibrium.
money. Second, if domestic and foreign bonds are not
These assumptions yield an equation for the perfect substitutes, as the monetary model
equilibrium exchange rate in terms of dif- assumes, the model must take into account
ferences between the two countries' money sup- changes in the composition of portfolios with
plies, interest rates, and real i n c ~ m e s . 'The
~ respect to these two assets. This consideration
partial effects of these variables are predicted to leads to the portfolio-balance model.
be as follows. An increase in the domestic Portfolio-balance model
money supply reduces the ,exchangerate as the
initial excess money supply drives domestic The portfolio-balance model views the ex-
prices up and hence, through purchasing power change rate and interest rates as determined
parity, the exchange rate down. An increase in
domestic real income causes excess money de-
19 The strength of commodity arbitrage in keeping in-
dividual prices in line was found to be weak by Irving B.
Kavis and Robert E. Lipsey, "Price Behavior in the Light
18 This assumes that the demand for money functions in of Balance of Payments Theories," Journal of Interna-
each country have identical parameters. tional Economics, May 1978, pp; 193-246.
Federal Reserve Bank of Kansas Citysimultaneously by the portfolio equilibrium original interest rates and exchange rate, port-
conditions for wealthholders in each country. folios would no longer be in their desired pro-
Residents of each country are assumed to portions, since domestic wealthholders would
allocate their net financial wealth among three want to redistribute their wealth increase
assets: the domestic monetary base, domestic toward domestic bonds and foreign bonds.
government bonds, and net foreign bonds With the foreign interest rate fixed, actions of
denominated in foreign currency.z0The desired domestic investors to realign their portfolios
proportions of these assets are assumed to de- would result in a drop in the domestic interest
pend on their respective yields, with domestic rate and a depreciation of the exchange rate."
and foreign bonds considered imperfect An increase in net holdings of foreign bonds
substitutes. An increase in the domestic resulting from a current-account surplus would
(foreign) interest rate causes investors to in- also increase domestic wealth and disturb port-
crease the desired proportion of their wealth in folio equilibrium. In that case, domestic
domestic (foreign) -bonds and to lower the wealthholders would want to hold some of the
desired proportions in the monetary base and wealth increment in the form of domestic
foreign (domestic) bonds. The outstanding assets. This would lead to a fall in the domestic
stocks of these assets are fixed at any point in interest rate and an appreciation of the ex-
time so that the exchange rate and the two in- change rate.
terest rates equal the values at which wealth- Unlike the first two cases, an increase in
holders are just willing to hold existing assets, domestic government bonds has an uncertain
assuming asset markets clear continuously. effect on the exchange rate. On the one hand,
Stocks of financial assets change over time, the increase in wealth would increase domestic
causing interest rates and the exchange rate to demand for foreign assets resulting in an ex-
change. Bond-financed government deficits change-rate depreciation. On the other hand,
(surpluses) increase (decrease) the private the increase in domestic government debt
holdings of government bonds. Money- would raise the domestic interest rate, making
financed deficits (surpluses) increase (decrease) foreign bonds less attractive. If this substitution
the monetary base. Current-account surpluses effect were larger than the wealth effect, the net
(deficits) increase (decrease) net domestic result would be an appreciation of the exchange
holdings of foreign debt. rate.
An increase in the domestic monetary base
would increase domestic wealth and raise the
proportion of wealth held in this asset. At the
z1 An increase in the monetary base causes an excess supply
of this asset at the original exchange rate and interest rates
under the usual assumption that the partial derivative of the
20 The model is concerned with the allocation of the net demand function for each asset with respect to wealth is less
wealth of all private domestic wealthholders. Since demand than one. The excess supply is matched by excess demands
deposits are liabilities of domestic banks, the monetary base for domestic and foreign bonds. The excess demand for
rather than the money supply appears in the model. The in- domestic bonds raises their price-lowers the domestic in-
clusion of domestic government debt in the hands of terest rate-which increases the proportion of wealth held
domestic residents assumes that this too is an "outside" in domestic bonds. The excess demand for foreign bonds
asset-that residents do not take account of the present (denominated in foreign currency) increases the demand for
value of the implied tax liability associated with the govern- foreign currency resulting in a depreciation that increases
ment debt. Note that an appreciation of the exchange rate the proportion of wealth held in foreign bonds.
lowers the domestic currency value of foreign assets and Equilibrium is restored when these proportions reach their
hence lowers domestic wealth. higher desired levels.
Economic Review February 1983The portfolio-balance model incorporates EMPIRICAL EVIDENCE ON
elements of both the traditional flow model and ALTERNATIVE THEORIES:
the monetary model. By including foreign THE U.S.-CANADIAN EXCHANGE RATE
currency-denominated assets, it allows current- This section examines how well the different
account imbalances to affect exchange rates as t h e o r i e s explain movements i n t h e
the flow model predicts. By including the U.S.-Canadian exchange rate. This particular
monetary base of each country, it allows dif- case was chosen for several reasons. First,
ferences in monetary growth to affect exchange Canada and the United States are each other's
rates, as the monetary model predicts. The largest trading partner, so fluctuations in this
channels of influence differ, however. Because exchange rate can have substantial effects on
the portfolio model focuses only on distur- trade flows. Second, Canada adopted a flex-
bances to asset portfolios, it ignores the ible-rate policy in June 1970, before most other
underlying determinants of trade as well as the countries, so a longer time period is available
role of purchasing power parity." for empirical tests. Third, data on bilateral
There have been reservations about the asset holdings, required for estimation of the
portfolio-balance model. Because comparative portfolio-balance model, are more extensive for
returns on domestic and foreign assets are im- these countries than for most other countries.
portant in the model, expected exchange-rate
movements must be considered. Different Graphical overview
assumptions about how a.gents form their ex- Before examining statistical estimates of the
pectations can lead to very different predictions models, a graphic overview may help show
from the model. This issue is particularly im- broad relationships between the exchange rate
portant if one country is a net debtor rather and its possible determinants. Chart 3 com-
than creditor in foreign currency-denominated pares movements in the ratio of Canadian to
bonds. Under some assumptions about the for- U.S. price levels, measured by the wholesale
mation of exchange-rate expectations, the price indexes, with the exchange rate measured
model may be unstable.23The model may also as Canadian dollars per U.S. dollar. According
be difficult to use in empirical work because of to the theory of purchasing power parity, these
the scarcity of data on domestic holdings of two series should move together quite closely.
foreign financial assets. As the chart shows, the price ratio does roughly
correspond with the exchange rate. While the
relationship is not very close in terms of
22 Changes in the composition of wealth that leave its level quarterly movements, the fall in the exchange
initially unchanged also have exchange rate effects accord-
ing to this theory. An open market purchase (sale) of value of the Canadian dollar since 1976 has
domestic government bonds by the central bank reduces the coincided with higher Canadian inflation, as
domestic interest rate and cause!; a depreciation (apprecia- the theory of purchasing power parity predicts.
tion) of the exchange rate. 1ntc:rvention in the exchange
market by the central bank in the form of purchases or sales
of foreign bonds has the same qualitative effects on the
domestic interest rate and the exchange rate as open market
operations.
23 If one country is a large net debtor in foreign currency tional and speculation is stabilizing. See Dale W. Hender-
denominated financial claims and agents have static expec- son and Kenneth Rogoff, "Negative Net Foreign Asset
tations-if they assume that exchange rates will not Positions and Stability in a World Portfolio Balance
change-the portfolio-balance model is generally unstable. Model," Journal of International Economics, August
This instability disappears, however, if expectations are ra- 1982, pp. 85-104.
26 Federal Reserve Bank of Kansas CityChart 3 Chart 4
CANADIAN-U.S. EXCHANGE RATE CANADIAN-U.S. EXCHANGE RATE AND
AND RATIO OF PRICE LEVELS INTEREST RATE DIFFERENTIAL
Canadian Dollars Interest Rate Canadian Dollars
Ratio of Prices Per U.S. Dollar Differential Per U.S. Dollar
1.35 1.25
Interest Rate ( ~ i ~ h ~
-
Ratio of Price
I I I I I I I I I I I I
Chart 4 compares the interest-rate differen- the decline in the differential from mid-1976 to
tial, measured by the Canadian commercial- mid-1978 occurred as the value of the Canadian
paper rate less the U.S. commercial-paper rate, dollar declined steeply.
with the exchange rate. The traditional flow Chart 5 compares the differences in real
model predicts that the two series should be in- growth rates, measured as the annualized rate
versely related, because it asserts that a wider of change in real GNP in Canada less the U.S.
differential will cause a net capital flow into counterpart, with the exchange rate. The tradi-
Canada, raising the value of the Canadian tional flow model asserts that higher economic
dollar. The monetary model, on the other growth in Canada should cause the Canadian
hand, predicts a positive relationship, because dollar to fall, due to its adverse effects on the
it assumes a wider differential reflects higher current account. In contrast, the monetary
expected inflation in Canada and, thus, a model asserts that faster real income growth
depreciation in the Canadian dollar. Graphic should strengthen the Canadian dollar, since it
evidence suggests that larger interest differen- raises the demand for Canadian money. Al-
tials are associated with a rising Canadian though the graphic evidence indicate no dis-
dollar, although the relationship appears weak. cernible short-run relationship between relative
The bulge in the interest differential in 1975-76 growth rates and the exchange rate, the Cana-
coincided with a stronger Canadian dollar and dian economy grew faster than the U.S.
Economic Review February 1983 27. Chart 5 used in past work to capture the essence of the
CANADIAN-U.S. EXCHANGE RATE alternative theories.14 The purchasing power
AND REAL GROWTH DIFFERENTIAL parity equation is also included because strict
Growth Rate Canadian Dollars purchasing power parity is an assumption of
Differential Per U.S. Dollar the monetary model and is assumed by the
6.0 1 11.25 traditional flow model to hold partially. Above
each coefficient is the sign expected from each
theory. Table 2 presents estimates of the dif-
ferent models, based on quarterly data over the
flexible-rate period from 1971:Q1 to 1982:Ql.
The estimation results point to the conclusion
that none of the theories is fully supported by
the Canadian-U. S. experience.15 The estimate
leal ~ r o w t t
of the purchasing power parity model implies
Differential that a Canadian inflation rate one percentage
1 (Left Scale) v point above the U.S. inflation rate is associated
with a depreciation of the Canadian dollar of
only 0.5 percentage points, half the impact
predicted by the theory.26
24 Other representations of the models have been pro-
posed. For a version of the monetary model that relaxes the
assumption of strict purchasing power parity, see Jeffrey
A. Frankel, "On the Mark: A Theory of Floating Exchange
economy in the first half of the 1970s and the Rates Based on Real Interest Differentials," American
Canadian dollar was strong. In the second half Economic Review, September 1979, pp. 610-22. Another
of the 1970s, U.S. growth was generally higher monetary model that allows for central bank intervention is
given in Lance Girton and Don Roper, "A Monetary
and the Canadian dollar fell. Thus, the Model of Exchange Market Pressure ~p'plied to the
evidence does not support the traditional flow Postwar Canadian Experience," American Economic
model but is weakly consistent with the Review, September 1977, pp. 537-48. An alternative version
of the portfolio model does not assume that the foreign in-
monetary model. These graphic implications terest rate is exogenous and therefore includes the cor-
could be misleading, however, since the responding foreign asset holdings.
theories predict the effect of one variable 25 Similar negative results, based on forecasting perfor-
mance, were found for other exchange rates by Richard A.
holding all others constant and the graphs allow Meese and Kenneth S. Rogoff, "Empirical Exchange Rate
other variables to change. The next section, Models of the Seventies: Are Any Fit to Survive?" Interna-
therefore, presents statistical evaluations of tional Finance Discussion Papers, No. 184, Board of
Governors of the Federal Reserve System, 1981.
each exchange-rate model.
26 The effect of the inflation differential on the exchange
rate was also not estimated precisely. Only at the 6 percent
Estimates of exchange rate models significance level can one reject both the hypothesis that the
Table 1 presents the single-equation represen- change in the exchange rate is unrelated to the inflation dif-
ferential and the hypothesis that the exchange rate moves
tations of the traditional flow, monetary, and on a one-to-one basis with the inflation differential (pur-
portfolio-balance models, which have been chasing power parity holds).
Federal Reserve Bank of Kansas Citystatistically significant effect on the exchange
Table 1
rate, while the interest-rate differential did not
ALTERNATIVE MODELS OF EXCHANGE
have the positive impact specified by the
RATE DETERMINATION
theory.=' The portfolio-balance model fares
A. Purchasing Power Parity little better. Canadian asset stocks had no
(+I discernible effect on the exchange rate,
In et = ag + a1 ln(Pc/Pu)t + ft although the U.S. interest rate did have the
B. Traditional Flow Model - predicted result. A higher U.S. interest rate was
associated with a lower exchange rate for the
(+I
In q = bo + bl l n ( ? / ~ ~+) ~ Canadian dollar ."
(+I (-I There could be several reasons for the lack of
b2 In(Pc/Pu)t + b3(rc- ru)t + e t success with the models. The models assume
C. Monetary Model stable asset-demand functions, a premise that
may not have held in the 1 9 7 0 ~The . ~ ~models
In q = co + (c1+I ln(MC/MU)t+ do not incorporate the behavior of speculators,
(-1 (+I and the frequent economic and political shocks
c2 l n ( f / ~ ~+ )c3(rC-rU)t
~ + et over the period may have made speculation an
D. Portfolio Balance Model important factor. The models, in assuming
(+I (*I (-I freely floating exchange rates, do not allow for
et = Q + dl M B +
~ d2 E$ + dj + intervention by central banksa30
(+)
d4ry + et
3
Definitions: 27 While the lack of support for purchasing power parity
may be viewed as a priori evidence that the monetary model
e = spot exchange rate defined as number of must be invalid, it has been argued that because published
. Canadian dollars per U.S. dollar price indexes are inadequate for evaluating purchasing
P1 = price level in country i power parity, monetary models should be tested directly.
y! = real income in country i This argument is made, for examule, by John F. 0. Bilson,
r1 = nominal interest rate in country i " ~ a t i o n a lExpectations and the-~xchangeRate," in The
Economics o f Exchanne Rates: Selected Studies. Estimates
M B =~ monetary base in Canada of the monetary model developed by Frankel ("On the
BC = Canadian government debt held by Canadian Mark...,"), which relaxes strict purchasing power parity,
residents also yield results that do not support the monetary model.
FC = net U.S. dollar claims held by Canadian residents 28 Estimates of the portfolio-balance model that include
c = Canada U.S. asset stocks instead of the U.S. interest rate produce
u = United States essentially similar results.
E = error term
29 The demand for money appears to have been unstable
over the 1970s and, assuming at least part of money de-
The estimate of the traditional flow model in- mand is for wealth portfolio needs, this implies instability
dicates that only the prediction that higher in other asset demand functions. For a survey of the money ,
demand evidence, see John P. Judd and John L. Scadding,
Canadian interest rates were associated with an "The Search for a Stable Money Demand Function," Jour-
appreciation of the Canadian dollar is consis- nal of Economic Literature, September 1982, pp. 993-1023.
tent with the evidence. Even this effect is not 30 Allowing for a reaction function by the Bank of Canada
strongly supported. The estimate of the mone- along the lines suggested by Branson, Halttunen, and
Masson, "Exchange Rates in the Short Run," does not,
tary model shows similarly negative results. The however, significantly change the estimation results for the
difference in money-supply growth had no portfolio-balance model.
Economic Review February 1983, ~.
l $' n tPi*d
.: Table 2
YESTIMATEDEXCHANGE RATE MODELS
Estimation Period: 19713-1982:I
Model (rC - rU)
Constant In (PC/PU) In (MC/MU) In (yC/yU) - R2 -
- SEE - 9
DW -
A. Purchasing Power .511 .015
Parity* (1.906)
B. Traditional Flow .l$3 .347 7: -.I37 - .004 .I36 .015 1.41 .99
.,- " :( (,321) (1.243) . "1" (- 1.155) (- 1,821) ' '
C. Monetary - ,285 0.54 - .154 - .004 .093 .016 1.24 .99
(.500) (351) (- 1.245) ( - 1.704)
Estimation Period: 1971:I-1981 :IV
Model Constant MBC - BC - Fc - ru SEE -
R2 -
- $
DW -
D. Portfolio Balance -, .917 .001 .'.. .003 - .001 .004 321' .019 1.84 .91
~ -
- p , ..,.(15,.881) (.086) ..:5-(1.451)
?, ( - .972)' . (3.222)
*~stim'atedin fist-differen2iform.
Note: See Table 1 for definitions of variables.
Numbers in parentheses are t-statistics.
R2 = multiple correlation coefficient
SEE = standard error of estimate
D y = Durbin-Watson statistic
,., P = estimated autocorrelation coefficient
,
r".
SUMMARY AND CONCLUSIONS government-budget or current-account im-
balances.
The recent rise in the foreign-exchange value Each of these models was estimated to see if
of the U.S. dollar has important implications it accounted for changes in the Canadian-U.S.
for many sectors of the U.S. economy as well as exchange rate over the flexible-rate period. The
for other countries. This article has reviewed empirical results suggest that none of the
the major factors thought to influence the ex- models can be considered an adequate guide for
change rate, especially relative inflation, economic policy. There was little evidence of a
relative growth in real income, and interest-rate systematic, short-run relationship between the
differentials. Three models of exchange-rate exchange rate and differences in money growth,
determination were discussed. differences in economic growth, or changes in
The first model focuses directly on the flow asset portfolios. Two regularities did emerge
demands and supplies in the foreign-exchange from the empirical work, however: first,
market arising from international trade in although the short-run relationship is im-
goods and assets. The second attributes precise, inflation higher than in other countries
exchange-rate changes to differences in the is linked to exchange-rate depreciation, and se-
growth rates of money supplies. The third cond, domestic interest rates higher than in
asserts that exchange-rate movements reflect other countries a r e associated with an
asset portfolio readjustments caused by exchange-rate appreciation.
30 Federal Reserve Bank of Kansas CityThe Economic Review (USPS 417-850), published, edited, and owned by the Federal Reserve Bank of
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