The Role of Exchange Rates. A Reconciliation of Alternative Approaches

Faus en, Die ich K. A icle The Role o Exchange Ra es. A Reconcilia ion o Al e na i e App oaches K edi und Kapi al P o ided in Coope a ion wi h: Duncke & Humblo , Be lin Sugges ed Ci a ion: Faus en, Die ich K. (1982) : The Role o Exchange Ra es. A Reconcilia ion o Al e na i e App oaches, K edi und Kapi al, ISSN 0023-4591, Duncke & Humblo , Be lin, Vol. 15, Iss. 4, pp. 556-565, h ps://doi.o g/10.3790/ccm.15.4.556 This Ve sion is a ailable a : h ps://hdl.handle.ne /10419/292942 S anda d-Nu zungsbedingungen: Die Dokumen e au EconS o dü en zu eigenen wissenscha lichen Zwecken und zum P i a geb auch gespeiche und kopie we den. Sie dü en die Dokumen e nich ü ö en liche ode komme zielle Zwecke e iel äl igen, ö en lich auss ellen, ö en lich zugänglich machen, e eiben ode ande wei ig nu zen. So e n die Ve asse die Dokumen e un e Open-Con en -Lizenzen (insbesonde e CC-Lizenzen) zu Ve ügung ges ell haben soll en, gel en abweichend on diesen Nu zungsbedingungen die in de do genann en Lizenz gewäh en Nu zungs ech e. Te ms o use: Documen s in EconS o may be sa ed and copied o you pe sonal and schola ly pu poses. You a e no o copy documen s o public o comme cial pu poses, o exhibi he documen s publicly, o make hem publicly a ailable on he in e ne , o o dis ibu e o o he wise use he documen s in public. I he documen s ha e been made a ailable unde an Open Con en Licence (especially C ea i e Commons Licences), you may exe cise u he usage igh s as speci ied in he indica ed licence. h ps://c ea i ecommons.o g/licenses/by/4.0/ The Role o Exchange Ra es A Reconcilia ion o Al e na i e App oaches By Die ich K. Faus en, Clay on* The exchange a e cons i u es a ela i e p ice. Howe e , he na u e o his p ice ela ionship has o la e become su ounded by con o e sy. One iew holds ha he exchange a e is he ela i e p ice o na ional ou pu s. This "con en ional" iew is gene ally associa ed wi h he pu chasing-powe -pa i y doc ine (PPP) as well as wi h he pa ial equilib ium (income-expendi u e and elas ici ies) app oaches o he balance o paymen s and he exchange a e, espec i ely. The al e - na i e, "mone a y", iew main ains ha he exchange a e is he ela i e p ice o na ional monies, s ic ly a mone a y phenomenon, and i is associa ed wi h he ecen ly de eloping mone a y o asse app oach o he exchange a e. P oponen s o he mone a y iew equen ly de- cla e he adi ional iew as "e oneous" o " allacious". Thus he imp ession is being gene a ed, and s a ed explici ly on occasion, ha he adi ional and mone a y iews cons i u e wo mu ually exclusi e concep ions o he ole and de e minan s o exchange a es. I is my con en ion ha his is a spu ious con adis inc ion, ha nei he he adi ional no he mone a y iew is in insically allacious bu ha hey cons i u e complemen a y app oaches o and concep ions o ex- change a es whose espec i e impo ance is o some ex en dependen o he ime dimension o analysis. This is no o deny ha ei he app oach can be, and has been, e oneously applied yielding misleading esul s and policy ecommenda ions. This is p ecisely he case whe e he analysis is exclusi ely p eoccupied wi h nai e e sions o ei he app oach. On he o he hand, he p ope ies o long- un s a iona y gene al equilib ium clea ly iden i y he exchange a e as he ela i e p ice o na ional ou pu s while he cha ac e is ics o dynamic adjus - * I g a e ully acknowledge help ul commen s om and discussions wi h Max Co den, Thomas Maye and Hans Molle , and inancial suppo om he Alexande on Humbold -Founda ion. OPEN ACCESS | Licensed unde CC BY 4.0 | h ps://c ea i ecommons.o g/abou /cclicenses/ DOI h ps://doi.o g/10.3790/ccm.15.4.556 | Gene a ed on 2023-01-16 12:48:20 The Role o Exchange Ra es 557 men beha iou sugges he impo ance o asse ma ke conside a ions in he sho - un de e mina ion o exchange a es. I. De e minan s o he Exchange Ra e The exchange a e mus clea he ma ke o o eign exchange. The obse a ion ha i cons i u es he ela i e p ice o na ional monies is au ologically ue and, he e o e, does no quali y as he di e en ia - ing c i e ion be ween he al e na i e app oaches. Such a c i e ion mus be sough in he pa icula beha io al concep ion o he cons i- uen elemen s o he o eign exchange ma ke . This issue is succinc ly epi omized in he alid con on a ion o low and s ock app oaches. 1. Flow App oach The balance o paymen s and i s a ious componen s a e iewed as equilib ium low phenomena. Demand o and supply o o eign ex- change a e de i ed om he ele an balance o paymen s lows. I is a cha ac e is ic and a po en ial weakness o he con en ional app oach ha i gene ally ocuses only on cu en accoun ansac ions as de e minan s o he o eign exchange ma ke , conside ing balance o paymen s adjus men as a special p oblem o gene al p ice heo y. In his basic model he demand o o eign exchange is de i ed om domes ic demand o impo s and he supply o o eign exchange om o eign demand o domes ic expo ables. Consequen ly, he exchange a e is de e mined by he de e minan s o he low demands o and supplies o adeables — p incipally ela i e commodi y p ices and incomes. These a iables also cons i u e he majo ehicles o he ansmission mechanism which p esupposes e icien commodi y a bi- age. Ano he impo an de e mining a iable is he s a e o expec- a ions which is usually ecognized in he con ex o "leads and lags" in o eign exchange paymen s, bu which can also exe di ec in luence on he ansac ions in adeables hemsel es. The equilib ium exchange a e is ha which balances he equilib ium lows o impo s and ex- po s, and i is in his sense de e mined in he commodi y ma ke and ega ded as he ela i e p ice o na ional ou pu s. The p eoccupa ion wi h he cu en accoun implies he i ual neglec o capi al mo emen s in he de e mina ion o exchange a es (S ii zel, 1958, Ch. 4.5). This neglec is explicable on he one hand in e ms o basic balance o paymen s accoun ing p inciples which ensu e OPEN ACCESS | Licensed unde CC BY 4.0 | h ps://c ea i ecommons.o g/abou /cclicenses/ DOI h ps://doi.o g/10.3790/ccm.15.4.556 | Gene a ed on 2023-01-16 12:48:20 558 Die ich K. Faus en ha he cu en accoun balance is equal o he nega i e capi al accoun balance including ese e mo emen s. On he o he hand, i was a classical con en ion ha sho - e m capi al mo emen s a e in insically accommoda ing and, he e o e, ansi o y, and ha long- e m capi al mo emen s, de e mined by he eal yield s uc u e, will p ecipi a e he equisi e adjus men s o he cu en accoun balance h ough ela i e p ice and income e ec s. In hose ins ances whe e he basic model is ex ended o inco po a e capi al mo emen s, i s essen ial low na u e emains una ec ed: capi al mo emen s, like commodi y ansac ions, a e concei ed o as equilib ium low phenomena. The olume o capi al lows is de e mined by in e na ional yield di e en- ials, and he low demands o and supplies o o eign exchange a e co - espondingly augmen ed. The exchange a e con inues o be de e mined in he low o in e na ional unds ma ke and, gi en e icien com- modi y a bi age, con inues o ep esen he ela i e p ice o na ional ou pu s. 2. S ock App oach The basic heo e ical p esump ion o his app oach is he pos ula e o pe asi e po olio balance beha io . Consequen ly, asse ma ke s occupy he cen e o analysis. Demands and supplies e e o he s ocks o he a ious asse s and a e de e mined acco dingly. Po olio imbalance gi es ise o lows which a e s ic ly disequilib ium adjus - men phenomena, in insically ansi o y in a s a iona y en i onmen , and hey play no pa in he de e mina ion o equilib ium asse p ices. Tha p ice is de e mined ins ead by he in e ac ion o he s ock demand o and supply o he espec i e asse . The impo an de e mining a iables o he s ock demands o asse s a e eal income and weal h, p ice le els and a es o e u n, and expec a ions. Applied o he exchange a e as he ela i e p ice o asse s de- nomina ed in di e en cu encies, his app oach main ains ha he equilib ium exchange a e is de e mined in asse ma ke s. As in he con en ional app oach, he exchange a e clea s he ma ke o in e - na ional lows o unds. These lows, howe e , a e no longe de i ed om equilib ium commodi y (and capi al) lows, bu om s ock dis- equilib ium in he a ious asse ma ke s und a e de e mined acco d- ingly. In he s ock app oach he in e na ional exchange o goods and se ices is i ually excluded om analysis, and he impo ance o commodi y a bi age is dep eca ed (F e ikel, 1976, p. 204). OPEN ACCESS | Licensed unde CC BY 4.0 | h ps://c ea i ecommons.o g/abou /cclicenses/ DOI h ps://doi.o g/10.3790/ccm.15.4.556 | Gene a ed on 2023-01-16 12:48:20 The Role o Exchange Ra es 559 One la en weakness o his app oach in he con ex o pe iod analysis is ha s ock and low equilib ium condi ions a e no neces- sa ily equi alen . Fo mally i can be shown ha equi alence holds in con inuous ime analysis (Foley, 1975, p. 319) bu ha in pe iod analysis s ock equilib ium implies low equilib ium only i he addi ional as- sump ion o pe ec o esigh is made (idem, p. 317). This p oblem, howe e , becomes less signi ican he highe a e adjus men speeds and he lowe a e adjus men cos s o po olio imbalance. II. The Mone a y App oach The mone a y app oach o exchange a es in i s ex an e sions (e.g. he con ibu ions in he Scandina ian Jou nal o Economics, 1976, No. 2 and in F enkel and Johnson, eds., 1978) is a subse o he s ock app oach. I is a subse o he s ock app oach because — designa ions o "asse app oach" and e e ences (usually in pa en heses o oo no es) o he gene ic concep o „asse s" no wi hs anding — i ocuses mainly on one single asse , namely money. "As usually o mula ed, he mone a y app oach s esses ha he exchange a e, as he ela i e p ice o wo monies, is de e mined by he equilib ium be ween he demands o and he supplies o he s ocks o money ou s anding" (Hod ick, 1978, p. 97). The usual assump ion in ha li e a u e is ha unde lexible exchange a es nominal money supplies a e exogenously de e mined. As a consequence, he de e minan s o he s ock demand o money assume s a egic impo ance o he de e mina ion o he equilib ium exchange a e. The simples s uc u e o his so o model is o de e mine mone a y s ock equilib ium, domes ic and o eign; o in oduce his in o he PPP ela ion which is explici ly di o ced om commodi y a bi age; o no e ha he economy unde conside a ion is small so ha he o eign p ice o he single commodi y is gi en and adjus men has o occu in he domes ic money demand de e mining a iable(-s); and o conclude ha he exchange a e is indeed he ela i e p ice o na ional monies, de e mined in he money ma ke . (Inciden ally, ha asse ion could be co obo a ed di ec ly, and wi hou signi ican loss o in o ma ional con en , by no ing ha he p ice o money is he in e se o he p ice le el and exp essing he PPP condi ion as he a io o hese quo ien s). The exchange a e so de e mined is usually o minimal signi icance o he ope a ion o he model excep pe haps o he speci ica ion o some expec a ions mechanism wi h an exogenous elas ici y pa ame e . OPEN ACCESS | Licensed unde CC BY 4.0 | h ps://c ea i ecommons.o g/abou /cclicenses/ DOI h ps://doi.o g/10.3790/ccm.15.4.556 | Gene a ed on 2023-01-16 12:48:20 560 Die ich K. Faus en In he speci ica ion o he demand o money unc ions "eclec icism" appea s o p edomina e in hese models and i gi es ise o a peculia admix u e o sho - and long- un conside a ions. The mone a y analysis is essen ially o ien ed owa d he elucida ion o he p ope ies o long- un s a iona y (o s able) equilib ium. This s a emen applies mos os ensibly o he mone a y app oach o he balance o paymen s unde ixed exchange a es, bu no less o i s "dual", he mone a y app oach o he exchange a e. Tha long- un ime ho izon is app op ia e o as- suming ha pe ec wage and p ice lexibili y secu e and main ain he ull employmen le el o eal ou pu . On he o he hand, he p ominen emphasis on asse conside a ions, based on he p esump ion o ela i ely high adjus men speeds in asse ma ke s, is pa icula ly apposi e in sho - un analysis "since wha go e ns in he sho un he equilib ium p ice o money is he s ock demand and he s ock supply" (Do nbusch, 1976 a, p. 276). Ye he assump ion o con inuous ull employmen main enance is unc i ically e ained in his con ex and, as a consequence, he eal income a iable is elimina ed om he demand o money unc ion. Fu he , i espec i e o speci ica ion, he demand o money is assumed o be a s able unc ion o a small numbe o a iables — a long- un p oposi ion. Tha assump ion is also un- c i ically e ained in he sho - un analysis e en hough he e is no e idence o subs an ia e i s e aci y no does i possess a p io i plau- sibili y (Pa kin, 1976, p. 253). In he speci ica ion o he demand o money unc ion one can ob- se e a a ie y o al e na i e hypo heses whose choice is no always es imony o he disin e es edness o he esea che . Fo example, in some models wi h money and equi ies he demand o eal balances is pos ula ed o be an in e es -dependen unc ion o eal weal h (Do n- busch, 1976 a; Myh man, 1976). In pu e mone a y models he expec ed a e o in la ion has been iden i ied as he dominan de e mining a iable o he demand o eal balances (F enkel, 1976) o , al e - na i ely, he exchange a e, cu en le el and expec ed a e o change, is ec ui ed as he s a egic de e minan o he demand o nominal balances (Mussa, 1976). These money demand unc ions usually also include he conspicuous "po man eau" a iable. The dis inguishing cha ac e is ic o his so o model is an exceedingly selec i e applica- ion o he s anda d con empo a y mone a y- heo e ic amewo k o analysis. And his selec i i y is he mani es a ion o he lack o a easonable comp ehensi e asse o po olio balance model. In such OPEN ACCESS | Licensed unde CC BY 4.0 | h ps://c ea i ecommons.o g/abou /cclicenses/ DOI h ps://doi.o g/10.3790/ccm.15.4.556 | Gene a ed on 2023-01-16 12:48:20 The Role o Exchange Ra es 561 a model money demand and, hus, he exchange a e would no longe be he p o enance o a single as u ely chosen a iable bu a he o he in e ac ion be ween asse , commodi y and labo ma ke s. The di o ce o he exchange a e om ou pu conside a ions could no be sus ained in a co ec ly speci ied model. The pu chasing powe pa i y ela ionship has been iden i ied as he "ideological an eceden " o he mone a y app oach o he exchange a e (Hod ick, 1978, p. 97). Indeed, F enkel (1976, p. 203) a gues ha "[ ]he o iginal o mula ion o Cassel was s a ed in e ms o he ela i e quan i ies o money", ha " he ole o p ices in Cassel's compu a ion o he equilib ium exchange a e se es only o p oxy he unde lying mone a y condi ions. The de e mina ion o exchange a es does no seem o ely, di ec ly o indi ec ly, on he ope a ion o a bi age in goods" (emphasis added). This conjec u e is designed o bu ess he e aci y o he claim ha he exchange a e is a mone a y phenomenon, and i iden i ies he PPP ela ionship as a pa icula ly a ac i e "build- ing block" o mone a y models. Bu i is a a iance wi h he ex ual e idence. "I is no easy o see how Cassel could be in e p e ed his way... The e could be li le doub ha wha de e mines he exchange a e, in his p esen a ion [ci ed by F enkel], a e p ices o goods, which a e he basic ac o in he model a he han a 'p oxy* o money... The 'p oxy ela ionship' be ween p ices and money is hus, in Cassel's wo k, he p ecise opposi e o ha which is a ibu ed o him by F enkel" Michaely, 1978, pp. 33 - 4). The impo ance o ou pu ma ke s and commodi y lows as one se o ac o s de e mining he equilib ium exchange a e is a basic con en ion o he PPP doc ine. Bu his is no an exclusi e emphasis. Dis u bances o igina ing in he mone a y sec o can in luence he exchange a e as well. The ex en o which he exchange a e is a "mone a y phenomenon" depends c ucially on he ela i e s abili y o he wo sec o s. Wi hin he pu iew o he PPP doc ine his is an empi ical and no an ap io is ic issue. III. Reconcilia ion The asse ion ha he exchange a e is an exclusi ely mone a y phen- omenon has no ben es ablished by he p ac ione s o he mone a y ap- p oach. A emp s o " es " he mone a y app oach and o co obo a e his asse ion ha e e aded he p oblem p e iously iden i ied by B anson and Hill (1971, p. 10) in a pa allel con ex : "we mus ely ai ly hea ily on ou a p io i heo e ical speci ica ion o he model s emming om OPEN ACCESS | Licensed unde CC BY 4.0 | h ps://c ea i ecommons.o g/abou /cclicenses/ DOI h ps://doi.o g/10.3790/ccm.15.4.556 | Gene a ed on 2023-01-16 12:48:20 562 Die ich K. Faus en he s ock-adjus men iew, and ob ain pa ame e es ima es mo e o less condi ional on ha heo e ical iew being co ec , as opposed o es ing he heo y agains he da a." This de iciency is pa icula ly no iceable in he cha ac e is ic speci ica ion o he money ma ke whe e he sho - un s abili y o he demand o money is aken o g an ed and he money supply is conside ed exogenous. In he sho un, he demand o money may be subjec o ansi o y shi s (Pa kin, 1976, p. 253), while he exogenei y o he money supply is an exceedingly unhelp ul assump ion (Co den, 1976, pp. 387 and 403). Fu he , con- side ing he demand o money as a single unc ional ela ionship o one o ano he "dominan " a iable may be expedi ious and plausible unde speci ic his o ical ci cums ances — such as F enkel's (1976) in- es iga ion o he Ge man hype in la ion — bu i is c ucially in- adequa e as he heo e ical ounda ion o gene al ap io is ic s a e- men s abou he ole and de e minan s o he exchange a e. I should be no ed ha no all applica ions o he asse app oach a e con ined o he na ow amewo k o he basic mone a y app oach delinea ed abo e and, indeed, ha ecen esea ch appea s o be in- c easingly o ien ed owa d b idging he e s while concep ual pola iza- ion be ween mone a y and eal app oaches (e.g. Do nbusch and Fische , 1980). Mussa (1976) de o es conside able e o owa d elucida - ing some o he " eal causes and e ec s" o exchange a e beha io . His discussion ge s aw ully muddled, howe e , in he a emp o e- concile and in eg a e hese conside a ions wi h he unde lying mone- a y pe spec i e. Empha ic insis ence ha eal ac o s in luence he exchange a e only h ough hei "impac on he demand o money" does no make he exchange a e " undamen ally an asse p ice" (p. 241). In a pape dis inguished by i s comp ehensi e pe spec i e which eluci- da es he join in luence o mone a y and eal a iables on he exchange a e, Do nbusch (1976 b) asse s ha "o ganizing hough abou [ he long- un de e mina ion o ] exchange a es a ound he mone a y sec o is likely o be a di ec and in o ma i e app oach" (p. 260). Tha poin emains o be es ablished and is con ingen upon an assump ion ha is a ely spelled ou in de ail and is s ill he subjec o deba e. The legi ima ion o concen a ing p incipally on money and c edi ma ke s in mac oeconomic analysis de i es om one o he unda- men al pos ula es o mone a ism, namely he p esump ion o he in- he en s abili y o he p i a e sec o (B unne , 1970). Subjec o his p o iso asse ma ke s, and mone a y policy in pa icula , assume s a- OPEN ACCESS | Licensed unde CC BY 4.0 | h ps://c ea i ecommons.o g/abou /cclicenses/ DOI h ps://doi.o g/10.3790/ccm.15.4.556 | Gene a ed on 2023-01-16 12:48:20 The Role o Exchange Ra es 563 egic impo ance o he de e mina ion o mac oeconomic equilib ium in gene al, and he exchange a e in pa icula . I , on he o he hand, he p i a e sec o is subjec o e a ic shocks and s uc u al changes a ec ing consump ion and p oduc ion pa e ns, hen hese ac o s dese e p ominen emphasis, e en wi hin he con ex o a s ock app oach. This poin is ecognized in Myh man's "mone a y impulse heo y" (1976, p. 186). Howe e , con a y o Myh man's asse ion, such a heo y would need o dis inguish be ween he easons o changes in he money supply. The e is a di e ence be ween mone a y policy passi ely accommoda ing budge imbalances o ac i ely coope a ing in he pu sui o s abiliza ion o dis ibu ion goals. Thus, a ela ionship e-eme ges be ween he exchange a e and ou pu conside a ions. The asse app oach o exchange a es has been help ul in o ien ing analysis away om an exclusi e p eoccupa ion wi h low phenomena. The emphasis on po olio balance clea ly iden i ies in e na ional asse lows as ansi o y adjus men phenomena and unde lines he im- po ance o expec a ions o exchange a e de e mina ion. I yields use ul explana ions o his o ical episodes cha ac e ized by highly ola ile exchange a e beha io . The alidi y o he app oach i sel is independen o speci ic ins i u ional ac o s such as he eedom o capi al mo emen s. E en in he p esence o pe asi e capi al con ols his app oach is se iceable in explaining he beha iou o asse holde s and i s e ec on he exchange a e and he balance o paymen s, espec i ely. Howe e , his in a iance wi h espec o his o ico-ins i- u ional ci cums ances does no apply o he .uses o which he app oach has been pu . The e a e ample incidences in economic his o y (up o he p esen ) whe e he p esump ion o mone a y ins abili y is app o- p ia e and whe e mone a y dis u bances ha e exe ed he p edominan in luence on exchange a es. Bu his obse a ion, and he "e idence" ex ac ed om such episodes, is no su icien o designa e he exchange a e a mone a y phenomenon and, con e sely, o denig a e as a "con- cep ual e o " (Mussa, 1976, p. 233) he con en ional iew which associa es he exchange a e wi h ela i e na ional commodi y p ice le els. This claim is simply unsus ainable as a gene al p oposi ion and i econcilable wi h he asse app oach i sel . On he one hand, he dis ibu ion o asse s is go e ned by hei a es o e u n, by p ices, ha is, which ca y a ime dimension and no by simple pu chase p ices. The e o e, he p ice o na ional monies which is ele an in he con ex o balance o paymen s analysis and adjus men is no he OPEN ACCESS | Licensed unde CC BY 4.0 | h ps://c ea i ecommons.o g/abou /cclicenses/ DOI h ps://doi.o g/10.3790/ccm.15.4.556 | Gene a ed on 2023-01-16 12:48:20