balance-of-payments flow model and exchange rate determination

8/8/2019 Balance-Of-Payments Flow Model and Exchange Rate Determination

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D E E C O N O M I S T 1 2 9 , N R . 3, 1 9 8 1

E X C H A N G E R A T E D E T E R M I N A T I O N A N D T H E B A L A N C EO F P A Y M E N T S , A T H E O R E T I C A L F R A M E W O R K

B Y

P .B . D E R I D D E R *

1 I N T R O D U C T I O N

I n t h e e a r l y 1 9 7 0 s , t h e B r e t t o n W o o d s s y s t e m o f fL x ed p a r i t ie s c o l la p s e d a n de x c h a n g e r a te s b e g a n t o f lo a t . S i n ce t h e n , m a n y p u b l i c a t io n s h a v e d r a w na t t e n t i o n t o t h e i s s u e o f h o w e x c h a n g e r a t es a r e t o b e d e t e r m i n e d i n a w o r l dw i t h f l o a t i n g r a t es .

P u r c h a s in g p o w e r p a r i t y t h e o r y , p o r t f o l io a n a ly s is a p p l ie d t o i n t e r n a t io n a lc a p i ta l fl o w s , a n d t h e m o n e t a r y a p p r o a c h to t h e p r o b l e m o f f l o at in ge x c h a n g e r a te s a r e t h e m a i n s tr e a m s i n e x c h a n g e r a t e l it e ra t u r e . T h e w o r k o fL y b e c k a n d J/ir nh ~ dl [ 9 ] , B f ls o n [ 4 ] a n d t h e O p t i c a R e p o r t [ 1 0 ] o f t h e E CS e c r e ta r ia t a r e e x a m p l e s o f t h e p u r c h a s i n g p o w e r p a r i t y a p p r o a c h . I n f a c t , t h em o n e t a r y a p p r o a c h t o t h e e x c h a n g e r a t e is a ls o b a s e d o n t h e p u r c h a s i n gp o w e r id e n t i t y . A m o n g o t h e r s , F r e n k e l [ 6 ] , T u l li o [ 1 3 ] , a n d a g a in B i l so n[ 4] h a v e f o u n d e m p i r i c al ev i d e n c e f o r t h i s v ie w o n t h e c a us e s f o r e x c h a n g e

r a te v a r ia b il it y . F i n a l l y A r m i n g t o n [ 1 ] , B r il le m b o u r g a n d S c h a d l e r [ 3 ] a n dA r t u s [ 2] d e v e l o p e d e x c h a n g e ra t e m o d e l s in s p i r e d b y t h e t h e o r y o f o p t i m a lp o r t f o l i o s e l e c t i o n .

I t w o u l d g o b e y o n d t h e s c o p e o f t h i s p a p e r t o r e v i e w al l t h e s e a r ti c le s . 1T h e m a i n p u r p o s e i s t o f o r m u l a t e a s y n t h es is b e t w e e n t h e t h e o r y o f o p t i m a lp o r t f o l i o s e l e c ti o n a n d t h e p u r c h a s i n g p o w e r p a r i t y a n a ly s is . T h e r e f o r e , am o d e l f o r t h e b a la n c e o f p a y m e n t s is c o n s t ru c t e d in w h i c h t h e c u r r e n tb a l a n c e i s d i s t i n g u i s h e d n e x t t o t h e c a p i t a l a c c o u n t . F o r t h e s a k e o fa r g u m e n t , a r a t h e r h i g h l e v e l o f a b s t r a c t io n is c h o s e n a n d n o a t t e n t i o n h a sb e e n p a i d to t h e d y n a m i c p r o p e r ti e s o f th e m o d e l .

I n S e c t i o n 2 , th e c u r r e n t a c c o u n t m o d e l is d e s c r ib e d . I n S e c t i o n 3 , t h ed e t e r m i n a n t s o f c a p i t a l i m p o r t s a n d e x p o r t s a r e c o n s i d e r e d , w h i l e S e c t i o n* F ormerly, C entral Planning Bureau, The Hague.1 Recently Bilson [5] published an excellent survey on the subject .


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EXCHANGE RATE DETERMINATION 375

w o rd s , f o r e i g n ex ch an g e m ark e t eq u i l ib r i u m, w h i ch i n t h a t ca se is i d en t ica lw i t h eq u i l i b r iu m o n cu r r en t a cco u n t , w i ll b e acco m p l i s h ed b y ex ch an g e r a t em o v e m e n t s o n ly .

F i n a ll y , t h e m o d e l a l so p ro v i d es a d e s c r i p t i o n o f man ag ed f l o a t in g . I n t h a tca s e, b o t h o f f i c ia l i n t e rv en t i o n b y t h e cen t r a l b an k , i . e ., ex o g en o u s ch an ges i nof f i c ia l reserves , and endogenous changes in the exchange ra te b r ing abou teq u i l ib r i u m i n t h e ex ch an g e m ark e t . I n t h e s e c i r cu ms t an ces , h o w e v e r , eq u il i-b r i u m d o es n o t n eces s a r il y i mp l y t h a t t h e cu r r en t acco u n t i s i n b a lan ce t o o .

In o rd e r t o s ee w h a t t h e fu n d am en t a l s o u rces o f ex ch an g e r a t e v a r i ab il it ya re i n a n ec o n o m y l ack in g s u b s t an ti a l ex p o r t s an d i mp o r t s o f cap it a l, t h em o d e l is so l v ed fo r t h e ex ch an g e r a te :

1= - ( ~ _ b 1 ) + [ ( m w - ~ ) +a + ~ - IS L - 1 A I R l ( 2 . 7 )B - 1 B - 1

L o o k i n g a t e q . (2 .7 ) , th ree sources o f exchange ra te var iab i l i ty can be d i s t in -gu i shed . F i r s t , l e t us co ns ider o f f i c ia l in te rven t ion . I t is no t su rp ri s ing , o fcourse , tha t an increase in in te rna t iona l reserves , tha t i s to sa y an increasedd em an d fo r fo r e i g n cu r ren c i e s , w i ll c au se a d ep rec i a t i o n . F ro m e q . (2 .7 ) , h o w -ev e r, i t c an b e s een t h a t a p o l i cy o f ex ch an g e r a te s t ab il is a t io n t h ro u g h d i r ec ti n t e rv en t i o n b eco m es h a rd e r t o i m p l emen t t h e h i g h e r t h e p r ice e l a st ic i ti e s o fex p o r t s an d i m p o r t s ( a + / ~) ar e .

A p a r t f ro m ch an g es i n i n t e rn a t i o n a l r e s e rv es , t w o o t h e r k i n d s o f d e t e r -m inan t s o f exchange ra te var iab i l i ty can be d i s tingu i shed . 3 On e is the so-ca ll ed " r ea l s o u rce o f ex ch an g e r a t e m o v e m en t s . " I f , f o r in s t an ce , i n te r -n a t i o n a l d eman d f a l l s r e l a t i v e t o d o mes t i c d eman d , i . e . , an ex an t e d e f i c i to n cu r r en t acco u n t , t h e cu r r en cy i n q u es t i o n w i l l t en d t o d ep rec i a t e r e l a t i v et o o t h e r s . A n o t h e r ex am p l e is t h e ex p l o i t a t i o n o f n a t u ra l r e s o u rces s u ch a s o ilan d g as. U n d e r t h e s e c i r cu ms t an ces, an ex an t e s u rp l u s o n cu r r en t acco u n tw i ll o ccu r , f o l l o w ed b y ap p rec i a t io n .

Fina l ly , i t i s a l so poss ib le to d i s t ingu i sh pure nominal exchange ra techanges . These a rise wh en th e ra te o f in f l a t ion d i f fe rs be tw ee n coun t r i es .Fo r i n s t an ce , i f t h e r a t e o f i n f l a ti o n i n t h e N e t h e r l an d s is b e l o w t h a t o f i tst rad ing par tners , the gu i lder wi l l apprec ia te v i s ? t v i s those t rad ing par tners .T h e r ea s o n w h y i n t h e s e c i r cu ms t an ces an ap p rec i a t i o n o f t h e g u i l d e r o ccu r s

3 F or an analogous way in treating the va rious sources for exchang e rate variability, seealso Korteweg, [7] and [8].


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376 P.B. DE RID DER

i s o b v i o u s . D u e t o a l o w er r a t e o f i n f la t io n , t h e co mp e t i t iv e p o s i t i o n o f D u t chi n d u s t ry i mp ro v es , w h i ch i n t u rn l ead s to a ri se in ex p o r t s , a f a l l i n i mp o r t sa n d t h u s t o a n i m p r o v e m e n t o f t h e c u r r e n t a c c o u n t . W i th n o i n te r v e n t io no f m o n e t a r y au t h o r i t ie s s u ch a s ex an t e s u rp lu s , i .e . , an ex cess d em an d fo rgu i lders , invo lves an upw ard-m oving exchan ge ra te in o rder to ach ieve a ne wcu r ren t acco u n t eq u i l i b r i u m.

3 PRIVATE CAPITAL FLOWS AND THE ECHANGE RATE

In t h is s ec t i o n a t h eo re t i ca l m o d e l i s co n s t ru c t ed acco rd i n g t o t h e an a ly s is o fp o r t fo l i o man ag em en t . O n l y p r iv a t e cap i ta l f l o w s a r e co n s i d e red , i mp l y i n gt h a t m o n e t a ry au t h o r i t ie s a r e a s s u med t o h av e fu l l co n t ro l o v e r fo r e i g nac t iv i ti e s o f t h e b an k i n g s y s t em.

L e t u s co n s i d e r an eco n o mi c ag en t s eek i n g t o i n v es t h i s w ea l t h i n t w ok i n d s o f a s se t s, f o re i g n an d d o m es t i c . T h e u t i l i ty h e g e t s b ack f r o m t h o s eas s e t s d ep en d s n o t o n l y o n i t s p o s s e s s i o n , b u t a l s o o n t h e f ac t t h a t t h ey a r ecap ab l e o f s u p p l y i n g t h e i n v es t o r w i t h an i n co me . T h e re fo re t h e u t i l i t y fu n c -t i o n i s o f t h e fo l lo w i n g s h ap e 4 : kU = (~.(1 + r*) 1ip + ( 1 - ~ ) ( 1 + r ~ ) ~ , W ~ p y l / p

- 1 < p < 0 (3 .1 )w h ere ,

U = u t i l i tyW1 = dom es t i c as se t s o f res iden t sW2 = fo re ign asse ts o f res iden t sr * = e x p e c t e d r a t e o f r e t u r nk * = e x p e c t e d e x c h a n g e r a tek = s p o t r a t e .

Fo r a g i ven p e r i o d o f t ime t h e i n v es t o r w i s h es t o m ax i mi ze h is u t i li t y su b -j ec t t o t h e fo l l o w i n g co n s t r a i n t:

W = W1 + W2 to ta l wea l th . (3 .2 )4 A same typ e o f CES-funct ion can be found in Steinhauer and Chang [12] and PaUada[11].


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T h e f i rs t o r d e r c o n d i t i o n f o r a m a x i m u m s t at e s:1 - X 1 + r2* k } l / O + p ) W 1 ( 3 . 3 )W 2 = { " - -X 1 + r ~ /~

S u b s t i t u t i o n o f e q . 3.2 in e q . 3 .3 a nd t a k ing f i r s t d i f f e r e nc e l e a ds to a n e x -p r e s s ion f o r c a p i t a l e xpor t s :

W2 1 W ~A W 2 = { A ( r ~ - r { ' ) + I c - ~ c * ) + ' A W ( 3.4 )W 1 1 + p W t

I t i s obv ious tha t c a p i t a l im p or t s c a n be t r e a t e d in the sa m e wa y , so tha t t heb a l a n c e o f i m p o r t s a n d e x p o r t s o f c a p it a l m a y b e t a k e n a s:

X W2 1SK--aX2-zxw : ( . 2 . . + ) { A ( r -r D +- X W l +pX 2+ ( -- ~ - A X - - ~ A W } , ( 3 .5 )

w h e r e ,S K =A X 2 =x 2 =. X =

c a pf f al a c c o un tc a p i t a l im p or t sdom e s t i c a s se ts o f non- r e s ide n t st o t a l w e a l t h o f n o n - r e s id e n t s

F r o m e q . ( 3 .5 ) i t a ppe a r s th a t a r is e in dom e s t i c in t e r e s t ra t e s le a ds to n e tC a pita l im po r t s , a s doe s a n a n t i c ip ia t e d a ppr e c ia t ion . I n bo th c a ses , a n e x -pe c te d im p r ove m e n t in f u tu r e r e ve nue c a use s a s l fi ft t ow a r ds d om e s t i c a s set s .A ri se in th e spo t r a t e , on the o the r ha nd , w i ll i n i ti a t e ne t c a p i t a l e xp or t s , be -cause asse t holders expec t to rea l ize some capi ta l ga ins . F ina l ly , one can a lsosee f rom e q . ( 3 . 5 ) t h a t a d i f fe r e n c e i n t h e r a t e o f w e a l t h a c c u m u l a t io n m a y b e asour c e o f im ba la nc e .

I n t h e s a m e w a y a s i n S e c t i o n 2 , t h e m o d e l i s c o m p l e t e d b y t h e a s s u m p -t ion th a t i n p rinc ip le a ny su r p lus o r de f i c i t on c a p i t a l a c c ou n t w i ll be o f f se tby a c ha nge in in t e r na t iona l r e se r ve s . Ta k ing the two e qua t ions toge the r ,a s su m i n g e q u a l r a t es o f w e a l t h a c c u m u l a t i o n a t h o m e a n d a b r o a d , an e x p re s -s ion f o r the e xc ha nge r a t e c a n be ob ta ine d :

X W= ~* + A (r~ - r~ ) - (1 + p ) ( + ~ ) A I R ( 3 . 6 )X2 W~


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E X C H A N G E R A T E D E T E R M I N A T I O N 37 9

In t he ca se o f managed f l oa t ing , i . e . , o f exogenous i n t e rna t iona l r e se rve s ,t h is m o d e l y i el d s a r e d u c e d f o r m e q u a t i o n f o r t h e e x c h a n g e r a t e :

1k = [ - A I R + S L _ 1 + ~ (17~w - ~ ) ) -+ t -l) + v- 5 (or + / ~ - 1 ) ( / ~ - / ~ 1 ) ++ v ( A ( r - + ] (4 . 4 )

A c lose r l ook a t t h i s expre s s ion show s tha t l i nk ing bo th mode l s l e ads t o t hesame qua l it a ti ve conc lus ions a s de r ived sepa ra t e ly in t h e fo rego ing sec tions .T h e r e la t io n s h i p b e t w e e n t h e e x c h a n g e ra t e a n d it s d e t e rm i n a n t s , h o w e v e r ,ha s bec om e m ore s tab l e. Th a t i s t o s ay : t he exch ange ra t e has beco m e le sssensi ti ve t o chan~ es i n i ts d e t e rmin an t s . Th i s m ay be de m on s t ra t ed bycom par ing , fo r i n s t ance , t he f i rs t de r iva tive o f ~c w i th re sp ec t t o /3 i n eq. (2 . 7 )w i t h t h e o n e i n eq. (4 . 4 ) . F rom eq. (2 .7) i t fo l lows:

a la/~ - 1, (4.5 )w h e r e f r o m eq. (4 . 4 ) one can com pu te a f i r s t de r iva t ive w h ich is le ss tha nu n i t y :

o = - > - 1 ( 4 . 6 )3p 5 ( a + / - 1 ) + 7More impor t an t , how eve r , t han th i s i nc rea sed s t ab i l i t y i s t he gene ra l conc lu -s i o n w h i c h c a n b e d r a w n f r o m t h e i n t e g r a t i o n o f b o t h m o d e l s . I n t h e o r y , i ts eems possib le t o exp la in exchange ra t e s s imu l t aneous ly by purchas ing po w e rp a r i ty t h e o r y a n d b y t h e t h e o r y o f o p t im a l p o r t f o li o s e l ec ti on .

5 SUMMARY AND CON CLUDING REMAR KS

T h i s p a p e r d e m o n s t r a t e s th e c o n s t r u c t i o n o f a t h e o r e ti c a l m o d e l f o r t h eba l ance o f pa ym ent s , w i th spec ia l a t t en t io n to t he exchange ra t e . I t s eemsposs ib l e , i gnor ing fo r t he sake o f a rgument t he dynamic cha rac t e r i s t i c s o ffo re ign t r ade and in t e rna t ion a l c ap i t a l f low s , to i n t eg ra t e pu rchas ing pow erp a r i t y t h e o r y w i t h p o r t f o l i o a n a ly s is i n t o o n e t h e o r e t i c a l f r a m e w o r k . F r o mth i s , i t fo l l ow s tha t t he va r i ab i l i t y O f exchange ra t e s depends on rea l pheno-m e n a , l ik e i n t e rn a t i o n a l d i f f e re n c e s i n e c o n o m i c g r o w t h a n d e x p l o i t a ti o n o fna tu ra l r e source s , a s w e l l a s on n om ina l phen om ena , i. e. , changes i n re l at ive


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3 8 0 P .B . D E R I D D E R

p r ic e s o f i n t e r n a t i o n a l l y t r a d e a b l e g o o d s a n d s e rv ic e s. A p a r t f r o m t h e s e ,m o n e t a r y s o u r c e s o f e x c h a n g e r a t e v a r i a b i l i ty s h o u l d a l so b e d i st i n gu i s h ed :t h a t i s t o s a y , c h a n g e s i n i n t e r e s t r a t e d i f f e r e n t i a l s as w e l l a s i n e x c h a n g e r a t ee x p e c t a t i o n s .

F i n a l ly i t m a y b e n o t i c e d t h a t , a p a r t f r o m o t h e r ( m o n e t a r y ) p o l i c ym e a s u r e s , e x c e s s d e m a n d o r s u p p l y o f a c u r r e n c y c a n b e s t e r i li z e d b y ac o u n t e r v a i l i n g c h a n g e i n i n t e r n a t i o n a l r e s e r v e s. I n o t h e r w o r d s , o f f i c i a l i n t e r -v e n t i o n i s o n e , b u t n o t t h e o n l y , i n s t r u m e n t t o c o p e w i t h u n d e s i r e d e x c ha n g er a t e c h a n g e s .

R E F E R E N C E S[ 1 ] Armington, P., A Multilateral Dynamic Model of Exchange Rates and Short-termInterest Rates, Paper presented at the VI th In ternat ional Conference of AppliedEconometr ics , Rome, 1979.[2] Artus, J .R., "E xch ange Ra te Stability and Managed Floating: T he Exp erience ofthe Federal Republic of Germ any," IMF-StaffPapers, XX III (1976).[3] Brillembourg, A. and S.M . Scliadler, A Model of Currency Substitution in Ex-

change Rate Determination, 19 73-19 78, Paper presented at the V I th In ternat ionalCo nference of Applied Econometrics, Ro m e, 1979.[4] Bilson, J .F.O., "T he M onetary Approach to the Exchange Rate: Some EmpiricalEvidence," IMF-StaffPapers, XXV (1978) .[5 ] - - "R ecen t Developments in Moneta ry Models o f Exchange Rate Dete rmina-t ion ," IMF- Staf f Papers, XXVI (1979) .[6] Frenkel , J .A. , "A M onetary Approach to the Exchange Rate: Doctr inal Aspectsand Empricat Evidence," Scandinavian Journal o f Economics, 78 (1976) .[7] Korteweg, P., "T he E urope an Mo netary System - W ill I t Really Bring MoreMonetary Stability fo r Eu rop e," De Economist, 128 (1980), pp. 15-49.[8 ] - - Exchange Rate Policy, Monetary Policy and Real Exchange Rate Varia-bility, Paper presented at the Conference on Exchange Rate Pol icy , London,1980.[9] Ly bec k, J.A. and B. J~/rnh~ll,A Simultaneous Model of Capital Flows, ExchangeRates, Interest Rates and Prices of Traded Goods: Theoretical Considerations andEstimations by Alternative Techniques, Paper presented at the Vlth In terna t ionalCon ference of Applied Econometrics, Ro me , 1979.[10] Optica Rep or t , Inflation and Exchange Rates: Evidence and Policy Guidelinesfor the European Community, Brussels, EC Com mission, 1976.[11] PaUa da, F .W.M., De substitutie tussen monetaire vermogenscomponenten, Occa-sional Paper no. 2 1, Cent ral Planning Bureau, 1980.[12] Steinhauer, L. and J. C hang, "O n Measuring the Nearness of Near-moneys: Com-m e n t , " American Economic Review, 62 (1972) .[13] Tullio, G., "T he Fluctu ation s of the Price of I talian Ba nkno tes in Zurich: A nEc ono m etric Analysis," Kyklos, 31 (1978) .


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SummaryEXCHANGE RATE DETERMINATION AND THE BALANCE OF PAYMENTS,

A THEORETICAL FRAMEWORKIn order to distinguish the more fundamental determinants of the exchange rate, a staticmodel for the balance of payments is constructed. From this theoretical exercise itfollows that the exchange rate is determined by three kinds of phenomena: first, realphenomena such as exploita tion of natural resources and the relative level of economi cactivity; second, nominal phenomena such as relative prices; and finally, monetaryphenomena such as interest rate differentials, exchange rate expectations and officialintervention.

balance-of-payments flow model and exchange rate determination

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