Optimal exchange market intervention EXCBANGE HARKET IBTERVENTIOU Philippa Susan Dee B-A,, Victoria...

OPTIBBL EXCBANGE HARKET IBTERVENTIOU

P h i l i p p a Susan D e e

B - A , , Victoria U n i v e r s i t y ( H - Z - ) , 1975

B. A,, U n i v e r s i t y o f Canterbury (N-25,) , 1976

A THESIS SUBNITTED IN PARTIAL FULFILLBENT OF

THE REQUIREMENTS PO3 THE DEGREE Of

DOCTOR OF PHILOSOPHY

i n t h e Department

Economics

P h i l i p p a Susan Dee 1983

SIPION FBASER DHIVERSITY

January 1983

A l l r i g h t s r e s e r v e d . T h i s work may not b e reproduced i n whole o r i n p a r t , by photocopy

o r o t h e r Beans, w i t h o u t p e r a i s s i o n of the author ,

APPROVAL

Name :

Degree:

T i t l e of Thesis:

P h i l i p p a Susan DEE

Doctor of Philosophy

Optimal Exchange Market ~ n t e r v e n t i o n

Examining Committee:

Chairperson: C. G. Reed

H.G. Grubel Senior Supervisor

T.M. Heaps

R.S. Boyer Ex te rna l Examiner Professor U n i v e r s i t y of western Ontario

D a t e Approved: 28 January 1983

PART I A b COPY11 I GHT L I CENSE, ."---

I heroby g ran t t o Simon f r a s e r U n i v e r s i t y the r i g h t t o lend

my thcl, is, p r o j e c t o r extended sssay ( t h e t i f l e o f which i s shown below9

t o u;cr s of tho Simon Frassr U n i v e r s i t y l..i brary, and t o make p a r t i a l o r

s i nq l c? cop i ( 2 1 ; on ly f o r such users or i n response to a request f ram tho

l i b r a r y o f dny o the r u n i v e r s i t y , o r o the r educat ional i n s t i t u t i o n , on

i t s own hehalf o r f o r one o f i t s users. I f u r t h e r agree t h a t permission

for m u l t i p l e copying o f t h i s work f o r scho la r l y purposes may be granted

by me or- tho Doan o f Graduate Studies. I t i s understood +hat copy i n!j

o r pub1 icc i t ion o f t h i s work f o r f inanc la l ga in shal i not be a l lbwad

w i thou t my w r i t t e n permission.

T i t l e o f Thes i s/Project/Extended Essay

OPTIMAL EXCHANGE MARKET INTERVENTION

Author-:

PHILIPPA SUSAN DEE -- .-.--- ----------

( name

ABSTB ACT

This t h e s i s e x a a i n e s t h e a p p r o p r i a t e j u s t i f i c a t i o n fo r , a n d

o p t i m a l a e t h o d s o f , g o v e r n m e n t i n t e r v e n t i o n i n - f o r e i g n e x c h a n g e

r m r k s t s , It begins w i t h a c r i t i q u e of t h e p r i n c i p a l a r q u ~ e n t s

f o r a n d a g a i n s t i n t e r v e n t i o n , T h o s e a r g u m e n t s which have

t r a d i t i o n a l l y been a c c e p t e d a s p o s s i b l e c r i t e r i a . f o r a n optimal

i n t e r v e n t i o n r u l e are r e j e c t e d , I n s t e a d , t h e p u r p o s e of

i n t e r v e n t i o n is taken t o b e t h e m i n i m i z a t i o n o f unpredictable

e x c h a n g e r a t e aoveaent, T h e thesis a l s o d e v i a t e s from ear l ie r

a p p r o a c h e s t o o p t i ~ a l i n t e r v e n t i o n by r e c o g n i s i n g t h e o p e r a t i n g

c o n s t r a i n t imposed by f i n i t e l e v e l s o f foreign exchange

r e s e r v e s ,

An optimal i n t e r v e n t i o n r u l e i s t h e n derived, given t h i s

o p e r a t i n g c o n s t r a i n t , The prablenn is f o r r a u l a t e d a s an i n v e n t o r y

o r r e s e r v e m a n a g e a e n t pro& lea, The optimal reserve a a n a g e m e n t

rule s p e c i f i e s t h e r e s e r v e behaoiour d e s i r e d ex ante by the

f o r e i g n exchange authority i n keri~s of o p t i n t a l l i m i t s o n e x p o s t

r e s e r v e b e h a v b o u r , The a a i n f e a t u r e of t h e s e li~its is that t h e

s t r e n g t h of c u r r e n t i n t e r v e n t i o n t o resist exchange r a t e

a d j u s t m e n t s h o u l d decrease t h e further reserves h a v e a w e d away

f r o @ some i n i t i a l . o r t a r g e t l e v e l ,

The ex -- post e x c h a n g e r a te b e h a v i o u r produced by this

r e s e r v e management r u l e is t h e n e x a m i n e d u s i n g s i ~ u l a t i o n

techniques i n a C a n a d i a n setting, E x p o s t p e r f o r m a n c e is

c o n s i d e r e d i n r e l a t i o n t o b o t h t h e p r i m a r y o b j e c t i v e and t o

a d d i t i o n a l c o n c e r n s , n a a e l y , t h e c o s t of the i ~ p l i e d a v e r a g e

r e s e r v e h o l d i n g and the p o s s i b l e cost fs ) of deviation froen a

free ly floating e x c h a n g e r a t e , The results shov that there is a

tradeof f between t h e rule's a b i l i t y t o s a o o t h unsyste~a* . ic

e x c h a n g e s a t e v a r i a t i o n and its a b i l i t y t o foflav the g e n e r a l

trends i n a freely floating exchange r a t e , They also show that

i n t h e absence of perfect future in forn ta t ion , the r e t u r n s t o

additional r e s e r v e holding d i a i n i s h and Ray e v e n t u a l l y hecotae

negative,

ACKBOYLEDGEHEBTS

I s h o u l d l i k e t o e x p r e s s my g r a t i t u d e t o a l l t h o s e who h a v e

h e l p e d me i n t h e p r e p a r a t i o n of t h i s t h e s i s .

The comments a n d criticisms of my s n p e r v i s o r y commi t t ee

h a v e been i n v a l u a b l e . I n p a r t i c u l a r , I s h o u l d l i k e t o t h a n k

P r o f e s s o r Herbert G r u b e l f o r h i s g u i d a n c e , e n c o u r a g e m e n t a n d

i n t u i t i v e i n s i g h t s on t h e issues, a n d Professor S t e v e E a s t o n f o r

h i s h e l p i n p r o v i d i n g m e w i t h t h e t o o l s t o t reat t h o s e i s s u e s -

Thanks are a l s o d u e t o my i n t e r n a l e x a m i n e r , P r o f e s s o r ~ e r r y

Heaps, a n d t o rep e x t e r n a l e x a n i n e r , P r o f e s s o r R u s s e l l Boyer , f o r

t h e i r h e l p f n l comrsents,

I s h o u l d a l so l i k e t o thank my fellow s t u d e n t s f o r t h e i r

s u p p o r t , b o t h a c a d e n i c a n d moral, P a r t i c u l a r t h a n k s a r e d u e to

Ben H e i j d r a , K e l l y Busche, B i l l G ibson , ~ a v e Bamrtles a n d J e a n

Turner, f o r r e a s o n s of which t h e y are aware, 1

F i n a l l y , I s h o u l d l i k e t o t h a n k a l l t h o s e who made comments

a n d s u g g e s t i o n s d u r i n g the s e m i n a r s i n which I p r e s e n t e d e a r l i e r

d r a f t s o f t h e s e i d e a s ,

Whi l e t h i s t h e s i s may reflect t h e h e l p given ae by o t h e r s ,

t h e r e r s a i n i n g e r r o r s a r e , of c o u r s e , my r e s p o n s i b i l i t y a l o n e -

E q u i l i b r i u m and the P r i v a t e Sector -,-.--.-- .-. .--- ---63

Expectat ions - Variation vs, U n p r e d i c t a b i l i t y --.. - - - - 7 8

IV. PEIYBTE S E C T O R B E H A V I O U R - THEORY AND ESTIWATIOM ,----84

Theoretical Framework , ., ,, . ,,,, ., .-..--.,--- , ..'-. ----. 88

E s t i m a t i o n Problems and R e s u l t s ,.,,.,-,.-------------98

Bibliography . ~ , , . . , , , - . , . . , , o , , - , . o . , ~ ~ ~ , , . . . - . ~ o - I I - - - - - . . - o - 194

' L I S T OF TABLES

P r i v a t e S e c t o r Behaviooral Equation-

Unsystematic Exchange 11 - Comparison of R a t e Variat ion, ,,,,,,,, ,,,,,,,,, o,-.-.- . . ,- , .o-.

Table IV - Target R e s e r v e s and Absolute Variat ion Beduction. , , . , , , , ,~ . . , , , , , . , , . , , o , , - , , , , -~II~- '~ . .

v i i i

LIST OF FIGURES

FIGURE PAGE

1, F i g u r e I - O p t i m a l R e s e r v e Change a n d t h e D e v i a t i o n of R e s e r v e L e v e l s from T b r g e t . .-- ,..,-- 58

2 . F i g u r e I1 - R e q u i r e m e n t s f o r P r i v a t e S e c t o r E q u i l i b r i u m . ,,,.,,-.-,,,,,,,,,,.g..-..--..---.-.- 6 7

3, F i g u r e 111 - T r a c k i n g A b i l i t y a n d Enhancement o f Exchange B a t e P r e d i c t a b i l i t y , - .- .,,. - -..- -- .--. - 144

4, F i g u r e I Y - T a r g e t B e s e r v e L e v e l s and Enhancement o f Exchange Bate P r e d i c t a b i l i t y - .- ., . . . -- - - ---. - 147

P i g u r e Y - Exchange B a t e s , Nominal D i s t u r b a n c e , C o n s t a n t w i t h I n d e p e n d e n t E r r o r . .-,, --.---- --,-.

F i g u r e V I - Exchange R a t e s , Nominal D i s t u r b a n c e , C o n s t a n t v i t h A n t o c o r r e l a t e d Error, ,-,---.. --- -.

F i g u r e V I I - Exchange B a t e s , Nominal D i s t u r b a n c e , C o n s t a n t with Bandom F a l k E r r o r . .- - - ., ..-,- - - - . -

F i g u r e V I I I - Exchange Rates, R e a l D i s t u r b a n c e , C o n s t a n t with I n d e p e n d e n t ~ r ro r ; .-.- - ..-. ., ..-

Figure I X - Exchange B a t e s , Real D i s t u r b a n c e , I

C o n s t a n t v i t h A u t o c o r r e l a t e d E r r o r . - . .--- -- .--- - F i g u r e X - Exchange Rates, R e a l D i s t u r b a n c e ,

C o n s t a n t w i t h ban do^ Ualk E r r o r , ,.,,---.- .- ..-.. F i g u r e X I - Exchange R a t e s , Nominal D i s t u r b a n c e ,

T r e n d v i t h I n d e p e n d e n t Error , ,.,,,., .-.-,.- F i g u r e X I 1 - Exchange Rates, Nominal D i s t u r b a n c e ,

T r e n d w i t h B u t o c o r r e l a t e d Error. .--- -..-. .. -.--. P i g u r e X I I I - Exchange Rates, Nominal D i s t u r b a n c e ,

T r e n d w i t h Random Walk Error , -., ..-.. .- ..--. F i g u r e X I V - Exchange R a t e s , R e a l D i s t u r b a n c e ,

T r e n d w i t h I n d e p e n d e n t E r r o r . .-.,-..---.*-..,--. F i g u r e X V - Exchange Bates, Real D i s t u r b a n c e ,

T r e n d w i t h A u t o c o r r e l a t e d E r r o r , - .--. .- .. . F i g u r e X V I - Exchange Bates, R e a l D i s t u r b a n c e ,

T r e n d v i t h Random Walk E r r o r . .--.,-, ..-.------..

17, F i g u r e XVII - Exchange B a t e s , Nominal D i s t u r b a n c e , S t e p w i t h 1 ndependen t Error, ,-,..,,, .--.--- -,-,, 187

18, F i g u r e XVIII - Exchange Rates, Nominal D i s t u r b a n c e , S t e p w i t h A u t o c o r r e l a t e d E r r o r - -,-, 188

19. F i g u r e X I X - Exchange R a t e s , Nominal D i s t u r b a n c e , S t e p w i t h Random Walk Error- - --,-:, ,----,- -,, ,, 189

2 0, F i g u r e X X - Exchange Rates, R e a l D i s t u r b a n c e , Step w i t h I n d e p e n d e n t E r r o r , ,,,,,,,,,,.-,,,,.,---I,., 190

2 1, F i g u r e X X I - Exchange B a t e s , Real D i s t u r b a n c e , S t e p with A u t o c o r r e l a t e d E r r o r , ,,,------,--,-,,, 191

2 2. F i g u r e X X I I - Exchange B a t e s , R e a l ~ i s t u r b a n c e , S t e p v i t h Random g a l k E r r o r , ,,,,,, ,, , ,,,,,. ,,, ,, 192

23. F i g u r e XXIZI - Exchange B a t e B e h a v i o u r , His tor ical D i s t u r b a n c e s 1970-79, ,, ,,,, ,,,.,,,,,,,,,--*----, 193

I, IMTBODUCTIOB

I n t h e 1 9 6 0 s a n d e a r l y 1970s , as it became i n c r e a s i n g l y

o b v i o u s t h a t t h e B r e t t o n Roods a g r e e m e n t c o u l d n o t s u r v i v e ,

t h e r e was much d e b a t e c o n c e r n i n g t h e i m p l i c a t i o n s of a s y s t e m of

more f l e x i b l e e x c h a n g e r a t e s . I n a d d i t i o n , t h e r e were many

p r o p o s a l s p u t f o r w a r d f o r t h e i m p l e m e n t a t i o n of s u c h a sys tem.1

The d e b a t e o n t h e i m p l i c a t i o n s of f l e x i b i l i t y r e v i v e d , among

o t h e r t h i n g s , t h e a r g u m e n t s f o r and a g a i n s t f r e e l y f l o a t i n g

e x c h a n g e rates. T h e r e was a g e n e r a l c o n s e n s u s , however, t h a t

w h i l e g r e a t e r f l e x i b i l i t y was d e s i r a b l e t o r e l i e v e t h e s t r a i n s

t h e n i m p i n g i n g on the s y s t e a , * t h i s f l e x i b i l i t y s h o u l d n o t

e x t e n d t o a free f l o a t , a t l e a s t i n t h e s h o r t term, I n d e e d , many

of t h e p r o p o s a l s f o r i ~ p l e m e n t i n g g r e a t e r flexibility i n v o l v e d

v a r i o u s rules f o r g o v e r n i n g or c o n t r o l l i n g p e r n i s s i b l e e x c h a n g e

r a t e m v e m e n t s . And s i n c e a n y r e g i m e o t h e r t h a n a free f l o a t

r e q u i r e s i n t e r v e n t i o n i n f o r e i g n e x c h a n g e o a r k e t s , t h e s e

p r o p o s a l s were i n effect r u l e s f o r e x c h a n g e e n a r k e t i n t e r v e n t i o n .

S i n c e 1 9 7 1 t h e B r e t t o n Woods a g r e e m e n t h a s n o t b e e n

r e p l a c e d by any similar l o n g term i n t e r n a t i o n a l a g r e e m e n t on t h e

1 Halea (1970) , f o r example , p r o v i d e s a v i v i d r e c o r d of s u c h d e b a t e .

2 T r i f f i n ( 1 9 6 0 ) , (1972) , B u n d e l l (1968), Cooper (1972) ' P o s n e r (7972) a n d Kenen (1973) p r o v i d e d e s c r i p t i o n s and a n a l y s i s o f t h e s t r a i n s caused by ' c o n f i d e n c e p rob lems ' a n d a s y m a e t r i e s of a d j u s t m e n t , J o h n s o n (1 9701, K r a o s e (1971) a n d Cooper (1976) g i v e a l t e r n a t i v e v i e u s o n t h e i a p o r t a a c e of t h e s t r a i n s c a u s e d b y s h o r t term s p e c u l a t i o n .

l i m i t s of e x c h a n g e r a t e f l e x i b i l i t y - The f a c t t h a t no s u c h

a g r e e m e n t h a s b e e n r a t i f i e d c a n b e a t t r i b u t e d t o s e v e r a l

f a c t o r s ,

The f i rs t was i n c o m p a t i b i l i t y of o b j e c t i v e s , The d e b a t e

c o n c e r n i n g t h e b e n e f i t s or o t h e r w i s e of e x c h a n g e ra te management

was c a r r i e d o u t o n two l e v e l s , On o n e hand, t h e r e were t h e

a r g u m e n t s which f o c u s e d on the w e l f a r e i m p l i c a t i o n s o f s u c h

management f o r an i n d i v i d u a l c o u n t r y - On t h e o t h e r hand , t h e r e

were t h o s e a r g u m e n t s which f o c u s e d o n t h e n e c e s s a r y c o n d i t i o n s

fo r t h e c o o r d i n a t i o n of i n d i v i d u a l c o u n t r i e s * a c t i o n s a n d t h e

smooth f n n c t i o n i n g of t h e i n t e r n a t i o n a l m o n e t a r y s y s t e m a s a

whole, The s u p p o r t f o r a new i n t e r n a t i o n a l a g r e e m e n t on e x c h a n g e

r a t e management g e n e r a l l y came f r o n t h o s e who b e l i e v e d t h a t

r n l e s of c o n d u c t were n e c e s s a r y f o r s ~ t o o t h f u n c t i o n i n g of t h e I

s y s tern, However, t h e a rgumen t s , b o t h p o l i t i c a l a n d economid,

used t o s u p p o r t t h i s b e l i e f p resumed t o a g r e a t e r o r lesser

e x t e n t t h a t s u c h r n l e s would t h w a r t t h e d e s i r e s of i n d i v i d u a l

c o u n t r i e s , G i v e n t h e p o l i t i c a l c l i m a t e of t h e time, a n d i n

p a r t i c u l a r t h e s t r o n g f e e l i n g s of n a t i o n a l i s m s t i r r e d by l e a d e r s

s u c h as De G a u l l e , t h e l a c k of c o n s e n s u s on t h e fora of a new

a g r e e m e n t was n o t s u r p r i s i n g , 3

The s e c o n d imped imen t t o a new i n t e r n a t i o n a l a g r e e m e n t was

r e j e c t i o n of u n e q u a l t r e a t m e n t , The s e a r c h f o r a r e p l a c e m e n t t o

t h e B r e t t o n Uoods s y s t e i a i n v o l v e d more than a s e a r c h f o r a

- -------------- 3 See, for example , K r a u s e (1970) a n d Coope r (1970) o n t h e s e p o i n t s .

ccmmon o b j e c t i v e - i t r e q u i r e d a s y s t e n o f m e t h o d s or r u l e s t o

a c h i e v e t h a t aim. Given t h e n e c e s s i t y of compromise on

o b j e c t i v e s , i t was f e l t t h a t a s e t o f r u l e s c o u l d min imize t h e

s c o p e f o r c h i s e l l i n g , or a t l e a s t p r o v i d e some' s t a n d a r d by which

t o m o n i t o r e a c h c o u n t r y ' s p e r f o r m a n c e , However, e v e n i f

a g r e e m e n t c o u l d be r e a c h e d on a s i n g l e o b j e c t i v e o r w e i g h t i n g of

c o m p e t i n g o b j e c t i v e s , t h e r e c o g n i t i o n of d i f f e r e n c e s be tween

c o u n t r i e s ~ i m p l i e d d i f f e r e n c e s i n t h e m e t h o d s of a c h i e v i n g t h a t

aim, Bany c o u n t r i e s were u n w i l l i n g , a g a i n fo r p o l i t i c a l r e a s o n s ,

t o a c c e p t t h e i n s t i t u t i o n a l i z a t i o n of u n e q u a l t r e a t m e n t w i t h i n

t h e terms of a l o n g term a g r e e m e n t , =

The l a s t imped imen t t o a new i n t e r n a t i o n a l a g r e e m e n t

c o n c e r n e d c h o i c e of r u l e s , Even among t h o s e who s u p p o r t e d t h e

c o n c e p t o f a new i n t e r n a t i o n a l a g r e e m e n t t h e r e were d o u b t s .as t o I

t h e a b i l i t y of any p a r t i c u l a r set of r u l e s t o a c h i e v e i ts a i m - w h e t h e r i n t e r a s o f p romot ing i n t e r n a t i o n a l h a r ~ o n y o r

i n c r e a s i n g t h e welfare of i n d i v i d u a l c o u n t r i e s - w h i l e a v o i d i n g

t h e p i t f a l l s of t h e B r e t t o n Uoods s y s t e m , One of t h e ma jo r flaws

of t h a t a g r e e m e n t was t h e d i f f i c u l t y of a p p l y i n g t h e c l a n s e on

' f u n d a m e n t a l d i s e q u i l i b r i u m ~ , T h i s c l a u s e a l l o w e d a n y c o u n t r y t o

d e v a l u e when i ts e s t a b l i s h e d p a r i t y was deemed t o be i n

------ ----- ------ 4 I n t h e 1 9 6 0 s a n d e a r l y 1 9 7 0 s d i s c u s s i o n c e n t r e d on t h e d i f f e r e n c e s o r a s y i m e t r i e s b e t w e e n s u r p l u s a n d deficit c o u n t r i e s a n d on t h e s p e c i a l ro le p l a y e d b y t h e U n i t e d States a s t h e wor ld1 s r e s e r v e c e n t r e ,

5 See Corden (1981) f o r t h i s p o i n t .

' f u n d a m e n t a l d i s e q u i l i b r i u m 1 , 6 N e v e r t h e l e s s , t h e IHP articles

c o n t a i n e d n o clear d e f i n i t i o n of t h e t e r ~ , More i m p o r t a n t l y ,

a u t h o r i t i e s w i t h less t h a n p e r f e c t knowledge a n d f o r e s i g h t f a c e d

t h e p rob lem of i d e n t i f y i n g e x a c t l y wha t t h e t f u e e q u i l i b r i u m

e x c h a n g e ra te s h o u l d be, A s a r e s u l t t h e y a l s o f o u n d d i f f i c u l t y

i n d i s t i n g u i s h i n g a d i s e q u i l i b r i u m t h a t was t r u l y pe rmanen t a n d

f u n d a m e n t a l , i n t h e s e n s e of a r i s i n g from s e c u l a s g r o w t h or

s t r u c t u r a l change , f rom o n e t h a t arose t h r o n g h t e m p o r a r y c h a n g e s

and would b e s u b s e q u e n t l y corrected w i t h o u t f u r t h e r a c t i o n - 7

T h i s problem was n o t u n i q u e t o t h e B r e t t o n Hoods s y s t e m - Those

who a t t e m p t e d t o f o r m u l a t e new p r o p o s a l s fo r exchange r a t e

management f a c e d t h e same dilemma, The p rob lem was t o t o d e s i g n

r u l e s which c o u l d a c h i e v e t h e i r aim w i t h o u t p resuming , f i r s t l y ,

a knowledge of t h e t r u e e q u i l i b r i u ~ e x c h a n g e ra te o r s e c o n d l y , a

r e c o g n i t i o n of t h e d i s t i n c t i o n be tween t r e n d , c y c l e a n d ' w h i t e

n o i s e 1 from a n y v i e w p o i n t o t h e r t h a n h i n d s i g h t - 8

So w h i l e t h e r e is no i n t e r n a t i o n a l a g r e e m e n t o n exchange

r a t e ~ a n a g e m e n t , t h e i n t e r n a t i o n a l m o n e t a r y s y s t e m is

------------------ 6 The U n i t e d S t a t e s , i n i t s p o s i t i o n a s t h e v o r l d l s r e s e r v e c e n t r e and * n t h c o u n t r y t , was of c o a r s e a n e x c e p t i o n .

7 I t c a n be a r g u e d t h a t t h i s d i f f i c u l t y i n r e c o g n i t i o n l e d t o d e l a y s i n c h a n g i n g p a r i t i e s u n t i l enough e v i d e n c e had a c c u m u l a t e d t o i n d i c a t e a d i s e q u i l i b r i u m of crisis p r o p o r t i o n s , The a d j u s t m e n t , v h e n it f i n a l l y came, was t h e r e f o r e more t r a u m a t i c t h a n it n e e d h a v e been , A n o t h e r r e a s o n f o r d e l a y s was t h a t p a r i t y a d j u s t m e n t s were s e e n a s a blow t o n a t i o n a l p r e s t i g e , It is p r o b a b l e t h a t t h e s e f a c t o r s were n o t i n d e p e n d e n t ,

8 See, for example , Coope r ( 1 9 7 0 ) , T o s i n i (1977) and Bigman (1980) on t h i s p o i n t -

n e v e r t h e l e s s now c h a r a c t e r i z e d b y 'managed f l o a t i n g ' , where t h e

term i n i t s b r o a d e s t s e n s e c a n be a p p l i e d t o a n y exchange r a t e

r e g i m e l y i n g be tween t h e e x t r e m e s of a free float or p e r f e c t

f i x i t y , S i n c e '1 971, i n d i v i d u a l c o u n t r i e s h a v e b e e n free to

c h o o s e t h e r e g i m e t h e y w i l l a d o p t , a f r e e d o m l e g i t i m i z e d i n t h e

J a m a i c a n Agreement among IMF members i n 1976, And w h i l e t h e

r e g i m e s h a v e d i f f e r e d w i d e l y i n form, m o s t h a v e . involved l i m i t e d

f l e x i b i l i t y , They h a v e b e e n d e s i g n e d t o allow more f r e q u e n t ,

t h o u g h n o t n e c e s s a r i l y l a r g e r , c h a n g e s t h a n t h o s e which o c c u r r e d

u n d e r t h e ' f u n d a m e n t a l d i s e q u i l i b r i u m ~ clause of t h e B r e t t o n

Roods a g r e e m e n t , However, n o n e h a v e a l l o w e d m a r k e t forces

u n f e t t e r e d sway-9

Some c o u n t r i e s h a v e a d o p t e d a n o m i n a l l y f l o a t i n g e x c h a n g e

ra te , b u t t h e i r f o r e i g n e x c h a n g e a u t h o r i t i e s h a v e a t v a r i o u s i

times engaged i n d i s c r e t i o n a r y i n t e r v e n t i o n i n f o r e i g n e x c h a n g e

m a r k e t s - 1 0 O t h e r c o u n t r i e s h a v e a d o p t e d a g r o u p f l o a t . 1 1 s e t t i n g

l i a i t s on r e l a t i v e novemen t s b e t w e e n members while a l l o w i n g

f l u c t u a t i o n s a g a i n s t non-&ember c u r r e n c i e s , S t i l l o t h e r s 1 2 h a v e

pegged t o a ' b a s k e t ' of c u r r e n c i e s , r a t h e r t h a n t o a s i n g l e

c u r r e n c y . The effect of t h i s is t h a t f l u c t u a t i o n s a g a i n s t e a c h

i n d i v i d u a l b a s k e t c u r r e n c y t e n d o n a v e r a g e t o be smaller t h a n i f

t h e c o u n t r y were pegged t o one of them a l o n e a n d t h e o t h e r s were --------- ------ 9 C h i l e is a p o s s i b l e e x c e p t i o n ,

1 0 I n c l u d e d i n this c a t e g o r y are Canada a n d t h e U n i t e d States,

11 An example is t h e European ' s n a k e ' a r r a n g e m e n t .

12 A u s t r i a a n d M e w Z e a l a n d are e x a m p l e s ,

f l o a t i n g a g a i n s t it, N e v e r t h e l e s s , t h e s e c o u n t r i e s c a n i n s t i t u t e

d e f a c t o f l o a t i n g by c h a n g i n g t h e w e i g h t s a p p l i e d t o t h e

components of t h e b a s k e t - 1 3 F i n a l l y , t h e r e h a s b e e n a t e n d e n c y

for pegged ra tes t o be a d j u s t e d more f r e q u e n t l y . l 4

While managed e x c h a n g e rates h a v e b e e n t h e o r d e r of t h e d a y I

s i n c e 1971, t h e h e a t of d i s c u s s i o n c o n c e r n i n g t h e t w i n i s s u e s o f

t h e j o s t i f i c a t i cn f o r e x c h a n g e rate management, and its

a p p r o p r i a t e fora a n d e x t e n t , h a s d r o p p e d c o n s i d e r a b l y , I n s t e a d ,

t h e f o c u s of t h e o r e t i c a l work h a s t u r n e d t o t h e d e t e r m i n a n t s of

f r e e l y f l o a t i n g e x c h a n g e rates, The a d v a n c e s in t h i s f i e l d h a v e

b e e n g r e a t , 1s Bigman a n d Taya (l98O,P, x) s u a m a r i z e t h e s t a t e o f

t h e a r t a s follows:

The a n a l y s i s of e x c h a n g e rates i n t h e s h o r t r u n h a s r a i s e d some s e r i o u s q u e s t i o n s i n r e g a r d t o many o f t h e i n t u i t i v e l y a t t r a c t i v e criteria t h a t h a v e been p u t f o r w a r d i n a d v o c a t i n g t h e f l o a t i n g sys t em, I

T h u s t h e a n a l y s i s h a s c o n s i d e r a b l y dampened a n y n a i v e e n t h u s i a s m

f o r f u l l f l e x i b i l i t y , F u r t h e r m o r e , it a p p e a s s t o h a v e

s t r e n g t h e n e d t h e a r g u m e n t s which were a p p l i e d i n t h e 1 9 6 0 s a n d

e a r l y 1 9 7 0 s a g a i n s t f r e e l y f l o a t i n g e x c h a n g e r a t e s -

If r e c e n t a n a l y s i s shows t h a t t h e t h e o r e t i c a l i s s u e s h a v e

not changed s u b s t a n t i a l l y s i n c e t h e breakdown of t h e B r e t t o n

Woods a g r e e m e n t , h a v e n o t t h e p o l i c y i s s u e s a l s o r e m a i n e d t h e

same? I f r e c e n t a n a l y s i s c o n f i r m s t h e # u n d e s i r a b l e 1 p r o p e r t i e s ---------------- 1 3 T h i s p o i n t h a s been made by Rope r a n d Tnrnovsky (1980)-

1 4 Reller 11977) d i s c u s s e s t h e f ac to r s inf l n e n c i n g a c o u n t r y ' s c h o i c e of i n s t i t u t i o n a l a r r a n g e m e n t ,

1s R e f e r e n c e s t o t h i s work are c o n t a i n e d i n C h a p t e r 2 -

o f f r e e l y f l o a t i n g e x c h a n g e rates, d o e s i t a l s o c o n f i r m t h e

p re sumpt ion , c l e a r l y a c c e p t e d by most c o u n t r i e s s i n c e 1971, t h a t

exchange rates s h o u l d b e managed? F i n a l l y , i f e x c h a n g e ra te

management is j u s t i f i e d , d o n o t t h e p r o b l e m s u h i c h p r e v e n t e d t h e

a d o p t i o n of a p o s t - B r e t t o n Woods a c c o r d now d e s e r v e a n s w e r s ?

T h i s t h e s i s p r o p o s e s t o a d d r e s s t h e s e q u e s t i o n s ,

The J a m a i c a n Agreement of 1976 d e f i n e s t h e - i n s t i t u t i o n a l

f ramework of t h e c u r r e n t i n t e r n a t i o n a l m o n e t a r y sys t em, S i n c e

i n d i v i d u a l c o u n t r i e s are now free t o c h o o s e t h e i r own e x c h a n g e

r a t e r e g i m e , some ~f t h e p r o b l e m s u h i c h f a c e d t h e would-be

a r c h i t e c t s of a B r e t t o n Woods r e p l a c e m e n t a r e n o l o n g e r

r e l e v a n t . . A t l e a s t from a n a n a l y t i c a l v i e w p o i n t , i t is now

p o s s i b l e t o s e p a r a t e t h e i s s u e of w h a t is o p t i m a l f o r a n

i n d i v i d u a l c o u n t r y f r o @ t h e issues which c o n c e r n t h e smooth I

f u n c t i o n i n g of t h e i n t e r n a t i o n a l monetary s y s t e m as a whole. 16

T h e r e f o r e , i t rests w i t h i n d i v i d u a l c o n n t r i e s t o d e f i n e t h e i r

o b j e c t i v e s , a l t h o u g h i n a n i n t e r d e p e n d e n t w o r l d a s i n g l e c o u n t r y

mus t o f n e c e s s i t y t a k e a c c o u n t of o t h e r c o u n t r i e s ' a c t i o n s when

d e c i d i n g how t o a c h i e v e t h e s e g o a l s , S i m i l a r l y , t h e

i n s t i t u t i o n a l f r amework is nou f l e x i b l e enough t o allow ' u n e q u a l

methods ' t o e v o l v e , w i t h o u t i n s t i t u t i o n a l i z i n g them i n a f o r m a l

agreement . l e v e r t h e l e s s , a n i n d i v i d u a l c o u n t r y is sti l l f a c e d

w i t h t h e p rob lem of f i n d i n g m e t h o d s o r r u l e s which d o n o t

presume o m n i s c i e n c e . Thus t h e p o l i c y i s s u e s t o w a r d s which a ---------------- 16 The J a m a i c a n Agreement d o e s a l l o w for IPIf s u r v e i l l a n c e of i n d i v i d u a l memberss p o l i c i e s , a l be i t i n a v e r y g e n e r a l and f l e x i b l e manner,

d e c a d e of a n a l y s i s a n d e x p e r i e n c e c a n b e a p p l i e d are a s follows:

by what cr i ter ia s h o u l d a c o u n t r y choose its e x c h a n g e r a t e

reg ime, is i n t e r v e n t i o n t h e r e f o r e j u s t i f i e d , a n d i f s o , what is

its a p p r o p r i a t e f o r m a n d e x t e n t ?

T h e r e h a s b e e n some p r o g r e s s i n t h e l i t e r a t u r e t o w a r d s

d e r i v i n g o p t i m a l r u l e s f o r e x c h a n g e ra te management. 1 7 The f o c u s

c o n t i n u e s t o be on r u l e s , r a t h e r t h a n d i s c r e t i o n a r y

i n t e r v e n t i o n . The r e a s o n n o l o n g e r l i e s i n t h e desire f o r a

s t a n d a r d fo r i n t e r n a t i o n a l e n f o r c e m e n t , but r a t h e r i n a

r e c o g n i t i o n o f the s a p e r i o r i t y of rules o v e r d i s c r e t i o n a r y

p o l i c y from a n i n d i v i d u a l c o u n t r y ' s v i e w p o i n t , ~ 8 I n t h i s

r e s p e c t , t h e l i t e r a t u r e a p p l i e s new t h e o r e t i c a l d e v e l o p m e n t s t o

o l d problems. However, it f a i l s i n s e v e r a l i m p o r t a n t areas t o

r e c o g n i s e t h e r e l e v a n c e of t h e d e b a t e f r o m t h e time of t h e .

B r e t t o n Woods breakdown. ,

F i r s t l y , t h e r e c e n t l i t e r a t u r e d e a l s i n a d e q u a t e l y v i t h t h e

j u s t i f i c a t i o n f o r i n t e r v e n t i o n , I t g e n e r a l l y s t a r t s from a n

u n c r i t i c a l a c c e p t a n c e of some ' i n t u i t i v e l y a t t r a c t i v e g c r i t e r i o n

for j u d g i n g e x c h a n g e r a t e r e g i m e s , T h i s c r i t e r i o n g e n e r a l l y

f o c u s e s o n w h a t is o p t i m a l f r o a a n i n d i v i d o a l c o u n t r y ' s

v i e w p o i n t , r a t h e r t h a n on what is r e q u i r e d t o promote

i n t e r n a t i o n a l harmony, However, much of t h e d e b a t e a t t h e time

1 7 See, for example , Boyer (1978) . Cox (1980) . F r e n k e h (1980) and Roper and Turnovsky (1980) .

18 T h i s a s p e c t o f p o l i c y making i s d i s c u s s e d i n t h e r a t i o n a l e x p e c t a t i o n s l i t e r a t u r e , See, f o r example , L u c a s (1972) a n d S a r g e n t a n d Wallace (1976) ,

o f t h e B r e t t o n Uoods breakdown c a n be t r a c e d t o d i s a g r e e m e n t

a b o u t t h e a p p r o p r i a t e o b j e c t i v e s o f e x c h a n g e r a t e p o l i c y , e v e n

f o r an i n d i v i d u a l c o u n t r y , T h i s d i s a g r e e m e n t was n o t

s u c c e s s f u l l y r e c o n c i l e d t h e n a n d h a s n o t been T u l l y a d d r e s s e d

s i n c e . T h e r e f o r e , t h i s t h e s i s b e g i n s w i t h a c r i t i c a l r e v i e w of

t h e d e b a t e. A c a r e f u l e x a m i n a t i o n o f t h e welfare economic

f o u n d a t i o n s o f many of t h e c r i t e r ia t h a t h a v e been r e c e n t l y

a d o p t e d shows them t o be s p e c i o u s , By c o n t r a s t , i t is shown t h a t

e x c h a n g e m a r k e t i n t e r v e n t i o n is j u s t i f i e d , b u t f o r r e a s o n s which

d i f f e r from t h o s e a d o p t e d t o date,

The r e c e n t l i t e r a t u r e on o p t i m a l e x c h a n g e r a t e management

a l s o f a i l s t o a d d r e s s some of t h e p r o b l e a s which have l o n g

s u r r o u n d e d t h e a p p r o p r i a t e form a n d e x t e n t of i n t e r v e n t i o n , By

a d o p t i n g t h e l e s s o n s a n d t e c h n i q u e s of o t h e r f i e l d s 1 9 t h e I

l i t e r a t u r e c a n d e a l e x p l i c i t l y w i t h t h e f o r e i g n e x c h a n g e

a u t h o r i t y ' s l a c k of p e r f e c t c u r r e n t and f u t u r e i n f o r m a t i o n ,

However, it f r e q u e n t l y f a i l s t o r e c o g n i s e what K r a u s e

(1970,P,223) h a s c a l l e d ' o p e r a t i n g c o n s t r a i n t s * , c o n s t r a i n t s

which a r i s e when a c o u n t r y has s e v e r a l c o m p e t i n g o b j e c t i v e s a n d

whose r e c o g n i t i o n c a n w e l l d e t e r m i n e t h e u l t i m a t e c h o i c e of

r u l e -

The most s i m p l e o p e r a t i n g c o n s t r a i n t , o n e which is

u n i v e r s a l l p i g n o r e d i n t h e r e c e n t l i t e r a t u r e , is t h a t

i n t e r n a t i o n a l r e s e r v e s are f i n i t e , T h i s c o n s t r a i n t mus t b e

----------------- 1 9 Again, t h e l i t e r a t u r e on r a t i o n a l e x p e c t a t i o n s i s r e l e v a n t ,

r e c o g n i s e d i f r u l e s a r e t o be made o p e r a t i o n a l . 2 0 T h e r e f o r e ,

t h i s t h e s i s d e r i v e s a n o p t i n a l i n t e r v e n t i o n r u l e which t a k e s

i n t o a c c o u n t t h i s c o n s t r a i n t ,

The f o r e i g n e x c h a n g e a u t h o r i t y n a y h a v e a d d i t i o n a l

c o n c e r n s , e a c h o f which i m p o s e s a n a d d i t i o n a l o p e r a t i n g

c o n s t r a i n t , One e x a m p l e is t h e c o n s t r a i n t imposed by t h e cos t of

h o l d i n g f o r e i g n e x c h a n g e r e s e r v e s f o r i n t e r v e n t i o n p u r p o s e s ,

A n o t h e r is t h a t imposed by t h e p o s s i b l e c o s t ( s ) o f w h a t e v e r

s y s t e m a t i c d i v e r g e n c e f r o a a f r e e l y f l o a t i n g e x c h a n g e r a t e t h e

i n t e r v e n t i o n r - u l e p roduces , T h i s t h e s i s e x a ~ i n e s t h e e x t e n t t o

which t h e a u t h o r i t y c a n , b y j u d i c i o u s choice of t h e p o l i c y

p a r a m e t e r s wh ich t h e a b o v e r u l e makes a v a i l a b l e , i n f l u e n c e t h e

ou tcome w i t h r e s p e c t t o t h e s e a d d i t i o n a l c o n s t r a i n t s - Thus t h e

a a r g i n s of c h o i c e are d e f i n e d b y wh ich t h e a a t h o r i t y c a n meet

its a d d i t i o n a l c o n c e r n s ,

The e x p o s i t i o n p r o c e e d s a s follows, Chapter 2 r e v i e w s t h e

a r g u m e n t s f o r a n d a g a i n s t e x c h a n g e r a t e management, a n d

i n d i c a t e s t h e c o n t r i b u t i o n of s e v e r a l r e c e n t t h e o r e t i c a l

d e v e l o p m e n t s t o t h i s d e b a t e . P r i m a r i l y , t h e mone ta ry a p p r o a c h t o

t h e b a l a n c e of paymen t s a n d its c o n v e r s e , t h e monetary or asset

v i ew of e x c h a n g e r a te d e t e r m i n a t i o n , h a v e h e l p e d t o c l a r i f y a

number o f i s s u e s , O f t h e v a r i o u s j u s t i f i c a t i o n s f o r e x c h a n g e

r a t e management, o n e is c h o s e n a s t h e a p p r o p r i a t e o b j e c t i v e of

e x c h a n g e m a r k e t i n t e r v e n t i o n , The o b j e c t i v e c h o s e n i s t h e

2 0 H e x i c o a s r e c e n t p r o b l e m s u n d e r s c o r e t h e i m p o r t a n c e o f t h i s c o n s t r a i n t ,

m i n i m i z a t i o n of u n p r e d i c t a b l e e x c h a n g e r a te movement.

C h a p t e r 3 d e r i v e s a n i n t e r v e n t i o n r u l e which w i l l a c h i e v e

t h e c h o s e n o b j e c t i v e s u b j e c t t o t h e c o n s t r a i n t t h a t reseme

l e v e l s are f i n i t e . The problem is f o r m u l a t e d bs a n i n v e n t o r y o r

r e s e r v e management problem, T h e r e s u l t i n g o p t i m a l r u l e s p e c i f i e s

t h e r e s e r v e b e h a v i o u r d e s i r e d e x a n t e b y t h e f o r e i g n e x c h a n g e

a u t h o r i t y i n terms of o p t i m a l l i m i t s o n e x p o s t . r e s e r v e

b e h a v i o u r ,

I n o r d e r t o e v a l u a t e t h i s r e s e r v e management r u l e i n terms

of c o m p e t i n g o b j e c t i v e s o r c o n s t r a i n t s , i ts i m p l i c a t i o n s f o r e x

p o s t e x c h a n g e ra te b e h a v i o u r mus t b e d e t e r m i n e d . S i n c e a n

a n a l y t i c a l s o l u t i o n p r o v e s d i f f i c u l t , t h e i m p f i c a t i o n s f o r

e x c h a n g e r a t e b e h a v i o u r are d e t e r m i n e d u s i n g s i n u l a t i o n

t e c h n i q u e s . T h e s i m u l a t i o n e n v i r o n m e n t is d e v e l o p e d i n C h a p t e r I

4, T h i s c h a p t e r d e r i v e s a n e q u i l i b r i u m r e l a t i o n s h i p be tween

r e s e r v e l e v e l a n d exchange ra te b e h a v i o u r a n d r e p o r t s t h e

results of e s t i m a t i n g t h i s r e l a t i o n s h i p i n a C a n a d i a n c o n t e x t ,

C h a p t e r 5 u s e s t h e r e s u l t s o f s i m u l a t i n g t h e o p t i m a l

r e s e r v e management r u l e i n a C a n a d i a n c o n t e x t to examine its

i m p l i c a t i o n s i n terms of s e v e r a l c o a p e t i n g o b j e c t i v e s o r

c o n s t r a i n t s , I t a l s o c o n s i d e r s t h e effects when t h e f o r e i g n

e x c h a n g e a u t h o r i t y v a r i e s t h e d e c i s i o n p a r a m e t e r s on which t h e

r u l e depends , From t h e s e r e s u l t s , i t d e f i n e s t h o s e r e m a i n i n g

m a r g i n s of c h o i c e b y which t h e f o r e i g n e x c h a n g e a u t h o r i t y c a n

meet its a d d i t i o n a l c o n c e r n s ,

Chapter 6 snnmar ize s the main t h e o r e t i c a l f i n d i n g s and

restates their p o l i c y implications.

11. JUSTIFICATIOI FOB IITEBVEXTIOR

T h i s c h a p t e r a d d r e s s e s t h e f o l l o w i n g i n t e r r e l a t e d

q u e s t i o n s : by what cr i ter ia s h o u l d a n i n d i v i d u a l c o u n t r y c h o o s e

its e x c h a n g e r a t e reg ime , and i s i n t e r v e n t i o n t h e r e f ore

j u s t i f i e d , T h e s e q u e s t i o n s h a v e n o t r e c e i v e d s a t i s f a c t o r y

a t t e n t i o n t o d a t e , However, t h e y must b e answered b e f o r e a n

o p t i m a l i n t e r v e n t i o n p o l i c y c a n b e d e r i v e d .

The d i s c u s s i o n of c r i te r ia by wh ich t o j u d g e e x c h a n g e r a t e

r e g i ~ e s h a s i ts g e n e s i s i n t h e now f a m i l i a r d e b a t e o n f i x e d

v e r s u s f r e e l y f l o a t i n g e x c h a n g e rates, Buch of t h e d i s p u t e o v e r

t h e r e l a t i v e merits o f t h e s e e x t r e m e r e g i m e s was f o u n d e d i n a

d i s a g r e e m e n t o v e r t h e a p p r o p r i a t e o b j e c t i v e s of e x c h a n g e r a t e

p o l i c y . S i n c e t h e breakdown o f t h e ~ r e t t o n ' Woods ag reemen t , a

c o u n t r y ' s o p t i o n s have been widen& t o i n c l u d e a n y r e g i n e

i n t e r m e d i a t e be tween c o m p l e t e f i x i t y a n d a free f loa t , However,

much of t h e c o n f u s i o n o v e r t h e a p p r o p r i a t e o b j e c t i v e s o f

exchange r a t e p o l i c y p e r s i s t s ,

T h i s c h a p t e r r e v i e w s t h e a r g u m e n t s f o r a n d a g a i n s t f r e e l y

f l o a t i n g e x c h a n g e r a t e s i n o r d e r t o f i r s t l y i so la te , a n d

s e c o n d l y e v a l u a t e , t h e i m p l i c i t cr i ter ia used t o j u d g e e x c h a n g e

r a t e reg imes . T h e s e a r g u m e n t s h a v e p r o c e e d e d on b o t h p o l i t i c a l

a n d economic l e v e l s , W i t h i n t h e f ramework o f t h e economic

a r g u m e n t s f o r and a g a i n s t f l e x i b i l i t y , t h i s c h a p t e r a l s o

c o n s i d e r s more r e c e n t c o n t r i b u t i o n s from t h e l i t e r a t u r e on

optimum c u r r e n c y a r e a s , r a t i o n a l e x p e c t a t i o n s and c h o i c e u n d e r

u n c e r t a i n t y , c o n t r i b u t i o n s which h a v e examined more f u l l y t h e

costs and b e n e f i t s o f e x c h a n g e r a t e f l e x i b i l i t y , A c a r e f u l

e x a m i n a t i o n of the welfare ecoqotnic f o u n d a t i o n s o f t h e a r g u m e n t s

fo r i n t e r v e n t i o n i n f o r e i g n e x c h a n g e m a r k e t s shows t h a t many of

them are b a s e d on i n a p p r o p r i a t e o b j e c t i v e s . T h e s e o b j e c t i v e s a r e

n o t t h e a p p r o p r i a t e t a r g e t s f o r e x c h a n g e rate p o l i c y i n t h e

w e l l - d e f i n e d s e n s e t h a t t o a c h i e v e them b y us ing- s u c h p o l i c y is

a s e c o n d b e s t s o l u t i o n - t h e f irst b e s t s o l n t i o n l ies e l s e w h e r e ,

F i n a l l y , t h i s c h a p t e r i d e n t i f i e s a n o b j e c t i v e f o r which e x c h a n g e

marke t i n t e r v e n t i o n r e p r e s e n t s a f i rs t best s o l u t i o n , ,

A Review of P o l i t i c a l Arquments - ---- T h e c l a s s i c p o l i t i c a l a r g u m e n t s f o r f r e e l y f l o a t i n g

e x c h a n g e r a t e s h a v e f o l l o v e d s e v e r a l l i n e s , It h a s b e e n a r g u e d

t h a t f r e e l y f l o a t i n g e x c h a n g e r a t e s are d e s i r a b l e b e c a u s e t h e y

promote n a t i o n a l autonomy, I n p a r t i c u l a r , f r e e l y f l o a t i n g

exchange ra tes a l l o u c o u n t r i e s t o select t h e i r p r e f e r r e d m i x t u r e

of i n f l a t i o n a n d unemployment ( t h e i r p r e f e r r e d p o i n t on t h e

s o - c a l l e d P h i l l i p s c u r v e ) free from t h e c o n s t r a i n t s imposed by

e x t e r n a l b a l a n c e a n d v i t h o u t t h e need t o c o n s i d e r t h e

s t a b i l i z a t i o n p o l i c i e s of o t h e r c o u n t r i e s , 1 Johnson (1 970) has

a l s o a r g u e d t h a t t h i s f r eedom f r o m b a l a n c e of payments

c o n s t r a i n t s would p r o m o t e t h e d i s m a n t l i n g of q u a n t i t a t i v e t r a d e ----------------- 1 S i n c e t h e e x c h a n g e r a t e moves t o c l e a r t h e f o r e i g n e x c h a n g e ~ a r k e t w i t h o u t t h e n e e d f o r r e s e r v e c h a n g e s a n d t h e i r a s s o c i a t e d d o m e s t i c mone ta ry i m p a c t , t h e gove rnmen t is t h e n free t o d e t e r m i n e t h e nomina l q u a n t i t y of money, a n d is n o t bound t o u s e demand management p o l i c i e s t o m a i n t a i n e x t e r n a l b a l a n c e ,

r e s t r i c t i o n s a n d t h u s allow f u l l e x p l o i t a t i o n o f t h e g a i n s from

t r a d e . I n a d d i t i o n , H i l t o n F r i edman h a s f r e q u e n t l y a r g u e d t h a t

s o c i e t y b e n e f i t s f r o m t h e a b s e n c e of a n y government c o n t r o l o v e r

t h e free m a r k e t mechanism, Such c o n t r o l map b e bes towed i n o r d e r

t o a c h i e v e t h e mos t l a u d a b l e of soc ia l aims, b u t when p l a c e d i n

t h e hands of f a l l i b l e men c a n b e u s e d t o restrict i n d i v i d u a l

A g a i n s t t h e s e , i t h a s b e e n a r g u e d t h a t t h e f r eedom by

government t o move a n economy a l o n g t h e P h i l l i p s c u r v e is o p e n

t o a b u s e f o r s h o r t term p o l i t i c a l g a i n , The d i s c i p l i n e imposed

on n a t i o n a l g o v e r n m e n t s u n d e r a f i x e d e x c h a n g e ra te reg ime

m i t i g a t e s a g a i n s t i r r e s p o n s i b l e v o t e buy ing - It c a n a l s o p r o m o t e

a h i g h d e g r e e o f i n t e r n a t i o n a l c o n s u l t a t i o n a n d c o o p e r a t i o n ,

W i t h i n s u c h a n e n v i r o n m e n t , t h e d a n g e r s of c o m p e t i t i v e ' b e g g a r

t h y n e i g h b o u r s p o l i c i e s are minimized.

T h e s e p o l i t i c a l i s s u e s a r e i a p l i c i t i n many of t h e

p r o p o s a l s for reform of t h e Bretton Woods sys t e r s t h a t were p u t

f o r w a r d i n t h e 1960s a n d e a r l y 1970s -2 However, t h e l a c k of

c o n s e n s u s a t t h i s l e v e l was o n e r e a s o n why t h e a t t e m p t t o f i n d a

r e p l a c e m e n t f o r t h e B r e t t o n Hoods a g r e e m e n t f o n n d e r e d . T b e s e

i s s u e s a r e st i l l i m p o r t a n t , b a t by t h e m s e l v e s t h e y p r o v i d e

l i t t l e g u i d a n c e on t h e i s s u e of i n t e r v e n t i o n v e r s u s

n o n - i n t e r v e n t i o n . The p e r c e i v e d d e s i r a b i l i t y of n a t i o n a l

2 See, f o r example , Harsh, Krause , F e l l e r a n d Willett i n B a l m (1970). T h e s e a r g u m e n t s c a n a l s o be f o u n d i n B i k e s e l l and G o l d s t e i n ( 1 9 7 5 ) , E t h i e r a n d B l o o m f i e l d (1975) a n d T o s i n i (1977).

autonomy, as opposed t o i n t e r n a t i o n a l

t o change a s t h e winds of n a t i o n a l i s m

s t r o n g l y . I t seems u n l i k e l y t h a t mere

c o o p e r a t i o n , w i l l c o n t i n u e

blow more o r less

c h o i c e o f exchange r a t e

regime c a n g r e a t l y i n f l u e n c e t h e c o u r s e o f t h e s e uinds.3

Fur thermore , t h e p o s s i b i l i t y of a b u s e of power by governments is

a l w a y s p r e s e n t , though presumably a d e m o c r a t i c s y s t e m is

d e s i g n e d t o min imize s u c h a b u s e - 4 Whether t h e o p p o r t u n i t y f o r

s u c h a b u s e s h o u l d be minimized by f o l l o w i n g a free f l o a t

r e q u i r e s a more c a r e f u l and comprehens ive s t u d y o f a l l t h e c o s t s

and b e n e f i t s , p o l i t i c a l and o t h e r w i s e , t h a t a l t e r n a t i v e a c t i o n s

may bestow-

A Review of Economic Arquments Fog F l e x i b i l i t y - The c l a s s i c economic argument for f r e e l y f l o a t i n g exchange

r a t e s h a s been p u t most f o r c e f u l l y by Friedman (1953) and Sohmen

(1969)- These writers n o t e t h a t t h e exchange r a t e is merely a

p r i c e - t h e p r i c e o f f o r e i g n c u r r e n c y , Demands f o r a n d s u p p l i e s

of f o r e i g n c u r r e n c y a r e d e r i v e d demands and s n p p l i e s which a r i s e

a s i n d i v i d n a l s make o r r e c e i v e payment f o r f o r e i g n g o o d s and

a s s e t s . I n a wor ld of f r e e markets , t h e e q u i l i b r i n m exchange

r a t e is that which e q u i l i b r a t e s t h e demands f o r and s u p p l i e s o f

------------------ 3 T h e e x t e n t t o which c h o i c e of exchange r e g i m e c a n i n f l u e n c e t h e d e g r e e of autonomy a n a t i o n a l government e n j o y s is i tself open t o q u e s t i o n , a s w i l l be d i s c u s s e d i n f u r t h e r d e t a i l later .

4 Aalm (1969) and Johnson (1970) have n o t e d t h a t t h e argument f o r f i x e d exchange r a t e s based on t h e p romot ion of d o m e s t i c and i n t e r n a t i o n a l r e s p o n s i b i l i t y i t s e l f l a r g e l y d i s a p p e a r s once p a r i t y a d j u s t m e n t s a r e p o s s i b l e .

f o r e i g n exchange. It u i l l , Like a11 o t h e r p r i c e s , be d e t e r m i n e d

i n a g e n e r a l e q u i l i b r i u m s y s t e m c o m p r i s i n g s u p p l i e s of and

demands f o r a l l goods and assets, b o t h d o m e s t i c and f o r e i g n ,

Fur the rmore , i n t h e a b s e n c e o f e x t e r n a l i t i e s , ' t h e r e s u l t i n g

compet i t7 ive e q u i l i b r i u m u i l l be P a r e t o o p t i n a l , World r e s o u r c e

a l l o c a t i o n w i l l b e e f f i c i e n t and wor ld w e l f a r e w i l l b e

maximized,

T h i s a rgument is a p o w e r f u l one a g a i n s t b o t h f i x e d exchange

r a t e s and any d e g r e e o f i n t e r v e n t i o n , , P r o p o n e n t s o f t h i s

a rgument m a i n t a i n t h a t t h e e x i s t e n c e of marke t i m p e r f e c t i o n s i s

by i t s e l f i n s n f f i c i e n t j u s t i f i c a t i o n f o r i n t e r v e n t i o n , If a

market d i s t o r t i o n e x i s t s , t h e a p p r o p r i a t e a c t i o n is t o d i r e c t l y

remove t h e d i s t o r t i o n . Thus exchange a a r k e t i n t e r v e n t i o n c a n

a p p a r e n t l y b e j u s t i f i e d o n l y i f it c a n be shown t h a t a f r e e l y

f l o a t i n g exchange r a t e r eg ime l e a d s t o e x t e r n a l i t i e s o r market

f a i l u r e s ,

A Review of Economic Arguments A g a i n s t F l e x i b i l i t y - ----- - ----- T h e most i n f l u e n t i a l a r g u m e n t s a g a i n s t f r e e l y f l o a t i n g

exchange rates d u r i n g t h e 1960s and e a r l y 1970s were t h o s e uhich

i n d i c a t e d why t h e regime would l e a d t o ' e x c e s s i v e * exchange ra te

f l u c t u a t i o n s . Among t h e s e a rguments were t h o s e t h a t p o i n t e d t o

t h e J - c u r v e phenomenon, t h e p o s s i b i l i t y of d e s t a b i l i z i n g

s p e c u l a t i o n a n d t h e d i f f i c u l t i e s of t r a n s i t i o n t o such a regime,

I s a p l i c i t i n t h e s e a rguments was t h e i d e a t h a t exchange rate

f l u c t u a t i o n s were d i s r u p t i v e and s h o u l d t h e r e f o r e b e smoothed,

R e c e n t a r g u m e n t s have t a k e n f o r g r a n t e d t h e e x i s t e n c e of

f l u c t u a t i o n s , * e x c e s s i v e 8 o r o t h e r w i s e , i n f r e e l y f l o a t i n g

e x c h a n g e r a t e s and have examined more c l o s e l y t h e cos ts a n d

b e n e f i t s a s s o c i a t e d w i t h them, I n p o r t a n t c o n t r i b u t i o n s h a v e come

from t h e l i t e r a t u r e on op t imun c u r r e n c y areas, r a t i o n a l

e x p e c t a t i o n s a n d c h o i c e u n d e r u n c e r t a i n t y , The a r g u m e n t s h a v e

g e n e r a l l y i d e n t i f i e d t h e cos t s a n d b e n e f i t s of e x c h a n g e ra te

v o l a t i l i t y i n terms of its i m p l i c a t i o n s f o r e i t h e r employment o r

consumpt ion .

Each t y p e of a rgumen t is now e x a m i n e d i n o r d e r t o e v a l u a t e

its i a p l i c i t %elf a x e economic f o u n d a t i o n .

Reasons f o r E x c e s s i v e Exchange R a t e I n s t a b i l i t y

(i) T h e J-cu=ve -

T h e J - c u r v e phencmenon c a n a r i se when t h e s h o r t r u n p r i c e

elasticit ies of demand f o r i m p o r t s a r e v e r y low, T h i s ra ises t h e

p o s s i b i l i t y t h a t i n t h e s h o r t run , u n d e r f i x e d e x c h a n g e rates, a

d e p r e c i a t i o n w i l l i n c r e a s e r a t h e r t h a n decrease import s p e n d i n g

a n d c a u s e a d e t e r i o r a t i o n r a t h e r t h a n a n improvement i n t h e

t r a d e b a l a n c e , = One e x p l a n a t i o n f o r low s h o r t r u n e l a s t i c i t i e s

is t h a t i m p o r t e r s are f r e q u e n t l y l o c k e d i n t o l o n g term

c o n t r a c t s , A n o t h e r is t h a t , e v e n w i t h o o t s u c h c o n t r a c t u a l

5 The e x a c t c o n d i t i o n s f o r t h i s t o o c c u r h a v e been f o r m a l i z e d b y Rob inson (3947) , Haberler (1949) a n d f l ach lup (1964) i n what h a s come t o b e c a l l e d t h e H a r s h a l l - L e r n e r c o n d i t i o n , T h e term '3-curve8 d e s c r i b e s t h e r e s u l t i n g t i m e p a t h o f t h e t r a d e b a l a n c e as it firstly d e t e r i o r a t e s a n d t h e n improves ,

a r r a n g e m e n t s , i t t a k e s t i n e t o l e a r n a b o u t p r i c e changes a n d

make and implement d e c i s i o n s b a s e d on them- However, o v e r time,

a s d e c i s i o n s a r e implemented and c o n t r a c t u a l a r r a n g e m e n t s a r e

r ev iewed , i m p o r t e last ici t ies i n c r e a s e a n d t h e more u s u a l

r e s p o n s e of t h e t r a d e b a l a n c e t o a d e p r e c i a t i o n is

r e s t o r e d , 6

P r i o r t o 1971, t h e p resumpt ion was t h a t t h e J -curve

phenomenon would, u n d e r a s y s t e a of f l e x i b l e exchange r a t e s ,

p roduce u i d e r t h a n 'normale e x c h a n g e ra te f l u c t u a t i o n s t o o f f s e t

p e r v e r s e s h o r t r u n movements i n t h e t r a d e accoun t , Some

academics and many b a n k e r s and bus inessmen saw s u c h v i d e

f l u c t u a t i o n s a s u n d e s i r a b l e b e c a u s e t h e u n c e r t a i n t y t h e y

engendered would b e i n i m i c a l t o i n t e r n a t i o n a l t r a d e and c a p i t a l

flows, i

Some writers have r e c e n t l y examined more c l o s e l y t h e

i n t e r a c t i o n of t r a d e a n d c a p i t a l a c c o u n t s under f r e e l y f l o a t i n g

exchange r a t e s , 7 They have shown t h a t i n d e e d s u c h exchange r a t e

v o l a t i l i t y c a n occur , e s p e c i a l l y when t h e t r a d e a c c o u n t

e i t h e r n o t a t a l l o r p e r v e r s e l y i n r e s p o n s e t o exchange

r a t e

6 The e m p i r i c a l s t u d y by Dornbusch a n d Krugman (1976) s u p p o r t s t h e p r o p o s i t i o n t h a t w h i l e t h e r e is c o n s i d e r a b l e price r e s p o n s i v e n e s s i n t h e long run, t h e s h o r t run e l a s t i c i t i e s are s m a l l and t h e a d j u s t m e n t l a g s c a n be s u b s t a n t i a l - S e e a l s o t h e e v i d e n c e i n Houthakker and Xagee ( 1 9 6 9 ) , J n n z and Rhomberg (1973) and Hagee (1975)-

7 A t t h e f o r e f r o n t of such s t u d i e s a r e t h e p r o p o n e n t s o f t h e a s s e t market view o f exchange r a t e d e t e r m i n a t i o n , See , f o r example, t h e a r t i c l e s i n t h e S c a n d i n a v i a n J o u r n a l o f Economics, Vol, 78, No, 2, Play 1976-

c h a n g e s , @ R e c e n t a n a l y s i s t he re fo re c o n f i r m s t h e e a r l i e r

p r e s u m p t i o n t h a t u n d e r f l e x i b l e e x c h a n g e rates, a J - c u r v e

phenomenon i n c r e a s e s exchange r a t e f l u c t u a t i o n s o v e r time,

T h e r e a re s e v e r a l r e a s o n s why s u c h excharige r a t e

f l u c t u a t i o n s need n o t be a s s e v e r e a s o r i g i n a l l y t h o u g h t , One

r e a s o n is t h a t t h e s e f l u c t u a t i o n s may s i m p l y reflect a n

i n a p p r o p r i a t e d o m e s t i c p o l i c y mix-9 Ano the r r e a s o n i s t h a t t h e

f l u c t u a t i o n s may b e dampened r a t h e r t h a n a m p l i f i e d by

s p e c u l a t i v e a c t i v i t y . 1 0 However, t h e e x c h a n g e r a t e f l u c t u a t i o n s

t h a t a r e p roduced by t h e J - c u r v e phenomenon h a v e been s i e v e d a s

u n d e s i r a b l e b e c a u s e o f t h e u n c e r t a i n t y t h e e n g e n d e r ,

P r o p o n e n t s of f r e e l y f l o a t i n g e x c h a n g e ra tes would claim ,'

t h a t ~ a r k e t r i g i d i t i e s u n d e r l y i n g t h e ' J - cu rve* criticisra of

f l e x i b l e e x c h a n g e rates c o n s t i t u t e a m a r k e t i m p e r f e c t i o n which

s h o u l d be removed d i r e c t l y , r a t h e r t h a n o f f se t b y f i x i n g o r

managing t h e e x c h a n g e rate, However, w h e t h e r s u c h m a r k e t

r i g i d i t i e s c o n s t i t u t e a t r u e m a r k e t i m p e r f e c t i o n is itself open

t o q u e s t i o n , I f t h e s e r i g i d i t i e s are t h e r e s u l t o f c o n t r a c t u a l

a r r a n g e m e n t s , t h e t h e o r y of in•’ o r r n a t i o n a n d c o n t r a c t s s u g g e s t s

v a r i o u s p r i c e t h e o r e t i c r e a s o n s why s u c h c o n t r a c t s might be --------------- a Dornbusch (1976) h a s shown tha t when e x c h a n g e ra te e x p e c t a t i o n s a re s t i c k y , e x c h a n g e r a t e o v e r s h o o t i n g i n t h e f a c e of a mone ta ry e x p a n s i o n o c c u r s i n o r d e r t o k e e p e x p e c t e d asset r e t u r n s i n l i n e , Dornbusch and Krugman (1976) n o t e t h a t t h i s o v e r s h o o t i n g w i l l i n c r e a s e t h e more p e r v e r s e l y t h e t r a d e a c c o u n t r e a c t s t o t h e e x c h a n g e ra te i n t h e s h o r t run ,

9 See Dornbusch a n d Kruglaan (1976) on t h i s p o i n t -

1 0 T h i s p o s s i b i l i t y h a s b e e n e x a m i n e d by B r i t t o n (1970) among o t h e r s , a n d rtlost r e c e n t l y b y D r i s k i l l a n d H c C a f f e r t y (1980) -

made. T h i s b e i n g t h e case, t h e i s s u e becomes one of w h e t h e r

e x c h a n g e r a t e v a r i a b i l i t y is of i tself u n d e s i r a b l e and ,

f u r t h e r m o r e , w h e t h e r i t is s o m e t h i n g t h a t i n d i v i d u a l s are u n a b l e

t o o p t i m a l l y p r o t e c t t h e m s e l v e s a g a i n s t by a p g r o p r i a t e

c o n t r a c t u a l a r r a n g e m e n t s , T h i s is a q u e s t i o n which w i l l be

c o n s i d e r e d i n more d e t a i l l a t e r i n t h e c h a p t e r ,

( i i ) D e s t a b i l i z i n g S p e c u l a t i o n

P r o p o n e n t s of f r e e l y f l o a t i n g e x c h a n g e r a t e s saw

s p e c u l a t o r s a s f u l f i l l i n g a v i t a l role of s m o o t h i n g t h e e x c h a n g e

r a t e v a r i a t i o n p roduced b y e x o g e n o u s shocks , A s e c o n d , r e c u r r e n t /

criticism of f r e e l y f l o a t i n g e x c h a n g e r a t e s d n r i a g t h e 1 9 6 0 s a n d

early 1 9 7 0 s was t h a t s p e c u l a t i o n c o u l d p l a y a d e s t a b i l i z i n g

r a t h e r t h a n s t a b i l i z i n g role, T h e p i c t u r e p a i n t e d a l was o n e of

m a s s i v e i n t e r n a t i o n a l movements i n s p e c u l a t i v e c a p i t a l ,

n o t i v a t e d by e x p e c t a t i o n s o f e x c h a n g e r a t e c h a n g e s , s e t t i n g

forces i n mo t ion t o ma te s u c h e x p e c t a t i o n s s e l f - j u s t i f y i n g .

Exchange rate c h a n g e s c o u l d t h e n f e e d e x p e c t a t i o n s of f u r t h e r

c h a n g e s a n d c r e a t e w i l d c u m u l a t i v e s w i n g s a n d c h a o s on f o r e i g n

e x c h a n g e marke t s ,

T h i s view was c h a l l e n g e d by J o h n s o n (1970,P1104), who

c l a i a e d :

- , , s p e c u l a t o r s who e n g a g e i n g e n u i n e l y d e s t a b i l i z i n g s p e c u l a t i o n , t h a t is, whose s p e c n l a t i o n s move t h e exchange r a t e away from r a t h e r t h a n t o w a r d i t s e q u i l i b r i u m l e v e l , w i l l c o n s i s t e n t l y l o se atoney, b e c a u s e t h e y w i l l c o n s i s t e n t l y be b u y i n g when t h e r a t e is * h i g h t and s e l l i n g when i t is *low1 b y c o m p a r i s o n w i t h its e q u i l i b r i u m v a l u e , -----------------

I t See, f o r example , F e l l n e r et al. (1966) a n d K r a u s e (1971) -

This c h a l l e n g e was a s much a comment a b o u t a n i n d i v i d u a l ' s

a b i l i t y t o f i g h t t h e rest of t h e n a r k e t as i t u a s a b o u t t h e

p o s s i b i l i t y of boaogenous d e s t a b i l i z i n g e x p e c t a t i o n s - The d e b a t e

a t the time was u n a b l e t o c o m p l e t e l y a l l a y t h e f e a r s a r o u s e d by

t h i s l a t t e r p o s s i b i l i t y , T h e u n d e r l y i n g f e a r seems t o b e t h a t

s p e c u l a t i o n c a n , a t least i n t h e s h o r t term, d i v o r c e exchange

r a t e d e t e r m i n a t i o n from t h e u n d e r l y i n g real f o r c e s i n t h e

economy and t u r n t h e f o r e i g n exchange marke t i n t o what Keynes

d e s c r i b e d t h e s t o c k marke t as b e i n g - a c a s i n o , l z

Recent a n a l y s i s h a s shown t h a t , e v e n i f exchange r a t e

e x p e c t a t i o n s a r e formed i n d e p e n d e n t l y o f real f o r c e s i n t h e

economy, t h e r e are l i m i t s on t h e e x t e n t t o which s p e c u l a t o r s c a n

o r u i l l w i s h t o m u s t e r t h e r e s o u r c e s t o c o n n t e r a c t t h o s e f o r c e s

f o r s i g n i f i c a n t p e r i o d s o f time.13 T h i s aryument s u g g e s t s l i m i t s

t o t h e p e r s i s t e n c e of s p e c u l a t i v e c a p i t a l f lows , b u t d o e s n o t

n e c e s s a r i l y imply a l i m i t o n t h e i r s i z e o r impac t i n t h e s h o r t

r u n , 1 4 T h i s i n p a c t depends i n turn o n t h e n a t u r e of e x p e c t a t i o n s

f ormation. However, r e c e n t t r e a t m e n t s of e x p e c t a t i o n s stress

t h a t i t i s n o t r a t i o n a l t o form e x p e c t a t i o n s i n a way t h a t l e a d s

----------------- 1 2 See Keynes (1976,P- 159)-

1 3 The a s s e t marke t a p p r o a c h t o exchange r a t e d e t e r m i n a t i o n stresses t h a t c a p i t a l flows w i l l be m a i n t a i n e d only u n t i l indnced c h a n g e s i n i n t e r e s t rates, p r i c e s and o t h e r v a r i a b l e s e n s u r e s t o c k asset e q u i l i b r i u a . T h i s p r o c e s s Hay o c c u r more q u i c k l y t h a n goods marke t a d j u s t m e n t ,

1 4 See Bigman and Taya (1980) f o r r e c e n t a s s e t market a p p r o a c h e s t o t h e issues o f i n s t a b i l i t y , o v e r s h o o t i n g and * d i s o r d e r l y market c o n d i t i o n s ' w i t h f r e e l y f l o a t i n g exchange r a t e s ,

t o c o n s i s t e n t l y wrong p r e d i c t i o n s , 15 F u r t h e r m o r e , u n b i a s e d

e x c h a n g e rate p r e d i c t i o n s are e n s u r e d i f e x p e c t a t i o n s are

formed, n o t i n some a d h o c manner, b u t w i t h a n u n d e r s t a n d i n g ~f

t h e u n d e r lying p r o c e s s o f e x c h a n g e r a t e d e t e r & i n a t i o n - The

r e s u l t i n g a n a l y s i s a p p e a r s t o r e e m p h a s i s e t h e g e n e r a l

e q u i l i b r i u m na t a r e of exchange rate d e t e r m i n a t i o n a n d t h e

s i g n a l l i n g f n n c t i o n of t h e p r i c e mechanism. However, it d o e s n o t

r u l e o a t t h e p o s s i b i l i t y of w i l d e x c h a n g e r a t e s w i n g s d r i v e n b y

a n a r b i t r a r y e l e m e n t i n e x p e c t a t i o n s t h a t a r e n e v e r t h e l e s s

u n b i a s e d a n d t h e r e f ore self - j u s t i f y i n g . l 6

T h e r e is n o d o u b t t h a t s p e c u l a t i v e a c t i v i t y b a s e d on

e x c h a n g e r a t e e x p e c t a t i o n s can of i t se l f cause v a r i a t i o n s i n t h e

e x c h a n g e rate, i n t e r e s t ra tes a n d p r i c e s which c a n have real

effects e l s e w h e r e i n t h e econoay , a t least i n t h e s h o r t run .

Whether s u c h f l u c t u a t i o n s s h o u l d b e s e e n as ' i l l e g i t i m a t e 8 i n

some s e n s e , t h u s j u s t i f y i n g i n t e r v e n t i o n , is a r g u a b l e - I f , on

t h e o t h e r h a n d , t h e s e f l u c t u a t i o n s a r e s e e n a s u n d e s i r a b l e p e r

se, t h e n i n t e r v e n t i o n , t o t h e e x t e n t t h a t it can r e d u c e t h e n ,

nay be j u s t i f i e d . A l a t e r s e c t i o n e x a m i n e s t h e costs of t h e s e

f l u c t a a t i o a s ,

(iii) T r a n s i t i o n C o s t s

A t h i r d a r g u m e n t a g a i n s t f r e e l y f l o a t i n g e x c h a n g e rates,

w h i l e a d m i t t i n g t h e b e n e f i t s of t h i s r eg ime , p o i n t e d t o t h e --- ------------- 1 5 See Lucas (1972) , S a r g e n t a n d g a l l a c e (1976) a n d Barro (1976), among o t h e r s , f o r s e m i n a l w o r k s o n r a t i o n a l e x p e c t a t i o n s f o r n a t i o n .

1 6 See F l o o d a n d G a r b e r (1980) on t h i s p o i n t -

l i k e l i h o o d of enormous t r a n s i t i o n costs, The c h a o s c a u s e d by

a b r u p t a d o p t i o n of f l o a t i n g rates b y many c o u n t r i e s would

u n d o u b t e d l y s p i l l o v e r i n t o d o m e s t i c marke ts . The s o c i a l cost of

t h i s u p h e a v a l was judged t o o u t w e i g h s u c h b e n e f i t s of t h e r e g i m e

a s may e v e n t u a l l y a c c r u e , C e r t a i n l y t h e l i m i t e d h i s t o r i c a l

e x p e r i e n c e uith t r u l y free e x c h a n g e rates would t e n d t o s u p p o r t

t h i s view, However, s u c h c o m p a r i s o n may b e u n f a i x . A d o p t i o n of a

free f l o a t , as in s e v e r a l European c o u n t r i e s a f t e r WVI,

g e n e r a l l y f o l l o w e d u i d e s p r e a d s o c i a l a n d e c o n o m i c upheava l .

Under t h e s e c o n d i t i o n s , f r e e l y f l o a t i n g e x c h a n g e r a t e s c o u l d n o t

be e x p e c t e d t o o p e r a t e s m o o t h l y t o p r o v i d e a g e n e r a l p a n a c e a f o r

more f u n d a m e n t a l p r o b l e a s - F i n a l l y , i f t h e cos t s are a s s o c i a t e d

w i t h t h e a b r u p t n e s s o f t r a n s i t i o n t o f r e e l y f l o a t i n g e x c h a n g e

rates, t h e y c o u l d b e a v o i d e d by a g r a d u a l t r a n s i t i o n ,

C o s t s ( a n d B e n e f i t s ) o f Exchange R a t e I n s t a b i l i t y

More r e c e n t a ~ p r o a c h e s t o t h e c h o i c e of e x c h a n g e r a t e

r eg i a i e b e g i n by n o t i n g t h a t t h e J - c u r v e phenomenon o r

d e s t a b i l i z i n g s p e c u l a t i o n a r e n o t t h e o n l y c a u s e s of i n s t a b i l i t y

o v e r time, They may i a p l y t h a t the a d j u s t m e n t of a f r e e l y

f l o a t i n g e x c h a n g e rate, as it r e s p o n d s to a s i n g l e e x o g e n o u s

shock ,17 d i s p l a y s v o l a t i l i t y t h a t is i n some s e n s e e x c e s s i v e * ,

However, s u c h s h o c k s are r a r e l y i s o l a t e d , Under any e x c h a n g e ------------------ 1 7 The word * e x o g e n o u s 9 is n o t u s e d i n t h i s t h e s i s t o d e n o t e s h o c k s f rom f o r e i g n s o u r c e s , It relates t o t h o s e e l e m e n t s which are ' g i v e n s * t o a c o u n t r y , e l e m e n t s which may t h e r e f o r e i n c l u d e i ts own endowments a n d p r e f e r e n c e s ,

r a t e r e g i m e , a c o u n t r y mus t c o n t i n u o u s l y a d j u s t t o e x o g e n o u s

s h o c k s of v a r i o u s k i n d s , fluch of t h e t h e o r e t i c a l work o v e r t h e

l a s t d e c a d e h a s c o n c e n t r a t e d o n t h e way i n which exogenous

s h o c k s from v a r i o u s s o u r c e s c a u s e a d j u s t m e n t a n d f l u c t u a t i o n s i n

a f r e e l y f l o a t i n g exchange r a t e , However, t h a t s e c t i o n o f t h e

l i t e r a t u r e w h i c h a r g u e s from t h e e x i s t e n c e of f l u c t u a t i o n s i n a

f r e e l y f l o a t i n g e x c h a n g e r a t e t o t h e d e s i r a b i l i t y o r o t h e r w i s e

o f e x c h a n g e n a r k e t i n t e r v e n t i o n g e n e r a l l y d o e s s o u s i n g t h e

f o l l o w i n g l i n e o f a rgument , /

The way i n which exogenous s h o c k s are t r a n s m i t t e d , b o t h

d o m e s t i c a l l y a n d i n t e r n a t i o n a l l y , o f c o n r s e d e p e n d s o n which

m a r k e t s c lear * i n s t a n t a n e o u s l y 9 a n d which clear * o v e r t i m e * ,

which g o o d s a n d assets a re i n t e r n a t i o n a l l y t r a d e d , a n d w h e t h e r

p r i c e s o r q u a n t i t i e s d o t h e a d j u s t i n g . . N e v e r t h e l e s s , t h e s h o c k s

u l t i m a t e l y l e a d t o f l n c t a a t i o n s o v e r time i n a t l e a s t some o f

t h e t h i n g s o n which welfare depends , G iven the u s n a l c o n c a v i t y

a s s u m p t i o n s a b o u t u t i l i t y f u n c t i o n s , ( e x p e c t e d ) utility u i l l ,

ceteris ~ a r i b u s b e a d e c r e a s i n g f u n c t i o n of t h e v a r i a n c e of its -- , - , f

a r g u m e n t s , T h e r d o r e , any e x c h a n g e r a t e r e g i m e which l e a d s t o

smaller v a r i a t i o n o v e r t i m e i n t h e s e a r g o m e n t s u i l l , ceteris

p a r i b u s , l e a d t o a h i g h e r l e v e l o f u e l f a re . 18

#any r e c e n t c o n t r i b u t i o n s t o t h e l i t e r a t u r e on o p t i m a l

e x c h a n g e rate management c a n be i n t e r p r e t e d a s a t t e m p t s t o f i n d ----------------- 1 % If a p o l i c y allows a l o w e r v a r i a n c e of some a r g u m e n t s o n l y a t t h e e x p e n s e of i n c r e a s i n g t h e v a r i a n c e of others, t h e n welfare i m p l i c a t i o n s c a n be made o n l y by r e f e r e n c e t o t h e u n d e r l y i n g u t i l i t y f u n c t i o n s . T h i s p o i n t i s made b y Lapan a n d E n d e r s (1980) , b u t is f r e q u e n t l y i g n o r e d e l s e w h e r e -

a n e x c h a n g e r a t e r e g i m e which c a n r e d u c e s u c h v a r i a t i o n a n d

i n c r e a s e w e l f a r e . However, a l l of t h e s e c o n t r i b u t i o n s h a v e

f o c u s e d o n e i t h e r enp loymen t o r c o n s u m p t i o n a s a n a rgumen t of

some i m p l i c i t s o c i a l v e l f a r e f u n c t i o n , H e n o u ' e v a l u a t e e a c h of

t h e s e a p p r o a c h e s i n t u r n ,

(i) Employment

T h e v i ew t h a t d i f f e r e n t e x c h a n g e ra te r e g i m e s h a v e \

d i f f e r e n t i m p l i c a t i o n s f o r t h e l e v e l of , a n d d e g r e e o f v a r i a t i o n

i n , employment e s s e n t i a l l y makes c h o i c e of e x c h a n g e r a t e r e g i m e

one a s p e c t of domestic s t a b i l i z a t i o n p o l i c y f o r a n o p e n economy,

As s u c h , a l l of t h e r e c e n t d e b a t e c o n c e r n i n g t h e d e s i r a b i l i t y o r

f e a s i b i l i t y o f s u c h s t a b i l i z a t i o n p o l i c y becomes r e l e v a n t ,

F r e q u e n t l y , however , t h e s e c o n s i d e r a t i o n s h a v e b e e n i g n o r e d ,

One s t r a n d o f t h e optimum c u r r e n c y a r e a a s a rgumen t u s e s

c o n s i d e r a t i o n s of v a r i a b i l i t y i n the l e v e l of employment t o

a r g u e for f r e e l y f l o a t i n g e x c h a n g e rates, Rhen d o m e s t i c wages

are s t i c k y a n d f a c t o r s n o t f u l l y m o b i l e i n t e r n a t i o n a l l y ,

exogenous s h o c k s saust l e a d to f l u c t u a t i o n s o v e r time i n t h e

a g g r e g a t e q u a n t i t y of employment i f e x t e r n a l b a l a n c e is t o b e

m a i n t a i n e d w i t h a f i x e d e x c h a n g e rate. Under f l e x i b l e e x c h a n g e

rates, by compar i son , d e p r e c i a t i o n c a n s u b s t i t u t e f o r d o m e s t i c ---------------- 19 The s e m i n a l works o n optimum c u r r e n c y areas are by H n n d e l l (1961), 11973) . PlcKinnon (1 963) a n d Kenea (1969) . The l i t e r a t u r e c o n s i d e r s t h e costs a n d b e n e f i t s of b o t h f i x e d a n d f r e e l y f l o a t i n g e x c h a n g e r a t e s i n terms of t h e i r i m p l i c a t i o n s for t h e optimum s i z e of c u r r e n c y a r e a s - areas w i t h i n which e x c h a n g e r a tes are f i x e d a n d be tween which e x c h a n g e rates are f l e x i b l e , To t h e e x t e n t t h a t t h e c o s t s a n d b e n e f i t s are are f u n c t i o n s of t h e s i z e of a c u r r e n c y a r e a , t h e optimum c u r r e n c y area is o n e for which t h e costs a n d b e n e f i t s are b a l a n c e d a t t h e margin..

d e f l a t i o n and a p p r e c i a t i o n f o r d o m e s t i c i n f l a t i o n , V a r i a t i o n

o v e r t i m e i n t h e q u a n t i t y of employment i s s e e n a s d e t r i m e n t a l

t o w e l f a r e , e i t h e r d i r e c t l y b e c a u s e v e l f a r e d e p e n d s o n

employment, o r i n d i r e c t l y b e c a u s e t h e v a r i a t i o n i n real income

r e q u i r e d f o r e x t e r n a l b a l a n c e c o n f l i c t s w i t h o t h e r d o m e s t i c

p o l i c y t a r g e t s , 20 Thus f l e x i b l e e x c h a n g e rates a r e p r e f e r a b l e , 2 1

Some of t h e r e c e n t a t t e a p t s 2 2 t o derive o p t - i m a l e x c h a n g e

a a r k e t i n t e r v e n t i o n r u l e s h a v e a l s o b e e n b a s e d on t h e o b j e c t i v e

o f s t a b i l i z i n g income o v e r time, A l s o i m p l i c i t i n t h e s e a t t e m p t s

is t h e judgement t h a t e x o g e n o u s s h o c k s , a n d t h e v a r i a t i o n s t h e y

c a u s e i n t h e l e v e l of employment, j u s t i f y s u c h i n t e r v e n t i o n .

R e c e n t work i n t h e t h e o r y of i n f l a t i o n and unemployment h a s

examined more c l o s e l y t h e c o n d i t i o n s u n d e r which t h e l e v e l of

unemployment c a n d e v i a t e f o r any p e r i o d of t i a e from t h e

s o - c a l l e d n a t u r a l r a t e , * J e v e n i n t h e face of exogenous s h o c k s ,

s n c h d e v i a t i o n s d e p e n d c r u c i a l l y on p r i c e a n d / o r wage r i g i d i t i e s

d e r i v e d f r o m what m i g h t b r o a d l y be c a l l e d i n f o r m a t i o n a l

i n e f f i c i e n c i e s , i n c l u d i n g money i l l u s i o n ,

------------------ 2 0 T h i s l a t t e r a r g u m e n t i s t h e e c o n o m i c a n a l o g u e o f t h e p o l i t i c a l a r g u m e n t c o n c e r n i n g n a t i o n a l autonomy,

2 1 Bore r e c e n t c o m p a r i s o n s of f i x e d a n d freely f l o a t i n g e x c h a n g e r a tes o n t h e b a s i s of income v a r i a t i o n are c o s t a i n e d i n Chan (1979) a n d Raminow (1979)-

22 S e e Boyer (1978), Hender son (1979). Cox (1980) a n d Roper a n d Turnovsky (1980).

2J The n a t u r a l r a te is, c r u d e l y s p e a k i n g , t h a t r a t e i m p l i e d by t h e f r i c t i o n a l unemployment a s s o c i a t e d w i t h j o b s e a r c h ,

A s e a r l y a s 1963, HcKinnon c o u n t e r e d t h e optimum c u r r e n c y

a r e a a rgumen t by n o t i n g t h a t a d e p r e c i a t i o n u n d e r f l e x i b l e

e x c h a n g e ra tes i m p o s e s a s much of a l o s s i n real income as a

mone ta ry c o n t r a c t i o n or i n c r e a s e i n t a x a t i o n a n d e r f i x e d

e x c h a n g e rates- D e p r e c i a t i o n f e e d s d o m e s t i c i n f l a t i o n by

i n c r e a s i n g t h e p r i c e of t r a d e d g o o d s and , a t a g i v e n wage l e v e l ,

t h e r e b y r e d u c e s r e a l income, T h i s allows t h e e x p e n d i t u r e

r e d u c t i o n n e c e s s a r y t o e l i m i n a t e t h e e x c h a n g e ra te p r e s s u r e o n l y

i f w o s k e r s d o n o t u s e t h e r e a l i n c o m e r e d u c t i o n t o n e g o t i a t e a

h i g h e r wage, HcKinnon therefore c o n c l u d e s t h a t t h e a rgumen t f o r

f l e x i b l e e x c h a n g e r a t e s b a s e d o n its a b i l i t y t o free d o m e s t i c

p o l i c y t o o l s f o r s t a b i l i z a t i o n p u r p o s e s must t h e r e f o r e rest on

t h e f a c t t h a t w o r k e r s are more l i k e l y to s u f f e r money i l l u s i o n

i n t h e face of e x c h a n g e r a t e c h a n g e s t h a n i n t h e f a c e o f

mone ta ry c o n t r a c t i o n o r t a x a t i o n , z *

nore r e c e n t l y , t h e t h e o r y of r a t i o n a l e x p e c t a t i o n s , i n b o t h

its weak a n d s t r o n g forms, h a s s u g g e s t e d t h a t t h e g o v e r n m e n t ' s

a b i l i t y t o e x p l o i t money i l l u s i o n is a t b e s t l i m i t e d t o t h e

s h o r t r a n , The e s s e n c e of t h e weak form of r a t i o n a l e x p e c t a t i o n s

h a s been p u t s u c c i n c t l y by P r i edman {1976,P0237):

, . , s i n c e you c a n ' t f o o l a l l of t h e p e o p l e a l l of t h e t i n e , t h e t r u e l o n g - r u n P h i l l i p s c u r v e is v e r t i c a l - 2 5

F r i edman n o t e s , however, t h a t t h e n a t u r a l rate of anemployment ---------------- ** T h i s of c o u r s e is more p l a u s i b l e t h e smaller t h e a t t e m p t e d d e c e p t i o n - t h a t is, t h e l a r g e r a n d t h e r e f o r e less open t h e economy,

2 s The s t r o n g form of r a t i o n a l e x p e c t a t i o n s s n g g e s t s t h a t e v e n t h e s h o r t s o n P h i l l i p s c u r v e may be v e r t i c a l -

i m p l i e d by a v e r t i c a l P h i l l i p s c u r v e is n o t a n i r r e d u c i b l e

minimntn - it can b e r e d u c e d by e l i m i n a t i n g f r i c t i o n s i n t h e

l a b o u r market. 2 6 Fur the rmore , i f the government c a n e x p l o i t

s u p e r i o r i n f o r m a t i o n t o r e d u c e s h o r t r u n i n c o d e v a r i a t i o n a round

t h e n a t u r a l r a t e , it c a n a c h i e v e t h e same result by s i m p l y

d i s s e m i n a t i n g t h a t i n f o r m a t i o n , 2 7

Recent d i s c u s s i o n s of exchange market i n t e r - v e n t i o n h a v e

t ended t o s i d e s t e p a l t o g e t h e r t h e s e i s s u e s r a i s e d i n t h e c o n t e x t

o f s t a b i l i z a t i o n p o l i c y f o r a c l o s e d economy-28 One r e a s o n is

t h a t , p r i o r t o t h e e a r l y 1970s, a c o u n t r y ' s exchange ra te r e g i m e

was n o t s e e n a s a n o b j e c t o f c h o i c e - i t u a s mere ly a g i v e n

w i t h i n which d o a e s t i c monetary a n d f i s ca l s t a b i l i z a t i o n p o l i c y

had t o o p e r a t e - From t h i s p e r s p e c t i v e , f u r t h e r m o r e , t h e

d i s c ~ s s i o n of s t a b i l i z a t i o n i n a n open economy h a s been

dominated by t h e a s s i g n m e n t approach , The i d e a h e r e was t o

a s s i g n t o e a c h t a r g e t a s i n g l e i n s t r u m e n t , I n g e n e r a l terms,

however, t h e b e s t policp mix may or may n o t t u r n o u t t o b e a

s i m p l e one-to-one ass ignment , I n t h i s c o n t e x t , t h e i s s u e of

n a t i o n a l autonomy and ' f r e e i n g of i n s t r u n e n t s ' c a n b e s e e n t o b e

2 6 It i s p o s s i b l e , however, t h a t t h e s e r i g i d i t i e s reflect a r a t i o n a l r e a c t i o n by workers a n d e m p l o y e r s t o t h e u n c e r t a i n t y engendered by exogenous shocks , See the l i t e r a t u r e on g n a s i - c o n t r a c t s ,

2 7 See Bar ro (1976) f o r t h i s p o i n t ,

2 8 Boyer ( 1978 , P- 1048) , f o r exarcple, e x p l i c i t l y d i s m i s s e s r a t i o n a l e x p e c t a t i o n s f o r m a t i o n a s i r r e l e v a n t t o t h e i s s u e o f o p t i m a l exchange r a t e s t a b i l i t y .

s o m e t h i n g of a r e d h e r r i n g , a s HcKinnon's comments i n d i c a t e - 2 9

C o n v e r s e l y , a n y t h i n g which may h a v e i m p l i c a t i o n s f o r a

g o v e r n m e n t ' s a b i l i t y t o a c h i e v e t h e t a r g e t , s u c h a s t h e

p o s s i b i l i t y of r a t i o n a l e x p e c t a t i o n s f o r m a t i o h , c a n n o t b e

i g n o r e d ,

The whole i s s u e of t h e e f f e c t i v e n e s s of a c t i v e

s t a b i l i z a t i o n p o l i c y r e m a i n s u n s e t t l e d a n d i s still e v o k i n g a

l a r g e body of l i t e r a t u r e , The r e c o g n i t i o n t h a t a n economy is

o p e n d o e s add e x c h a n g e f a t e management p o l i c y t o t h e

g o v e r n m e n t ' s a r s e n a l , a l t h o u g h as t h e a b o v e comments make clear,

it nay b e t h a t t h i s p c l i c y i n s t r u m e n t c a n n o t b e o p e r a t e d

i n d e p e n d e n t l y , However, r e c e n t a n a l y s i s h a s r a i s e d s e r i o u s

q u e s t i o n s a b o u t t h e u s e f u l n e s s o f t r y i n g t o s t a b i l i z e i ncome b y

monetary, f i s c a l o r e x c h a n g e r a t e methods- It h a s g e n e r a l l y

c o n f i r m e d t h e a r g u m e n t t h a t if rea l income v a r i e s i n t h e face o f

exogenous s h o c k s because of m a r k e t r i g i d i t i e s , t h e n t h e first

b e s t , and p o s s i b l y t h e o n l y s o l u t i o n is t o remove t h e s e

r i g , i d i t i e s d i r e c t l y ,

( i i ) Consumpt ion

T h e v iew t h a t d i f f e r e n t e x c h a n g e rate r e g i m e s h a v e

d i f f e r e n t i a p l i c a t i o n s f o r t h e d e g r e e of v a r i a t i o n i n

consumpt ion i n t r o d u c e s i s s u e s of s a v i n g b e h a v i o n r a n d

i n t e r t e m p o r a l c h o i c e i n t o t h e d i s c u s s i o n of o p t i ma1 e x c h a n g e

r a t e management, ------------------ 2 9 These p o i n t s are r e c o g n i s e d by Boyer (1980) , who n e v e r t h e l e s s a r g u e s f o r a s p e c i a l i z e d a s s i g n m e n t , g i v e n i n p e r f ect i n f o r a a t i o n a n d c o s t s of i n t e r v e n t i o n ,

One s t r a n d of t h e optimum c u r r e n c y area a rgumen t n o t e s t h a t

when t h e r e is s u f f i c i e n t wage a n d p r i c e f l e x i b i l i t y t o e n s u r e

f u l l employment , b u t when f u l l s t o c k e q u i l i b r i u m i n money

m a r k e t s is a c h i e v e d o n l y o v e r time, a f i x e d el tchange r a t e s y s t e m

c a n allow a s m o o t h i n g of f l a c t u a t i o n s i n e x p e n d i t u r e r e l a t i v e t o

o u t p u t t h a t would n o t o t h e r w i s e o c c u r , I m p l i c i t i n t h i s a p p r o a c h

is t h e judgemen t t h a t s i n c e w e l f a r e d e p e n d s on r - e a l c o n s u m p t i o n ,

which n e e d n o t e q u a l r ea l income, i n t e r v e n t i o n which c a n r e d u c e

t h e v a r i a t i o n i n r ea l consumpt ion o v e r time i s j u s t i f i e d .

T h i s a r g u m e n t is i ~ p l i c i t i n f i u n d e l l (1973,P.IlS):

,,,a h a r v e s t f a i l u r e , s t r i k e s o r war i n o n e of t h e c o u n t r i e s c a u s e s a loss of r e a l income, b u t t h e u s e of a common c u r r e n c y (or f o r e i g n e x c h a n g e r e s e r v e s ) a l lows t h e c o u n t r y t o r u n down i ts c u r r e n c y h o l d i n g s a n d c u s h i o n t h e i m p a c t of t h e loss , d r a w i n g o n t h e r e s e r v e s of t h e o t h e r c o u n t r y u n t i l t h e cost o f a d j u s t m e n t h a s been s p r e a d e f f i c i e n t l y o v e r t h e f u t u r e , I f , on t h e o t h e r hand, t h e two. c o u n t r i e s u s e s e p a r a t e monies w i t h f l e x i b l e rates t h e whole l o s s ( w i t h a q u a l i f i c a t i o n ) h a s t o b e b o r n e a l o n e ,

It h a s a l so b e e n f o r m a l i z e d by F i s c h e r (1977) i n t h e c o n t e x t o f

e v a l u a t i n g f i x e d v e r s u s f l e x i b l e e x c h a n g e rates, and by F r e n k e l

(1980) i n t h e c o n t e x t of d e t e r m i n i n g t h e o p t i m a l d e g r e e of

exchange m a r k e t i n t e r v e n t i o n , T h e s e writers h a v e a l s o shown t h a t

t h e a p p r o p r i a t e e x c h a n g e ra te r e g i m e w i l l ia g e n e r a l depend on

t h e source of t h e e x o g e n o u s s h o c k s f a c i n g a n economy. I n

p a r t i c u l a r , F i s c h e r (1977) shows t h a t i f t h e s h o c k s a re

p r i m a r i l y r e a l , J o t h e n f i x e d e x c h a n g e r a t e s a r e p r e f e r a b l e , I f ,

---------------- JoTBese are d e f i n e d a s s h i f t s i n a g g r e g a t e s u p p l y ,

however, d i s t u r b a n c e s a r e nominal, 31 f l e x i b l e exchange r a t e s

l e a d t o a l o w e r v a r i a t i o n i n r e a l consumpt ion o v e r time,

S i m i l a r l y , i f d i s t u r b a n c e s o r i g i n a t e o v e r s e a s , t h e n f l e x i b l e

exchange r a t e s a r e p r e f e r a b l e , 32

However, t h e s e c o n c l u s i o n s c a n b e s e e n a s a r i s i n g from a

marke t i m p e r f e c t i o n , one which p r e v e n t s i n t e r n a t i o n a l c a p i t a l

mobi l i ty .33 Helpoaan a n d Razin (1979). among o t h e r s , have p o i n t e d

o u t t h a t i n t h e s i m p l e model used by F i s c h e r (1977) and F r e n k e l

(1980), a n economy w i t h f l e x i b l e exchange rates and n o .

i n t e r n a t i o n a l c a p i t a l aovements i s e s s e n t i a l l y c l o s e d . There a r e

no c h a n n e l s by which i t c a n borrow t o f i n a n c e consumpt ion i n t h e

f a c e o f a h a r v e s t f a i l u r e , Under f i x e d exchange r a t e s , by

comparison, f o r e i g n borrowing and l e n d i n g , w i t h t h e accompanying

t r a n s f e r of r e a l r e s o u r c e s , is p e r m i t t e d t h r o u g h t h e f o r e i g n

exchange a u t h o r i t y ,a*

Clearly c a p i t a l i s n o t c o ~ p l e t e l y immobile i n t e r n a t i o n a l l y -

N e v e r t h e l e s s , t h o s e who a r g u e t h a t i n t e r v e n t i o n i s j u s t i f i e d on

t h e g r o u n d s t h a t it c a n still r e d u c e t h e v a r i a t i o n i n r e a l

con sumption o v e r t i m e must first answer a n o t h e r q u e s t i o n - namely, why it is t h a t p r i v a t e i n d i v i d u a l s , by t h e i r own ---------------- 3 % T h e s e a r e d e f i n e d as shifts i n a g g r e g a t e money demand,

3 2 T h i s l a t t e r c o n c l u s i o n c o n f i r m s t h e i n s u l a t i n g p r o p e r t i e s o f f l e x i b l e exchange r a t e s d i s c u s s e d p r e v i o u s l y ,

33 Hundell (1973) is aware of the uay i n which c a p i t a l f l o w s a f f e c t h i s c o n c l u s i o n ,

3 4 T h i s asymmetry is a l s o i m p l i c i t l y r e c o g n i s e d by L a f f e r (1973) and i n t h e l i t e r a t u r e on c u r r e n c y s u b s t i t u t i o n - see, for example, Br i l l en tbourg and S c h a d l e r (1979, P-515)-

a c t i o n s , c a n n o t smooth t h e i r c o n s u m p t i o n streams t o t h e optimum

e x t e n t .

T h i s q u e s t i o n h a s r e c e n t l y b e a d d r e s s e d by r e f e r e n c e t o t h e

l i t e r a t u r e on c h o i c e u n d e r u n c e r t a i n t y - 3 5 ~ m p l i c i t n o t o n l y i n

t h e s e a r g u m e n t s f o r i n t e r v e n t i o n b a s e d on c o n s u m p t i o n , b u t a l s o

i n some of t h o s e b a s e d on employment , i s c o n s i d e r a t i o n o f t h e

e x t e n t t o w h i c h c h o i c e of e x c h a n g e r a t e r e g i m e c a n a f f e c t t h e

s h a r i n g o f r i s k - 3 6 The welfare i m p l i c a t i o n s of r i s k s h a r i n g are

a s f o l l o w s , Under t h e u s u a l a s s u m p t i o n of r i s k a v e r s i o n , ,

i n d i v i d u a l s f a c e a t r a d e o f f b e t w e e n t h e e x p e c t e d l e v e l of r e a l

inco ise ( o r c o n s u m p t i o n ) and i ts v a r i a n c e or r i s k i n e s s - T o e x t e n t

t h a t t h e e x o g e n o u s s h o c k s t o v a r i o u s g o o d s s u p p l i e s or a s s e t

r e t u r n s a re n e g a t i v e l y c o r r e l a t e d , a i v e r s i f i c a t i o n a l l o w s a

r e d u c t i o n i n r i s k f o r a g i v e n l e v e l of e x p e c t e d r e a l income

( consumpt ion ) - 3 7 F u r t h e r m o r e , t h e t h e o r y of c h o i c e u n d e r

u n c e r t a i n t y s u g g e s t s i n d i v i d u a l s w i l l d i v e r s i f y t o the most

----------------- 35 See, f o r example , t h e s e m i n a l work b y Tobin (1958) - E x t e n s i o n s i n t o t h e t h e o r y of i n t e r n a t i o n a l f i n a n c e h a v e b e e n made by S o l n i k (1974) a n d G r a u e r , L i t z e n b e r g e r a n d S t e h l e (1976)- A p p l i c a t i o n s t o i n t e r n a t i o n a l t raae i n c l n d e R n f f i n (1974a) , (1974b) a n d Hayer (1976)-

36 See, f o r example , f l u n d e l l (1973) f o r a n e x p o s i t i o n i n t h e s e terms, T h e r i s k a s p e c t is s e e n e v e n more c l e a r l y when t h e r e is some d e g r e e of non-homogeneity w i t h i n , a s w e l l a s b e t u e e n , c o u n t r i e s , H u n d e l l (1961) c o n s i d e r s g e o g r a p h i c a l aon-homogenei ty and Lapan a n d E a d e r s (1980) c o n s i d e r d e m o g r a p h i c non-homogenei t yo They t h e n e x a m i n e bow r i s k s h a r i n g b e t ween r e g i o n s o r g e n e r a t i o n s c a n s u b s t i t u t e f o r r i s k s h a r i n g be tween c o u n t r i e s .

3 7 Such d i v e r s i f i c a t i o n b e h a v i o u r c a n sometimes be b roken i n t o two componen t s - t h e i n s u r a n c e a n d t h e g a n b l i n g m o t i v e s n o r m a l l y a s s o c i a t e d w i t h h e d g i n g a n d s p e c u l a t i o n -

e f f i c i e n t e x t e n t - t h e y w i l l ac t so a s t o e n s u r e t h e l o w e s t

p o s s i b l e r i s k f o r a g i v e n e x p e c t e d r e t u r n , If t h e government c a n

d o better, it c a n o n l y be because i t c a n affect a t r a n s f e r o f

r e a l r e s o u r c e s be tween i n d i v i d u a l s , r e g i o n s o s c o u n t r i e s which

c o u l d n o t o t h e r w i s e t a k e p l a c e , a n d t h e r e f o r e a l l o w f u r t h e r

d i v e r s i f i c a t i o n . J e \

T h i s p o i n t s t o t h e f u n d a m e n t a l d i f f i c u l t y w i t h t h e s e

a r g u m e n t s f o r i n t e r v e n t i o n , R i s k s h a r i n g be tween i n d i v i d u a l s ,

r e g i o n s o r c o u n t r i e s w i l l n o t be c a r r i e d o u t t o t h e o p t i a u m

e x t e n t when t h e r e are barr iers t o t h e t r a n s f e r o f r e a l

r e s o u r c e s , T h e s e b a r r i e r s c o u l d p r e v e n t t h e t r a n s f e r o f e i t h e r

goods , f a c t o r s or f i n a n c i a l assets, 39 T h e i r removal , r a t h e r t h a n

i n t e r v e n t i o n , w i l l a l l o u i n d i v i d u a l s t o i n c r e a s e r i s k s h a r i n g

a n d hence v e l f are,

The J u s t i f i c a t i o n for I n t e r v e n t i o n - A t h i r d s t r a n d of t h e optimum c u r r e n c y area argument h a s

f o c u s e d on t h e i m p l i c a t i o n s of d i f f e r e n t e x c h a n g e r a t e r e g i m e s

for t h e u s e f u l n e s s of money,*o f i r s t l y , t h e smaller a n d more ---------------- 38 I n t h e l a n g u a g e of t h e l i t e r a t u r e , t h e gove rnmen t c a n c o n t r i b u t e t o w a r d t h e achieveir tent of c o m p l e t e ' m a r k e t s , a s i t u a t i o n which a l l o w s a P a r e t o o p t i ~ a l a l l o c a t i o n of r i s k ,

39 G r a u e r , L i t z e n b e r g e r a n d S t e h l e (1 976) h a v e shown t h a t , u n d e r c e r t a i n c o n d i t i o n s , t h e e f f i c i e n t a l l o c a t i o n of r i s k d o e s n o t r e q u i r e free t r a d e i n goods a n d s e r v i c e s , so l o n g a s f i n a n c i a l assets are f r e e l y n o b i l e ,

4 0 The first two s t r a n d s h a v e g e n e r a l l y l ead t o t h e c o n c l u s i o n t h a t t h e b e n e f i t s of h a v i n g f l e x i b l e e x c h a n g e ra tes be tween c u r r e n c y areas i n c r e a s e , t h e smaller a n d more open is e a c h c u r r e n c y a r e a . The t h i r d s t r a n d p r o v i d e s t h e quid p r o quo,

numerous are s e p a r a t e c u r r e n c y areas, t h e h i g h e r a r e t h e c o s t s

a s s o c i a t e d w i t h c o l l e c t i n g i n f o r m a t i o n a b o u t f o r e i g n p r i c e s a n d

c o n v e r t i n g c u r r e n c i e s i n t h e c o u r s e of t r a d e - 4 1 Second ly , t h e

fewer members t h e r e a r e i n a c o r r e n c y area, t h e smaller are t h e

s a v i n g s a v a i l a b l e by p o o l i n g f o r e i g n e x c h a n g e r e s e r v e s - 4 2

F i n a l l y , f l u c t u a t i n g e x c h a n g e r a t e s a t t h e b o r a e r o f t h e

c u r r e n c y a r e a c a u s e f l a c t u a t i o n s i n t h e p r i c e l e v e l w i t h i n t h e

c u r r e n c y a r e a - The smaller a n d more o p e n t h e c u r r e n c y a r e a , t h e

l a r g e r t h e e x c h a n g e rate a n d p r i c e l e v e l f l u c t u a t i o n s are l i k e l y

t o be, T h e s e f l o c t u a t i o n s t h e a s e l v e s i m p o s e a c o s t . T h e a reaas

c u r r e n c y w i l l h a v e a low l i q u i d i t y v a l u e a n d i n d i v i d u a l s w i l l

seek t o a c c u m u l a t e asse ts whose rea l v a l u e is more s tab le -43 4 4

T h i s t h i r d s t r a n d of a r g u m e n t h a s b e e n e x t e n d e d i n o r d e r t o

a r g u e t h a t f o r any c o u n t r y , i r r e s p e c t i v e of w h e t h e r i t

c o n s t i t u t e s a n optimum c u r r e n c y area, t h e s e cos ts of e x c h a n g e

rate f l e x i b i l i t y b y t h e m s e l v e s j n s t i f y i n t e r v e n t i o n i n f o r e i g n

e x c h a n g e marke t s , G r u b e l (1973) . 11977) h a s argued t h a t e v e n

u n d e r t h e most i d e a l c i r c u m s t a n c e s t h e s e c o s t s r ema in , and

f u r t h e r , t h a t t h e y c o n s t i t a t e a n e x t e r n a l i t y - To i l l u s t r a t e t h i s

-------------- 4 1 See ~ u n d e l l (1968) , (1973) -

4 2 See H u n d e l l (1973) , I s h i y a m a (1975) .

4 3 See HcKinnon (1 963) - o nd f l u

F i s c h e r (1 e s i r a b l e . c t o a t i o n s

977) a l so j u d g e s t h a t p r i c e l e v e l f l u c t u a t i o n s are H e a r g u e s t h a t t h e costs arise b e c a u s e p r i c e l e v e l c o u l d l e a d to o u t p u t c h a n g e s v i a a P h i l l i p s c a r v e

r e l a t i o n s h i p . Hence h i s a r g u m e n t is a v a r i a n t of t h e one t h a t f o c u s e s o n employment l e v e l s , r a t h e r t h a n p a r t of t h e c u r r e n t a rgument .

p o i n t , h e p o r t r a y s t h e f o l l o w i n g s c e n a r i o ,

Wages and p r i c e s a r e assumed f u l l y f l e x i b l e and f a c t o r s

i n t e r n a l l y mobile , Hence f u l l eap loyment i s main ta ined i n t h e

f a c e o f exogenous shocks - I n t e r n a t i o n a l c a p i t a l m o b i l i t y a l l o w s

i n d i v i d u a l s t o c h o o s e their d e s i r e d consumpt ion p a t h o v e r t i m e ,

T h e f o r e i g n exchange effects o f exogenous s h o c k s a r e

accommodated by a l l o w i n g t h e exchange r a t e t o f l o a t f r e e l y - The

r e s u l t i n g exchange r a t e f l u c t u a t i o n s c a u s e i n s t a b i l i t y i n t h e

d o a e s t i c p r i c e of t r a d e d goods, a n d hence i n s t a b i l i t y i n t h e

d o m e s t i c p r i c e l e v e l , These p r i c e a n d exchange r a t e f l u c t u a t i o n s

w i l l be dampened by s p e c u l a t i v e a c t i v i t y , b u t w i l l n o t be

e n t i r e l y e l i m i n a t e d , * s Hence some i n s t a b i l i t y remains,

I n t h i s s c e n a r i o , t h e r e a r e no s o c i a l c o s t s a s s o c i a t e d p i t h

f l u c t u a t i n g employment o r consumpt ion, If f a c t o r r e a l l o c a t i o n s

occur i n s t a n t a n e o u s l y and c o s t l e s s l y , t h e n t h e r e are a l s o n o --.

- -d., s o c i a l c o s t s a s s o c i a t e d w i t h f l u c t u a t i n g r e l a t i v e p r i c e s ,

N e v e r t h e l e s s , t h e c o s t s a s s o c i a t e d w i t h f l u c t n a t i o n s i n t h e

p r i c e l e v e l remain. G r u b e l (1 973, P, 354) comlaents t h a t , i n

p a r t i c u l a r :

The lower y i e l d of s e r v i c e s from money i n d u c e s reduced ho ld ings , The p u b l i c makes do v i t h less e f f i c i e n t s u b s t i t u t e s a n d moves closer t o t h e s y s t e n of b a r t e r , I n t h e p r o c e s s , some of t h e b e n e f i t s from s p e c i a l i z a t i o n i n a money economy are s a c r i f i c e d , -- -------------

4s The r e a s o n is a s f o l l o w s . P r i c e c h a n g e s o v e r time p r o v i d e a n o p p o r t u n i t y f o r i n t e r t e m p o r a l a r b i t r a g e , The b e n e f i t s o f s u c c e s s f u l a r b i t r a g e remain s o l o n g a s p r i c e s a r e less t h a n f u l l p s t a b l e . However, e f f i c i e n c y r e q u i r e s t h a t s p e c u l a t i o n be c a r r i e d o n l y t o t h e p o i n t where t h e b e n e f i t s a r e e q u a t e d a t t h e margin v i t h t h e f o r e c a s t i n g , i n v e n t o r y s t o r a g e a n d r i s k prenium c o s t s ,

G r u b e l t h e n asser ts t h a t t h e c o s t s o f p r i c e l e v e l i n s t a b i l i t y

c o n s t i t u t e a n e x t e r n a l i t y - a c o s t t o s o c i e t y which i s n o t taken

i n t o a c c o u n t i n p r i v a t e c o s t - b e n e f i t c a l c u l a t i o n s . Hence

i n t e r v e n t i o n i n f o r e i g n e x c h a n g e m a r k e t s i s j d s t i f i e d .

T h i s a r g u m e n t raises a p l e t h o r a of i s s u e s which lie a t t h e

h e a r t of monetary a n d c a p i t a l t h e o r y , The first i n v o l v e s

c o n s i d e r a t i o n of w h a t c o n s t i t u t e s t h e y i e l d of s e r v i c e s from

money, a n d w h e t h e r p r i c e f l u c t u a t i o n s d o i n fact l o v e r t h e

m a r g i n a l y i e l d a n d i n d u c e l o v e r h o l d i n g s , Host c o n t r i b u t i o n s i n

t h i s area h a v e c o n c e n t r a t e d o n t h e demand, r a t h e r t h a n t h e

s u p p l y , s i d e of t h e a a r k e t ,

The classic r e a s o n s f o r h o l d i n g money h a v e been

c h a r a c t e r i z e d a s t h e ' t r a n s a c t i o n s g a n d 'asset' m o t i v e s , T h e s e

m o t i v e s e x p l a i n , r e s p e c t i v e l y , why money r a t h e r t h a n b a r t e r is

u s e d t o c a r r y o u t t r a n s a c t i o n s a t a g i v e n p o i n t i n time, a n d why

--- money r a t h e r t h a n some i n t e r e s t - e a r n i n g asset is h e l d t o

t r a n s f e r p n r c h a s i n g power t h r o u g h time, D i f f e r e n t s t r a n d s of

monetary and c a p i t a l t h e o r y h a v e i n d i c a t e d how t h e e x i s t e n c e of

p r i c e f l u c t u a t i o n s o v e r t i m e a l ters t h e m a r g i n of c h o i c e be tween

aoney a s a s tore of w e a l t h a n d money a s a medinm of exchange ,

An a n a l y s i s of money h o l d i n g b e h a v i o n r which a t t e m p t s t o

i n t e g r a t e money's r o l e a s a medium of e x c h a n g e a n d store of

v a l u e is c o n t a i n e d i n t h e i n v e n t o r y - t h e o r e t i c mode l s of Baumol

(1952) a n d Hiller a n d O r r (1966) - 4 6 T h e i r cost m i n i m i z a t i o n ----------------- 4 6 They d e r i v e a n optimum a v e r a g e money h o l d i n g where t h e b r o k e r a g e c o s t s associa tea w i t h h o l d i n g i n t e r e s t - e a r n i n g a s se t s are b a l a n c e d a g a i n s t moneyg s o p p o r t u n i t y cos t i n terms of f o r e g o n e i n t e r e s t ,

approach l e a d s t o a n optimum a v e r a g e nominal money h o l d i n g which

w i l l i n c r e a s e wi th t h e s i z e o f v a r i a t i o n i n nominal payments

f lows, a v a r i a n c e which itself may result from f l u c t u a t i n g

p r i c e s .

On t h e o t h e r hand, r e c e n t work i n t h e t h e o r y o f

i n t e r t e m p o r a l c h o i c e under u n c e r t a i n t y , p a r t i c u l a r l y i n t h e

f i n a n c e l i t e ra ture , h a s i n v e s t i g a t e d asset p r e f e r e n c e s when

a s s e t s , i n c l u d i n g money, a r e t h e means of t r a n s f e r r i n g

p u r c h a s i n g power t h r o u g h t i l g e - 4 7 I n t h i s case, a n i n c r e a s e i n

p r i c e l e v e l v a r i a t i o n l e a d s t o a n i n c r e a s e i n t h e v a r i a n c e o f

t h e r e a l r e t u r n on money and w i l l , ceteris ~ a r i b n s , l e a d t o a

r e d u c t i o n i n t h e demand fo r t h a t a s s e t , --- T h e r e f o r e , t h e s e two t h e o r i e s , which by n o means c o v e r a l l

o f t h e s u b t l e t i e s o f mot ive b e h i n d aoney h o l d i n g , s n g g e s t t h a t

w h i l e t h e e x i s t e n c e o f p r i c e l e v e l v a r i a t i o n a l ters t h e margin

,..,..of c h o i c e be tween money i n i ts v a r i o u s roles, t h e effect on t h e

q u a n t i t y of money demanded is ambiguous, F u r t h e r a o r e , n e i t h e r

s n g g e s t s t h a t t h e e x i s t e n c e of p r i c e f l n c t u a t i o n s o v e r t i m e

imposes a n e x t e r n a l c o s t ,

However, b o t h t h e s e a p p r o a c h e s a b s t r a c t from c e r t a i n

a s p e c t s o f money h o l d i n g b e h a v i o u r which are p a r t i c u l a r l y

r e l e v a n t fo r t h e p r e s e n t purpose. f o r example, b o t h t h e f i n a n c e --------------- 4 7 When t h e p r i c e l e v e l is stable, money is a r i s k l e s s a s s e t and w i l l be h e l d i n a d i v e r s i f i e d p o r t f o l i o d e s p i t e a z e r o nominal r e t u r n , S e e Tobin (1958)- When t h e p x i c e l e v e l f l u c t u a t e s , money becomes a r i s k y a s s e t whose demand t h e n depends o n the e x t e n t t o which its r e t u r n p r o v i d e s p r o t e c t i o n a g a i n s t v a r i a t i o n i n o t h e r s e c u r i t y re turns, or a g a i n s t v a r i a t i o n i n a g g r e g a t e r e a l wea l th , See Grauer , L i t z e n b e r g e r a n d Stehle (1976).

l i t e r a t u r e a n d t h e i n v e n t o r y - t h e o r e t i c models d i s t i n g u i s h

b e t ween money and o t h e r i n t e r e s t - b e a r i n g nominal a s s e t s ,

However, n e i t h e r a p p r o a c h makes an e x p l i c i t d i s t i n c t i o n between

a s s e t s whose r e t u r n s are denominated i n nomina l terms and t h o s e

whose r e t u r n s a r e denominated i n r e a l terms. 4 8 The f a c t t h a t

t h i s is i g n o r e d c o u l d be c r u c i a l , f o r i t is a t t h i s margin of

c h o i c e t h a t p r i c e f l u c t u a t i o n s would b e e x p e c t e d - t o b i t e i n

terms of money h o l d i n g behav iour , Fur the rmore , n e i t h e r approach

t a k e s e x p l i c i t a c c o u n t o f t h e way i n which t h e u s e of money, i n

t h e words of H i r s h l e i f e r (1970,P- 134) , . , , e n l a r g e s p r o d u c t i v e and consumpt ive o p p o r t n n i t i e s by r e d u c i n g t r a n s a c t i o n s c o s t s a , i m p e r f e c t i o n s of t h e exchange p r o c e s s , from what t h e y would b e nnder b a r t e r .

K l e i n (1974a) . (1977) has n o t e d t h a t t h e s e d e f i c i e a c i e s c a n

be c o r r e c t e d b y p l a c i n g g r e a t e r e m p h a s i s on t h e money s u p p l y

p r o c e s s - o r more c o r r e c t l y , t h e p r o d u c t i o n p r o c e s s by which a

g i v e n s t o c k o f r e a l money b a l a n c e s s u p p l i e s t h e flow o f s e r v i c e s

f o r which it is h e l d , Indeed , it is c e r t a i n a s p e c t s o f t h e s e

none t a r y s e r v i c e s t o which H i r s h l e i f e r refers, Host a n a l y s i s o f

t h e demand f o r money i m p l i c i t l y a s s o n e s t h a t t h e m a r g i n a l

p r o d u c t i v i t y of monetary s e r v i c e s from a g i v e n r e a l noney s t o c k

is c o n s t a n t - K l e i n (1974a) , (1977) e x p l o r e s khe n a t u r e of

monetary e q u i l i b r i u m vhen t h e ' q u a l i t y 8 o f aoney is n o t

c o n s t a n t , b u t a t l e a s t p a r t i a l l y u n d e r t h e c o n t r o l of t h e

s u p p l i e r s of money, P r o @ t h i s a n a l y s i s , h e d e t e r m i n e s t h e n a t u r e -------------- 4 % T h i s l a t t e r d i s t i n c t i o n is c o n c e p t u a l l y p o s s i b l e i n t h e paradigm of c h o i c e nnder u n c e r t a i n t y , b u t i ts i n c l u s i o n i m p o s e s s e v e r e a n a l y t i c a l d i f f i c u l t i e s ,

of t h e c o s t a s s o c i a t e d w i t h p r i c e v a r i a b i l i t y ,

The h o l d e r s o f r e a l money b a l a n c e s demand t h e s e b e c a u s e of

the s e r v i c e s t h e y p r o v i d e , The s u p p l i e r s of money c a n meet a n

i n c r e a s e i n t h i s demand e i t h e r by s u p p l y i n g more n o m i n a l money

b a l a n c e s , whose r e a l v a l u e t h e y c a n n o t g u a r a n t e e , o r by

i n c r e a s i n g t h e q u a l i t y o f t h e e x i s t i n g s t o c k of n o m i n a l money

ba l ances .49 E q u i l i b r i u m w i l l o c c u r at b o t h a p o s i t i v e i m p l i c i t

p r i c e o f mone ta ry s e r v i c e s a n d a t a p o s i t i v e l e v e l of

e x p e n d i t u r e o n t h e q u a l i t y of money, I f money is c o ~ p e t i t i v e l y

s u p p l i e d , a d e c r e a s e i n t h e q u a l i t y of a p a r t i c u l a r s u p p l i e r ' s

money g i l l n o t c h a n g e t h e e q u i l i b r i u r a price of mone ta ry s e r v i c e s

b u t w i l l d r i v e denand f o r t h i s money t o zero-50 If money is n o t

c o m p e t i t i v e l y s u p p l i e d , a decrease i n t h e q u a l i t y of money w i l l

r a i s e t h e i m p l i c i t p r i c e of m o n e t a r y s e r v i c e s a n d l e a d t o lower

denand for r e a l money b a l a n c e s on t h i s c o u n t - However, it w i l l

a l s o i n c r e a s e t h e q u a n t i t y of r e a l b a l a n c e s r e q u i r e d t o p r o d u c e

a g i v e n s e r v i c e s t r e a n a n d i n c r e a s e t h e demand f o r r e a l money

b a l a n c e s on t h i s c o u n t , R i t h two a d d i t i o n a l a s s u m p t i o n s , s l it

c a n be shown t h a t t h e l a t t e r effect w i l l d o m i n a t e - a d e c r e a s e

i n t h e q u a l i t y of noney will l e a d t o a n i n c r e a s e i n t h e

------------------ 4 9 K l e i n (1974a) a r g u e s t h a t it is b e c a u s e d i f f e r e n t mon ies a r e d i s t i n g u i s h a b l e b y t h e i r q u a l i t y that t h e c o m p e t i t i v e s u p p l y of money would n o t l e a d to a n i n f i n i t e p r i c e l e v e l ,

s o See K l e i n (1974a) for t h e s e p o i n t s ,

5 1 These a s s u m p t i o n s are t h a t t h e demand f o r money is i n t e r e s t i n e l a s t i c , a s aost e a p i r i c a l s t u d i e s f i n d , a n d t h a t t h e flow of s e r v i c e s i s p r o p o r t i o n a l t o t h e r e a l money s t o c k , w i t h t h e c o n s t a n t of p r o p o r t i o n a l i t y b e i n g a measure of q u a l i t y ,

e q u i l i b r i u m q u a n t i t y o f r ea l money b a l a n c e s demanded-52

T h e s e c o n s i d e r a t i o n s h a v e p a r t i c u l a r r e l e v a n c e t o t h e i s s u e

o f e x c h a n g e m a r k e t i n t e r v e n t i o n . One f a c t o r which a d d s q u a l i t y

t o a g i v e n q u a n t i t y o f r e a l money b a l a n c e s i s ' p r e d i c t a b i l i t y - An

i n c r e a s e i n p r i c e v a r i a b i l i t y r e d u c e s t h e q u a l i t y o f money b y

making its f u t u r e r e a l v a l u e more u n c e r t a i n , Given t h a t money is

n o t c o m p e t i t i v e l y s u p p l i e d , b a t t h a t t h e c e n t r a l monetary

a u t h o r i t y a c t s a s t h e s o l e , o r a t l e a s t d o m i n a n t , p r o d u c e r , a n

i n c r e a s e i n p r i c e v a r i a b i l i t y c a n b e e x p e c t e d t o i n c r e a s e t h e

q u a n t i t y of r e a l money b a l a n c e s demanded.53 If o n e were t o

f o l l o w G r u b e l (1973) i n d r a w i n g welfare c o n c l u s i o n s b a s e d o n

wha t h a p p e n s t o t h e r e a l q u a n t i t y of money denanded , t h e n i t

would a p p e a r t h a t a n i n c r e a s e i n p r i c e v a r i a t i o n i n c r e a s e s

welfare. However, K l e i n ' s a n a l y s i s shows t h a t t h e s e w e l f a r e

c o n c l u s i o n s c a n b e j u s t a s m i s l e a d i n g a s t h o s e drawn by

o b s e r v i n g t h e nomina l q u a n t i t y of money-S* An i n c r e a s e i n p r i c e

v a r i a b i l i t y r e d u c e s welfare, d e s p i t e a n i n c r e a s e i n t h e q u a n t i t y

of real b a l a n c e s demanded, b e c a u s e it l e a d s t o az i n c r e a s e i n

t h e i m p l i c i t p r i c e of monetary s e r v i c e s a n d a f a l l i n t h e

consumer s u r p l u s d e r i v e d f r o m t h e m o n e t a r y s e r v i c e f low.

T h e r e f o r e , t h e a r g u m e n t d o e s u l t i m a t e l y s u p p o r t 6 r u b e l S s (1973)

p r o p o s i t i o n t h a t p r i c e v a r i a b i l i t y i m p o s e s a c o s t , ---------------- 5 2 See K l e i n (1977) f o r t h e s e p o i n t s ,

53 K l e i n (1 977) p r o v i d e s e n p i r i c a l s u p p o r t f o r t h i s p r o p o s i t i o n -

5 4 K l e i n (1977) n o t e s how t h e c o n f u s i o n be tween nomina l s t o c k s , r e a l s t o c k s a n d s e r v i c e f lows p e r s i s t s i n some o f t h e l i t e r a t u r e on t h e optimnm q u a n t i t y of money-

However, K l e i n ' s a n a l y s i s d o e s n o t s u g g e s t t h a t t h i s cost

is a n e x t e r n a l c o s t , H i s a n a l y s i s s h o w s t h a t t h e q u a l i t y of

money c a n command a p o s i t i v e i m ~ l i c i t p r i c e , T o t h e e x t e n t t h a t

a c e n t r a l monetary a u t h o r i t y c a n p r o d u c e q u a l i t y t h r o u g h

e x c h a n g e n a r k e t i n t e r v e n t i o n , e i t h e r b e c a u s e e x c h a n g e ra te

s t a b i l i z a t i o n d i r e c t l y p r o a o t e s ' m o n e t a r y c o n f i d e n c e ' o r b e c a u s e

it smoo ths p r i c e l e v e l v a r i a t i o n a n d e n h a n c e s p r e d i c t a b i l i t y , 5s

market e f f i c i e n c y r e q u i r e s t h a t s u c h a c t i v i t y be c a r r i e d o u t a t

soBe p o s i t i v e l e v e l , I f t h e r e is a n e x t e r n a l i t y o r m a r k e t

i m p e r f e c t i o n a t a l l , it lies i n t h e f a c t t h a t t h e monetary

a u t h o r i t y , as a m o n o p o l i s t i c s u p p l i e r , h a s a n i n c e n t i v e t o

a n d e r i n v e s t i n q a a l i t y . 5 6 However, t h e q u e s t i o n o f m a r k e t

i m p e r f e c t i o n s a r i s i n g from a p o s s i b l y n a t u r a l monopoly i n t h e

p r o v i s i o n of money57 c a n be s e p a r a t e d f r o n t h e j u s t i f i c a t i o n for

e x c h a n g e m a r k e t i n t e r v e n t i o n , a n a r g u m e n t which need not a p p e a l

t o marke t i m p e r f e c t i o n s a t a l l , A s K l e i n {1974a, P1 584) h i m s e l f

n o t e s ,

. -. t h e s e , , . c o n s i d e r a t i o n s a r g u e f o r f i x e d exchange rates, b a t n o t n e c e s s a r i l y f o r a d o m i n a n t money- - ---------------

5s I f e x p e c t a t i o n s a r e formed r a t i o n a l l y , t h e l a t t e r is more l i k e l y t o be t h e case,

5 6 One r e a s o n f o r t h i s is t h a t a n i n c r e a s e i n in•’ l a t i o n , t o t h e e x t e n t t h a t i t r e d u c e s f u t u r e p r i c e p r e d i c t a b i l i t y a n d i n c r e a s e s t h e q u a n t i t y of money demanded, t h e r e b y i n c r e a s e s t h e t a x base f r o m which t h e g o v e r n m e n t ' s i n f l a t i o n t a x is drawn,

57 K l e i n (1974a) a t t r i b u t e s t h e n a t u r a l n e s s of t h e monopoly t o t h e d i a i n i s h i n g m a r g i n a l c o s t of p r o v i d i n g n o n e t a r y c o n f i d e n c e , a s t h e optimum c u r r e n c y area a r g u m e n t s u g g e s t s , and t o t h e e x t r e m e l y h i g h cost of s w i t c h i n g t o a n a l t e r n a t i v e dominan t money, as i n d i c a t e d b y t h e c o n t i n u e d u s e o f e s t a b l i s h e d Boney d u r i n g many h y p e r i n f l a t i o n s ,

I n s h o r t , m a r k e t e f f i c i e n c y r e q u i r e s some e x p e n d i t u r e on t h e

p r o d u c t i o n of q u a l i t y , o r i n v e s t m e n t i n ' b r a n d name c a p i t a l ' ,

i r r e s p e c t i v e of w h e t h e r money is s u p p l i e d c o a p e t i t i v e l y o r

m o n o p o l i s t i c a l ly, I n a n o p e n economy c o n t e x t , & t h i s i m p l i e s t h a t

t h e c o s t of h o l d i n g i n t e r n a t i o n a l r e s e r v e s s h o u l d b e i n c u r r e d in

o r d e r t o u s e them f o r e x c h a n g e r a t e s t a b i l i z a t i o n pu rposes ,

N e v e r t h e l e s s , t h i s d o e s n o t n e c e s s a r i l y a r g u e f o r

a b s o l u t e l y a n d p e r m a n e n t l y f i x e d e x c h a n g e rates, The f e a t u r e

which is c r u c i a l t o t h e q u a l i t y of money is its p r e d i c t a b i l i t y ,

A s K l e i n (1974a) n o t e s , p r e d i c t a b i l i t y may be f a c i l i t a t e d a s

much by a c o n s t a n t r a t e o f d e p r e c i a t i o n of t h e e x c h a n g e r a t e o r

i n f l a t i o n of t h e p r i c e l e v e l a s b y a c o n s t a n t e x c h a n g e r a t e or

p r i c e l e v e 1 , s s I n d e e d , t h e e x p e r i e n c e u n d e r t h e B r e t t o n Hoods

- s y s t e m s u g g e s t s t h a t e x c h a n g e ra te movements a re r e q u i r e d i f

r e s e r v e s are n o t t o be e x h a u s t e d , T h e r e f o r e , t h e a rgumen t is o n e

f o r a n e x c h a n g e r a t e r e g i m e of t h e t y p e t h a t p roved s o e l u s i v e

i n t h e 1960s a n d e a r l y 1 9 7 0 s - o n e which c a n srnooth e x c h a n g e

r a t e a n d p r i c e f l u c t u a t i o n s w i t h o u t p r e j u d g i n g l e v e l s , I n d e e d ,

t h i s w i l l b e t h e f o c u s of t h e r e m a i n i n g c h a p t e r s , Does s u c h a n

e x c h a n g e r a t e r e g i m e e x i s t ?

To summar ize , t h e e c o n o m i c a r g u m e n t f o r f u l l y f l e x i b l e

exchange r a t e s is s t r o n g , S t s s t r e n g t h d e r i v e s from i ts bas is i n

c o n s i d e r a t i o n s o f e f f i c i e n c y , c o n s i d e r a t i o n s which l i e a t t h e

h e a r t o f economic t h e o r y , B y c o n t r a s t , many a r g u m e n t s f o r ------------------ s a A r e g i m e which allows e x c h a n g e rate o r p r i c e t r e n d s a l s o a l l o w s t h e p r i c e mechanism t o p e r f o r m i ts s i g n a l l i n g f u n c t i o n , a n a s p e c t of ' e f f i c i e n t ' r e g i m e s f o r which Corden (1981) a r g u e s -

i n t e r v e n t i o n i n f o r e i g n e x c h a n g e m a r k e t s h a v e been b a s e d o n t h e

e x i s t e n c e of some m a r k e t i m p e r f e c t i o n , R e c e n t t h e o r e t i c a l

a n a l y s i s h a s r e a f f i r m e d t h e i m p o r t a n c e of i n s t a b i l i t y ,

o v e r s h o o t i n g a n d * d i s o r d e r l y m a r k e t c o n d i t i o n s ' w i t h f r e e l y

f l o a t i n g e x c h a n g e r a t e s , T o t h e e x t e n t t h a t t h i s i m p o s e s a

s o c i a l c o s t i n terms o f v a r i a t i o n s i n employment o r c o n s u m p t i o n

l e v e l s , t h e f irst b e s t s o l u t i o n is t h e r e m o v a l of t h e u n d e r l y i n g

m a r k e t i m p e r f e c t i o n s ,

However, t o t h e e x t e n t t h a t e x c h a n g e r a t e v a r i a t i o n s i n d u c e

price l e v e l v a r i a t i o n s t h a t a f f e c t t h e q u a l i t y o r ' n s e f u l n e s s *

of money, e f f i c i e n c y demands some e x p e n d i t u r e by t h e s u p p l i e r ( s )

of money on q u a l i t y - p r o d u c i n g a c t i v i t y , I n t e r v e n t i o n i n f o r e i g n

e x c h a n g e m a r k e t s which r e d u c e s p r i c e v a r i a t i o n or i n c r e a s e s

p r i c e p r e d i c t a b i l i t y is t h e r e f o r e j u s t i f i e d b e c a u s e it e n s u r e s

e f f i c i e n c y a t a m a r g i n i g n o r e d b y t h e p r o p o n e n t s of f r e e l y

f l o a t i n g e x c h a n g e r a t e s - t h e demand f o r and s u p p l y of money,

T h e r e f o r e , s u b s e q u e n t c h a p t e r s t a k e t h e m i n i m i z a t i o n of e x c h a n g e

r a t e and p r i c e v a r i a t i o n a s t h e a p p r o p r i a t e o b j e c t i v e of

e x c h a n g e m a r k e t i n t e r v e n t i o n ,

111, OPTIMAL EXCHANGE MARKET IPTEBBElTIOI

C o n s i d e r t h e f o l l o w i n g problem, A c o u n t r y h a s a f i x e d s t o c k

of f o r e i g n e x c h a n g e r e s e r v e s . I n t h e a b s e n c e of exogenous

s h o c k s , t h e e x c h a n g e r a t e i n t h a t c o u n t r y would be c o n s t a n t a t

some l e v e l , I n t h e face of e x o g e n o u s s h o c k s , b u t i n t h e a b s e n c e

of i n t e r v e n t i o n , t h e e x c h a n g e r a t e would f l u c t u a t e a r o u n d t h a t

l e v e l , The f o r e i g n e x c h a n g e a u t h o r i t y w i s h e s t o m i n i m i z e

v a r i a t i o n i n t h e e x c h a n g e r a t e , l b u t c a n n o t f i x t h e r a t e

c o m p l e t e l y b e c a u s e t h e r e are l i m i t s t o t h e amount of r e s e r v e s

t h a t t h e c o u n t r y c a n h o l d , If o f f i c i a l i n t e r n a t i o n a l b o r r o w i n g

is r u l e d o u t , t h e n r e s e r v e s c a n n o t b e n e g a t i v e , An u p p e r l i m i t

i s set where t h e c o u n t r y h a s a c c u r n u l a t e d a l l t h e r e s e r v e s i n t h e

world, a l t h o u g h c l e a r l y . s u c h s t r o n g economic a n d p o l i t i c a l

p r e s s u r e wonld b e b r o u g h t t o b e a r i n t h i s s i t o a t i o n t h a t t h e

e f f e c t i v e u p p e r bound c o u l d b e much lower, Given t h a t r e s e r v e

l e v e l s c a n n o t move i n a c o m p l e t e l y u n r e s t r i c t e d way, v h a t

r e s e r v e management role s h o u l d t h e a u t h o r i t y follow so as t o

min imize t h e v a r i a t i o n i n t h e e x c h a n g e r a t e ?

A t t h i s s t a g e it is u s e f u l t o draw a n a n a l o g y . T h i s p r o b l e ~ t l

of r e s e r v e management is sisnilar t o t h e p r o b l e a o f h y d r o e l e c t r i c

power g e n e r a t i o n , C o n s i d e r a h y d r o dam which h a s b e h i n d it a

l a k e o r r e s e r v o i r of a f i x e d s i z e a n d fed b y a r i v e r , I f t h e dam ----------- ----- 1 When s a n a g e d f l o a t i n g is used i n a n n - c o u n t r y wor ld t o smoo th . e a c h c o u n t r y ' s p r i c e l e v e l , n-1 c o u n t r i e s can do t h i s i n d i r e c t l y by s t a b i l i z i n g t h e i r e x c h a n g e rates, The n t h c o u n t r y n u s t s t a b i l i z e its p r i c e l e v e l d i r e c t l y ,

h a s no s p i l l w a y , t h e n t h e o n l y o u t l e t f o r t h e water f l o w i n g i n t o

t h e r e s e r v o i r is t h r o u g h t h e t u r b i n e s , Suppose t h a t t h e power

a u t h o r i t y w i s h e s t o minimize v a r i a t i o n i n e l e c t r i c i t y s u p p l y , I•’

t h e ra te of flow of t h e r i v e r i s c o n s t a n t , t h e a u t h o r i t y c a n

s i m p l y match t h e r a t e of f l o w t h r o u g h t h e t u r b i n e s , a n d h e n c e

t h e s u p p l y , t o t h e r a t e o f flow i n t o t h e r e s e r v o i r , By

e l e m e n t a r y p h y s i c s , t h e l e v e l o f w a t e r i n t h e r e s e r v o i r would

a l s o be c o n s t a n t . However, s u p p o s e t h a t t h e r e is a random

component t o t h e i n f l o w owing t o random r a i n f a l l i n t h e

c a t c h m e n t area. The a u t h o r i t y c a n a b s o r b t h e random component o f

t h e i n f l o w b y a l l o w i n g t h e l e v e l o f t h e r e s e r v o i r t o vary, w h i l e

m a i n t a i n i n g a c o n s t a n t rate of e l e c t r i c i t y g e n e r a t i o n . However,

it c a n o n l y d o s o a s l o n g a s t h e l e v e l of t h e r e s e r v o i r s t a y s

w i t h i n its laaxiaum a n d minimum l e v e l s , d e t e r m i n e d by t h e f l o o r

of t h e r e s e r v o i r a n d t h e h e i g h t of t h e dam, O t h e r w i s e i t must

i n c r e a s e o r d e c r e a s e t h e rate of flow t h r o n g h t h e t u r b i n e s , The

problem i s o n e of d e t e r m i n i n g t h e o p t i m a l managelaent of t h e

r e s e r v o i r l e v e l .

Both p r o b l e a s a r e i n v e n t o r y management problems. C l e a r l y ,

b o t h have a dynamic a s p e c t - It would be feasible t o a l l o w t h e

r e s e r v e / r e s e r v o i r l e v e l t o v a r y s o a s t o f u l l y o f f s e t a l l random

s h o c k s u n t i l the r e s e r v e / r e s e r v o i r l i m i t s a r e r e a c h e d , However,

t h e r e is n o g u a r a n t e e t h a t w h i l e t h e e x c h a n g e r a t e / e l e c t r i c i t y

s u p p l y is t h e n a l l o w e d t o a d j u s t , s u b s e q u e n t s h o c k s w i l l

i m m e d i a t e l y r e t u r n r e s e r v e s / t h e r e s e r v o i r t o more n o r m a l l e v e l s .

Thus i t may be b e t t e r t o allow a smaller a d j u s t m e n t i n t h e

e x c h a n g e r a t e / e l e c t r i c i t y s u p p l y a t a n earl ier s t a g e a n d s o

a v o i d p r o l o n g e d f l u c t u a t i o n s i n t h e e x c h a n g e r a t e / e l e c t r i c i t y

s u p p l y l a t e r .

The f o l l o w i n g model of r e s e r v e management r e c o g n i s e s t h e

dynamic a s p e c t of t h e problem a n d t h u s y i e l d s a n o p t i m a l r e s e r v e

management p o l i c y which l e a n s a g a i n s t t h e wind i n t h i s f a s h i o n ,

F u r t h e r m o r e , t h e s ize of t h e e x c h a n g e r a t e a d j u s t m e n t which is

p e r m i t t e d i n c r e a s e s a s r e s e r v e s a p p r o a c h t h e i r l i m i t s ,

B Simple R o d e l of R e s e r v e Banaqement - -- T h e a o d e l b e g i n s v i t h a n a s s u m p t i o n a b o u t t h e s t r u c t u r e of

t h e e x o g e n o u s s h o c k s , Suppose t h a t t h e s e are s u c h t h a t , u n d e r a

f i x e d e x c h a n g e r a t e reg ime, r e s e r v e s would f o l l o v a random

walk.2 From o n e p e r i o d t o t h e n e x t , t h e y would e i t h e r i n c r e a s e

by an amount $M, s a y , w i t h p r o b a b i l i t y p o r d e c r e a s e by $B v i t h

p r o b a b i l i t y (1-p) - 3 A t t h i s l e v e l o f a b s t r a c t i o n , i t is a l s o

assumed t h a t t h e f i x e d e x c h a n g e ra te is se t a t i ts scorrectg \

pe rmanen t or e q n i l i b r i u m l e v e l , I n terms of t h e h y d r o a n a l o g y ,

t h i s means t h a t t h e rate of e l e c t r i c i t y g e n e r a t i o n matches t h e

a v e r a g e r a t e of water i n f l o w . The model c o n s i d e r s o n l y t h a t ----------------- 2 T h i s a s s u m p t i o n was used by Miller a n d O r r (1966) i n t h e i r i n v e n t o r y - t h e o r e t i c model of t h e demand f o r money by firms, The s u b s e q u e n t d e s c r i p t i o n of r e s e r v e b e h a v i o u r cf o s e l y f o l l o w s t h e i r a p p r o a c h , a l t h o u g h t h e o p t i m i z a t i o n problem d i f f e r s ,

3 The random v a l k a s s u m p t i o n shows i n t h e s t r o n g e s t way p o s s i b l e t h a t r a n d o m n e s s of d i s t u r b a n c e s i s c o n s i s t e n t w i t h c u m u l a t i v e change, Even when t h e random v a l k is driftless, so t h a t p=1/2, t h e v a r i a n c e of r e s e r v e l e v e l s t e n d s t o i n f i n i t y , The f o l l o w i n g a n a l y s i s c a n be e a s i l y g e n e r a l i z e d s o t h a t e a c h t r i a l o c c u r s w i t h i n some f r a c t i o n ( l /k ) of a p e r i o d ,

random v a r i a t i o n i n r e s e r v e l e v e l s w h i c h arises from random

s h o c k s whose i m p a c t i s o v e r a n d a b o v e t h e s y s t e m a t i c f o r c e s

which would d e t e r m i n e what t h e e q u i l i b r i u m exchange r a t e would

be, 4 T h e r e f o r e , it is assumed t h a t t h e s h o c k s t h e m s e l v e s h a v e n o

s y s t e m a t i c effect on r e s e r v e l e v e l s i n t h e s e n s e t h a t , from o n e

p e r i o d t o t h e n e x t , r e s e r v e s e i t h e r i n c r e a s e or d e c r e a s e w i t h

e q u a l p r o b a b i l i t y , I n what follows, it is t h e r e f o r e assumed t h a t

p = (1-p) = 1/2,

T h e r e f o r e , t h e s t a r t i n g p o i n t is t h i s r e s e r v e b e h a v i o n r

u n d e r a f i x e d e x c h a n g e r a t e r e g i m e - t h a t is, a d r i f t l e s s random

walk w i t h s t e p s i z e $PI, One i m p l i c a t i o n of s u c h b e h a v i o u r is

t h a t r e s e r v e d e p l e t i o n o r e x c e s s i v e a c c u m u l a t i o n is a n e v e n t u a l

c e r t a i n t y . 5 However, b y c h o o s i n g a s m a l l e r s t e p size IU, i n t h e

saBe d i r e c t i o n as H, t h e f o r e i g n e x c h a n g e a u t h o r i t y c a n e x e r c i s e

c o n t r o l o v e r r e s e r v e ~ o v e m e n t s a n d c a n t h e r e b y a v o i d t h e

p o s s i b i l i t y o f r e s e r v e d e p l e t i o n or e x c e s s i v e a c c u m u l a t i o n , I n

t h i s case, by d e f i n i t i o n , t h e e x c h a n g e rate c a n no l o n g e r r e m a i n

f i x e d a t its @correcte e q u i l i b r i n m l e v e l , However, i t is

a s s u n e d , f i r s t l y , t h a t t h e e x c h a n g e ra te w i l l now v a r y a round

its p e r m a n e n t o r e q u i l i b r i u m v a l u e , a n d s e c o n d l y , t h a t t h i s

e x c h a n g e r a t e v a r i a t i o n a r o u n d i t s p e r m a n e n t r a t e w i l l be

s n a l l e r , t h e closer is m t o K,

----------------- 4 The n e x t s e c t i o n c o n s i d e r s ~ h a t t h o s e s y s t e m a t i c f o r c e s m i g h t be by d e v e l o p i n g a s i m p l e model of e x c h a n g e rate d e t e r r a i n a t i o n - The t h i r a s e c t i o n c o n s i d e r s t h e i m p l i c a t i o n of i n t r o d u c i n g e x c h a n g e ra te e x p e c t a t i o n s i n t o t h i s model-

s S e e f o o t n o t e 3 i n t h i s c h a p t e r .

T h e r e f o r e , t h i s s e c t i o n e x a m i n e s o n l y t h e r e s e r v e

management a s p e c t of t h e o p t i m a l i n t e r v e n t i o n problem, The

i m p l i c a t i o n s of t h e c h o i c e of m f o r a c t u a l e x c h a n g e r a t e

b e h a v i o u r are examined more c l o s e l y i n l a t e r s e c t i o n s , where a n

e x p l i c i t model of exchange r a te d e t e r m i n a t i o n is i n t r o d u c e d ,

However, a r e s u l t which c a n be d e r i v e d from a l m o s t any model of

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 is t h a t , when r e se rv . e c h a n g e s are

s m a l l e r t h a n , b u t i n t h e same d i r e c t i o n as, t h o s e r e q u i r e d t o

f i x t h e e x c h a n g e r a t e c o m p l e t e l y , t h e n t h e e x c h a n g e r a t e u i l l

a d j u s t by a n amount t h a t is s m a l l e r t h a n , b n t i n t h e same

d i r e c t i o n a s , t h e a d j u s t m e n t i n a f r e e l y f l o a t i n g rate, It is

t h e r e f o r e a s s u ~ e d , i n t h i s s e c t i o n , t h a t e x c h a n g e r a t e v a r i a t i o n

c a n be m i n i n i z e d by ' l e a n i n g ' as s t r o n g l y ' a g a i n s t t h e wind' a s

r e s e r v e l e v e l s w i l l allow, The p rob lem of min imiz ing e x c h a n g e

r a t e v a r i a t i o n is s i m p l y t a k e n t o b e making m a s close t o M a s

p o s s i b l e , w h i l e t h e r e s e r v e management a s p e c t i m p o s e s t h e

c o n s t r a i n t t h a t r e s e r v e l e v e l s c a n n o t , now o r i n t h e f u t u r e ,

move o u t s i d e of c e r t a i n l i m i t s , T o r e t u r n t o t h e h y d r o a n a l o g y ,

t h e p rob lem i n this s e c t i o n i s t a k e n t o be d e t e r m i n i n g t h e

p e r i o d - b y - p e r i o d c h a n g e i n r e s e r v o i r l e v e l s t h a t would absorb as

much of t h e r a n d o n component of r a i n f a l l a s p o s s i b l e , s u b j e c t t o

t h e c o n s t r a i n t t h a t t h e r e s e r v o i r l e v e l c a n n e v e r go beyond t h e

p h y s i c a l l i m i t s o f r e s e r v o i r c a p a c i t y ,

A t t h i s s t a g e a d i s t i n c t i o n is drawn be tween r e s e r v e

management a n d hydro management, The i n f o r m a t i o n a v a i l a b l e t o

t h e f o r e i g n e x c h a n g e a u t h o r i t y r e g a r d i n g t h e n a t u r e of t h e

random e x o g e n o u s s h o c k s is less t h a n t h e i n f o r m a t i o n a v a i l a b l e

t o t h e power a u t h o r i t y r e g a r d i n g r a i n f a l l . It h a s been a r g u e d s o

f a r t h a t t h e o b j e c t i v e of p o l i c y is t o make r e s e r v e / r e s e r v o i r

c h a n g e s a s close a s p o s s i b l e t o t h o s e c h a n g e s 'which would o c c u r

w i t h c o m p l e t e i n t e r v e n t i o n . T h e q u e s t i o n h e r e is w h e t h e r t h e

a u t h o r i t i e s know a h e a d of time what t h a t f u l l - i n t e r v e n t i o n

change would be, A h y d r o a u t h o r i t y c a n o b t a i n al.most immediate

r e p o r t s , o r a t l ea s t f a i r l y a c c u r a t e s h o r t term f o r e c a s t s , on

t h e s i z e a n d d u r a t i o n of t h e s i n g l e d i s t u r b a n c e i t faces - r a i n f a l l v a r i a t i o n i n t h e c a t c h m e n t area, The f o r e i g n e x c h a n g e

a u t h o r i t y , by c o n t r a s t , faces s h o c k s f r o m a number of d i f f e r e n t

s o u r c e s , Even w i t h knowledge of t h o s e s h o c k s , t h e a u t h o r i t y may

n o t be a b l e t o a n t i c i p a t e t h e effect t h e y v o u l d have on r e s e r v e s

u n d e r a f i x e d e x c h a n g e r a t e r e g i m e , If t h e a u t h o r i t y c o u l d

a l w a y s know wha t t h a t c h a n g e would b e , i t c o u l d u s e t h a t

i n f o r m a t i o n when s e t t i n g i ts o p t i r a l management r u l e , W i t h o u t

t h i s knowledge, t h e b e s t i t c a n d o is t o c a l c u l a t e some maximum

d e s i r e d r e s e r v e c h a n g e e x a n t e , t h e n w a i t t o see w h e t h e r t h i s

change is s u f f i c i e n t t o f i x t h e e x c h a n g e r a t e ex p o s t , or

whe the r i t l e a n s a g a i n s t t h e wind,=

The l i a i t a t i o n on r e s e r v e l e v e l s p l a c e s a c o n s t r a i n t o n t h e

c h o i c e of t h e r e s e r v e c h a n g e m, T h e r e i s a c r i t i c a l l o v e r bound

on r e s e r v e s , namely zero, a n d some cr i t ica l u p p e r bound $h,

u h i c h d e f i n e a c o u n t r y ' s * r u i n 8 , The d u r a t i o n {in p e r i o d s ) of a ----------------- 6 Forma l ly , t h i s n e a n s t h a t t h e e x a n t e o p t i m a l s t e p s ize m is n o t a f u n c t i o n of #, b u t t h a t e x p o s t , t h e r e s e r v e c h a n g e w i l l b e t h e s i a a l l e r of m a n d fl,

random w a l k which s t a r t s f r o m a n i n i t i a l o r t a r g e t r e s e r v e l e v e l

$2, t a k e s s t e p s izes $la e a c h p e r i o d , a n d t e r m i n a t e s a t e i t h e r $h

or z e r o is a random v a r i a b l e whose e x p e c t a t i o n i s g i v e n by:'

ED = z(h-z)/rnz (1)

The a u t h o r i t y ' s p rob lem is t o make t h e c u r r e n t r e s e r v e c h a n g e o r

s t e p s i z e m as l a r g e a s p o s s i b l e , s u b j e c t t o t h e c o n s t r a i n t t h a t

t h i s s t e p s ize , were it t o c o n t i n u e i n f u t u r e p e r i o d s , l e a d t o a

random walk whose e x p e c t e d d u r a t i o n is a t least a s l o n g a s t h e

a u t h o r i t y ' s own p l a n n i n g h o r i z o n H. By s o l v i n g t h e c o n s t r a i n t

for a, t h e maximum p e r m i s s i b l e s t e p s i z e i n t h e c u r r e n t p e r i o d

is g i v e n by:*

m = [z(h-z) /H]dz ( 2 )

However, i f t h e p r o s p e c t of r u i n i s t o be a v o i d e d , t h e n

c l e a r l y t h i s s t e p s ize c a n n o t c o n t i n u e i n f u t u r e p e r i o d s , One

way t o v iew t h e problem i s t o n o t e t h a t a t t h e b e g i n n i n g of t h e

n e x t p e r i o d , t h e a u t h o r i t y w i l l h a v e a s its s t a r t i n g p o i n t a n

i n i t i a l r e s e r v e l e v e l which h a s moved away from z and t o w a r d s

o n e o f t h e cr i t ical l e v e l s by a n amount ml, where m 1 is t h e

c u r r e n t p e r ~ i s s i b l e r e s e r v e c h a n g e , If t h e a u t h o r i t y is t h e n t o

c h o o s e a new r e s e r v e c h a n g e m2 s u c h t h a t , i f m2 were t o c o n t i n u e

---------------- 7 T h i s f o r m u l a is a p p r o p r i a t e o n l y f o r t h e case where p=1/2, a s was assumed above , See Feller (1957,pp,348-9) f o r a p r o o f of t h e r e s u l t .

8 T h i s f o r a u l a a s s u m e s t h a t s h o c k s h i t , a n d i n t e r v e n t i o n o c c u r s , o n c e p e r p e r i o d , When s h o c k s h i t a n d i n t e r v e n t i o n o c c u r s k times p e r p e r i o d , t h e d e n o m i n a t o r becomes Bk i n s t e a d of H, Thus t h e d e s i r e d s t e p s i ze d e p e n d s o n l y on t h e number o f s h o c k s t h a t h i t d u r i n g t h e p l a n n i n g h o r i z o n , a n d i s n o t s e n s i t i v e t o how a ' p e r i o d s is d e f i n e d ,

i n f u t u r e p e r i o d s , it would l e a d t o a random

d u r a t i o n is a l s o a t l e a s t a s l o n g a s H, t h e n

t h a n ml i n s i t u a t i o n s where t h e new s t a r t i n g

walk whose e x p e c t e d

m2 will be s m a l l e r

p o i n t i s c l o s e r t o

one o f t h e b a r r i e r s t h a n t h e o l d s t a r t i n g p o i r t t z, T h i s

a s sumpt ion a b o u t f o r e i g n exchange a u t h o r i t 1 behav iour i m p l i e s

t h a t t h e a u t h o r i t y r e c o g n i s e s t h e a y n a a i c a s p e c t o f its r e s e r v e

management problem by employing p i e c e v i s e s t a t i c . o p t i m i z a t i o n , 9

It l e a d s t o a r e s e r v e management r u l e whereby t h e c u r r e n t

r e s e r v e c h a n g e depends on how c l o s e t h e p r e v i o u s p e r i o d ' s

r e s e r v e l e v e l is t o t h e b a r r i e r s , 10

A similar a p p r o a c h is t o view t h e c u r r e n t r e s e r v e change a s

b e i n g dependen t on, n o t how c l o s e r e s e r v e s are t o t h e b a r r i e r s ,

b a t how f a r t h e y a re from t h e i n i t i a l s t a r t i n g p o i n t 2.. C o n s i d e r

a g a i n t h e a u t h o r i t y ' s s t r a t e g y i n t h e second p e r i o d , Suppose it

were t o c h o o s e t h e maximum a l l o w a b l e r e s e r v e change in2 such

t h a t , had m2 begun i n t h e first p e r i o d and c o n t i n u e d i n t o t h e

f u t u r e , i t would l e a d t o a random walk whose e x p e c t e d d u r a t i o n

is a t l e a s t a s l o n g a s 8+1 when measured from t h e first p e r i o d ,

o r H when measured from the c u r r e n t p e r i o d , T h i s second view o f

f o r e i g n exchange a u t h o r i t y b e h a v i o u r a g a i n c o r r e s p o n d s t o

p i e c e w i s e s t a t i c o p t i m i z a t i o n , Hovever, i t is n o t e x a c t l y ------------we---

9 T h e o p t i m a l c o n t r o l f o r m u l a t i o n p r o v e s t o be d i f f i c u l t t o s o l v e a n a l y t i c a l l y , s i n c e i t i n v o l v e s Knhn-Tocker c o n d i t i o n s . However, it c a n b e a rgued t h a t , i n p r a c t i c a l terms, t h e in fo rma t i o n r e q u i r e d t o implement a fully dy nalsic o p t i m a l c o n t r o l s o l u t i o n woula f a r exceed t h a t a v a i l a b l e t o a f o r e i g n exchange a u t h o r i t y -

10 The ' o p t i m a l 1 r e s e r v e change would t h e n be g i v e n by a = [ R(t-1) [ h-3 ( t -1) 3 / 3 ] N 2 r

e q u i v a l e n t t o t h e first view, s i n c e t h e f i r s t p e r i o d ' s r e s e r v e

c h a n g e w i l l a c t u a l l y h a v e b e e n ml, n o t m2, I n t h i s s e n s e , t h i s

s e c o n d a p p r o a c h b e g i n s by i g n o r i n g t h e p a s t h i s t o r y of r e s e r v e

c h a n g e s a n d t h u s w i l l n o t a b s o l u t e l y r u l e o u t ' r e s e r v e d e p l e t i o n

u n l e s s some c u t o f f is i ~ p o s e d t o e n s u r e m=O o n c e t h e B o u n d a r i e s

a r e r e a c h e d , The i s s u e of c u t o f f is d i s c u s s e d f u r t h e r i n

Appendix I, w h e r e i t is shown t h a t o n c e s u c h c u t o f f is imposed,

t h e two a p p r o a c h e s do y i e l d s imi la r r e s u l t s , And w h i l e t h e

s e c o n d a p p r o a c h may seem more aukward t h a n t h e first, i t w i l l b e

s e e n t h a t b e c a u s e it i n i t i a l l y makes t h e #timeg a s p e c t of t h e

problem e x p l i c i t , it a l l o w s t h e g e n e r a l i z a t i o n of t h e r u l e which

is i n t r o d u c e d i n t h e s e c o n d s e c t i o n of t h i s c h a p t e r .

Us ing t h i s s e c o n d a p p r o a c h , t h e ' o p t i m a l ' r e s e r v e

management r u l e a p p e a r s t o depend on time:

m (t) = [ 2 (h-z)/ (H+t) ].rl2 (3)

Houever, what is c r u c i a l i s n o t t h e p a s s a g e o f time d i r e c t l y ,

b u t t h a t as more t i ~ e p a s s e s , t h e f u r t h e r r e s e r v e s c a n

c o n c e i v a b l y h a v e wa lked away f rom t h e i r i n i t i a l l e v e l z a n d

t o w a r d s t h e c r i t i ca l l e v e l s h or zero, To state t h i s p o i n t

a n o t h e r vay , i f r e s e r v e s happen t o h a v e wa lked back t o t h e i r

i n i t i a l l e v e l z, t c a n b e reset t o zero a n d t h e whole p r o c e s s

s t a r t e d anew.11 T h e r e f o r e , what matters is n o t r e a l t i m e , b u t

t h e minimum t i m e r e q u i r e d t o a c h i e v e a n y p a r t i c u l a r s i z e d

d e v i a t i o n i n r e s e r v e s from t a r g e t , T h i s is how t h e time v a r i a b l e

--------------- 11 F e l l e r (1957,P- 86-88) h a s a n i n t e r e s t i n g example of t h e s e n s i t i v i t y of random ~ a l k b e h a v i o u r t o t h e p o i n t c h o s e n a s t = O ,

t w i l l be i n t e r p r e t e d i n t h i s s e c t i o n , 1 2

I f a r e l a t i o n s h i p c o n l d be o b t a i n e d be tween any p a r t i c u l a r

d e v i a t i o n f R ( t -1) -zl i n r e s e r v e s B from t a r g e t , a n d t h e minimum

t i m e t r e q u i r e d t o a c h i e v e t h a t d e v i a t i o n , t h e n t h e a b o v e

r e s e r v e management r u l e c o n l d be r e s t a t e d i n t e r n s o f d e v i a t i o n s

- t h a t is, i n terms of how f a r r e s e r v e s a re from t h e i r i n i t i a l

o r t a r g e t l e v e l z. Such a r e l a t i o n s h i p c a n b e o b t a i n e d by n o t i n g

t h a t t h e m a g n i t u d e of t h e c u r r e n t d e v i a t i o n from t a r g e t is j u s t

t h e sum of p a s t r e s e r v e c h a n g e s ~ ( t ) , where t h e s e c h a n g e s i n

t a r n depend o n time-13 The d e r i v a t i o n of t h i s r e l a t i o n s h i p

be tween time a n d d e v i a t i o n s is g i v e n i n Appendix I, where i t is

t h e n s u b s t i t u t e d i n t o t h e a b o v e e x p r e s s i o n f o r m ( t ) - A c u t o f f is

t h e n i n p o s e d t o e n s u r e m=O o n c e t h e b o u n d a r i e s a r e r e a c h e d , and

t h e r e s e r v e management r u l e c a n t h e n b e e x p r e s s e d i n t h e

a p p r o x i m a t e l y l i n e a r form:

m* = - where A =

c h a n g e m*

t h i s a p p r o a c h l e a d s t o an o p t i m a l d e s i r e d r e s e r v e

wh ich d e p e n d s on how f a r r e s e r v e s are from t h e i r

i n i t i a l o r t a r g e t l e v e l . F u r t h e r m o r e , t h e larger t h e c u r r e n t

d e v i a t i o n , t h e smaller t h e c u r r e n t d e s i r e d r e s e r v e c h a n g e so t h e

more a c u r r e n t s h o c k n u s t b e a b s o r b e d b y e x c h a n g e r a t e r a t h e r -------------- 1 2 The n e x t s e c t i o n e x a m i n e s a s e c o n d s e n s e i n which time m a t t e r s -

8 3 F u r t h e r m o r e , 8 m i n i r t l u ~ times i m p l i e s t h a t a l l p a s t r e s e r v e c h a n g e s must h a v e b e e n i n t h e same d i r e c t i o n , so t h e r e is no a m b i g u i t y a b o u t t h e d i r e c t i o n of s u c c e s s i v e s t e p s i zes m,

t h a n r e s e r v e c h a n g e s , l 4 Thus t h e r u l e s p e c i f i e s t h a t t h e

s t r e n g t h of i n t e r v e n t i o n t o resist e x c h a n g e r a t e movement s h o u l d

d e c r e a s e , t h e f u r t h e r r e s e r v e s h a v e moved away f rom t a r g e t ,

D u r i n g t h e time of t h e B r e t t a n Voods breakdown, n a r s h

(1970) p u t f o r w a r d a p r o p o s a l f o r reform which i n v o l v e d a

r e v e r s a l of t h e B r e t t o n Roods s y s t e m , H e s u g g e s t e d t h a t r e s e r v e

l e v e l s , r a t h e r t h a n exchange r a t e l e v e l s , be r e s t r i c t e d t o l i e

w i t h i n a n a r r o w band a r o u n d p a r i t y - 1 s The r e s e r v e management

p o l i c y j u s t d e v e l o p e d is p e r h a p s c losest t o a r e v e r s a l o f , t h e

band-and-crawl p r o p o s a l s which seemed t o g a i n w i d e s t a c c e p t a n c e

a t t h e time.16 T h e s e p r o p o s a l s r e q u i r e d t h e exchange r a t e t o b e

k e p t v i t h i n a band a round a n a d j u s t a b l e p a r i t y , w i t h v a r i o u s

r u l e s b e i n g s u g g e s t e d t o g o v e r n how t h e p a r i t y s h o u l d move, The

problem w i t h s u c h p r o p o s a l s f o r e x c h a n q e rate management i s t h a t 7-

i f t h e i m p l i e d c o n s t r a i n t o n e x c h a n g e r a t e f l e x i b i l i t y is

b i n d i n g a t a l l , t h e n r e s e r v e l e v e l s m u s t a b s o r b w h a t e v e r

a d d i t i o n a l i n c i p i e n t exchange r a t e p r e s s u r e arises- Such

p r o p o s a l s d i c t a t e when t h e f o r e i g n e x c h a n g e a u t h o r i t y s h o u l d

e n t e r t h e m a r k e t , b u t once i n , t h e a u t h o r i t y iaust face t h a t

p r e s s u r e , e v e n t o t h e p o i n t of r u i n , By c o n t r a s t , t h e r e s e r v e

nanagement r u l e of t h i s s e c t i o n r e q u i r e s r e s e r v e s t o b e k e p t

----------------- 1 4 The p a r t i a l d e r i v a t i v e of a* w i t h r e s p e c t t o J R ( t - I ) - z J is n e g a t i v e .

1s I n d e e d , h e a r g u e d t h a t s u c h a f e a t u r e was a n e c e s s a r y a n d s u f f i c i e n t c o n d i t i o n for s t a b i l i t y i n t h e i n t e r n a t i o n a l mone ta ry system.

16 See, f o r e x a m p l e , J o h n s o n (1970) a n d Willett (1970) -

w i t h i n a band a r o u n d a n ad j u s t a b l e l e v e l , t h a t l e v e l b e i n g

w h a t e v e r r e s e r v e s were i n t h e p r e v i o u s p e r i o d a n d t h e band b e i n g

n a r r o w e r , t h e f u r t h e r is t h a t l e v e l f r o n t a r g e t , The a u t h o r i t y

i n effect u s e s t h e r u l e t o ca lcula te t h e maximum q u a n t i t y o f

r e s e r v e s it w i l l s e l l s h o u l d t h e e x c h a n g e rate b e g i n t o rise

d u r i n g t h e p e r i o d , a n d t h e maximum q u a n t i t y it w i l l buy s h o u l d

t h e e x c h a n g e r a t e b e g i n t o f a l l d u r i n g t h e p e r i o d , T h i s p o l i c y

t h e r e f o r e d i c t a t e s when t h e f o r e i g n e x c h a n g e a u t h o r i t y s h o u l d

l e a v e , r a t h e r t h a n enter, t h e marke t , The r u l e e n s u r e s t h a t t h e

a u t h o r i t y a l w a y s l e a v e s b e f o r e t h e p o i n t of r u i n , a n d i n d e e d if

r u i n is a l r e a d y close enough, t h e n t h e a u t h o r i t y may n o t e n t e r

t h e m a r k e t a t a l l . 17 L i k e t h e b a n d - a n d - c r a u l ~ r o p o s a l , it l i m i t s

e x c h a n g e r a t e f l e x i b i l i t y , b u t u n l i k e t h e band-and-crawl

p r o p o s a l , i t e l i m i n a t e s t h e p o s s i b i l i t y of r u i n b y a l l o w i n g t h e

e x c h a n g e r a t e t o a b s o r b a l l r e m a i n i n g p r e s s u r e a n d i n t h a t

s e n s e , f i n d i t s own level,

T h e r e s e r v e management r u l e l i m i t s t h e s t r e n g t h of

i n t e r v e n t i o n by a l l o w i n g r e s e r v e l e v e l s t o f l u c t o a t e by an

amount t h a t is i n v e r s e l y r e l a t e d t o how f a r r e s e r v e s are f r o n

t h e i r i n i t i a l o r t a r g e t l e v e l , It u a s a r g u e d earlier, hoveve r ,

t h a t b e c a u s e of i n s u f f i c i e n t i n f o r m a t i o n , the f o r e i g n e x c h a n g e

a u t h o r i t y c a n n o t t e l l ahead of t i m e w h e t h e r t h e s e f l n c t u a t i o n s

would b e s u f f i c i e n t t o fix t h e e x c h a n g e r a t e c o m p l e t e l y , o r ---------------- 1 7 AS p r e s e n t e d , t h e r u l e e n s u r e s m*=O e x a c t l y a t t h e p o i n t of r u i n . However, t h e c r i t ica l barriers $0 a n d Sh c a n be r e d e f i n e d or r e s c a l e d s o t h a t t h e y r e p r e s e n t r e s e r v e l e v e l s close t o , b u t j u s t s h o r t o f , t h o s e which would c a u s e r e a l p o l i t i c a l o r economic r a i n .

whether t h e y would s imply l e a n a g a i n s t t h e wind. A The r u l e i tself

mere ly g i v e s a s t a t e m e n t o f i n t e n t , and i ts i m p l i c a t i o n s f o r e x

p o s t r e s e r v e b e h a v i o u r w i l l a l s o depend o n t h e a d d i t i o n a l

a s s u m p t i o n s made a b o u t i ts i m p l e n e n t a t i o n , l a his c a n b e

i l l u s t r a t e d u s i n g F i g u r e I,

A t t h e b e g i n n i n g of t h e p e r i o d , the a u t h o r i t y uses t h e r u l e

t o c a l c u l a t e t h e maximum p e r m i s s i b l e r e s e r v e change m* f o r t h a t

p e r i o d , on t h e b a s i s of how f a r t o t a l r e s e r v e l e v e l s a r e from

t h e t a r g e t l e v e l z, The l i n e J-K-L shows t h i s o p t i m a l e x a n t e

r e s e r v e change m* a s a f u n c t i o n of how f a r r e s e r v e s have

d e v i a t e d from t a r g e t . Suppose, a s b e f o r e , t h a t d u r i n g t h e

p e r i o d , t h e exchange market r e c e i v e s a shock which would r e q u i r e

a r e s e r v e change of s ize M i n o r d e r t o keep t h e exchange r a t e

f i x e d a t its p r e v i o u s l e v e l , The l i n e D-E shows t h e r e s e r v e

c h a n g e M which is r e q u i r e d t o f i x t h e exchange r a t e ,

If t h e r e s e r v e s c a r r i e d f o r w a r d f r o & t h e p r e v i o u s p e r i o d

a r e n o t f a r f rom t a r g e t and l i e between t h e p o i n t s X and Y , then

t h e c u r r e n t p e r m i s s i b l e r e s e r v e change at* is more t h a n

s u f f i c i e n t t o f u l l y a b s o r b t h e shock, The a u t h o r i t y can

t h e r e f o r e meet a l l c o n t r a c t s a t t h e p r e v a i l i n g exchange ra te

w i t h o u t v i o l a t i n g t h e r u l e , a n d t h e exchange r a t e c a n remain

f i x e d a t i ts p r e v i o u s l e v e l - 1 9 I f t h e r e s e r v e s c a r r i e d fo rward

1 8 Formally, t h e r e q u i r e m e n t t h a t ) B ( t ) -R (t- 1) ! = @ i n (m*, Pi) i s now imposed e x p o s t ,

19 I f , however, t h e shock were v e r y l a r g e r e l a t i v e t o t h e t a r g e t s t o c k of r e s e r v e s , t h e l i n e D-E would l i e a b o v e t h e p o i n t K and t h e r e u o a l d b e no s u c h r e g i o n of ' a u t o m a t i c ' f i x i t y ,

f i g u r e I - O p t i m a l & s e r v e Chanqe the @ v i a t i o n qf

R e s e r v e L e v e l s from T a r q e t -

-- 1/1-12 J G X I n i t i a l P L

L e v e l Z

Reserve L e v e l R (t-1)

happen t o be a l i t t l e f u r t h e r from t a r g e t , i n t h e r a n g e J - X o r

Y-L, t h e n t h e c u r r e n t p e r m i s s i b l e r e s e r v e c h a n g e is less t h a n

r e q u i r e d t o f u l l y a b s o r b t h e shock , Suppose , f o r example, t h a t

r e s e r v e l e v e l s h a v e f a l l e n below t a r g e t a n d are a t t h e p o i n t G,

I f t h e s h o c k of s i z e El i m p l i e s a f u r t h e r r e d u c t i o n i n r e s e r v e s ,

t h e n t h e r u l e r e q u i r e s t h e a u t h o r i t y t o meet t h i s e x c e s s demand

for f o r e i g n e x c h a n g e a t t h e p r e v a i l i n g e x c h a n g e r a t e o n l y t o t h e

e x t e n t o f F-G, T h e r e f o r e , b y d e f i n i t i o n , t h e exchange rate m u s t

a l s o a d j u s t , b u t by less t h a n it would u n d e r a free f l o a t . In

t h i s c a s e , t h e p o l i c y l e a n s a g a i n s t t h e wind, Suppose , on t h e

o t h e r hand, t h a t t h e s h o c k of s i z e IY is i n t h e o p p o s i t e

d i r e c t i o n , r e q u i r i n g r e s e r v e a c c u m u l a t i o n i n o r d e r t o a b s o r b it-

A t t h e b e g i n n i n g of t h e p e r i o d , t h e a u t h o r i t y d o e s n o t know i n

which d i r e c t i o n t h e s h o c k %ill be. A c c o r d i n g t o t h e e x a n t e

o p t i m a l r u l e , it s h o u l d l i m i t t h i s r e s e r v e a c c u m u l a t i o n , s i n c e

i t c o u l d e q u a l l y h a v e been r e s e r v e d e p l e t i o n , However,

i m p l e m e n t a t i o n of t h e r u l e c l e a r l y r e q u i r e s m o n i t o r i n g d u r i n g

t h e p e r i o d a n d t h e r e f o r e p r o v i d e s a n o p p o r t u n i t y f o r e x p o s t

a d j u s t m e n t , I n s u b s e q u e n t c h a p t e r s , i t is assumed t h a t when

s h o c k s would t a k e r e s e r v e s back t o t a r g e t , t h e n n o l i m i t a t i o n is

p l a c e d on s u c h kovement and t h e e x c h a n g e ra te r e m a i n s f i x e d a t

i ts p r e v i o u s l e v e l , ~ o T h e r e f o r e , i n t h e r a n g e J - X o r P-L t h e

a u t h o r i t y is assumed t o l e a n o n l y a g a i n s t t h o s e winds wh ich

v o u l d t a k e r e s e r v e s f u r t h e r fro& t a r g e t , Once t h e r e s e r v e s ---------------- 20 However, with r e s e r v e s be low t a r g e t , f o r example, a c c u m u l a t i o n would b e l i m i t e d i f it mere g r e a t enough t o t a k e r e s e r v e l e v e l s i n t o t h e r a n g e P-L,

c a r r i e d f o r w a r d r e a c h t h e p o i n t s 3 o r L, a n d t h e c u r r e n t s h o c k

would t a k e them f u r t h e r t o w a r d s r u i n , t h e c u r r e n t p e r m i s s i b l e

r e s e r v e c h a n g e becomes z e r o a n d t h e e x c h a n g e rate f l o a t s

c o m p l e t e l y i n t h e c u r r e n t p e r i o a ,

To r e c a p i t u l a t e s l i g h t l y , t h i s s e c t i o n began w i t h t h e

a s s u m p t i o n t h a t t h e ~ r o b l e n of m i n i m i z i n g e x c h a n g e ra te

v a r i a t i o n c o u l d be s o l v e d by l e a n i n g a g a i n s t t h e ' wind. It was

t h e n shown that w i t h f i n i t e r e s e r v e l e v e l s , t h e r e s e r v e

management a s p e c t of t h e p r o b l e m would d i c t a t e when, and .how

s t r o n g l y , t o l e a n a g a i n s t t h e wind, The r e s u l t is a r u l e which

in some i n s t a n c e s l e a n s c o m p l e t e l y a n d t h e r e b y f i x e s t h e

e x c h a n g e r a t e a t i t s p r e v i o u s l e v e l , i n o t h e r i n s t a n c e s l e a n s

n o t a t a l l a n d a l l o w s t h e e x c h a n g e r a t e t o f l o a t f r e e l y , a n d i n

y e t o t h e r i n s t a n c e s l e a n s p a r t i a l l y a n d a l l o u s some m i x t u r e of

e x c h a n g e r a t e a d j u s t m e n t a n d r e s e r v e accoxnmodation.. A t t h i s

s t a g e , t h e p r a c t i c a l i m p l i c a t i o n s of l e a n i n g a g a i n s t t h e wind

d e s e r v e d i s c u s s i o n ,

T h e e x a c t dynaipics, d u r i n g t h e p e r i o d , of t h e a i x t u r e o f

# p r i c e ' a n d * q u a n t i t y g a d j u s t m e n t u i l l depend i n part o n t h e

i n s t i t u t i o n a l a r r a n g e m e n t s under which t h e l e a n i n g is c a r r i e d

o u t . For e x p o s i t i o n a l p u r p o s e s , t h e d e s c r i p t i o n s o f a r h a s

s u g g e s t e d t h a t q u a n t i t y a d j u s t m e n t u i l l o c c u r before p r i c e

a d j u s t m e n t , I n p r a c t i c e , however, t h e a u t h o r i t y will h a v e t o

ref r a i n f r o m i n t e r v e n i n g u n t i l some ( s n a l l ) e x c h a n g e r a t e

a d j u s t m e n t makes clear t h e d i r e c t i o n of t h e c u r r e n t shock , The

exact s e q u e n c e will t h e n depend on w h e t h e r t h e a u t h o r i t y

i m m e d i a t e l y b u y s ( o r sells) f o r e i g n e x c h a n g e r e s e r v e s u p t o t h e

f u l l amount p e r m i t t e d by t h e r u l e , o r w h e t h e r it buys ( o r sells)

some f r a c t i o n of t h e p e r m i t t e d amount and waits t o see whe the r

t h e exchange r a t e r e v e r t s t o i ts p r e v i o u s l e v e i o r a d j u s t s

f u r t h e r i n t h e same d i r e c t i o n , b e f o r e commi t t ing t h e remainder

of its a l l o w e d r e s o u r c e s - 2 1 I n g e n e r a l terms, the i m p l i c a t i o n is

t h a t , even i f t h e exchange r a t e i s s u c c e s s f n l l p . * f i x e d t

end-of-period, it Bay n o t remain a b s o l u t e l y s t a b l e d u r i n g t h e

p e r i o d , T h e s e p r a c t i c a l i ~ p l i c a t i o n s of l e a n i n g a g a i n s t t h e wind

a r e mere ly n o t e d h e r e - Subsequen t e f f o r t w i l l e r a n i n e t h e

e f f e c t s of t h e above r u l e , one which d i c t a t e s how s t r o n g l y t o

l e a n , b u t w i l l assume t h a t t h i s l e a n i n g o c c u r s i n a n i d e a l i z e d

f a s h i o n . I n p a r t i c u l a r , it w i l l b e assumed t h a t when exchange

ra tes a r e f i x e d end-of-per iod , t h e y a r e a l s o f i x e d d u r i n g t h e

pe r iod ,

T h e above r e s e r v e management r u l e sets t h e s t r e n g t h o f

c u r r e n t i n t e r v e n t i o n , ceteris -- p a r i b u s , a c c o r d i n g t o how f a r

r e s e r v e s have deviated from t a r g e t , N o w t u r n t o t h e a d d i t i o n a l

d e t e r m i n a n t s of t h e s t r e n g t h of i n t e r v e n t i o n , a s g i v e n by t h e

c o m p a r a t i v e s t a t i cs o f t h e rule, F i r s t l y , f o r a g i v e n d e v i a t i o n

i n r e s e r v e s f rom t a r g e t , t h e c u r r e n t r e s e r v e change c a n be

l a r g e r , and s o a b s o r b more of t h e c u r r e n t p e r i o d ' s exogenous

--- -------- ------ 2 1 If i t were t o commit t h e f u l l amount when r e s e r v e s were i n t h e r a n g e X-Y i n F i g u r e I, it would r e v e r s e t h e d i r e c t i o n of t h e exchange ra te a d j u s t m e n t from what i t would have been under a f r e e f l o a t . However, a s Sohmen (1969) n o t e s , s u c h ' m i s t a k e s * can still l e a d t o e x c h a n g e r a t e b e h a v i o u r which is smoother t h a n u n d e r a free f l o a t ,

shock, t h e f u r t h e r a r e t h e c r i t i c a l r e s e r v e l e v e l s from t h e

i n i t i a l o r t a r g e t l e v e l - 2 2 Secondly , t h e l o n g e r is t h e p l a n n i n g

h o r i z o n H, o r t h e more c a u t i o u s is t h e f o r e i g n exchange

a u t h o r i t y , t h e s m a l l e r i s t h e c u r r e n t p e r m i s s i B l e r e s e r v e

change-23 Host i m p o r t a n t l y , b u t n o t s u r p r i s i n g l y , t h e l a r g e r is

t h e i n i t i a l r e s e r v e l e v e l z, t h e more t h e f o r e i g n exchange

a u t h o r i t y c a n a b s o r b a g i v e n s h o c k i n r e s e r v e change's r a t h e r

t h a n exchange r a t e changes-2* Houever, t h i s l a s t r e s u l t h a s a n

i m p o r t a n t p r o v i s o - t h e i n i t i a l o r t a r g e t r e s e r v e l e v e l m u s t b e

less t h a n h a l f way between t h e c r i t i ca l u p p e r and l o v e r bounds

for t h i s result t o hold. The s i g n i f i c a n c e of t h e p r o v i s o c a n

best be s e e n by n o t i n g t h a t i f z were itself a n o b j e c t of

c h o i c e , a t a r g e t r a t h e r t h a n a n a r b i t r a r y i n i t i a l p o i n t , t h e n

t h e v a l u e u h i c h would make m* a s l a r g e a s p o s s i b l e would b e o n e

h a l f way between t h e two c r i t i c a l bounds-2s A l t e r n a t i v e l y ,

s u p p o s e b o t h h and z i n c r e a s e t o g e t h e r i n s u c h a way t h a t h=2z,

----------------- 2 2 The p a r t i a l d e r i v a t i v e o f IB* w i t h r e s p e c t t o (h-z) i s p o s i t i v e , I n terms o f f i g u r e I, t h e p o i n t K moves upwards a s (h-z) i n c r e a s e s ,

2 3 The p a r t i a l d e r i v a t i v e o f B w i t h r e s p e c t t o H i s p o s i t i v e , f o r H>1, a n d t h e p a r t i a l d e r i v a t i v e of A/B w i t h r e s p e c t t o H is z e r o . I n F i g u r e I, t h e p o i n t K moves downward as H i n c r e a s e s .

2 4 The p a r t i a l d e r i v a t i v e of m* w i t h r e s p e c t t o z i s p o s i t i v e , f o r z less t h a n h/2- I n F i g u r e I, t h e p o i n t K moves up a s z i n c r e a s e s t o w a r d h/2-

2 5 T h i s c a n b e s e e n from e q u a t i o n ( 3 ) . I n e q u a t i o n (4), c u t o f f h a s been imposed i n a way t h a t a s sumes z=h/2. T h i s a o p t i m a l * z is s m a l l e r t h a n t h a t o b t a i n e d by Miller a n d O r r (1966) because t h e y c o n s i d e r t h e o p p o r t u n i t y c o s t of h o l d i n g r e s e r v e s as w e l l a s some p e n a l t y f o r b r e a k i n g t h e b a r r i e r s a n d t h u s i n t r o d u c e a n i n c e n t i v e t o economize on r e s e r v e s ,

I n terms o f t h e h y d r o a n a l o g y , t h i s is e q u i v a l e n t t o i n c r e a s i n g

t h e s i z e of t h e r e s e r v o i r . I n t h i s case, t h e c u r r e n t p e r m i s s i b l e

r e s e r v e c h a n g e n* unambiguous ly i n c r e a s e s , 2 6

To summar ize t h e r e s u l t s of this s e c t i o n , t h e r e s e r v e

management p rob lem o u t l i n e d a t t h e b e g i n n i n g of t h i s c h a p t e r h a s

a dynamic a s p e c t . Phen t h i s a s p e c t is r e c o g n i s e d , a l b e i t i n a

p i e c e w i s e s t a t i c f a s h i o n , t h e n t h e o p t i n a l r e s e r v e management

s t r a t e g y a l l o w s t h e s t r e n g t h of i n t e r v e n t i o n t o v a r y a c c o r d i n g

t o how f a r r e s e r v e s h a v e d e v i a t e d from t a r g e t , F u r t h e r m o r e ,

s i n c e t h e r u l e , as a s t a t e n e n t of i n t e n t , d o e s n o t p r e j u d g e what

s t r e n g t h would b e r e q u i r e d t o f i x t h e e x c h a n g e r a t e c o m p l e t e l y ,

it may i n f ac t do s o e x p o s t when r e s e r v e s are close t o t a r g e t -

F o r r e s e r v e l e v e l s a l i t t l e f u r t h e r from t a r g e t , t h i s o p t i m a l

s t r a t e g y w i l l m e r e l y l e a n a g a i n s t t h e u i n d , F i n a l l y , i f r e s e r v e s

are c l o s e t o ' r u i n q l e v e l s , t h e e x c h a n g e ra te will f l o a t f r e e l y

i n t h a t p e r i o d -

E g g i l i b r i u m a n d t h e P r i v a t e Sector - --- -- - -- I n the p r e v i o u s s e c t i o n , t h e d i s c u s s i o n of r e s e r v e

managennent began with t h e a s s u m p t i o n t h a t t h e e x c h a n g e rate,

u n d e r a f i x e d r e g i m e , was set a t i ts *correctg p e r m a n e n t o r

e q u i l i b r i n m l e v e l . I n terms of t h e hyd ro a n a l o g y , it was assumed

a p r i o r i t h a t t h e a v e r a g e rate o f water i n f l o w i n t o t h e

r e s e r v o i r was raatched by t h e r a t e of e l e c t r i c i t y g e n e r a t i o n . ----------------- 2 6 I n t h e e x p r e s s i o n f o r ~ a * , t h e term z (h-z) i s r e p l a c e d by 22. The p a r t i a l d e r i v a t i v e of this w u a* w i t h r e s p e c t t o z is p o s i t i v e .

T h i s a s s u m p t i o n a l l o w e d t h e a r t i f i c e of c h a r a c t e r i z i n g a f i x e d

e x c h a n g e ra te r e g i m e as o n e w h e r e r e s e r v e g a i n s a n d losses of

e q u a l s i z e H o c c u r r e d w i t h e q u a l p r o b a b i l i t y . . The i n r p l i c i t

a s s n m p t i o n was t h e r e f o r e t h a t t h e r e s e r v e management r u l e would

min imize e x c h a n g e ra te v a r i a t i o n a r o u n d its l o n g r u n e q u i l i b r i u m

r a t e .

T h i s s e c t i o n c o n s i d e r s t h e i m p l i c a t i o n s of r e l a x i n g t h a t

a s s u m p t i o n a n d e x a m i n e s t h e case w h e r e r e s e r v e g a i n s a n d losses

n e e d n o t b e of e q u a l size, n o r o c c u r w i t h e q u a l p r o b a b i l i t y .

I n s t e a d , t h e s i m p l e c h a r a c t e r i z a t i o n of r e s e r v e b e h a v i o u r u n d e r

a f i x e d e x c h a n g e ra te r e g i m e is r e p l a c e d by a n economic model

d s c r i b i n g e x p l i c i t l y t h e i m p a c t t h a t e x o g e n o n s s h o c k s would

h a v e on t h e e x c h a n g e ra te i n t h e a b s e n c e of i n t e r v e n t i o n , or on

r e s e r v e s u n d e r f i x e d exchange rates, T h i s s e c t i o n t h e n

r e e x a m i n e s t h e e x p o s t e x c h a n g e r a t e and r e s e r v e b e h a v i o n r

r e s u l t i n g from t h e o p e r a t i o n of t h e r e s e r v e management r u l e i n

t h i s new e n v i r o n m e n t . The first q u e s t i o n i s whe the r t h e s i m p l e

r u l e of t h e p r e v i o u s s e c t i o n c a n i n d e e d e n s u r e min imal v a r i a t i o n

i n t h e e x c h a n g e rate, a s was assumed earlier, A s e c o n d q u e s t i o n

is whe the r t h i s d n i m a l v a r i a t i o n v i l l c o n t i n u e t o o c c u r a r o u n d

t h e correct l o n g f u n e q u i l i b r i u m , e v e n t h o u g h t h a t e q u i l i b r i u m

n e e d n o t b e c a n s t a n t , b u t may i t se l f c o n t a i n a t r e n d component,

F i n a l l y , a n amended v e r s i o n of t h e s i m p l e r u l e is d e r i v e d -

However, i n t h e same way t h a t t h e s i m p l e r u l e , as a s t a t e m e n t of

i n t e n t , d i d n o t a s sume p r i o r knowledge of t h e s i z e or d i r e c t i o n

of t h o s e r e s e r v e c h a n g e s r e q u i r e d t o fix t h e e x c h a n g e r a t e , t h e

amended v e r s i o n d o e s n o t p re sume p r i o r knowledge of t h e t r u e

l o n g r a n e q u i l i b r i u m , no r , e q u i v a l e n t l y , t h e t r u e p r o b a b i l i t i e s

of r e s e r v e g a i n s a n d Z o s s e s , ~ 7

The first s t e p is t o make e x p l i c i t t h e u a i i n which

exogenous s h o c k s a f fec t e x c h a n g e r a t e and /o r r e s e r v e b e h a v i o n r

t h r o u g h t h e r e q u i r e m e n t s for e q u i l i b r i u m i n t h e p r i v a t e sector,

Con s i d e r t h e s i m p l e system: 28

Demand for r e a l money b a l a n c e s : Md/P = f(x) (6

Supp ly of nomina l money b a l a n c e s : M s = eR + D (7

Monetary e q u i l i b r i u m c o n d i t i o n : 4d = Pls ( 8 )

p u r c h a s i n g power p a r i t y : P = eP* (9 1

where a d a n d as are n o m i n a l money demand a n d s u p p l y , P and P*

are t h e d o m e s t i c a n d f o r e i g n p r i c e l e v e l s , e is t h e e x c h a n g e

r a t e d e f i n e d a s t h e p r i c e of f o r e i g n c u r r e n c y , R is f o r e i g n

exchange r e s e r v e s d e n o m i n a t e d i n f o r e i g n c u r r e n c y , D is t h e

d o m e s t i c component of t h e m o n e t a r y base,29 a n d x c a p t u r e s a l l

o t h e r i n f l u e n c e s on t h e demand f o r real money b a l a n c e s .

T h i s s y s t e m g i v e s t h e r e l a t i o n s h i p be tween r e s e r v e c h a n g e s

a n d e x c h a n g e r a t e c h a n g e s t h a t most be s a t i s f i e d i n o r d e r t o ----------------- 2 7 F o r t h i s r e a s o n , t h e amended v e r s i o n is n o t d e r i v e d i n a g e n e r a l i z e d randoxa walk f ramework ,

2 8 T h i s s y s t e m , l i k e t h e F i s c h e r (1977) model d i s c u s s e d i n C h a p t e r 2 , assumes t h a t f o r e i g n b o r r o w i n g and l e n d i n g o c c u r s o n l y t h r o u g h t h e f o r e i g n e x c h a n g e a u t h o r i t y , I n t h i s env i ronmen t , a d e c i s i o n t o i n t e r v e n e i s a d e c i s i o n t o a l l o w s u c h bo r rowing a n d l e n d i n g t o t a k e p l a c e , The effects of p r i v a t e l y i n i t i a t e d c a p i t a l f lows a n d c u r r e n c y s u b s t i t u t i o n a r e i n t r o d u c e d i n C h a p t e r 4.

2 9 F o r s i m p l i c i t y , t h i s a b s t r a c t s from the effect of a f r a c t i o n a l r e s e r v e b a n k i n g s y s t e m ,

p r e s e r v e monetary e q u i l i b r i u m i n t h e p r i v a t e s e c t o r i n t h e f a c e

o f exogenous d i s t u r b a n c e s . By s o l v i n g t h i s sys tem f o r B i n terms

of e and d i f f e r e n t i a t i n g w i t h r e s p e c t t o time (where t h e d o t

n o t a t i o n r e p r e s e n t s t i m e d e r i v a t i v e s ) , t h i s r e l a t i o n s h i p is: * 0 . *

R = g ' (x) x - D / e + (D/ez) e (10)

where t h e d e t e r m i n a n t P* h a s been subsumed i n t o x , s o t h a t

P*f (x) h a s b e e n w r i t t e n a s g(x ) , F o r t h e p u r p o s e s o f e x p o s i t i o n ,

t h i s r e l a t i o n s h i p w i l l be assumed, i n t h e neighbourhood of some

p o i n t x=xo, e=eo, t o t a k e t h e a p p r o x i m a t e l y l i n e a r form: . 0 .) 0 (. - R = f ( e , x ) = ae + gx i 10'

whe re t h e d e t e r m i n a n t D h a s a l s o been subsumed i n t o x-

T h i s r e l a t i o n s h i p shows how d i s t u r b a n c e s i n t h e real demand

f o r money impinge on t h e exchange market , a n d g i v e s t h e amount

by which t h e exchange rate and/or r e s e r v e l e v e l would rsove i n

t h e face of t h e s e shocks , T h i s c a n be i l l u s t r a t e d i n F i g u r e 11,

where t h e l i n e A 3 shows t h e a b o v e r e l a t i o n s h i p f o r a shock which

i n c r e a s e s t h e r e a l demand for money, Under f i x e d exchange rates,

r e s e r v e s would f u l l y a c c o m o d a t e t h e s h o c k and accumula te b y a n 0 0

amount B = g x , as shown a t p o i n t A, I n t h i s c a s e t h e nominal

s u p p l y of money would i n c r e a s e t o match t h e deaaad, A t t h e o t h e r

ex t reme o f f r e e l y f l o a t i n g exchange r a t e s , r e s e r v e s would n o t - change bu t t h e exchange r a t e would a p p r e c i a t e by a n amount e = . - (g/ot) x, a s shown a t p o i n t B. I n this case t h e r e a l v a l u e o f a

f i x e d nominal s u p p l y of money would i n c r e a s e t o match t h e

demand. B y c h o o s i n g to l e a n a g a i n s t t h e wind, the f o r e i g n

exchange a u t h o r i t 1 p i c k s a n i n t e r m e d i a t e p o i n t X , s a y , i n o r d e r

Figure XI - Bequireaents fog P r i v a t e Sector g-ibrium

Reserve Change B

I I 1 * - - 0

I R=oce+@x (x>O)

0 0 . .

R=ose+gx ( x < O )

Change e

t o l i m i t t o XC t h e amount o f t h e r e s e r v e a d j u s t m e n t t h a t

accompanies t h e p a r t i c u l a r s h o c k , but must a l so a c c e p t an

exchange r a t e change o f t h e amount XD imposed by t h e

r e q u i r e m e n t s of monetary e q u i l i b r i u m i n t h e p r i v a t e s e c t o r . The

line PQ l i k e w i s e d e s c r i b e s t h e a u t h o r i t y ' s o p t i o n s i n a

s i t u a t i o n where t h e exogenous s h o c k d e c r e a s e s t h e r e a l demand

f o r money. The p r e v i o u s s e c t i o n c o n s i d e r e d t h e s p e c i a l case

where t h e c o n f i g u r a t i o n s PQ a n d A % o c c u r r e d wi th e q u a l

p r o b a b i l i t y a n d where t h e r e s e r v e c h a n g e s OA and OP were .of

e q u a l size. T h a t r e s t r i c t i o n no l o n g e r a p p l i e s ,

T h u s t h e a b o v e relations hi^ shows t h e t r a d e o f f s t h a t t h e

f o r e i g n e x c h a n g e a u t h o r i t y f a c e s vhen i t a a n a g e s t h e exchange

rate, b y g i v i n g t h e env i ronment w i t h i n which a n i n t e r v e n t i o n

r u l e mast o p e r a t e , An i n t e r v e n t i o n r u l e d e s c r i b e s t h e l o c n s o f

c h o s e n p o i n t s X f o r a l l p o s s i b l e t y p e s of shock. Ex p o s t

exchange r a t e and r e s e r v e b e h a v i o u r is d e t e r m i n e d b y t h e

i n t e r a c t i o n of these components,

Now c o n s i d e r t h e o p t i m a l r e s e r v e management r u l e from t h e

previous s e c t i o n , T h i s r u l e s p e c i f i e s p e r m i s s i b l e r e s e r v e

movements which, b e c a a s e t h e y l e a n a g a i n s t t h e wind, c a n b e

e x p r e s s e d as a f r a c t i o n t# of t h e amount by which r e s e r v e s would

move were t h e exchange r a t e f ixed :30 ------------------ 3 0 From t h e p r e v i o u s s e c t i o n , t h e i n t e r v e n t i o n p a r a m e t e r c a n a l s o t a k e t h e v a l u e s I and 0; c o r r e s p o n d i n g t o c o m p l e t e f i x i t y and a free f l o a t . T h e f o l l o w i n g d i s c u s s i o n c o n c e n t r a t e s on t h e i m p l i c a t i o n s f o r exchange r a t e b e h a v i o u r vhen it is known t h a t t h e p a r a a e t e r l ies i n t h e c l o s e d i n t e r v a l f 0 , I], b u t d o e s n o t c o n s i d e r i n a f o r a a l way t h e dependence o f its e x a c t v a l u e o n r e s e r v e l e v e l s .

The p r e v i o u s s e c t i o n a r g u e d t h a t b e c a u s e of c o n s t r a i n t s on

r e s e r v e l e v e l s , t h e o p t i m a l v a l u e of i n turn d e p e n d s on how

f a r r e s e r v e s have d e v i a t e d from t h e i r i n i t i a l *or t a r g e t l e v e l ,

The effects c a n b e i l l u s t r a t e d u s i n g F i g u r e 11, Suppose, f o r

e x a a p l e , t h a t t h e exogenous d i s t u r b a n c e s c o n s i s t e n t l y l e a d t o

t r a d e o f f c o n f i g u r a t i o n s s n c h a s AB, s o t h a t any r u l e which l e a n s

a g a i n s t t h e wind l e a d s t o r e s e r v e a c c u m u l a t i o n , However, t h e

l o n g e r t h i s p e r s i s t s , t h e g r e a t e r r e s e r v e l e v e l s w i l l be .and t h e

weaker w i l l b e t h e s t r e n g t h of f u r t h e r i n t e r v e n t i o n , I n t e r n s of

F i g u r e 11, t h e o p t i m l p o i n t X w i l l move t o w a r d s B, t h e p o i n t a t

which t h e exchange r a t e f l o a t s f r e e l y , Likewise , t h e l o n g e r t h a t

c o n f i g u r a t i o n s s n c h a s PQ p e r s i s t , t h e closer t h e o p t i m a l p o i n t

w i l l nove t o w a r d s Q r a t h e r t h a n P.31

l o w t h a t b o t h t h e p r i v a t e sector b e h a v i o u r and t h e

a u t h o r i t y ' s r e s e r v e nanagement r u l e h a v e b e e n s p e c i f i e d , t h e y

can be s o l v e d f o r e x p o s t exchange r a t e changes:J*

T h i s shows t h a t , a s i n t h e p r e v i o u s s e c t i o n , e x p o s t exchange

rate b e h a v i o u r depends on t h e p a t t e r n of exogenous d e t e r m i n a n t s

------------------ 3 1 Roper and Turnovsky (1980) use a s imilar p r e s e n t a t i o n t o d e p i c t t h e i r o p t i m a l i n t e r v e n t i o n r u l e , b u t b e c a u s e t h e y i g n o r e t h e c o n s t r a i n t imposed by f i n i t e r e s e r v e l e v e l s , t h e i r e q u i v a l e n t of t h e chosen p o i n t X does n o t move over tine,

32 It is a n o n - t r i v i a l problem t o d e r i v e a n a n a l y t i c a l s o l u t i o n f o r e x p o s t e x c h a n g e r a t e l e v e l s , s i n c e t h e p a r a m e t e r + i n t u r n depends o n t h e endogenous v a r i a b l e 8, However, t h i s e q u a t i o n d o e s a l l o w c o n s i d e r a t i o n of e x p o s t exchange rate v a r i a t i o n , a s measured by the v a r i a n c e of exchange ra te changes .

i n t h e same way t h a t e l e c t r i c i t y g e n e r a t i o n d e p e n d s on r a i n f a l l ,

I n p a r t i c u l a r , e x c h a n g e r a t e b e h a v i o u r w i l l h a v e a s y s t e m a t i c

a n d a n u n s y s t e m a t i c component a c c o r d i n g as t h e exogenous

d e t e r m i n a n t s h a v e a s p s t e a a t i c and a n u n s y s t e i a t i c component,

However, f o r a g i v e n se t o f e x o g e n o u s d e t e r m i n a n t s , s y s t e m a t i c

o r o t h e r w i s e , e x p o s t e x c h a n g e r a t e b e h a v i o u r a l s o d e p e n d s o n

t h e i n t e r v e n t i o n p o l i c y of t h e f o r e i g n e x c h a n g e . a u t h o r i t y , How

t u r n t o t h e q u e s t i o n s r a i s e d a t t h e b e g i n n i n g of t h i s s e c t i o n ,

The first q u e s t i o n is w h e t h e r t h e s i m p l e r e s e r v e management

r u l e c a n c o n t i n n e t o e n s u r e m i n i a a l v a r i a t i o n i n t h e e x c h a n g e

rate. The s o l u t i o n above shows t h a t any p o l i c y which l e a n s

a g a i n s t t h e wind r e d u c e s the t o t a l amount of e x c h a n g e r a t e

v a r i a t i o n r e l a t i v e t o what it would h a v e b e e n w i t h o u t

i n t e r v e n t i o n , T o t h e e x t e n t t h a t t h e s i m p l e r e s e r v e management

r u l e l e a n s as s t r o n g l y a s p o s s i b l e , g i v e n t h e c o n s t r a i n t imposed

by f i n i t e r e s e r v e s , it t h e r e b y d o e s e n s u r e minirsal t o t a l

v a r i a t i o n i n t h e e x c h a n g e rate, g i v e n t h i s c o n s t r a i n t - 3 3

The s e c o n d q u e s t i o n is w h e t h e r t h i s minimal v a r i a t i o n

c o n t i n u e s t o o c c u r a r o u n d t h e c o r r e c t l o n g r u n e q u i l i b r i u m

e x c h a n g e rate. I n o t h e r words, d o e s t h e s i a p l e r u l e r e d u c e t o t a l

e x c h a n g e r a te v a r i a t i o n by o p e r a t i n g o n l y o n t h e u n s y s t e m a t i c

c o n p o n e n t of e x c h a n g e ra te b e h a v i o u r , o r d o e s it a l s o a f fec t t h e

s y s t e a a t i c c o n p o n e n t ? T h i s q u e s t i o n e n c a p s u l a t e s the p r o b l e a \

f a c e d b y t h e would-be a r c h i t e c t s of a r e p l a c e m e n t t o t h e B r e t t o n ----------------- 33 Prom t h e a b o v e a n a l y s i s , t h e v a r i a n c e of e x c h a n g e r a t e c h a n g e s is p r o p o r t i o n a l t o (+-1) 2 a n d is lower, t h e closer is 4 t o u n i t y ,

Woods agreement , The l a c k o f a g r e e m e n t on r u l e s f o r exchange

r a t e management, a s opposed t o r e s e r v e management, was p r e c i s e l y

b e c a u s e t h e l e v e l of t h e exchange rate, on a v e r a g e through time,

c a n n o t be a d e c i s i o n v a r i a b l e , I n s t e a d , t h e exchange r a t e must

b e a l lowed t o nove w i t h t h e t r e n d s i n t h e e rogenous

d e t e r m i n a n t s , a s i t would w i t h o u t i n t e r v e n t i o n , 0 t h e r u i s e , n o t

on1 y is t h e c o u n t r y p r a c t i c a l l y e n s u r i n g e v e n t u a l - r e s e r v e

d e p l e t i o n or e x c e s s i v e accumula t ion , b u t it is a l s o a c c r u i n g

w h a t e v e r c o s t s a r e a s s o c i a t e d w i t h h a v i n g t h e wrong exchange

r a t e f o r p r o l o n g e d p e r i o d s of t i m e , The r e s e r v e management r u l e

of t h e p r e v i o u s s e c t i o n e l i m i n a t e s t h e p o s s i b i l i t y of r e s e r v e

d e p l e t i o n , The q u e s t i o n h e r e is v h e t h e r i t c a n a l s o t r a c k t h e

g e n e r a l t r e n d s i n a f r e e l y f l o a t i n g exchange rate.

Tbe above s o l t l t i o n shows t h a t e x c h a n g e r a t e behaviour w i l l

on a v e r a g e be t h e saate wi th i n t e r v e n t i o n a s w i t h o u t it s o l o n g

a s reserve l e v e l s a r e o n a v e r a g e t h e same w i t h i n t e r v e n t i o n a s

w i t h o u t it. I n o t h e r words, t h e s i m p l e r e s e r v e managezuent r u l e

w i l l minimize t h e u n s y s t e m a t i c c o ~ p o n e n t of exchange r a t e

b e h a v i o u r w i t h o o t a f f e c t i n g its s y s t e m a t i c component s o l o n g a s

r e s e r v e s are c o n s t a n t , on a v e r a g e , o v e r t i m e - 3 4 The c o r o l l a r y is

t h a t t h e f o r e i g n exchange a u t h o r i t y d o e s n o t need t o know t h e

l o n g r u n a v e r a g e o r e q u i l i b r i u m e x c h a n g e rate, s o l o n g a s i t h a s

a way of e n s u r i n g t h a t r e s e r v e s a r e on a v e r a g e e q u a l t o t h e i r ---------------- \

3 4 I n terms o f t h e a b o v e a n a l y s i s , t h e management r u l e r i l l not a l t e r t h e s y s t e m a t i c component i f E[d/dt { (1-$) x) ]=El d / d t [x) 3, where i t is nou r e c o g n i s e d t h a t , with t h e c o n s t r a i n t s , 9 a l s o v a r i e s o v e r time, T h i s w i l l h o l d i f E[d/dt[$x) ]=O, o r , v i a e q u a t i o n (11) , i f t h e e x p e c t e d r e s e r v e change is zero,

i n i t i a l o r t a r g e t l e v e l - Now t h e s i m p l e r e s e r v e management rule

a l l o w s r e s e r v e c h a n q e s a s c l o s e a s p o s s i b l e t o t h o s e which would

o c c u r u n d e r f u l f . i n t e r v e n t i o n , w h i l e r e s e r v e l e v e l s a re i n

effect r e s t r i c t e d s o a s t o l i e w i t h i n a band d round t h e i r

i n i t i a l o r t a r g e t l e v e l ( t h e i n t e r v a l J-L i n F i g u r e I), Iiouever ,

this d o e s n o t e n s u r e t h a t r e s e r v e s a r e e q u a l , on a v e r a g e , t o

t h a t i n i t i a l o r t a r g e t l e v e l ,

T h e r e f o r e , it c a n be shown t h a t when t h e s i m p l i f y i n g

a s s u m p t i o n s o f t h e p r e v i o u s s e c t i o n a r e r e l a x e d , t h e r e s e r v e

management r u l e d e r i v e d i n t h a t s e c t i o n c a n c o n t i n u e t o m i n i a i z e

t o t a l e x c h a n g e r a t e v a r i a t i o n , b u t t h a t t h i s minimal v a r i a t i o n -- n e e d n o t occur a r o u n d t h e c o r r e c t l o n g r u n e q u i l i b r i u m , I n o t h e r

words, t h e r e is n o g u a r a n t e e t h a t t h e r n l e r e d u c e s t o t a l

e x c h a n g e r a t e v a r i a t i o n by o p e r a t i n g o n l y on t h e u n s y s t e m a t i c

coinponent o f e x c h a n g e ra te b e h a v i o u r , T h i s c a n be f u r t h e r

i l l u s t r a t e d w i t h a c o u p l e of examples .

I n the p r e v i o u s s e c t i o n , i t w a s assumed t h a t r e s e r v e g a i n s

and l o s s e s of e q u a l size o c c u r r e d w i t h e q u a l p r o b a b i l i t y ,

s u p p o s e nou t h a t r e s e r v e l o s s e s are more l i k e l y t h a n g a i n s - I f

t h e r n l e o p e r a t e d s o a s t o e n s u r e t h a t r e s e r v e losses were a l s o

s m a l l e r , on a v e r a g e , t h a n t h e g a i n s , t h e n r e s e r v e s c o u l d still

o n a v e r a g e be c o n s t a n t a n d t h e e x c h a n g e rate c o u l d still on

a v e r a g e be t h e same a s it vould w i t h o u t i n t e r v e n t i o n . When ex

p o s t a d j u s t m e n t of the r n l e is a l l o w e d d u r i n g i m p l e m e n t a t i o n , s o

t h a t p a r t i a l l e a n i n g o c c u r s o n l y a g a i n s t t h o s e winds which would

t a k e r e s e r v e s f u r t h e r from t a r g e t , t h e n a n e l e m e n t of i n b u i l t

asymmetry is i n t r o d u c e d which al lows t h i s s o r t o f r e s e r v e

behav iou r . I f t h e g r e a t e r f r e q u e n c y of r e s e r v e l o s s e s f o r c e s

r e s e r v e s i n c r e a s i n g l y below t a r g e t , t h e n p e r m i s s i b l e f u r t h e r

downward movements beconie s i n a l l e r w h i l e upward movements, t o t h e

e x t e n t t h a t t h e y o c c u r , are c o n s t r a i n e d o n l y when t h e y would

t a k e r e s e r v e s a b o v e target,

However, t h e r e are s i t u a t i o n s i n which even ' t h i s a symmet ry

i s i n s u f f i c i e n t t o e n s u r e t h a t t h e e x c h a n g e ra te is on a v e r a g e

t h e same a s i t wonld b e were r e s e r v e s f i x e d a t t h e i r t a r g e t a n d

t h e exchange r a t e free to f l o a t , C o n s i d e r t h e c a s e where r e s e r v e

l o s s e s o c c u r w i t h c e r t a i n t y . The s i m p l e r u l e vou ld allow

r e s e r v e s t o f a l l t o t h e i r l o w e s t p e r x u i s s i b l e l e v e l ( p o i n t J on

F i g u r e I ) , a t which p o i n t no f u r t h e r r e s e r v e c h a n g e s would t a k e

p l a c e and t h e e x c h a n g e r a t e wonld f l o a t f r e e l y . However, t h e r e

is t h e n n o mechanism t o t a k e r e s e r v e s b a c k t o t a r g e t , I n t h i s

i n s t a n c e t h e e x c h a n g e rate would b e s y s t e ~ a t i c a l l y d i f f e r e n t

f r o m t h a t which would o c c u r w i t h r e s e r v e s f i x e d on t a r g e t .

N e v e r t h e l e s s , t h e s i m p l e r u l e c a n be amended so as t o rule

o u t t h i s l a t t e r p o s s i b i l i t y , C o n s i d e r a g a i n t h e a rgnmen t of t h e

p r e v i o u s s e c t i o n . T h i s d e v e l o p e d a n o p t i m a l e x a n t e r e s e r v e

c h a n g e which a p p a r e n t l y depended on t i n e , the c r u c i a l p o i n t

b e i n g t h a t a s more time p a s s e d , t h e f u r t h e r r e s e r v e s c o u l d

c o n c e i v a b l y h a v e moved away f r o m t a r g e t , T h e r e f o r e , time was

i n t e r p r e t e d a s t h e minimum p o s s i b l e time r e q u i r e d t o a c h i e v e a n y

p a r t i c u l a r s i z e d d e v i a t i o n i n r e s e r v e s f rom t a r g e t , I n t h e a b o v e

example , however, t h e e x c h a n g e r a t e d e v i a t e s s y s t e m a t i c a l l y from

a f r e e l y f l o a t i n g r a t e p r e c i s e l y b e c a u s e t h e t i m e s p e n t by

r e s e r v e s away from t a r g e t is f a r g r e a t e r t h a n t h e minimum time

r e q u i r e d t o a c h i e v e a d e v i a t i o n of t h a t size, If r e s e r v e s c o u l d

e v e n t u a l l y b e b r o u g h t back t o t a r g e t , t h e n t h i ' s s y s t e m a t i c

deviation from a f r e e l y f l o a t i n g e x c h a n g e r a t e c o u l d e v e n t u a l l y

b e e l i m i n a t e d .

T h i s a r g u m e n t s n g g e s t s a n a l t e r n a t i v e i n t e r p r e t a t i o n of t h e

time v a r i a b l e i n e q u a t i o n ( 3 ) - It s u g g e s t s t h a t it is n o t r e a l

time, o r e v e n a i n i a n m time, wh ich matters, b u t r a t h e r , t h e t o t a l

time t h a t r e s e r v e s h a v e s p e n t o n o n e s i d e o r t h e o t h e r of

t a r g e t . I n t h i s s e c t i o n , t h a t is how t h e t i m e v a r i a b l e w i l l be

i n t e r p r e t e d . However, t h i s t o t a l time c a n b e s p l i t i n t o t w o

components. L e t t be t h e minimum time r e q u i r e d t o a c h i e v e a

g i v e n d e v i a t i o n from t a r g e t , as before, a n d let T be t h e e x c e s s

t i ~ e , o v e r a n d a b o v e t h i s ainimum, t h a t a d e v i a t i o n o n one s i d e

o r t h e o t h e r h a s p e r s i s t e d , T h e r e f o r e , t h e t o t a l time t h a t

r e s e r v e s h a v e s p e n t o n one s i d e o r t h e o t h e r o f t a r g e t is t h e

sum of t and I f , a n d equation (3) c a n be amended t o become

t h u s g i v i n g t h e o p t i a a l e x a n t e r e s e r v e c h a n g e as a f u n c t i o n o f

time i n t h e two s e n s e s i n which i t matters, T h i s r e s e r v e c h a n g e

is nou smaller t h a n that allowed by e q u a t i o n (3) -

However, i f r e s e r v e s are e v e n t u a l l y t o be b r o u g h t back t o

t a r g e t , t h e n n o t o n l y must a n y r e s e r v e c h a n g e of s ize a be

s m a l l e r t h a n t h a t a l l o w e d by t h e simple r u l e , i t may a l so h a v e

t b be i n t h e o p p o s i t e d i r e c t i o n , C o n s i d e r t h e above example

where r e s e r v e losses o c c u r w i t h c e r t a i n t y . The a u t h o r i t y may

i n i t i a l l y accommodate t h i s e x c e s s demand f o r f o r e i g n e x c h a n g e b y

r u n n i n g down its s t o c k o f r e s e r v e s . However, t h e a u t h o r i t y mus t

a t some p o i n t b e g i n b u y i n g , r a t h e r t h a n selling, f o r e i g n

exchange , t h e r e b y a d d i n g t o t h e e x c e s s demand, r a t h e r t h a n

accommodat ing it, i f t h o s e r e s e r v e s are t o b e b r o u g h t back t o

t a r g e t . E v e n t u a l l y , f o r some f i n i t e v a l u e of e x c ' e s s time T, t h e

p e r m i s s i b l e r e s e r v e c h a n g e m u s t h a v e a m a g n i t u d e m which i s

n e g a t i v e , so a s t o be i n t h e o p p o s i t e d i r e c t i o n from t h e . c u r r e n t

d e v i a t i o n i n r e s e r v e s from t a r g e t , T h e r e f o r e , t h i s a p p r o a c h n o t

o n l y r e q u i r e s t h e i m p o s i t i o n of some cutoff s o a s t o r u l e ou t

r e s e r v e d e p l e t i o n o r e x c e s s i v e a c c u m u l a t i o n , it a l so r e q u i r e s

t h e i m p o s i t i o n .of a c u t o f f t o e n s u r e t h a t r e s e r v e s c a n be

b r o u g h t b a c k t o t a r g e t i n t h i s f a s h i o n ,

Once a g a i n , a r e l a t i o n s h i p c a n be o b t a i n e d be tween a n y

p a r t i c u l a r d e v i a t i o n 1 R ( t - 1)-z 4 i n r e s e r v e s from t a r g e t and t h e

iainimum t i n e t r e q u i r e d t o a c h i e v e t h a t d e v i a t i o n - 3 5 The

d e r i v a t i o n of t h i s r e l a t i o n s h i p is g i v e n i n Appendix I, where it

is t h e n s u b s t i t u t e d i n t o t h e a b o v e e x p r e s s i o n f o r m[t,T), B

c u t o f f is t h e n imyosed , a s before, t o ensure t h a t m=O when t h e

r e s e r v e b o u n d a r i e s are r e a c h e d . A s e c o n d c u t o f f is a l s o imposed

t o e n s u r e that r e s e r v e s will e v e n t u a l l y be b r o u g h t back t o

t a r g e t f o r a f i n i t e v a l u e of T, T h e amended v e r s i o n of t h e ---------- ------- , 35 Hore e x a c t l y , a r e l a t i o n s h i p t=t (X,T) is d e r i v e d from which b o t h minimum t i m e and e x c e s s time c a n be d e r i v e d , Minimum time is g i v e n by t(X,O) a n d e x c e s s time by T=To-t(X,O), whe re To is t h e t o t a l number of p e r i o d s t h a t r e s e r v e s h a v e s p e n t on o n e s i d e o r t h e o t h e r of t a r g e t ,

o p t i m a l r e s e r v e management r u l e c a n t h e n be e x p r e s s e d i n t h e

a p p r o x i m a t e l y l i n e a r form:

where C =

T h i s amended r u l e can b e v i s u a l i z e d i n terms o f F i g n r e 1 by

n o t i n g t h a t a s r e s e r v e s spend i n c r e a s i n g amoun t s of t i n e on o n e

s i d e or t h e o t h e r of , t a r g e t , t h e l i n e s 3 -K-I , , which show t h e

o p t i m a l e x a n t e r e s e r v e c h a n g e , move i n w a r d s t o w a r d t h e o r i g i n ,

A s t h e l i n e s move i n , t h e c u r r e n t d e v i a t i o n i n r e s e r v e s may f a l l

o u t s i d e t h e c u r r e n t c r i t i c a l p o i n t s J and L, i n which c a s e t h e

d i r e c t i o n of i n t e r v e n t i o n is no l o n g e r d i c t a t e d by t h e d i r e c t i o n

o f the c u r r e n t shock , The a u t h o r i t y m u s t a d j u s t i ts r e s e r v e s i n

t h e d i r e c t i o n t h a t w i l l b r i n g them b a c k t o w a r d s t h e new cri t ical

bounds, a n d t o w a r d s t a r g e t - 3 6 I n t h e l i n i t ; t h e l i n e s c o n v e r g e

t o t h e o r i g i n a n d r e s e r v e s are f o r c e d back t o t a r g e t , One

i m p l i c a t i o n , however , is t h a t t h e f o r e i g n e x c h a n g e a u t h o r i t y n o

l o n g e r n e e d a l w a y s l e a n a g a i n s t t h e wind, I f r e s e r v e s a r e t o b e

f o r c e d back t o t a r g e t , t h e a u t h o r i t y may f i n d itself b e t t i n g

w i t h , r a t h e r t h a n a g a i n s t , t h e marke t ,

T h i s amended rule e n s u r e s t h a t a s m a l l d e v i a t i o n i n

r e s e r v e s from t a r g e t c a n n o t p e r s i s t f o r e v e r , A s s u c h , i t e n s u r e s

t h a t i n a t l eas t some s i t u a t i o n s w h e r e t h e l o n g r u n a v e r a g e

36 T h e size of t h a t a d j n s t m e n t , however , may still depend o n t h e d i r e c t i o n of t h e shock , S u p p o s e e x p o s t a d j u s t a e n t of t h e r u l e is a l l o w e d d u r i n g i a p l e m e n t a t i o n . I f t h e c u r r e n t s h o c k would t a k e r e s e r v e s back t o w a r d s t a r g e t anyway, t h i s aovement c a n be u n r e s t r i c t e d ,

e x c h a n g e r a t e h a s a t r e n d component , i n t e r v e n t i o n a c t i v i t y w i l l

n o t c a u s e s y s t e m a t i c d e v i a t i o n s f rom t h a t t r e n d , F u r t h e r m o r e ,

t h e amended r u l e , l i k e its s i a p l e c o u n t e r p a r t , i m p o s e s o n l y v e r y

s i m p l e i n f o r m a t i o n r e q u i r e m e n t s a n d d o e s n o t aksume t h a t t h e

f o r e i g n e x c h a n g e a u t h o r i t y knows t h e t r u e e q u i l i b r i u m t r e n d ,

The r e s u l t s of t h i s s e c t i o n c a n b e summar ized a s follows,

g h e n t h e s i n t p l i f g i n g a s s u n p t i o n s of t h e p r e v i o u s ' s e c t i o n a r e

r e l a x e d , t h e s i m p l e r e s e r v e management r u l e d e r i v e d i n t h a t

s e c t i o n c a n c o n t i n u e t o min imize t o t a l e x c h a n g e r a t e v a r i a t i o n ,

However, t h e r e is no g u a r a n t e e in t h e o r e t i c a l terms t h a t i t d o e s

s o by o p e r a t i n g o n l y on t h e u n s y s t e m a t i c component of e x c h a n g e

r a t e b e h a v i o u r , A c o u n t e r e x a m p l e showed t h a t i t c a n p r o d u c e e x

post e x c h a n g e ra te b e h a v i o u r which d i f f e x s s y s t e ~ a t i c a l l y f r o n

t h a t p r o d u c e d were r e s e r v e s f i x e d a t t a r g e t a n d t h e e x c h a n g e

r a t e free t o f l a a t , F roan c o n s i d e r a t i o n of t h i s c o u n t e r e x a m p l e ,

a n amended v e r s i o n of the s i m p l e r e s e r v e management r u l e was

d e r i v e d ,

From a p o l i c y p e r s p e c t i v e , however , t h e d e v i a t i o n s produces

by e i t h e r rule are i m p o r t a n t o n l y i f t h e y i n p o s e a cost - w h a t e v e r cos t i s a s s o c i a t e d w i t h h a v i n g t h e wrong e x c h a n g e r a t e

f o r p r o l o n g e d p e r i o d s of time, F u r t h e r m o r e , s u c h cos t s m a t t e r

o n l y when they o u t w e i g h t h e b e n e f i t s o b t a i n e d by t h e r e d u c t i o n

i n u n s y s t e m a t i c e x c h a n g e rate v a r i a t i o n , w i t h its a s s o c i a t e d

i n c r e a s e i n e x c h a n g e f a t e p r e d i c t a b i l i t y , From a p o l i c y

p e r s p e c t i v e , t h e r e f o r e , what matters is t h e r a t e of t r a d e o f f

between t h e r e d u c t i o n i n u n s y s t e m a t i c v a r i a t i o n a n d t h e i n p a c t

on s y s t e m a t i c a d j u s t m e n t . T h i s i n t u r n d e p e n d s on how t h e

r e d u c t i o n i n t o t a l exchange r a t e v a r i a t i o n is d i v i d e d e x p o s t

be tween t h e s y s t e m a t i c a n d u n s y s t e m a t i c c o m p o n e n t s of e x c h a n g e

ra te b e h a v i o u r , A p r i o r i , t h e d i v i s i o n c a n b e ' e x p e c t e d t o d e p e n d

on t h e s i z e of t h e u n s y s t e m a t i c component of t h e exogenous

s h o c k s r e l a t i v e t o t h e i r s y s t e m a t i c componen t, However, f o r \

e i t h e r v e r s i o n of t h e r e s e r v e management r u l e , t h e e x a c t

d i v i s i o n c a n n o t e a s i l y be d e t e r m i n e d a n a l y t i c a l l y , Nor is it a

simple m a t t e r t o d e t e r m i n e hou the d i v i s i o n is a f f e c t e d by t h e

t a r g e t q u a n t i t y of r e s e r v e s , J 7 T h e r e f o r e , s u b s e q u e n t c h a p t e r s

lap t h e groundwork f o r a n e m p i r i c a l e x a m i n a t i o n of t h e s e

q u e s t i o n s u s i n g s i m u l a t i o n t e c h n i q n e s i n a C a n a d i a n c o n t e x t .

Expectations = V a r i a t i o n vs, U n p r e d i c t a b i l i t y

The p r e v i o u s s e c t i o n examined t h e s i m p l e r e s e r v e management

r u l e u s i n g a s i m p l e model of 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 s a

f ramework f o r d i s c a s s i o n . T h a t model, however , a b s t r a c t e d from

t h e i n f l u e n c e o f e x c h a n g e r a t e e x p e c t a t i o n s . This s e c t i o n

e x a m i n e s t h e i m p l i c a t i o n s f o r t h e s i m p l e v e r s i o n of the r u l e

when s u c h e x p e c t a t i o n s are i n t r o d u c e d ,

The i n t r o d u c t i o n of e x p e c t a t i o n s raises a q u e s t i o n n o t

p r e v i o u s l y r a i s e d by s i a p l e c o n s i d e r a t i o n s of e x c h a n g e r a te

d e t e r m i n a t i o n . The a rgumen t d e v e l o p e d i n t h e p r e v i o u s c h a p t e r t o

j u s t i f y e x c h a n g e m a r k e t i n t e r v e n t i o n was t h a t e x c h a n g e rate a n d --------------- 3 7 F o r m a l l y , an a n a l y t i c a l s o l u t i o n r e q u i r e s s o l v i n g equation ( l o ) , t o g e t h e r w i t h e i t h e r e q u a t i o n (4) o r e q u a t i o n (14), a s a s i a u l t a n e o u s d i f f e r e n t i a l e q u a t i o n s y s t e m ,

p r i c e l e v e l o n p r e d i c t a b i l i t y was d e l e t e r i o u s t o w e l f a r e , t h e

r e a s o n b e i n g t h a t i t r e d u c e d t h e u s e f u l n e s s o r q u a l i t y of money.

T h e r e f o r e , it is n o t exchange r a t e v a r i a t i o n p e r se which

m a t t e r s , b u t exchange ra te u n p r e d i c t a b i l i t y , i n g e n e r a l terms,

however, what c o n s t i t u t e s u n p r e d i c t a b i l i t y depends on t h e

s o p h i s t i c a t i o n of t h e p e o p l e d o i n g t h e p r e d i c t i n g - I n o r d e r t o

d e t e r m i n e which component o f exchange ra te behav5.our is

u n p r e d i c t a b l e or u n a n t i c i p a t e d , t h e mechanism by which

p r e d i c t i o n s o r e x p e c t a t i o n s a r e f o r ~ e d must be known.

As a c a s u a l o b s e r v a t i o n , K l e i n (1974a) n o t e s t h a t

p r e d i c t i o n may be f a c i l i t a t e d a s much by a c o n s t a n t d e p r e c i a t i o n

a s by a c o n s t a n t exchange r a t e l e v e l , K l e i n 9 s o b s e r v a t i o n c a n be

i n t e r p r e t e d a s i m p l y i n g t h a t p e o p l e c a n i d e n t i f y and p r e d i c t a

c o n s t a n t exchange rate t r e n d , R e d u c t i o n o f u n p r e d i c t a b i l i t y

t h e r e f ore i n v o l v e s r e d u c i n g u n p r e d i c t a b l e exchange r a t e

var i a t i o a a r o u n d t h a t t r e n d , However, when t h e s e e x p e c t a t i o n s

a r e c o r r e c t , t h e n t h e p r e d i c t a b l e component of exchange ra te

b e h a v i o u r c o i n c i d e s wi th i ts a c t u a l s y s t e m a t i c movement- T h e r e

is t h e n no d i f f e r e n c e b e t v e e n t h e u n p r e d i c t a b l e component and

the u n s y s t e m a t i c component of e x c h a n g e r a t e v a r i a t i o n ,

T h i s argument c a n be g e n e r a l i z e d , Phen e x p e c t a t i o n s are

r a t i o n a l , t h e n exchange r a t e b e h a v i o u r w i l l have a s y s t e m a t i c or

e q u i l i b r i u m component which v i l l reflect a l l t h a t is known o r

p r e d i c t a b l e e x ante a b o u t t h e p r o c e s s of exchange rate

d e t e r m i n a t i o n , g i v e n t h e i n f o r m a t i o n c u r r e n t l y a v a i l a b l e , There

w i l l a l s o be a component o f v a r i a t i o n a r o u n d t h a t e q u i l i b r i u m

exchange r a t e which will reflect a l l t h a t i s unknown o r

u n p r e d i c t a b l e a b o u t t h e p r o c e s s of exchange rate d e t e r m i n a t i o n ,

T h e r e f o r e , if t h e s i m p l e r e s e r v e management r u l e can minimize

u n s y s t e m a t i c v a r i a t i o n i n t h e exchange r a t e around its

s y s t e m a t i c e q u i l i b r i u m component, t h e n it w i l l a l s o minimize t h e

u n p r e d i c t a b l e component o f exchange r a t e behav iour , The q u e s t i o n

remain ing , o n c e aga in , i s w h e t h e r a r u l e which l e a n s a g a i n s t t h e

wind c a n minimize t h e u n s y s t e m a t i c component w i t h o u t a f f e c t i n g

t h e s y s t e m a t i c conponent ,

T h i s q u e s t i o n is examined i n Appendix 11, w h e r e t h e s i m p l e

@ o d e 1 o f exchange ra te d e t e r a i n a t i o n is e x t e n d e d t o i n c l u d e t h e

e x p e c t a t i o n s of f u t u r e exchange r a t e s and a r a t i o n a l

e x p e c t a t i o n s s o l u t i o n is t h e n d e r i v e d , The above q u e s t i o n i s i n

many ways e a s i e r t o answer t h a n p r e v i o u s l y . W i t h r a t i o n a l

e x p e c t a t i o n s , t h e p u b l i c ' s presumed knowledge of t h e s t r u c t u r e

of t h e exogenous shocks , though n o t t h e i r e x a c t va lue , i tself

h a s a b e a r i n g on t h e s y s t e m a t i c component o f exchange r a t e

b e h a v i o u r , w i t h o r w i t h o u t i n t e r v e n t i o n , T h e r e f o r e , t h e answer

d o e s n o t depend on t h e s t r u c t u r e of t h e shocks , F u r t h e r n o r e ,

Appendix I1 s h o w s t h a t t h e s i m p l e r e s e r v e management r u l e

a f f e c t s o n l y t h e u n p r e d i c t a b l e component of exchange r a t e

behav iour , By l e a n i n g a g a i n s t t h e u ind ,3* i t r e d u c e s t h i s

component w i t h o u t a f f e c t i n g t h e s y s t e a a t i c component.

-------------- 38 As i n t h e p r e v i o u s s e c t i o n , t h e r u l e is c h a r a c t e r i z e d by a n i n t e r v e n t i o n p a r a i a e t e r l y i n g i n t h e c l o s e d i n t e r v a l 10,1],

An i n t u i t i v e e x p l a n a t i o n o f t h i s r e s u l t can be g i v e n b y

r e f e r e n c e t o t h e e a r l i e r l i t e r a t u r e on t h e i r a p l i c a t i o n s o f

r a t i o n a l e x p e c t a t i o n s i n a macroeconomic c o n t e x t , Sargent and

a a l l a c e (1976) , f o r example , have a r g u e d t h a t ;hen e x p e c t a t i o n s

a r e r a t i o n a l , t h e r e is no f e e d b a c k r u l e t h a t t h e monetary

a u t h o r i t y c a n use t o s y s t e m a t i c a l l y d i r e c t t h e l e v e l of

unemployment t o some d e s i r e d l e v e l , Unetaployment' w i l l s i m p l y

r e v e r t t o t h e n a t u r a l r a t e , a s i t would w i t h o u t c o u n t e r c y c l i c a l

p o l i c y , u n l e s s u n a n t i c i p a t e d s h o c k s i n t h e f o r n of u n a n t i c i p a t e d

i n f l a t i o n c a n s e s h o r t term d e v i a t i o n s , Soch a r g n n e n t s h a v e been

used to s u p p o r t M i l t o n Fre idmant s c o n s t a n t monetary growth r u l e

r a t h e r t h a n i n t e r v e n t i o n a r y p o l i c y . 3 9 However, S h i l l e r (1978)

and Roper and Turnovskp (1980). f o r example, n o t e t h a t t h e

monetary a u t h o r i t y may b e able t o r e d u c e t h e v a r i a t i o n i n

unemployment a round its n a t u r a l r a t e a n d offse t the i m p a c t of

u n a n t i c i p a t e d shocks, I n t h e same way, t h e s i m p l e r e s e r v e

management r u l e can r e d u c e t h e i m p a c t t h a t u n a n t i c i p a t e d s h o c k s

have on t h e exchange r a t e , a l t h o u g h when e x p e c t a t i o n s a r e

r a t i o n a l , i t c a n n o t i n f l u e n c e t h e s y s t e m a t i c , a n t i c i p a t e d

component of exchange rate behav iour , T h i s r e m a i n s t h e saiae a s

it would w i t h o u t i n t e r v e n t i o n -

Fur the rmore , a s is a l s o conf i rmed i n Appendix 11, t h e

amount by which t h e r e s e r v e management r u l e r e d u c e s t h e i m p a c t

----------------- 39 Another r e a s o n f o r t h e advocacy of a c o n s t a n t a o n e t a r p growth ru le is t h e b e l i e f t h a t monetary p o l i c y o p e r a t e s on unemployment w i t h a l o n g and v a r i a b l e l a g , b u t t h e same c a n n o t b e s a i d of t h e o p e r a t i o n o f r e s e r v e c h a n g e s o n t h e exchange r a t e .

o f u n a n t i c i p a t e d s h o c k s d e p e n d s on how l o n g t h o s e s h o c k s , o n c e

t h e y h i t , a r e e x p e c t e d t o l a s t , A t one ext reme, when t h e shock

is e x p e c t e d t o l a s t f o r o n l y one p e r i o d , t h e r e s e r v e management

r u l e c a n have its s t r o n g e s t effect on l i m i t i n g t h e u n p r e d i c t a b l e

exchange rate a d j u s t n e n t . It r e i n f o r c e s t h e limits a l r e a d y

p l a c e d on t h a t a d j u s t m e n t by t h e e x p e c t a t i o n o f t h e s h o c k ' s

f u t u r e e l i m i n a t i o n , Whereas p r e v i o u s l y , t h e s e t t i n g o f l i m i t s on

c u m u l a t i v e r e s e r v e moveaents a l l o w e d t h e r e s e r v e management r u l e

t o s c r e e n o u t t e m p o r a r y exchange r a t e movement w h i l e allowing a t

l e a s t some pe rmanen t a d j u s t m e n t t o t a k e p l a c e , t h i s a u t o n a t i c

s e l e c t i o n is now r e i n f o r c e d b y t h e p u b l i c a s own knowledge o f t h e

n a t u r e of t h e shocks. Bouever, t h e l o n g e r t h e shock i s e x p e c t e d

t o l a s t , t h e l a r g e r would be t h e immedia te exchange r a t e

a d j u s t m e n t i n t h e a b s e n c e of i n t e r v e n t i o n , . The r u l e would t h e n

fie l e a n i n g a g a i n s t a s t r o n g e r wind, and i ts irapact i s d i l u t e d

a c c o r d i n g l y -

T h e a n a l y s i s i n Appendix 11 y i e l d s one f i n a l r e s u l t ,

C o n s i d e r t h e a rgument reviewed i n t h e p r e v i o u s c h a p t e r which s a v

i n t e r v e n t i o n a s aimed a t e l i a i n a t i n g t h e p o s s i b i l i t y of

d e s t a b i l i z i n g s p e c u l a t i o n , T h e r e it was a r g u e d t h a t t h i s view

was based on a s p u r i o u s d i s t i n c t i o n between t h e e q u i l i b r i u m

exchange rate c o n s i s t e n t w i t h u n d e r l y i n g e rea le f o r c e s and t h e

e q u i l i b r i u n s u l l i e d , a s i t were, by ( u n r e a l ? ) asset p o r t f o l i o

a d j n s t s e n t s , Eiowever, it was a l s o n o t e d t h a t t h e r e was no

g u a r a n t e e t h a t r a t i o n a l e x p e c t a t i o n s c o u l d n o t b e d e s t a b i l i z i n g ,

i n t h e s e n s e of p r o d u c i n g e x p l o s i v e exchange r a t e movements,

Appendix I1 shows t h a t so l o n g as d o m e s t i c mone ta ry p o l i c y 4 0 is

n o t ' t o o f a r 1 o u t of l i n e w i t h t h e u n d e r l y i n g exogenous

d e t e r n i n a n t s of t h e p r i v a t e sector's w i l l i n g n e s s t o h o l d money,

t h e n r a t i o n a l e x p e c t a t i o n s p i l l n o t b e d e s t a b i h i n g .

F u r t h e r m o r e , this c o n d i t i o n does n o t depend o n exchange m a r k e t

i n t e r v e n t i o n , o r t h e l a c k of it, T h i s s u g g e s t s , t h e r e f o r e , that

a t l e a s t i n t h e c o n t e x t of t h e s i m p l e e x c h a n g e r a t e model u n d e r

c o n s i d e r a t i o n , t h e s i m p l e r e s e r v e management policy d e v e l o p e d i n

t h i s s e c t i o n v i l l n o t , by i t se l f , i n d u c e i n s t a b i l i t y -

---------------- 4 0 T h i s is d e f i n e d a s t h e b e h a v i o u r of t h e d o m e s t i c component of t h e monetary base.

IV. PBIVATE SECTOR BEHAYIOlJB - THEORY A I D ESTIMATION

The p r e v i o u s c h a p t e r d e r i v e d b o t h s i m p l e and amended

v e r s i o n s of a r e s e r v e management r u l e v h i c h were d e s i g n e d t o

a i n i m i z e e x c h a n g e rate v a r i a t i o n w h i l e r e c o g n i s i n g t h a t t h e r e

are l i m i t s t o cumulative r e s e r v e ~ o v e m e n t , T h e problem was

f o r m o l a t e d a s a n i n v e n t o r y o r r e s e r v e management problem- The

r e s u l t i n g r u l e s ~ p e c i f y t h e r e s e r v e b e h a v i o u r d e s i r e d e x a n t e by

the f o r e i g n e x c h a n g e a u t h o r i t y i n terms of o p t i m a l l i m i t s on e x

p o s t r e s e r v e b e h a v i o u r ,

However, t h e r u l e s were d e r i v e d u n d e r a v e r y s i m p l e

a s s u m p t i o n about e x p o s t r e s e r v e b e h a v i o u r i n t h e a b s e n c e of

s u c h o p t i m a l i n t e r v e n t i o n , T h i s a s s u m p t i o n was t h e n r e p l a c e d by

a more g e n e r a l r e l a t i o n s h i p , v h i c h s h o v e d t h a t while t h e

a u t h o r i t y n i g h t c h o o s e t h e amount of r e s e r v e a d j u s t m e n t t h a t

a c c o m p a n i e s a n y p a r t i c u l a r shock , t h e amount of e x c h a n g e r a t e

a d j u s t m e n t is d e t e r m i n e d a s well by p r i v a t e sector b e h a v i o u r a n d

t h e r e q u i r e m e n t s f o r a o n e t a r p e q o i l i b r i u a , R i t h i n t h i s more

g e n e r a l e n v i r o n m e n t , t h e r u l e s ' i n p a c t on e x p o s t e x c h a n g e ra te

and r e s e r v e b e h a v i o u r was d i f f i c u l t t o d e t e r m i n e a n a l y t i c a l l y ,

a t l e a s t i n s i t u a t i o n s where i n d i v i d u a l s d i d n o t have s u f f i c i e n t

i n f o r m a t i o n t o form s t r i c t l y r a t i o n a l e x c h a n g e r a t e

e x p e c t a t i o n s , I n p a r t i c u l a r , x u h i l e it c o u l d b e shown t h a t the

s i m p l e r u l e c o n t i n u e d t o minimize t o t a l e x c h a n g e r a t e v a r i a t i o n ,

t h e r e l a t i v e i m p a c t s of e i t h e r r u l e on t h e s y s t e m a t i c and

u n s y s t e m a t i c c o m p o n e n t s of e x c h a n g e r a t e b e h a v i o u r c o u l d n o t

e a s i l y be de te rmined . T h e r e f o r e , t h i s q u e s t i o n r e q u i r e s f u r t h e r

e x a m i n a t i o n on a n e m p i r i c a l l e v e l ,

T h e c h a p t e r which f o l l o w s r e p o r t s t h e r e su l t s of a n

e m p i r i c a l e x a m i n a t i o n , u s i n g s i m l a t i o n t e c h n i q u e s , i n a

Canadian c o n t e x t . However, i n o r d e r t o p e r f orrn t h a t s i m u l a t i o n ,

the s i m p l e model o f p r i v a t e s e c t o r n e e d s t o b e deve loped i n two

ways, On a t h e o r e t i c a l l e v e l , t h e s o u r c e and i m p a c t o f t h e

exogenous shocks h i t t i n g t h e exchange marke t must b e i d e n t i f i e d

Bore p r e c i s e l y , Second ly , t h e p r i v a t e sector b e h a v i o u r a l .

e q u a t i o n mast be e s t i m a t e d i n t h e same c o n t e x t i n which t h e

s i m u l a t i o n s a r e performed. This c h a p t e r r e p o r t s t h e s e

developments , and t h u s d e s c r i b e s t h e s i m u l a t i o n envi ronment ,

The e x t e n d e d n o d e l of p r i v a t e b e h a v i o u r is m o n e t a r i s t , a s

b e f o r e , i n t h e s e n s e t h a t i t r e g a r d s asset demands and t h e

a d j u s t m e n t t o p o r t f o l i o e q u i l i b r i u m a s p l a y i n g a n i m p o r t a n t p a r t

i n exchange rate d e t e r m i n a t i o n , a l t h o u g h i n t e r n a t i o n a l t r a d e i n

gooas is no l o n g e r ignored , I n a d d i t i o n , many o f t h e

a s s u m p t i o n s , r e f l e c t i n g some of t h e juagements made i n Chap te r

2, a r e d i s t i n c t l y m o n e t a r i s t i n f l a v o u r . The i m p o r t a n t

a s s n m p t i o n s are:

( i ) d o m e s t i c p r i c e l e v e l f l e x i b i l i t y ,

( i i ) a s i n g l e t r a d e d good,

( i i i ) p e r f e c t goods a r b i t r a g e be tween c o u n t r i e s ,

( i v ) p e r f e c t capital m o b i l i t y , b a t n o t p e r f e c t s u b s t i t u t a b i l i t y ,

b e t ween d o m e s t i c and f o r e i g n bonds,

(v) t h e p o s s i b i l i t y o f c u r r e n c y s u b s t i t u t i o n ,

P r i c e l e v e l f l e x i b i l i t y e n s u r e s t h a t f u l l employment is

m a i n t a i n e d , T h i s a s s u m p t i o n reflects t h e judgement t h a t

v a r i a t i o n i n t h e l e v e l of employment , t o t h e e x t e n t t h a t i t d o e s

o c c u r , d o e s not p r o v i d e a j u s t i f i c a t i o n f o r fo;eign e x c h a n g e

m a r k e t i n t e r v e n t i o n , The a s s u m p t i o n of a s i n g l e t r a d e d good

means t h a t s t r u c t u r a l effects a n d t h e d i f f e r e n t i a l i m p a c t of

e x o g e n o u s s h o c k s o n t r a d e d and n o n - t r a d e d g o o d s sectors, o r

i m p o r t a n d e x p o r t sectors, c a n n o t be s t u d i e d , Again, t h i s

s i m p l i f i c a t i o n reflects t h e judgemen t t h a t s u c h s t r u c t u r a l

effects, t o the e x t e n t t h a t t h e y h a v e welfare i m p l i c a t i o n s

b e c a u s e o f m a r k e t i a t l pe r f ec t ions , a r e n o t t h e p r o p e r c o n c e r n of

t h e f o r e i g n e x c h a n g e a u t h o r i t y , P e r f e c t i n t e r n a t i o n a l a r b i t r a g e

o f a s i n g l e t r a d e d good i m p l i e s t h a t t h e d o m e s t i c a n d f o r e i g n

p r i c e l e v e l s a r e l i n k e d t h r o u g h t h e p u r c h a s i n g power p a r i t y

c o n d i t i o n , I n c o n t r a s t , t h e a s s u m p t i o n of less t h a n p e r f e c t

s u b s t i t u t a b i l i t y b e t w e e n d o m e s t i c a n d f o r e i g n bonds means t h a t

t h e s t a n d a r d i n t e r e s t p a r i t y c o n d i t i o n is n o t invoked , T h i s

l a t t e r c o n d i t i o n p r e s u m e s r i s k n e u t r a l i t y , The c u r r e n t

f o r m u l a t i o n t h e r e f ore allows t h a t t h e r e may b e i m p o r t a n t

c o m p o n e n t s of t h e o v e r a l l r e t u r n t o bond h o l d i n g , p a r t i c u l a r l y

r i s k p remia , which a re r e f l e c t e d i n o n c o v e r e d i n t e r e s t rate

d i f f e r e n t i a l s . If a l l r i s k s h a r i n g o c c u r s t h r o u g h c a p i t a l

m a r k e t s , t h e r e w i l l be n o c o m p a r a b l e r i s k premia a t t a c h e d t o

g o o d s p r i c e s , F i n a l l y , it is assumed t h a t i n d i v i d u a l s c a n h o l d

b o t h d o m e s t i c and f o r e i g n aoney, T h u s c u r r e n c y s u b s t i t o t i o n by

p r i v a t e i n d i v i d u a l s i s p o s s i b l e ,

f rom t h e s e a s s u m p t i o n s , a n e q u a t i o n is d e r i v e d which

d e s c r i b e s t h e r e l a t i o n s h i p b e t w e e n e x c h a n g e rate and r e s e r v e

c h a n g e s t h a t i s c o n s i s t e n t v i t h s t o c k a n d flow e q u i l i b r i u m i n

t h e p r i v a t e sector, T h i s e q u a t i o n is t h e r e f o r & a n a l o g o u s t o t h e

s i m p l e d e s c r i p t i o n o f p r i v a t e sector b e h a v i o u r from t h e p r e v i o u s

c h a p t e r , a l t h o u g h , t h r o u g h a s u p p l y a n d demand s y s t e m , t h e

exogenous i n f l u e n c e s are now i d e n t i f i e d e x p l i c i t 3 y .

The p a r a m e t e r s o f t h i s e q u a t i o n a re t h e n e s t i m a t e d i n a

C a n a d i a n c o n t e x t , T h e r e f ore, Canada becomes t h e * d o m e s t i c *

c o u n t r y a n d i t s major t r a d i n g p a r t n e r , t h e U n i t e d S t a t e s , is

t r e a t e d a s t h e * f o r e i g n * c o u n t r y or t h e *rest of t h e wor lds , The

p a r a m e t e r e s t i m a t i o n d r a w s on d a t a f r o a b o t h t h e s e c o u n t r i e s

o v e r t h e p e r i o d J u l y 1970 t o March 1979, a p e r i o d i n which t h e

e x c h a n g e rate be tween them f l o a t e d , t h o u g h n o t freely,

F u r t h e r i n o r e , it is assumed t h a t t h e o p t i m a l i n t e r v e n t i o n r u l e

o p e r a t e s a s a s h o r t term p o l i c y - t h e d e c i s i o n o n p o l i c y

s e t t i n g s is t a k e n monthly, r a t h e r t h a n q u a r t e r l y o r y e a r l y , i n

o r d e r t o smoo th s h o r t term e x c h a n g e r a t e v a r i a t i o n , T h e r e f o r e ,

month ly d a t a a r e u s e d i n e s t i m a t i n g p a r a m e t e r v a l u e s for t h e

p r i v a t e sector b e h a v i o u r a l e q u a t i o n ,

The d i s c u s s i o n p r o c e e d s i n s e v e r a l p a r t s - F i r s t l y , t h e

r e q u i r e d e q u a t i o n is d e r i v e d from a demand a n d s u p p l y f r a n e w o r k ,

Next t h e a p p r o p r i a t e e s t i m a t i o n t e c h n i q u e s are s e l e c t e d and t h e

r e s u l t s , o b t a i n e d u n d e r s e v e r a l a l t e r n a t i v e t e c h n i q u e s and

f o r m u l a t i o n s , a r e r e p o r t e d , F i n a l l y , t h e o b s e r v e d e s t i m a t e s are

compared vith a p r i o r i b e l i e f s a b o u t t h e i r v a l u e s .

T h e o r e t i c a l Framework ---- P r i v a t e sector r e a c t i o n t o r e s e r v e a n d exchange r a t e

c h a n g e s d e r i v e s f r o m t h e r e q u i r e m e n t s f o r equ i ' l i b r ium i n t h e

m a r k e t s f o r g o o d s a n d assets. B e g i n by c o n s i d e r i n g t h e demands

f o r t h o s e g o o d s a n d assets,

I n d i v i d u a l s a re assumed t o c h o o s e c u r r e n t r e a l c o n s u m p t i o n

c, nomina l h o l d i n g s of d o m e s t i c money a n d b o n d s 8 d a n d Bd

(denomina ted i n d o m e s t i c c u r r e n c y ) , a n d h o l d i n g s o f f o r e i . g n

money and b o n d s i9f a n d B f (denomina ted i n f o r e i g n c u r r e n c y ) , s o

a s t o maximize a u t i l i t y f u n c t i o n o f t h e form

U = U (c,Hd/P,e&f/P,Bd/P,eBf/~) = U (c,md,mf, bd,bf) (75)

where e Is t h e e x c h a n g e ra te , d e f i n e d a s t h e d o m e s t i c c u r r e n c y

p r i c e of f o r e i g n c u r r e n c y , and P is t h e domestic p r i c e level,

The m a x i n i z a t i o n i s s u b j e c t t o a w e a l t h c o n s t r a i n t

a n d a n income c o n s t r a i n t

where y is r e a l income f r o m human s o u r c e s , r and r* a re t h e

d o m e s t i c a n d f o r e i g n nomina l i n t e r e s t rates and a is t h e

e x p e c t e d rate of e x c h a n g e d e p r e c i a t i o n , 1

I n t h i s timeless f o r m u l a t i o n of t h e c h o i c e problem, u t i l i t y

d e p e n d s o n t h e rea l v a l u e of t h e s t o c k h o l d i n g s of nomina l

T h i s a p p r o a c h is similar t o t h a t of Klein 1797LCb) a n d Bordo and Choudhr i (1982).

a s s e t s , i n c l u d i n g money. The u t i l i t y f u n c t i o n c a n be r e g a r d e d as

a n i n d i r e c t u t i l i t y f u n c t i o n , a p p r o x i m a t i n g t h e outcome o f some

e x p l i c i t i n t e r t e m p o r a l maximizat ion i n which nominal a s s e t s Bay

o r may n o t y i e l d d i r e c t non-pecun ia ry s e r v i c e s ; b u t c e r t a i n l y

a p p e a r i n t h e i n t e r t e m p o r a l b u d g e t c o n s t r a i n t a s a means o f

t r a n s f e r r i n g p u r c h a s i n g power t h r o u g h time. The above u t i l i t y

f u n c t i o n c a n a l s o reflect d i f f e r e n c e s i n a t t i t u d e t o w a r d s

d o m e s t i c and f o r e i g n nominal a s s e t s , p a r t i c u l a r l y t h o s e which

a r i s e from a t t i t u d e s toward r i s k , T h e r e f o r e , t h i s g e n e r a l .

u t i l i t y •’ u n c t i o ~ c a n c a p t u r e i n d i v i d u a l p r e f e r e n c e s w i t h r e s p e c t

t o bo th t h e consumpt ion-sav ings d e c i s i o n a n d t h e p o r t • ’ o l i o

c o m p o s i t i o n d e c i s i o n ,

The w e a l t h c o n s t r a i n t t a k e s t h e s t a n d a r d fern- T h e income

c o n s t r a i n t s t a t e s t h a t c u r r e n t r e a l consumpt ion is l i m i t e d by

t h e s u m o f r e a l i n c o m e s f r o @ human and f i n a n c i a l s o u r c e s . The

income and wea l th c o n s t r a i n t s c a n b e combined, by e l i m i n a t i n g

domestic band h o l d i n g s , t o g i v e

y + ru = c + rmd + (r-a)mf + (r-r*-ajbf i 1 8 )

The l e f t hand s i d e of t h i s e q u a t i o n is a measure of t h e r e a l

income s t r e a m d e r i v e d f r o a b o t h human and non-human s o u r c e s .

T h i s must e q u a l c u r r e n t r e a l ' consumpt ion8 of goods and a s s e t s ,

where t h e a s s e t s a re weighted by t h e i r o p p o r t u n i t y cost r e l a t i v e

t o domes t i c bonds. \

Baximiza t ion of u t i l i t y s u b j e c t t o t h i s combined budge t

c o n s t r a i n t g i v e s t h e demand e q u a t i o n s f o r real consumpt ion and

r e a l a s s e t h o l d i n g s a s f u n c t i o n s of r e a l human income, r e a l

f i n a n c i a l w e a l t h a n d t h e s e o p p o r t u n i t y c o s t s , T h e s e demand

e q u a t i o n s c a n t h e n be r e a r r a n g e d s o a s t o b e f u n c t i o n s of r e a l

human income, real f i n a n c i a l wea l th , nominal i n t e r e s t r a t e s and

t h e e x p e c t e d r a t e o f d e p r e c i a t i o n :

Without a s suming an e x p l i c i t f u n c t i o n a l form f o r t h e

u t i l i t y f u n c t i o n , t h e f o l l o w i n g s i g n s c a n be imputed t o t h e

p a r t i a l d e r i v a t i v e s o f t h e demand f u n c t i o n s :

where c i , li, m i , n i and q i are p a r t i a l d e r i v a t i v e s o f t h e

c o r r e s p o n d i n g demand f u n c t i o n s wi th r e s p e c t t o t h e i t h argument,

T h i s a s s i g n m e n t reflects t h e a s s u m p t i o n t h a t a n i n c r e a s e i n t h e

o p p o r t u n i t y c o s t of a p a r t i c u l a r a s s e t d e c r e a s e s demand f o r t h a t

a s s e t and i n c r e a s e s demand f o r i ts s u b s t i t u t e s , It a l s o assumes

t h a t *ounl o p p o r t u n i t y c o s t effects domina te a c r o s s a ef fects.2

F i n a l l y , i n c r e a s e s i n r e a l human income o r real f i n a n c i a l wea l th

a r e assumed t o have positive effects on a l l demands- The s i g n s

of t h e s e p a r t i a l d e r i v a t i v e s a r e i m p o r t a n t i n t h a t t h e y

d e t e r m i n e t h e e x p e c t e d s i g n s of t h e c o e f f i c i e n t s a t t a c h e d t o t h e ----------------- \

2 For exalaple, t h e d o m e s t i c i n t e r e s t r a t e r a f f e c t s t h e denand f o r d o m e s t i c money md because it a f f e c t s , n o t only money's own o p p o r t u n i t y cost , b u t a l s o t h e o p p o r t u n i t y c o s t s of two of its s u b s t i t u t e s - f o r e i g n soney and f o r e i g n bonds, It i s assumed t h a t t h e f irst effect domina tes -

e s t i m a t i n g e q u a t i o n ,

Lf f o r e i g n e r s face a s imilar c h o i c e problem, a n a n a l o g o u s

a r g u m e n t g i v e s f o r e i g n demands f o r t h e c o n s u m p t i o n good c*, f o r

f o r e i g n money and bonds mf* and bf* a n d f o r d6mes t ic money a n d

b o n d s md* and bd*, I f it is assumed t h a t f o r e i g n e r s h a v e t h e

same b e l i e f s a b o u t t h e exchange ra te a s d o m e s t i c r e s i d e n t s , t h e n

a r e p r e s e n t s , t o f o r e i g n e r s , t h e e x p e c t e d ra te of a p p r e c i a t i o n

of t h e i r c u r r e n c y . With t h i s i n mind, t h e f o r e i g n demand

e q u a t i o n s c a n be w r i t t e n a s

c* = c* (r,r*,a,y*, w*) ad* = I* (r,r*,a.y*,w*) mf * = m* ( r , r* ,a , y*, w*) bd* = n*(r,r*,a,y*,w*) bf * = q* (r,r*,a,f*,w*)

and t h e following s i g n s c a n be i m p u t e d t o t h e p a r t i a l

d e r i v a t i v e s :

So f a r n o e x p l i c i t f u n c t i o n a l form has been assumed fo r t h e

u t i l i t y f u n c t i o n s or demand e q u a t i o n s i n e a c h c o u n t r y , However,

s n b s e q u e n t a n a l y s i s w i l l make u s e of t h e p a r t i a l d e r i v a t i v e s of

t h e demand e q u a t i o n s , r e p r e s e n t i n g a s t h e y do t h e income,

i n t e r e s t etc, s e n s i t i v i t i e s of g o o d s a n d asset demands- I n

a d d i t i o n , i t w i l l b e assumed t h a t t h e s e s e n s i t i v i t i e s are a t \

l e a s t a p p r o x i m a t e l y c o n s t a n t , T h e r e f o r e , the f o l l o w i n g a n a l y s i s

is c o n s i s t e n t w i t h any demand s y s t e m which y i e l d s p a r t i a l

d e r i v a t i v e s o f t h i s form,

The c h o i c e p r o b l e m f o r a s i n g l e i n d i v i d u a l i n e a c h c o u n t r y

h a s now b e e n o u t l i n e d , If t h a t i n d i v i d u a l is a * r e p r e s e n t a t i v e n

i n d i v i d u a l , t h e n t h e demand e q u a t i o n s d e r i v e d above c a n a l s o b e

used t o c h a r a c t e r i z e a g g r e g a t e demands i n eacg c o u n t r y , It

r e m a i n s t o s p e c i f y t h e s u p p l i e s of g o o d s and a s s e t s a n d t o

i n v o k e marke t c l e a r i n g c o n d i t i o n s ,

It is assumed t h a t t h e r e is s u f f i c i e n t wage a n d p r i c e

f l e x i b i l i t y i n e a c h c o u n t r y t o e n s u r e t h a t f u l l employment is

~ a i n t a i n e d . T h e r e f o r e , t h e l e v e l of o u t p u t of t h e s i n g l e

c o n s u m p t i o n g o o d i n e a c h c o u n t r y will be t h a t p roduced by t h e

f u l l y e a p l o y e d l a b o u r force. Hence t h e terms y a n d y*, which now

measure a g g r e g a t e r ea l income from human s o u r c e s , a l s o measure

a g g r e g a t e r e a l o u t p u t i n e a c h c o u n t r y , J a n d a r e t r e a t e d a s

exogenous,

The s u p p l y of d o m e s t i c money i s a c o n s t a n t f r a c t i o n k of

t h e d o m e s t i c mone ta ry base, T h i s base h a s a aomestic and a

f o r e i g n component , The d o m e s t i c componen t D c o m p r i s e s d o m e s t i c

government b o n d s h e l d by t h e b a n k i n g sys t em- ' The f o r e i g n

component c o m p r i s e s t h e d o m e s t i c c u r r e n c y v a l u e of f o r e i g n

exchange r e s e r v e s e R , where R m e a s u r e s t h e f o r e i g n c u r r e n c y

v a l u e o f t h e s e r e s e r v e s a n d e is t h e e x c h a n g e rate. Hence t h e

d o m e s t i c money s u p p l y c a n be w r i t t e n :

3 S i n c e t h e a n a l y s i s a b s t r a c t s from r e p r o d u c i b l e c a p i t a l , t h e r e a l r e t u r n t o capital need n o t be a d d e d i n o r d e r t o measure t o t a l o u t p u t ,

4 It is assumed t h a t domestic b a n k s do n o t h o l d f o r e i g n b o n d s a s r e s e r v e s .

PI = k ( e R + D)

f o r s i m p l i c i t y , it is assumed t h a t k = 1,

The s u p p l y o f f o r e i g n money is s i m i l a r l y g i v e n by:

#* = k*(R*/e + D*) [24)

where h e r e a l l m a g n i t u d e s e x c e p t R* are denomina ted i n f o r e i g n

c u r r e n c y and , a g a i n , i t is assumed t h a t k* = 1,

F i n a l l y , s u p p l i e s of d o m e s t i c b o n d s B a n d f o r e i g n b o n d s B*

are assumed t o be e x o g e n o u s l y g i v e n , The a n a l y s i s a b s t r a c t s f rom

t h e i s s u i n g of d e b t i n s t r u n e n t s by p r i v a t e i n d i v i d u a l s , s o t h a t

a l l bonds a r e government bonds, The t o t a l s t o c k of b o n d s

o u t s t a n d i n g is t h e r e f o r e d e t e r a i n e d by c n r r e n t and p a s t

government budge t d e f i c i t s , whose v a l u e i s se t by c o n s i d e r a t i o n s

o u t s i d e t h e ~ o d e l , In a d d i t i o n , i t is assumed t h a t t h e

government can c o n t r o l t h e number o f bonas D h e l d by t h e b a n k i n g

s y s t e a - t h a t is, i t c a n c o n t r o l , by open marke t o p e r a t i o n s , t h e

d o m e s t i c component of the mone ta ry b a s e ,

Rhen t h e ~ a r k e t c l e a r i n g c o n d i t i o n s are invoked , it must be

remembered t h a t t h e m a r k e t s f o r a l l g o o d s and assets e x t e n d

beyond t h e b o r d e r s of a n y o n e c o u n t r y , I n t h e goods m a r k e t , t h i s

a e a n s t h a t t o t a l g o o d s deraand e q u a l s t o t a l goods supp ly :

c + c * = P + Y* ( 2 5 )

o r t h a t a t r a d e d e f i c i t ( d i s s a v i n g ) i n o n e c o u n t r y is b a l a n c e d

by a trade s u r p l p l s ( s a v i n g ) i n t h e o t h e r , S i m i l a r l y , t h e s u p p l y

of d o m e s t i c money e q n a l s t h e sum of demands by d o m e s t i c

r e s i d e n t s a n d f o r e i g n e r s : s

5 = e R + D = a d + md* P P

Likewise , t h e s u p p l y o f f o r e i g n money e q u a l s t h e sum of demands

by f o r e i g n e r s and dcmestic r e s i d e n t s :

w h e r e P* is t h e f o r e i g n p r i c e l e v e l , The s u p p l y of d o m e s t i c

bonds e q u a l s t h e sum o f h o l d i n g s by d o a e s t i c r e s i d e n t s ,

f o r e i g n e r s a n d t h e d o m e s t i c b a n k i n g sys tem:

B = bd + bd* + g - P P

The s u p p l y of f o r e i g n bonds e q u a l s t h e sum of h o l d i n g s by

d o m e s t i c r e s i d e n t s , f o r e i g n e r s a n d t h e f o r e i g n b a n k i n g sys tem:

The m a r k e t c l e a r i n g c o n d i t i o n s a l r e a d y i n c o r p o r a t e a n

i m p l i c i t assu s p t i o n of p u r c h a s i n g power p a r i ty:6

P = eP* (30)

It is f a r t h e r assumed t h a t t h e f o r e i g n p r i c e l e v e l is

e x o g e n o u s l y g i v e n - e i t h e r b e c a u s e t h e d o m e s t i c c o u n t r y is s m a l l

by compar i son , or beca u s e f o r e i g n p r i c e s are some ( n n s p e c i f i e d )

f u n c t i o n of f o r e i g n mone ta ry a n d f i s c a l p o l i c y i n i t i a t i v e s -

F i n a l l y , t h e t o t a l wor ld s u p p l y of f o r e i g n e x c h a n g e r e s e r v e s is ------we---------

5 A marke t c l e a r i n g c o n d i t i o n of t h i s form p r e s u m e s t h a t b o t h d o m e s t i c a n d f o r e i g n h o l d e r s < o f d o m e s t i c c u r r e n c y h o l d t h e s e d e p o s i t s i n d o m e s t i c banks , Hence t h e a n a l y s i s a b s t r a c t s from s o - c a l l e d E u r o c u r r e n c y d e p o s i t s .

6 O t h e r w i s e t h e c l e a r i n g c o n d i t i o n f o r d o m e s t i c money, f o r example, would c o n t a i n t h e term [ eP*/P]md* i n s t e a d of md*,

assumed f i x e d ( i n f o r e i g n c u r r e n c y t e rms)

R + e R * = R o

so a s t o be c o n s i s t e n t w i t h t h e a r g u m e n t s of t h e p r e v i o u s

c h a p t e r ,

T h e g o o d s marke t clearing c o n d i t i o n d e s c r i b e s world f low

s a v i n g s e q u i l i b r i u m . It is a d i r e c t s t a t e m e n t of Walras law

a p p l i e d to f lows, T h e n e x t f o u r c o n d i t i o n s d e s c r i b e world s t o c k

p o r t f o l i o e g u i l i b r i u a . B u t by t h e world w e a l t h c o n s t r a i n t ,

only t h r e e of t b e s e f o a r s t o c k c o n d i t i o n s are independen t -

T h e r e f o r e , a t o t a l o f f o u r i n d e p e n d e n t marke t c l e a r i n g

c o n d i t i o n s c o u l d , t o g e t h e r wi th t h e demand e q u a t i o n s , d e t e r m i n e

e q u i l i b r i u m v a l o e s f o r four endogenous v a r i a b l e s . However, t h e r e

a r e e i g h t endogenous v a r i a b l e s i n t h e model - r, r*, W, ~ * 8 a ,

e, R and P. 7 N e v e r t h e l e s s , a ' r e d u c e d form' i n e, B, a and P can

be d e r i v e d which d e s c r i b e s t h a t r e l a t i o n s h i p between t h e s e

v a r i a b l e s c o n s i s t e n t wi th s t o c k and f l o w e q u i l i b r i u m . T h i s would

t h e n be t h e r e q u i r e d e s t i m a t i n g e q u a t i o n ,

I n o r d e r t o simplify the d e r i v a t i o n , s e v e r a l a d d i t i o n a l

assunaptions a r e made, F i r s t l y , Wal ras l a v i s n o t invoked

d i r e c t l y t o e l i m i n a t e one s t o c k c o n d i t i o n , b u t r a t h e r , a l l f o u r

c o n d i t i o n s a r e used , t o g e t h e r w i t h t h e flow s a v i n g s c o n d i t i o n ,

on t h e u n d e r s t a n d i n g t h a t s a t i s f a c t i o n of t h e world wealth

c o n s t r a i n t places c e r t a i n ' a d d i ~ g up' c o n s t r a i n t s on t h e

------- ---- ------ N o w M, H* a n d R* are a l so endogenous , b u t e q u a t i o n (23) g i v e s

R, and e g n a t i o n s t24) and (31) g i v e a* and It*,

( u n s p e c i f i e d ) p a r a m e t e r s o f t h e demand f u n c t i o n s ,

Now c o n s i d e r t h e two bond m a r k e t c l e a r i n g c o n d i t i o n s . F o r

any g i v e n set of v a l u e s f o r w, v*, a, e, B a n d P, t h e r e w i l l be

s o l u t i o n v a l u e s f o r t h e d o m e s t i c a n d f o r e i g n i n t e r e s t rates r

a n d r* which e n s u r e t h a t t h e s e two c o n d i t i o n s are s a t i s f i e d a n d

t h a t t h e t o t a l s t o c k of e a c h c o u n t r y ' s b o n d s is w i l l i n g l y h e l d -

T h e r e f o r e , i n t h e r e m a i n i n g t h r e e m a r k e t c l e a r i n g c o n d i t i o n s , r

and r* c a n be t r e a t e d a s g i v e n s , b u t o n t h e u n d e r s t a n d i n g t h a t

t h e i r g i v e n v a l u e s a re c o n s i s t e n t w i t h s t o c k e q u i l i b r i u m . in t h e

bond m a r k e t s , And t o t h e e x t e n t t h a t c h a n g e s i n r a n d s* are

s u b s e q u e n t l y h y p o t h e s i z e d t h a t a r e i n d e p e n d e n t of c h a n g e s i n D

a n d D*, it is u n d e r s t o o d t h a t t h e r e mus t be accommodat ing

c h a n g e s i n I3 and B* i n o r d e r f o r t h e s e c h a n g e s t o b e c o n s i s t e n t

w i t h c o n t i n u o u s bond m a r k e t e q u i l i b r i u m - 8

F i n a l l y , t h e t o t a l f o r e i g n money s u p p l y W * i s r e g a r d e d a s

being g i v e n , r a t h e r t h a n b e i n g composed o f a n exogenous d o m e s t i c

component a n d a n e n d o g e n o u s r e s e r v e component- T h i s a s s u m p t i o n

i m p l i e s a n i n d e p e n d e n t f o r e i g n mone ta ry p o l i c y . 9

The r e r a a i n i n g t h r e e e q u i l i b r i u m c o n d i t i o n s , t o g e t h e r w i t h

t h e demand e q u a t i o n s , g i v e a n e g n i l i b r i u i e r e l a t i o n s h i p r e l a t i n g

t h e e n d o g e n o u s v a r i a b l e s e, B, a a n d P t o t h e exogenous

a T h i s s i a p l i f y i n g a s s u m p t i o n d o e s n o t i m p l y t h e view t h a t i n t e r e s t r a t e s are d e t e r m i n e d ' s o l e l y i n t h e bond marke t s1 . S i m p l i f i c a t i o n c o u l d e q u a l l y \ h a v e b e e n a c h i e v e d by s e x o g e n i z i n g l e a n d B, t h u s g i v i n g a n e v a l u a t i o n of i n t e r e s t r a t e p o l i c i e s ?

9 I t a l s o means t h a t , f o r t h e s a k e of s i m p l i c i t y , t h e i s s u e of i n t e r n a t i o n a l c o o r d i n a t i o n of d o m e s t i c mone ta ry p o l i c i e s i s i g n o r e d .

v a r i a b l e s (now i n c l u d i n g r a n d r*) a n d t h e p a r a m e t e r s o f t h e

demand f u n c t i o n s , D i f f e r e n t i a t i o n of t h e e q u i l i b r i u m c o n d i t i o n s

and demand f u n c t i o n s with r e s p e c t t o time g i v e s a r e l a t i o n s h i p

r e l a t i n g t h e tiroe p a t h s of e, B, a a n d P t o t h e time p a t h s of

t h e e x o g e n o n s v a r i a b l e s a n d t o t h e income , i n t e r e s t etc.

s e n s i t i v i t i e s o f t h e demand f u n c t i o n s , And If t h e s y s t e m starts

f rom e q u i l i b r i u m , t h e time p a t h s of e, 8, a a n d P m i l l b e

e q u i l i b r i u m time p a t h s ,

The d e r i v a t i o n is c a r r i e d o u t i n Appendix 111. Forma l ly ,

t h e goods m a r k e t a n d f o r e i g n money m a r k e t c l e a r i n g c o n d i t i o n s

a r e u sed t o e l i m i n a t e t h e d o m e s t i c a n d f o r e i g n w e a l t h terms from

t h e d o m e s t i c ziioney marke t c l e a r i n g c o n d i t i o n , The r e s u l t is a n

e x p r e s s i o n of t h e f o r m

where t h e b i c o e f f i c i e n t s are, i n g e n e r a l , q u i t e complex

f u n c t i o n s of t h e income, i n t e r e s t etc, s e n s i t i v i t i e s of t h e

d o m e s t i c a n d foreign goods and money demand f u n c t i o n s - 1 0 T h e

p u r c h a s i n g power p a r i t y c o n d i t i o n h a s n o t g e t b e e n i n v o k e d

t h r o u g h o u t , s o t h a t t h e d o s e s t i c p r i c e l e v e l P a l s o a p p e a r s

e x p l i c i t l y , P u r c h a s i n g power p a r i t y is i n v o k e d d u r i n g s i m u l a t i o n

i n its a b s o l u t e form, w i t h o u t t i m e d i f f e r e n t i a t i o n , t o t ie t h e

s y s t e m down a n d e n s u r e t h a t t h e time p a t h s of e, 3, a a n d P are e q u i l i b r i u m t i m e p a t h s , ,

---------------- l o These e x p r e s s i o n s are examined i n t h e t h i r d s e c t i o n of t h i s c h a p t e r -

T h i s e q u a t i o n was d e r i v e d from t h e r e q u i r e m e n t t h a t s u p p l y

e q u a l demand i n t h e m a r k e t s f o r goods and a s s e t s . It g i v e s t h e

i n t e r a c t i o n be tween r e s e r v e a n d e x c h a n g e r a t e c h a n g e s t h a t i s

n e c e s s a r y t o meet t h e s e e q u i l i b r i u m r e q u i r e m e i t s i n t h e f a c e o f

s h o c k s t o e x o g e n o u s s u p p l i e s a n d t o t h e e x o g e n o u s d e t e r m i n a n t s

of demand.11 I t is t h e r e f o r e a n a l a g o n s t o t h e s i m p l e d e s c r i p t i o n

of p r i v a t e sector b e h a v i o u r f r o n t h e p r e v i o u s c h a p t e r , where

t h r o u g h t h e s u p p l y and demand s y s t e m , t h e e x o g e n o u s in•’ l u e n c e s

h a v e now b e e n i d e n t i f i e d e x p l i c i t l y ,

The a b o v e e q u a t i o n is n o t t h e form which is e s t i m a t e d .

F i r s t l y , its d e p e n d e n t v a r i a b l e , m e a s u r i n g t h e c h a n g e i n t h e

r e a l v a l u e of i n t e r n a t i o n a l r e s e r v e s , i s t h e sum o f two

components , T h e first measu res t h e i m p a c t of c h a n g e s i n nomina l

r e s e r v e s or t h e d o m e s t i c p r i c e l e v e l a n d is g i v e n by

e .d/dt (R/P) . The s e c o n d m e a s u r e s t h e i m p a c t of exchange g a i n s - a n d l o s s e s a n d i s g i v e n by e(R/P) , G i r t o n and Roper (3977) a r g u e

t h a t t h e s e c o n d colaponent, t o t h e e x t e n t t h a t it i n c r e a s e s t h e

d o m e s t i c money s u p p l y , s h o u l d b e a t t r i b u t e d t o t h e d o a e s t i c

component of t h e monetary base . T h e r e f o r e , o n l y t h e first

component is used as r e g r e s s a n d , w h i l e t h e s e c o n d component is

subsumed i n t o t h e d o m e s t i c mone ta ry r e g r e s s o r - F u r t h e r m o r e , ----------------- , 11 And w h i l e t h i s f o r m u l a t i o n , i n v o l v i n g t h e time d e r i v a t i v e of e x p e c t a t i o n s , may at first sight seem peculiar, i t p a r a l l e l s a p e r h a p s more f a m i l i a r c o n c e p t f o u n d i n mode l s of a c l o s e d economy, w h e r e changes i n a o n e y h o l d i n g depend o n c h a n g e s i n t h e e x p e c t e d r a t e of i n f l a t i o n ,

while t h e model s u g g e s t s t h a t t h e c o e f f i c i e n t of t h i s r e g r e s s o r

is -1, its v a l u e is l e f t u n r e s t r i c t e d d u r i n g t h e e s t i m a t i o n , A s

s e v e r a l writers h a v e no ted , 12 a n o b s e r v e d magn i tude smaller t h a n

o n e is c o n s i s t e n t w i t h less t h a n i n s t a n t a n e o u s a d j u s t m e n t t o

e q u i l i b r i u m i n the marke t f o r domestic money,

Second ly , t h e e g u a t i o n i s e s t i n a t e d w i t h a c o n s t a n t term

a n d e l e v e n s e a s o n a l doamp v a r i a b l e s f o r t h e months J a n u a r y

t h r o u g h November. A s u s u a l , t h e e s t i m a t e d c o e f f i c i e n t s o f t h e

dummy v a r i a b l e s c a n b e i n t e r p r e t e d a s t h e amount by which,

ceteris p a r i b u g , t h e c h a n g e i n t h e real v a l u e of i n t e r n a t i o n a l --- r e s e r v e s i n t h e a s s o c i a t e d months d i f f e r s f rom t h a t i n December,

Bowever, s i n c e t h e model s u g g e s t s t h a t t h e t r u e c o n s t a n t is

z e r o , t h e e s t i m a t e d c o n s t a n t c a n a l s o b e i n t e r p r e t e d as a k i n d

of s e a s o n a l dummy - t h e amount by u h i c h , ceteris p a r i b u s , t h e

c h a n g e i n t h e r e a l v a l u e of i n t e r n a t i o n a l r e s e r v e s i n December

d i f f e r s f roxa t h a t u h i c h would o c c u r w i t h o u t s e a s o n a l i n f l u e n c e s ,

With t h e s e ~ o d i f i c a t i o n s , t h e e s t i a a t i n g e q u a t i o n c a n b e

w r i t t e n , i n d i s c r e t e t i m e form, a s

RR (t) = c O + c l D D ( t ) + c2HM* (t) + c3rr ( t ) + c W r * ( t )

where BR ( t ) D D (t) M M * (t) rr (t) rr* ( t ) a a ( t ) PP f t) J Y * (t)

= e (t- 1) d e l l R (t) /P (t) ] = del[D ( t ) /P ( t ) 1 = d e l l a* ( t ) /P* (t) j = delC r ( t ) ] = d e l l r * ( t ) 3 = d e l l a (t) j = d e l C y W 1 = d e l i y* ( t ) ]

---------------- 12 See, f o r example , Dornbnsch (1976) ,

a n d where D U M i d e n o t e s t h e s e a s o n a l dummy f o r t h e i t h month a n d

de l [ . ] d e n o t e s t h e d i f f e r e n c e o p e r a t o r ,

T h e m o n t h l y d a t a used f o r t h e e s t i m a t i o n are o b t a i n e d f r o m

* I n t e r n a t i o n a l F i n a n c i a l S t a t i s t i c s *, p u b l i s h e d b y t h e

I n t e r n a t i o n a l B o n e t a r g Fund, 13

Canad ian i n t e r n a t i o n a l r e s e r v e s are measured i n m i l l i o n s o f

U S d o l l a r s , e n d of p e r i o d . S i n c e t h e a n a l y s i s is. p r i m a r i l y

c o n c e r n e d w i t h i n t e r v e n t i o n a c t i v i t y a n d b a s a b s t r a c t e d from

exogenous changes i n world r e s e r v e s , t h e d a t a series is a d j u s t e d

t o e x c l u d e two i m p o r t a n t s o u r c e s of e x o g e n o u s i n c r e a s e - g o l d

p r i c e r e w a l o a t i o n p r o f i t s l * a n d S D R a l l o c a t i o n s ,

T h e C a n a d i a n e x c h a n g e r a t e is measured i n C a n a a i a n d o l l a r s

p e r OS d o l l a r , e n d o f p e r i o d ,

The d o m e s t i c component o f t h e C a n a d i a n monetary base,

measured i n n i l l i o n s of C a n a d i a n d o l l a r s , i s c a l c u l a t e d by

s u b t r a c t i n g the e n d of p e r i o d C a n a d i a n d o l l a r v a l u e o f

i n t e r n a t i o n a l r e s e r v e s , d e s c r i b e d a b o v e , from t h e end of p e r i o d

Canadia a mone ta ry b a s e ,

The U S m o n e t a r y base is measured i n b i l l i o n s o f U S d o l l a r s ,

e n d of p e r i o d , P r e v i o u s l y , no d i s t i n c t i o n was made between t h e

f o r e i g n m o n e t a r y b a s e and t h e f o r e i g n money supp ly , Here t h e

f o r m e r is c h o s e n s o a s t o k e e p t h e f o r e i g n monetary a g g r e g a t e

c o n s i s t e n t w i t h t h e d o m e s t i c a o n e y a g g r e g a t e s , ---------------- 1 3 T h i s s o u r c e u a s c h o s e n o v e r p r i m a r y s o u r c e s b e c a u s e t h e e s t i i a a t i o n r e q u i r e s d a t a f o r b o t h Canada and the U n i t e d S ta tes on a c o m p a r a b l e bas is ,

l a Gold i s v a l u e d a t $(US)35 p e r o u n c e t h r o u g h o u t ,

The C a n a d i a n and US p r i c e i n d i c e s a r e t h e n o n t h l y a v e r a g e

consumer p r i c e i n d i c e s , w i t h b a s e s 1975 = 1, Consumer p r i c e s

i n d i c e s are c h o s e n o v e r a l t e r n a t i v e i n d i c e s on t h e a s s u m p t i o n

t h a t , i n a model of a s s e t p r e f e r e n c e , t h e b e h d v i o u r o f w e a l t h

h o l d e r s is d o m i n a t e d by c o n s u m e r s r a t h e r t h a n firms, so t h a t t h e

consumer p r i c e i n d e x b e s t reflects t h e p r i c e of t h e g o o d s i n t o

which most asse ts i n t h e economy would b e conve r t ed .

The C a n a d i a n a n d U S i n t e r e s t rates a r e measured a s s i a p l e

a v e r a g e s of t h e r a t e f o r t h r e e lon nth T r e a s u r y b i l l s , a s h o r t

term rate, a n d t h e y i e l d f o r g o v e r n ~ e n t b o n d s w i t h m a t u r i t i e s of

t e n y e a r s o r more, a l o n g term rate, where e a c h of t h e s e

component r a t e s h a v e been c o n v e r t e d f r o m a r a t e p e r annnm t o a

r a t e p e r w o n t h , l s The a v e r a g i n g of T r e a s u r y b i l l and gove rnmen t

bond r a t e s reflects t h e r e t u r n t o a bond p o r t f o l i o t h a t i s

d i v e r s i f i e d , a t l e a s t teria-wise, The c o n v e r s i o n f son a n n u a l t o

. monthly ra tes p l a c e s t h e i n t e r e s t ra te m e a s u r e s on t h e same

t h e o r e t i c a l f o o t i n g a s t h e e x p e c t e d r a t e of exchange

d e p r e c i a t i o n . Both reflect t h e g a i n s a v a i l a b l e f r o m month t o

month.

T h e p r e f e r r e d m e a s u r e s f o r C a n a d i a n a n d US r ea l income a re

monthly i n d i c e s of GNP a t c o n s t a n t p r i c e s , u n f o r t u n a t e l y , t h e s e

f i g o r e s are n o t a v a i l a b l e i n t h e ' I n t e r n a t i o n a l F i n a n c i a l

S t a t i s t i c s 1 f o r t h e e n t i r e p e r i o d of e s t i m a t i o n . T h e r e f o r e ,

Is T h e c o n v e r s i o n is c a r r i e d o u t by r e g a r d i n g t h e a n n u a l ra tes a s a g e o m e t r i c mean o f mon th ly rates, Hence t h e c o n v e r s i o n t a k e s a c c o u n t of compounding, b u t i g n o r e s t h e p e n a l t i e s a s s o c i a t e d w i t h e a r l y r e d e m p t i o n ,

monthly s e a s o n a l l y ad j n s t e d i n d i c e s of i n d u s t r i a l p r o d u c t i o n ,

w i t h b a s e s 1975 = 100, a re used a s a n e m p i r i c a l proxy, T h i s

c h o i c e c a n b e d e f e n d e d on t h e g r o u n d s t h a t i n d u s t r i a l p r o d u c t i o n

is g e n e r a l l y more l a b o u r i n t e n s i v e t h a n a g r i c u l t u r e , f o r

example, so t h a t t h e index reflects t h e p r o d u c t a v a i l a b l e f o r

d i s t r i b u t i o n t o a s i g n i f i c a n t p r o p o r t i o n of t h e i n d i v i d u a l s i n

p r i m a r y a n d s e c o n d a r y i n d u s t r i e s - However, t h e o m i s s i o n of t h e

s e r v i c e i n d u s t r i e s may b e a n i m p o r t a n t one, e s p e c i a l l y i f i n c o a e

i n t h i s sector is e i t h e r more v o l a t i l e t h a n , or n e g a t i v e l y

c o r r e l a t e d w i t h , t h a t i n t h e i n d u s t r i a l sector,

F i n a l l y , a n e m p i r i c a l m e a s u r e is r e q u i r e d f o r a a , t h e

c h a n g e i n t h e e x p e c t e d rate of e x c h a n g e d e ~ r e c i a t i o n , T h e r e a s o n

i t is i n c l u d e d , e v e n though s u b s e q u e n t s i m u l a t i o n s abstract from

e x p e c t a t i o n s , is t h a t a n y p r i v a t e sector b e h a v i o u r a l e q u a t i o n

e s t i m a t e d f rom h i s t o r i c a l d a t a w i t h o u t a n e x p e c t a t i o n s term

c l e a r l y i n c o r p o r a t e s s p e c i f i c a t i o n error. N o w the s t a n d a r d

app roach , w h i c h i n v o k e s i n t e r e s t ra te p a r i t y t o e m p i r i c a l l y

e s t i m a t e t h e way i n wh ich e x p e c t a t i o n s have h i s t o r i c a l l y b e e n

formed, is n o t a d o p t e d , U n l e s s a n c e r t a i n t y i s t r e a t e d

e x p l i c i t l y , t h i s a p p r o a c h c o n f o u n d s f o r e c a s t errors w i t h r i s k

T h e p r i v a t e sector b e h a v i o u r a l e q u a t i o n can be estimated,

houeve r , using any p r e - s p e c i f i e d e x p e c t a t i o n s mechanism- S e v e r a l

a l t e r n a t i v e s p e c i f i c a t i o n s are t r i e d , so a s t o see how s e n s i t i v e

---------------- 1 6 F o r t h e sarae r e a s o n , t h e f o r w a r d p a r i t y c o n d i t i o n is n o t u s e d t o e s t i m a t e e x p e c t a t i o n s ,

t h e p a r a m e t e r estimates are t o p o s s i b l e m i s s p e c i f i c a t i o n of t h e

e x p e c t a t i o n s v a r i a b l e , l 7 The first f o r m u l a t i o n is t h a t

e x p e c t a t i o n s a re s t a t i c , Under t h i s s cheme aa d o e s n o t a p p e a r i n

t h e e s t i m a t i n g e q u a t i o n , The s e c o n d f o r i a u l a t i o n i s t h a t

e x p e c t a t i o n s a r e r e g r e s s i v e , a n a s s u m p t i o n t h a t h a s become

w i d e l y a c c e p t e d a s a 8 u s e f u l c h a r a c t e r i z a t i o n t of e x c h a n g e r a t e

e x p e c t a t i o n s , l * The n o r m a l e x c h a n g e rate , t o which t h e s e

r e g r e s s i v e e x p e c t a t i o n s r e t u r n , i s t a k e n t o be a 6 month moving

a v e r a g e of p a s t m a r k e t rates, T h i s case, however , l e a d s t o a

f a m i l i a r i d e n t i f i c a t i o n problem - t h e measurement of t h e

u n d e r l y i n g b e h a v i o u r a l p a r a m e t e r is confounded by a n u n s p e c i f i e d

s p e e d o f a d j u s t n e n t pa ra i ae t e r , T h e t h i r d f o r m u l a t i o n i s t h a t

e x p e c t a t i o n s are a d a p t i v e , K l e i n * s method fo r direct e s t i m a t i o n

of d i s t r i b u t e d lag models is adopted .19 The a d v a n t a g e of t h i s

method is t h a t , by g r i d s e a r c h , a naximum l i k e l i h o o d e s t i m a t e of

t h e s p e e d of a d j u s t m e n t p a r a m e t e r is o b t a i n e d , t h u s a v o i d i n g t h e

i d e n t i f i c a t i o n p rob lem men t ioned e a r l i e r , F o r t h e s a k e o f

b r e v i t y , t h e s e r e s u l t s a r e n o t r e p o r t e d i n f a l l a n d o n l y t h e

results a s s o c i a t e d w i t h t h e b e s t v a l u e fo r t h e s p e e d of

---------- ------ I ? I n e a c h case, t h e a s s n a p t i o n a b o u t e x p e c t a t i o n s f o r m a t i o n is c o n v e r t e d t o t h e a p p r o p r i a t e measu re of aa , t h e c h a n g e i n t h e e x p e c t e d rate of e x c h a n g e d e p r e c i a t i o n , It i s assumed t h r o u g h o u t t h a t t h e current e x c h a n g e ra te is known,

2 8 See, f o r example , Roper a n d Turnovsky (1980)-

1 9 S e e Hadda la (1977,pp. 361-2) f o r a d i s c u s s i m of t h i s method and t h e p r o p e r t i e s of t h e estimates i t p roduces ,

a d j u s t m e n t p a r a m e t e r are p re sen ted .20 The f i n a l f o r m u l a t i o n is

t h a t e x p e c t a t i o n s are r a t i o n a l , The u n b i a s e d n e s s p r o p e r t y of

r a t i o n a l f o r e c a s t s is used t o r e p l a c e a n e x p e c t e d f u t u r e r a t e b y

its t r u e v a l u e , s o t h a t t h e r e g r e s s i o n r e s i d u a l s a l s o c o n t a i n

t h e f o r e c a s t e r r o r s - e r r o r s which by t h e a s s u m p t i o n of

r a t i o n a l i t y a r e s e r i a l l y u n c o r r e l a t e d with a ( c o n d i t i o n a l )

e x p e c t a t i o n of zero,

The p a r a m e t e r s of t h e p r i v a t e sector b e h a v i o u r a l e q u a t i o n

a r e e s t i m a t e d , u s i n g t h e a l t e r n a t i v e f o r m u l a t i o n s for a a , by

o r d i n a r y l e a s t s q u a r e s (OLS) r e g r e s s i o n , However, t h e r e is a n

i n p o r t a n t a n d o b v i o u s s o u r c e of s i m u l t a n e o n s e q u a t i o n b i a s - s o E e r e g r e s s o r s are endogenous i n t h e o v e r a l l model o f exchange

r a t e d e t e r m i n a t i o n , The f u l l model c o m p r i s e s this e s t i m a t i n g

e q u a t i o n , t h e p u r c h a s i n g power p a r i t y c o n d i t i o n , and an e x c h a n g e

n a r k e t i n t e r v e n t i o n r a l e o r r e a c t i o n f u n c t i o n , P i t h i n t h i s

model, t h e e x c h a n g e r a te a n d t h e d o m e s t i c p r i c e l e v e l are

endogenous , s o that t h e r e g r e s s o r s D D and aa i n which they

a p p e a r are a l s o endogenous, T h e r e f o r e , t h e p r i v a t e s e c t o r

b e h a v i o u r a l e q u a t i o n is a l s o e s t i m a t e d u s i n g t h e two-s t age l e a s t

s q u a r e s (2SLS) t e c h n i q u e , 2 1

I m p l e m e n t a t i o n of t h i s t e c h n i q u e , however, r e q u i r e s a n

a s s u m p t i o n t o b e a a d e a b o u t t h e t y p e of i n t e r v e n t i o n p o l i c y i n ---------------- 2 0 I n a g r i d s e a r c h o v e r v a l u e s 0.1, 0 - 2 -,, 0-9 t h e v a l u e 0-1 p r o v i d e d t h e smallest sum of s q u a r e d r e s i d u a l s ,

2 1 The r e g r e s s o r DD is a n o n - l i n e a r f u n c t i o n of P, s o t h a t DD n e e d n o t b e c o n t e m p o r a n e o a s l y l i n e a r l y c o r r e l a t e d with t h e d i s t u r b a n c e term, even t hough P may be, N e v e r t h e l e s s , t h e 2SLS i n s t r u m e n t s a re a p p l i e d t o DD a s w e l l a s t o aa,

u s e d u r i n g t h e p e r i o d 05 e s t i m a t i o n , T h i s a s s u m p t i o n d e t e r m i n e s

which v a r i a b l e s c a n b e used a s 2SLS i n s t r u m e n t s . It is d o u b t f u l

t h a t Bank of Canada a c t i o n s d u r i n g t h e 1970s can a c c u r a t e l y be

d e s c r i b e d by t h e o p t i m a l r u l e of t h e p r e v i o u s . chap te r , I n s t e a d ,

it is assumed t h a t , d u r i n g t h e p e r i o d of e s t i m a t i o n , e x c h a n g e

r a t e p o l i c y was formed u s i n g c u r r e n t a n d p a s t v a l u e s of r e s e r v e s

and t h e e x c h a n g e rate a s i n d i c a t o r v a r i a b l e s . A g e n e r a l l a g

s t r u c t u r e is assumed f o r this r e a c t i o n f u n c t i o n , and 15 l a g s 2 2

on b o t h t h e e x c h a n g e rate and t h e r e s e r v e l e v e l are t h e r e f o r e

used a s i n s t r u m e n t s , 2 3

T a b l e I shows t h e r e g r e s s i o n r e s u l t s p roduced by b o t h OLS

and 2SLS e s t i a a t i o n of t h e p r i v a t e sector b e h a v i o u r a l e q u a t i o n ,

using a l t e r n a t i v e f o r m u l a t i o n s of the e x p e c t a t i o n s term aa a n d

102 monthly o b s e r v a t i o n s f rom S e p t e m b e r 1970 t o F e b r u a r y 1979-24

T h e t a b l e g i v e s t h e c o e f f i c i e n t est imates f o r e a c h r e g r e s s o r ,

w i t h t h e m a g n i t u d e s of t h e associated t s t a t i s t i c s r e p o r t e d i n

p a r e n t h e s e s . A s n o t e d p r e v i o u s l y , t h e t h e o r e t i c a l f rameuork

s u g g e s t s t h a t t h e c o e f f i c i e n t of DD, t h e c h a n g e i n t h e real

v a l u e o f t h e d o m e s t i c component of t h e C a n a d i a n mone ta ry base,

22 T h i s number o f l a g s l e a v e s s u f f i c i e n t d e g r e e s of f r eedom f o r t h e K l e i n method t o be l e g i t i m a t e ,

23 The r e m a i n i n g i n s t r u m e n t s a re t h e e x o g e n o u s r e g r e s s o r s , i n c l u d i n g s e a s o n a l dummies, t h e f o r e i g n p r i c e l e v e l , a n d t h e l a g g e d e n a o g e n o u s v a r i a b l e e ( t -1) R (t- 1) /P ( t - 1) which a p p e a r s on t h e l e f t hand s i d e o f t h e e s t i m a t i n g e q u a t i o n ,

2. A l l e m p i r i c a l results i n t h i s t h e s i s u s e t h e TBOLL (Time-shared R e a c t i v e On-Line L a b o r a t o r y ) e c o n o m e t r i c package , n a i n t a i n e d by t h e C e n t r e f o r C o m p u t a t i o n a l R e s e a r c h i n Economics a n d Banagement S c i e n c e a t H I T ,

s h o u l d be -1, The t s t a t i s t i c r e p o r t e d f o r t h e DD c o e f f i c i e n t i s

t h e r e f o r e a p p r o p r i a t e f o r a tes t a g a i n s t - 1 - z s The t s t a t i s t i c s

r e p o r t e d f o r a l l o t h e r c o e f f i c ' i e n t s a re t h e u s u a l o n e s

a s s o c i a tea w i t h tests of s i g n i f i c a n c e , The c r i t i c a l v a l u e f o r

o n e - s i d e d t tests a t t h e 5 p e r c e n t level is 1,671, Durb in-Ratson

s t a t i s t i c s l y i n g be tween 1-78 a n d 2 - 2 2 i n d i c a t e no f i rs t o r d e r

a u t o c o r r e l a t i o n i n t h e r e g r e s s i o n r e s i d u a l s - 2 6 .

F o r b r e v i t y , t h e c o e f f i c i e n t estimates f o r t h e s e a s o n a l

dummy v a r i a b l e s are n o t r e p o r t e d , I n a l l cases, however, . t h e y

are s i g n i f i c a n t , e v e n a t t h e o n e p e r c e n t l e v e l , a n d u n i f o r m l y

n e g a t i v e , S i m i l a r l y , t h e estimates of t h e c o n s t a n t term a r e n o t

r e p o r t e d , It is i n v a r i a b l y s i g n i f i c a n t a n d p o s i t i v e . 2 7 The

r e s u l t s f o r t h e r e m a i n i n g c o e f f i c i e n t s l i k e w i s e s h o n an

i n s e n s i t i v i t y t o e i t h e r t h e e x p e c t a t i o n s f o r m l a t i o n o r

e s t i m a t i o n t e c h n i q u e a d o p t e d , One e x c e p t i o n o c c u r s w i t h t h e

c o e f f i c i e n t of t h e e x p e c t a t i o n s v a r i a b l e i t se l f , b u t it s h o u l d

b e remembered t h a t f o r d i f f e r e n t f o r m u l a t i o n s , t h i s estimate

m e a s u r e s d i f f e r e n t t h i n g s . On ly t h e estimates i n t h e a d a p t i v e

and r a t i o n a l f o r m u l a t i o n s p r o v i d e a d i r e c t e s t i m a t e of t h e

u n d e r l y i n g b e h a v i o u r a l p a r a m e t e r . --------------- 2 5 I n a l l cases, t h e c o e f f i c i e n t is s i g n i f i c a n t l y d i f f e r e n t from zero, e v e n a t t h e o n e p e r c e n t l e v e l ,

2 6 The h y p o t h e s i s o f n o a n t o c o r r e l a t i o n is a c c e p t e d , e v e n f o r t h e OLS r e g r e s s i o n s . T h i s c o n t r a s t s w i t h t h e r e s u l t s of s i m i l a r e s t i m a t i o n e x e r c i s e s b y G i r t o n a n d Rope r (1977) and U j i i e (1978) , where first o r d e r error c o r r e c t i o n was r e q u i r e d .

2 7 T h e s e r e s u l t s t o g e t h e r s u g g e s t t h a t t h e c h a n g e i n t h e r e a l v a l u e of C a n a d i a n r e s e r v e s h a s b e e n s y s t e m a t i c a l l y h i g h e r i n December t h a n i n a n y o t h e r month,

T h e m vs, ~ v i d e n c e -- T h e s i g n s and d e g r e e s of s i g n i f i c a n c e of t h e e s t i m a t e d

c o e f f i c i e n t s are now c o n s i d e r e d i n r e l a t i o n td t h e t h e o r e t i c a l

model of p r i v a t e sector b e h a v i o n r ,

F i r s t l y , t h e c o e f f i c i e n t of t h e C a n a d i a n monetary v a r i a b l e

DD is n o t s i g n i f i c a n t l y d i f f e r e n t from -1, a t least u n d e r 2SLS

e s t i m a t i o n . T h e r e h a s been a p r e s u m p t i o n t h a t models which

i n c o r p o r a t e t h e a s s u m p t i o n s of p u r c h a s i n g power p a r i t y

i n s t a n t a n e o u s s t o c k a n d flow e q u i l i b r i u m are a p p r o p r i a t e o n l y t o

t h e l o n g e r r u n , The fac t t h a t t h e c o e f f i c i e n t of DD is close t o

-1 when e s t i m a t e d u s i n g mon th ly data r u n s c o u n t e r t o t h i s

p r e s u m p t i o n ,

Second ly , the c o e f f i c i e n t of t h e US mone ta ry v a r i a b l e ME*

is u n i f o r m l y n e g a t i v e , b n t n o t s i g n i f i c a n t - T h i s l a c k of

s i g n i f i c a n c e c a n b e e x p l a i n e d a p r i o r i by t h e p o s s i b i l i t y of

c u r r e n c y s u b s t i t u t i o n , U i t h t h i s p o s s i b i l i t y , t h e c o e f f i c i e n t is

found , i n Appendix 111, t o e q u a l (15c5*-c5f 5*)/ (m5c5*-c5m5*) r

where ~5 and c5* a re t h e w e a l t h s e n s i t i v i t e s of c a a a d i a n a n d US

demands f o r t h e c o n s u m p t i o n good , 15 a n d 15* are t h e w e a l t h

s e n s i t i v i t i e s of Canad ian and US demands f o r C a n a d i a n money, a n d

m5 and m 5 * are t h e w e a l t h s e n s i t i v i t i e s of C a n a d i a n a n d US

demands f o r US money. H i t h c u r r e n c y s u b s t i t u t i o n , U S c u r r e n c y

c a n he h e l d i n the w e a l t h p o r t f o l i o s of US a n d C a n a d i a n

c i t i z e n s . It is t h e r e f o r e n o t s u r p r i s i n g t h a t t h e i a r p a c t of a n

s e n s i t i v i t i e s o f c i t i z e n s i n b o t h c o u n t r i e s t o w a r d s t h a t money,

r e l a t i v e t o t h e w e a l t h s e n s i t i v i t i e s of its s u b s t i t u t e s - t h a t

is, t h e i m p a c t d e p e n d s o n t h e p a t t e r n of p o r t f o l i o a d j u s t m e n t i n

b o t h c o u n t r i e s . S i n c e a l l s e n s i t i v i t i e s h e assumed p o s i t i v e ,

however, t h e c o e f f i c i e n t c a n n o t be s i g n e d unambiguous ly- By

compar i son , v h e n c u r r e n c y s u b s t i t u t i o n is n o t p o s s i b l e , t h e

a p p r o p r i a t e e x p r e s s i o n for t h e c o e f f i c i e n t is g2ven b y

- (l5cS*)/ (c5m5*) a n a is unambignous ly n e g a t i v e - 2 8

T h i s con tpa r i son shows t h a t v h e n i n t e r n a t i o n a l t r a d e . i n

d o a e s t i c a l l y * p r o d u c e d v a s s e t s , a s w e l l a s i n goods, is a l l o w e d ,

t h e p a t t e r n of g a i n s f rom t r a d e i n t h o s e a s s e t s d e p e n d s on t h e

p a t t e r n o f d i f f e r e n c e s i n p r e f e r e n c e s be tween c o u n t r i e s . The

l a c k of s i g n i f i c a n c e i n t h e e s t i m a t e d c o e f f i c i e n t of t h e U S

monetary v a r i a b l e may s i m p l y reflect t h a t t h e d i f f e r e n c e i n

p r e f e r e n c e s b e t w e e n Canada a n d t h e U n i t e d S t a t e s is n o t

p a r t i c u l a r l y s t r o n g , However, u n d e r t h e i n t u i t i v e l y a p p e a l i n g

a s s u m p t i o n s t h a t c5 e q u a l s cS*, b u t t h a t i n e a c h c o u n t r y t h e

w e a l t h s e n s i t i v i t y w i t h r e s p e c t t o t h e home c u r r e n c y e x c e e d s

t h a t w i t h r e s p e c t t o the o f f s h o r e c n r r e n c y . 2 9 t h e n t h e

c o e f f i c i e n t i s n e g a t i v e , a s o b s e r v e d ,

The s i g n s of t h e r e m a i n i n g c o e f f i c i e n t s are now e s t a b l i s h e d

a p r i o r i . I n Appendix 111, t h e c o e f f i c i e n t of e a c h r e g r e s s o r is

----------------- 28 Without c u r r e n c y s u b s t i t u t i o n , m5 a n d 15* e q u a l z e r o -

2 9 Such a n a s s u m p t i o n c a n be j u s t i f i e d o n t h e g r o u n d s t h a t t h e o f f s h o r e c u r r e n c y is held p r i m a r i l y f o r t r a n s a c t i o n s p u r p o s e s and , as s u c h , is s e n s i t i v e more t o c h a n g e s i n income t h a n t o a n y t h i n g else,

f o u n d t o be a s follows:

rr : ( 1 + 1 1 * ) - (ml+ml*)b l + ( c l * c l * ) Y

where b7 is t h e c o e f f i c i e n t of HX*, given above , and

Y = [15m5*-rn515*1/[m5~5*-~5m5*

* (12+12*) - (m2+m2*) b l + (c2+c2*) Y

aa : (13+13*) - ( m 3 + ~ 3 * ) b l + (c3+c3*) Y

yy : 1 4 - m4bl - (1-c4) Y

yy*: 14* - m4*bl - (I-&*) Y

where t h e li, li*, mi, m i * , c i a n d ci* p a r a m e t e r s are t h e

s e n s i t i v i t e s of money and goods demands w i t h r e s p e c t t o c h a n g e s

i n t h e a s s o c i a t e d r e g r e s s o r ,

T h e s e e x p r e s s i o n s measu re t h e i m p a c t of t h e a s s o c i a t e d

r e g r e s s o r o n t h e r e a l v a l u e o f Canada 8 s i n t e r n a t i o n a l r e s e r v e s ,

R e s e r v e flows be tween c o u n t r i e s reflect t h e b e l o w - t h e - l i n e a o n e y

flows which b a l a n c e t h e a b o v e - t h e - l i n e flows of g o o d s a n d bonds,

T h e r e f o r e , t h e i m p a c t of t h e s e r e g r e s s o r s d e p e n d s on t h e

p o r t f o l i o a d j u s t m e n t i n C a n a d i a n a n d U S h o l d i n g s of C a n a d i a n

ntoney, a s r e f e c t e d i n t h e li and li* terns, a n d i n C a n a d i a n a n d

U S h o l d i n g s of U S money, a s r e f l e c t e d i n t h e m i and ut i* teras-

The i m p a c t a l s o d e p e n d s o n a d j u s t m e n t s i n p o r t f o l i o s ize , a n

o u t c o n e of t h e comsnmpt ion / sav ings d e c i s i o n a n d reflected i n t h e

c i and ci* t e r m s 3 0

3 0 T h i s c a n b e s e e n n o s t c l e a r l y i n t h e e x p r e s s i o n s f o r t h e c o e f f i c i e n t s of yy a n d yy*, where t h e terms (1-c4) a n d (1-c4*) r e p r e s e n t t h e C a n a d i a n a n d US p r o p e n s i t i e s t o s a v e out of i ncome from human s o u r c e s ,

E a r l i e r , r e a s o n a b l e a s s u m p t i o n s were s u g g e s t e d u n d e r which

b l would b e n e g a t i v e , Under t h e same c o n d i t i o n s , t h e t e r n Y is

a l s o n e g a t i v e , f i n a l l y , t h e s i g n s i m p u t e d i n t h e first s e c t i o n

o f t h i s c h a p t e r t o t h e income, i n t e r e s t , etc. & s e n s i t i v i t i e s of

goods a n d money demands s u g g e s t t h e f o l l o w i n g s i g n s f o r t h e

r e m a i n i n g terms:

Now t h e s e a s s u m p t i o n s are still n o t s u f f i c i e n t t o remove

a l l sign a m b i g u i t y f o r t h e c o e f f i c i e n t s of t h e income a n d

i n t e r e s t rate r e g r e s s o r s , A prob lem r e m a i n s w i t h t h e c o n f l i c t i n g

s i g n s o f t h e c i a n d ci* terms, N e v e r t h e l e s s , i f i t is assumed

t h a t a d j u s t x e e n t s i n p o r t f o l i o c o m p o s i t i o n d o m i n a t e a d j u s t m e n t s

i n p o r t f o l i o size, t h e n n e g a t i v e s i g n s are o b t a i n e d a p r i o r i f o r

t h e c o e f f i c i e n t s of the domestic a n d f o r e i g n i n t e r e s t r a t e

v a r i a b l e s rr a n d rr*, and p o s i t i v e s i g n s a p r i o r i for t h e

d o m e s t i c a n d f o r e i g n income v a r i a b l e s yy a n d yy*. 31 Once a g a i n ,

t h e s e are t h e s i g n s wh ich would be a l l o c a t e d w i t h o u t t h e

a s s u m p t i o n of c n r r e n c y s u b s t i t u t i o n , 32

31 The s i g n of t h e c o e f f i c i e n t f o r t h e e x p e c t a t i o n s v a r i a b l e aa still d e f i e s a p r i o r i d e f i n i t i o n , b u t i t s o b s e r v e d p o s i t i v e v a l u e is c o n s i s t e n t w i t h t h e . s i t u a t i o n where t h e i m p a c t o f e x p e c t a t i o n s o n C a n a d i a n h o l d i n g s of U S c u r r e n c y o u t w e i g h s t h e i m p a c t o n U S h o l d i n g s of C a n a d i a n c u r r e n c y -

' 32 The c o r r e s p o n d i n g c o e f f i c i e n t s c a n be found b p s e t t i n g m i and Xi* ( i 1 , - 5 ) t o zero i n t h e e x p r e s s i o n s (36) t h r o u g h (40)-

T h e e m p i r i c a l r e s u l t s o b t a i n e d f rom b o t h

e s t i m a t i o n a r e t h e r e f o r e gene r a l l y c o n s i s t e n t

OLS and 2SLs

w i t h t h e model of

p r i v a t e s e c t o r behav ioa r , The e s t i m a t e d c o e f f i c i e n t s of rr*, yy

and t h e monetary a g g r e g a t e s DD a n d HH* are i n v a r i a b l y o f t h e

c o r r e c t s i g n , B i t h t h e e x c e p t i o n of t h e c o e f f i c i e n t f o r BH*,

d i s c u s s e d above , t h e y a r e a l s o g e n e r a l l y s i g n i f i c a n t , The

c o e f f i c i e n t s o f rr and yy* have t h e wrong s i g n , b u t a r e

i n v a r i a b l y i n s i g n i f i c a n t , The anomalous r e s u l t f o r t h e v a r i a b l e

sr can be e x p l a i n e d by n o t i n g t h a t , o v e r t h e l a s t t e n years, t h e

Canadian i n t e r e s t ra te h a s t e n d e d t o be a n i n s t r u m e n t o f

exchange ra te p o l i c y , a f e a t u r e n o t c a p t u r e d by t h e e a r l i e r

a s sumpt ion on Bank o f Canada c o n d u c t d u r i n g t h a t p e r i o d -

The d e s c r i p t i o n of p r i v a t e sector b e h a v i o u r examined i n

t h i s c h a p t e r b e a r s s i m i l a r i t i e s t o t h e o n e s d e r i v e d i n G i r t o n

and Roper (1977), U j i i e (1978) , Roper a n d Tnrnovsky (1980) and

a l m o s t any a p p r o a c h which u s e s t h e d o m e s t i c s t o c k money

e q u i l i b r i u m c o n d i t i o n , p o s s i b l y combined w i t h o t h e r c o n d i t i o n s ,

a s an o r g a n i s i n g s t r u c t u r e w i t h i n which t o d i s c u s s b a l a n c e o f

payments and/or exchange r a t e d e t e r m i n a t i o n , I n p a r t i c u l a r , it

is s i m i l a r t o t h o s e d e r i v e d i n models o f exchange market

p ressure .33 However, t h e s i g n s which h a v e been a l l o c a t e d a

p r i o r i t o the c o e f f i c i e n t s of t h e e s t i m a t i n g e q u a t i o n d i f f e r i n

many c a s e s from t h o s e which would h a v e b e e n a l l o c a t e d i n s u c h ,

exchange marke t p r e s s u r e n o d e l s , The d i f f e r e n c e s a r i s e from t h e

----------- ----- 33 See, f o r e x a a p l e , t h e s e m i n a l a r t ic le by G i r t o n and Roper (1976)-

p r e s e n t t r e a t m e n t of money demand i n a g e n e r a l e q u i l i b r i u m

con t e x t .

Models of e x c h a n g e marke t p r e s s u r e g e n e r a l l y c o n s i d e r o n l y

t h e r e q u i r e m e n t of s t o c k money e q u i l i b r i u m , ~ h l e y a r b i t r a r i l y

s u b t r a c t a f o r e i g n f r o m a d o m e s t i c mone ta ry e q u i l i b r i u m

c o n d i t i o n t o o b t a i n a n e q u a t i o n e x p l a i n i n g t h e sum of r e s e r v e

and e x c h a n g e ra te movement i n terms of t h e d e t e r m i n a n t s o f

d o m e s t i c a n d f o r e i g n money demand, On t h e b a s i s of t h i s

a r b i t r a r y m a t h e m a t i c a l o p e r a t i o n , t h e r e g r e s s o r s a s s o c i a t e d w i t h

t h e f o r e i g n c o u n t r y a r e g i v e n s i g n s o p p o s i t e t o t h o s e o f t h e i r

d o m e s t i c c o u n t e r p a r t s , 34 N e v e r t h e l e s s , r e c e n t e m p i r i c a l

e s t i m a t i o n of s u c h e q u a t i o n s , e s p e c i a l l y i n a shor t r u n c o n t e x t ,

h a v e p r o d u c e d * p o o r t r e s u l t s , a n ou tcome which h a s been

a t t r i b u t e d t o t h e i n a p p r o p r i a t e n e s s of t h e u n d e r l y i n g a s s u m p t i o n

of c o n t i n u o u s s t o c k e q n i l i b r i u m , 3 5

By c o n t r a s t , t h e p r e s e n t d e r i v a t i o n t a k e s a c c o u n t o f t h e

r e q u i r e m e n t for f l o w s a v i n g s e q n i l i b r i u m a s w e l l a s f o r s t o c k

asset e q u i l i b r i u m . 3 b T h e r e f o r e , t h e effect t h a t a n i n c r e a s e i n

---------------- 3 4 I n p a r t i c u l a r , t h e c o e f f i c i e n t of t h e f o r e i g n money s u p p l y is assumed p o s i t i v e a n d t h e c o e f f i c i e n t s of f o r e i g n income a n d i n t e r e s t r a tes are assumed t o h a v e s i g n s o p p o s i t e t o t h e i r d o r n e s t i c c o u n t e r p a r t s ,

3s See, f o r example , Hacche a n d Tounend (1981) -

3 6 It t h e r e f o r e i m p l i c i t l y i n v o l v e s a d d i n g t h e f o r e i g n t o t h e d o m e s t i c i u o n e t a q e q u i l i b r i u m c o n d i t i o n , so a s t o o b t a i n a n e x p r e s s i o n f o r t h e l e v e l of w o r l d asset a c c u r a u l a t i o n t o combine w i t h the flow c o n d i t i o n t h a t n e t w o r l d s a v i n g be zero, T h i s u a s i m p l i c i t l y r e c o g n i s e d i n some of t h e s e m i n a l a n a l y s i s o f t h e g l o b a l m o n e t a r i s t a p p r o a c h t o t h e b a l a n c e of p a y s e n t s , See, f o r example , D o r n b a s c h (1 973)-

the r e a l US money s u p p l y , f o r example , h a s o n t h e r e a l v a l u e o f

C a n a d i a n r e s e r v e s reflects, n o t a n a r b i t r a r y m a t h e m a t i c a l ,

o p e r a t i o n , b u t the r e q n i r e m e n t s f o r t h a t r e a l f o r e i g n s u p p l y

i n c r e a s e t o b e w i l l i n g l y h e l d b y U S and ~ a n a d i a n r e s i d e n t s . 3 7

The i m p l i c a t i o n is t h a t t h e anomalous s h o r t r u n e m p i r i c a l

r e s u l t s o b t a i n e d from models which t a k e a c c o u n t ~ n l y of s t o c k

money e q u i l i b r i u m c a n be e x p l a i n e d , n o t b y a s suming l a g g e d

a d j u s t m e n t , a s Racche and Townsend (1981) s u g g e s t , b u t by a l s o

t a k i n g a c c o u n t of flow s a v i n g s e q u i l i b r i u m , as h a s been done

h e r e ,

F i n a l l y , o n e of t h e sets o f c o e f f i c i e n t e s t i m a t e s must be

c h o s e n f o r u s e i n t h e s u b s e q u e n t e n p i r i c a l e x a m i n a t i o n o f t h e

r e s e r v e management r u l e s , A s h a s a l r e a d y b e e n n o t e d , t h e

c o e f f i c i e n t e s t i m a t e s are g e n e r a l l y i n s e n s i t i v e t o e i t h e r t h e

e x p e c t a t i o n s f o r m u l a t i o n o r t h e e s t i m a t i o n t e c h n i g u e . The

e q u a t i o n c h o s e n i s t h e OLS e s t i m a t i o n which i n c o r p o r a t e s

r a t i o n a l e x p e c t a t i o n s f o r m a t i o n , N o t o n l y d o e s t h i s e q u a t i o n

h a v e t h e a d v a n t a g e of a v o i d i n g i d e n t i f i c a t i o n p rob lems , b u t it

a l s o p r o v i d e s OLS estimates which are closest t o most of t h e

2SLS estimates, Appea l c a n t h e n b e made t o t h e r o b u s t n e s s o f OLS

estimates in t h e p r e s e n c e of o t h e r e s t i m a t i o n p rob lems and t o

t h e f a c t t h a t OLS e s t i m a t e s p r o v i d e p r e d i c t i o n s which compare

f a v o u r a b l y w i t h t h o s e from a l t e r n a t i v e e s t i m a t i o n t e c h n i q o e s , , -- --------------

37 It must come a t l e a s t p a r t l y a t t h e e x p e n s e of p r i v a t e h o l d i n g s of C a n a d i a n c u r r e n c y , s i n c e it i s assumed t h a t p o r t f o l i o s u b s t i t u t i o n d o m i n a t e s t h e w e a l t h - i n d u c e d i n c r e a s e i n s a v i n g .

V, RULE BERFOBMAHCE UNDER SIBULATIOI

C h a p t e r 3 d e r i v e d two v e r s i o n s of a r e s e r v e management r u l e

which were d e s i g n e d t o m i n i m i z e u n s y s t e m a t i c exchange r a t e

v a r i a t i o n and e n h a n c e p r e d i c t a b i l i t y , w h i l e a l l o w i n g s y s t e m a t i c

a d j u s t m e n t t o t a k e p l a c e so a s r e c o g n i s e t h e o p e r a t i n g

c o n s t r a i n t imposed by f i n i t e r e s e r v e l e v e l s , It was t h e n a r g u e d

t h a t t h e f o r e i g n exchange a u t h o r i t y may h a v e a d d i t i o n a l

c o n c e r n s , o n e being t h e c o s t f s ) of w h a t e v e r d i v e r g e n c e frona a

f r e e l y f l o a t i n g e x c h a n g e r a t e s u c h i n t e r v e n t i o n a c t i v i t y

p r o d u c e s - A s e c o n d possible c o n c e r n is t h e c o s t of a c q u i r i n g a n d

h o l d i n g f o r e i g n e x c h a n g e r e s e r v e s f o r i n t e r v e n t i o n purposes .

E i t h e r c o s t c o u l d m i t i g a t e a g a i n s t t h e a c h i e v e m e n t of t h e

p r i m a r y o b j e c t i v e .

One a p p r o a c h t o s u c h m u l t i p l e , c o n f l i c t i n g o b j e c t i v e s would

b e t o r e f o r m u l a t e t h e o p t i m a l i n t e r v e n t i o n r u l e , e i t h e r by

v i e w i n g the a d d i t i o n a l c o n c e r n s a s p l a c i n g a d d i t i o n a l o p e r a t i n g

c o n s t r a i n t s o n i n t e r v e n t i o n a c t i v i t y , o r by g i v i n g t h e m a

w e i g h t i n g i n sonae h y p o t h e s i z e d socia l welfare f u n c t i o n , The

a p p r o a c h a d o p t e d i n t h i s c h a p t e r is t o e n a a i n e how t h e f o r e i g n

e x c h a n g e a u t h o r i t y c a n , by j u d i c i o u s c h o i c e of t h e p o l i c y

p a r a m e t e r s which t h e e x i s t i n g r e s e r v e management r u l e makes

a v a i l a b l e , i n f l u e n c e t h e outcome w i t h r e s p e c t t o t h e s e

a d d i t i o n a l c o n c e r n s ,

T h i s c h a p t e r t h e r e f o r e c o m p a r e s t h e d i f f e r e n t v e r s i o n s *

ability t o - t r a c k t h e g e n e r a l t r e n d s i n a f r e e l y f l o a t i n g

e x c h a n g e r a t e , r e l a t i v e t o t h e i r s u c c e s s i n e n h a n c i n g e x c h a n g e

r a t e p r e d i c t a b i l i t y , It a l s o e x a m i n e s how e i t h e r v e r s i o n ' s

smoo th ing a b i l i t y is a f f e c t e d b y a l t e r n a t i v e t a r g e t r e s e r v e

l e v e l s . It therefore i d e n t i f i e s m a r g i n s of c h o i c e , o v e r v e r s i o n s

of t h e r u l e a n d o v e r t a r g e t r e s e r v e l e v e l s , by which t h e f o r e i g n

e x c h a n g e a u t h o r i t y c a n meet its a d d i t i o n a l conce rns . The p r e c i s e

c h o i c e c a n t h e n be made o n c e c o s t s a n d b e n e f i t s h a v e been

i n p o t e d e x p o s t t o t h e s e outcomes,

It was f o u n d i n C h a p t e r 3, however , t h a t t h e s e ou tcqmes

c o u l d n o t e a s i l y be d e t e r m i n e d a n a l y t i c a l l y - I n p a r t i c u l a r , t h e

s i m p l e v e r s i o n of t h e rule was d e r i v e d u n d e r a s i m p l i f y i n g

a s s u m p t i o n a b o u t t h e n a t u r e o f t h e e x o g e n o u s s h o c k s h i t t i n g t h e

e x c h a n g e marke t . T h e s e were assumed t o be s u c h t h a t , when t h e

e x c h a n g e r a t e was f i x e d a t its * c o r r e c t 8 permanent o r

e q u i l i b r i u m l e v e l , r e s e r v e s would f o l l o u a ranaom walk, It was

a l s o assumed t h a t a r e s e r v e management r u l e which l e a n e d a g a i n s t

t h e wind would m i n i m i z e e x c h a n g e r a t e v a r i a t i . c n a r o u n d its

pe rmanen t or e q u i l i b r i u m rate, Rhen t h e f irst of t h e s e

s i m p l i f y i n g a s s u m p t i o n s u a s r e l a x e d , it c o u l d be shown t h a t t h e

s i m p l e r e s e r v e xmnageaent r u l e c o u l d i n d e e d min imize t o t a l

e x c h a n g e r a t e v a r i a t i o n , However, t h e r e w a s no g u a r a n t e e i n

t h e o r e t i c a l terms t h a t i t would d o so b y o p e r a t i n g o n l y on t h e

u n s y s t e m a t i c component of e x c h a n g e r a t e b e h a v i o n r , a t l e a s t f o r

t h o s e s i t u a t i o n s where i n d i v i d u a l s d i d n o t h a v e s u f f i c i e n t

i n f o r m a t i o n t o form s t r i c t l y r a t i o n a l e x c h a n g e r a t e

e x p e c t a t i o n s . The amended v e r s i o n was d e r i v e d f r o m c o n s i d e r a t i o n

of a p a r t i c u l a r c o u n t e r e x a m p l e , F o r e i t h e r v e r s i o n of t h e rule,

however, its r e l a t i v e i m p a c t o n t h e s y s t e m a t i c a n d u n s y s t e m a t i c

components o f e x c h a n g e r a t e b e h a v i o n r c o u l d n o t b e d e t e r m i n e d

a n a l y t i c a l l y i n a l l s i t u a t i o n s , Nor was it a s i m p l e matter t o

d e t e r m i n e how t h e s e i m p a c t s m i g h t be a f f e c t e d by a l t e r n a t i v e

t a r g e t r e s e r v e l e v e l s ,

T h i s c h a p t e r t h e r e f o r e e x a m i n e s t h e s e q n e s t 5 o n s

e m p i r i c a l l y , u s i n g s i m u l a t i o n t e c h n i q u e s , As i n p r e v i o u s

c h a p t e r s , C a n a d i a n e x p e r i e n c e d u r i n g t h e 1 9 7 0 s p r o v i d e s t h e

s e t t i n g , R u l e p e r f o r m a n c e is t h e n examined i n t h e f a c e o f a v i d e

v a r i e t y of e x o g e n o u s s h o c k s ,

N e v e r t h e l e s s , a n y e v a l u a t i o n of t h e r e s e r v e management

r u l e s is m e a n i n g l e s s u n l e s s i t c a n be shown t h a t t h e y o u t p e b f o r m

e x i s t i n g p o l i c i e s , Dur ing t h e 1970s , t h e C a n a d i a n d o l l a r f l o a t e d

a g a i n s t t h e U S d o l l a r , t hough n o t f r e e l y , t h u s s u g g e s t i n g some

i n t e r v e n t i o n p o l i c y was b e i n g f o l l o w e d by t h e Bank of Canada,

T h e r e f o r e , e a c h a s p e c t of r u l e e v a l u a t i o n is c a r r i e d out, n o t

o n l y fo r a v i d e v a r i e t y of hypothetical shocks, bat also f o r

t h o s e s h o c k s which h i t t h e C a n a d i a n d o l l a r i n the 1970s - I n t h i s

way, t h e p e r f o r l a a n c e of t h e r e s e r v e ~ a n a g e z u e n t r u l e s c a n be

c o n p a r e d w i t h t h e p e r f o r ~ a n c e of t h e Bank of Canadaqs p o l i c i e s ,

a s embodied i n a c t u a l e x c h a n g e r a t e b e h a v i o u r , o v e r t h a t p e r i o d -

The first s e c t i o n of t h i s c h a p t e r d e s c r i b e s t h e e c o n ~ m i c ,

e n v i r o n m e n t w i t h i n v h i c h t h e s i m u l a t i o n s are pe r fo rmed , The

second s e c t i o n d e s c r i b e s t h e s i m u l a t i o n r e s u l t s . It c o m p a r e s t h e

p e r f o r m a n c e of t h e r e s e r v e manageaent r u l e s , b o t h a l o n e a n d

r e l a t i v e t o Bank sf Canada a c t i o n s , a c c o r d i n g t o t h e above t h r e e

c o n c e r n s - enhancement o f p r e d i c t a b i l i t y , t r a c k i n g a b i l i t y , a n d

performance u n d e r a l t e r n a t i v e t a r g e t r e s e r v e l e v e l s , T h e t h i r d

s e c t i o n summar izes t h e s e results, d i s c a s s i n g them i n r e l a t i o n t o

what h a s a l r e a d y been e s t a b l i s h e d a b o u t t h e r u l e s ' i m p a c t on ex

p o s t exchange r a t e and r e s e r v e b e h a v i o u r , and i n r e l a t i o n t o t h e

p o l i c y t r a d e o f f s which t h e y s u g g e s t ,

z h e S i m u l a t i o n Environment

T h e p r e v i o u s two c h a p t e r s deve loped s e p a r a t e l y t h e

components of a f n l l model of ex p o s t exchange r a t e and r e s e r v e

behaviour , w i t h i n which t o examine t h e pe r fo rmance o f t h e

o p t i m a l r u l e s , The f u l l model i s a s f o l l o u s :

I n t e r v e n t i o n Rule: . R = F(t)

P r i v a t e S e c t o r Behaviour: * - . *

d = b l d D + b2d H* + b 3 r + b4r* + b6y + b7y* - - - - d t P a t F dtp*

P u r c h a s i n g Power Parity:

The endogenous v a r i a b l e s are t h e exchange r a t e e, t h e r e s e r v e

l e v e l B and t h e d o m e s t i c p r i c e l e v e l P. The p o l i c y v a r i a b l e is

F. The exogenous v a r i a b l e s are t h e d o m e s t i c component o f t h e

monetary b a s e D, t h e f o r e i g n \money s u p p l y M*, t h e f o r e i g n p r i c e

l e v e l P*, t h e d o m e s t i c and f o r e i g n i n t e r e s t rates r and r* and

t h e d o m e s t i c a n d f o r e i g n r e a l income l e v e l s 1 and y*-

The form i n which t h e i n t e r v e n t i o n r u l e is w r i t t e n a l l o w s

c h a r a c t e r i z a t i o n , by a l t e r n a t i v e c h o i c e s of P, of n o t o n l y t h e

s i m p l e a n d amended v e r s i o n s of t h e o p t i m a l r u l e , b u t a l s o t h e

benchmark of f r e e l y f l o a t i n g e x c h a n g e rates, T'he p r i v a t e sector

b e h a v i o u r a l e q u a t i o n is i d e n t i c a l t o t h a t d e v e l o p e d i n t h e

p r e v i o u s c h a p t e r , e x c e p t t h a t t h e e x p e c t a t i o n s term h a s been

o m i t t e d , C h a p t e r 3 shoved t h a t when e x p e c t a t i o n s ' are r a t i o n a l ,

t h e p e r f o r m a n c e of a n y r u l e which l e a n s a g a i n s t t h e wind c a n be

d e t e r n i n e d a n a l y t i c a l l y . E v a l u a t i o n is p r o b l e m a t i c o n l y when

i n d i v i d u a l s do n o t h a v e s u f f i c i e n t i n f o r m a t i o n t o form f u l l y

r a t i o n a l e x p e c t a t i o n s , The o ~ l i s s i on of t h e e x p e c t a t i o n s terra is

e q u i v a l e n t t o a s s u m i n g t h a t e x p e c t a t i o n s are s ta t ic .=

I n a s i m u l a t i o n e x p e r i m e n t , a l l p a r a m e t e r v a l u e s a n d time

p r o f i l e s of t h e e x o g e n o u s v a r i a b l e s a re p r e - s p e c i f i e d a n d t h e

s y s t e m is s o l v e d f o r t h e time p r o f i l e s of t h e endogenous

v a r i a b l e s . The s i m u l a t i o n e n v i r o n m e n t c a n t h e r e f o r e b e d e s c r i b e d

i n terms of t h e p a r a m e t e r a n d exogenous v a r i a b l e v a l u e s chosen ,

The p r e v i o u s c h a p t e r r e p o r t e d t h e p a r a a e ter e s t i m a t e s f o r

t h e p r i v a t e sector b e h a v i o n r a l e q u a t i o n , o b t a i n e d f rom C a n a d i a n

a n d U S month ly d a t a o v e r t h e p e r i o d S e p t e m b e r 1970 t o F e b r u a r y

The s p e c i f i c a t i o n of t h e p o l i c y v a r i a b l e d e p e n d s o n t h e

r u l e t o be s i m u l a t e d , I n t h e case of t h e benchmark reg ime, t h e ,

p a r a m e t e r s p e c i f i c a t i o n is s t r a i g h t f o r w a r d , F o r f l e x i b l e

1 Such e x p e c t a t i o n s may n e v e r t h e l e s s be r a t i o n a l , d e p e n d i n g o n t h e s t r a c t n r e of t h e e x o g e n o u s v a r i a b l e s ,

e x c h a n g e rates, t h e s e t t i n g F ( t ) = O is used, T h e r u l e t h e n

s p e c i f i e s t h a t no r e s e r v e c h a n g e occur i n a n y p e r i o d -

The s p e c i f i c a t i o n o f t h e p a r a m e t e r v a l u e s f o r t h e s i m p l e

and amended v e r s i o n s of t h e o p t i m a l r u l e is s i i g h t l ~ less

s t r a i g h t • ’ orward- T h e r u l e s s p e c i f y t h e r e s e r v e b e h a v i o u r d e s i r e d

e x a n t e b y t h e f o r e i g n exchange a u t h o r i t y , i n terms of o p t i m a l

l i m i t s on e x p o s t r e s e r v e chanqes , A l t e r n a t i v e l y , d e f i n e u p p e r

a n d l o w e r bounds Bu a n d 31 on t h e c u r r e n t r e s e r v e l e v e l , o n e

e a c h s i d e of t h e t a r g e t l e v e l z,2 whose d i s t a n c e from z i s

d e t e r m i n e d by two t h i n g s - t h e d e v i a t i o n front z t o date, p l u s

t h e c u r r e n t p e r m i s s i b l e c h a n g e i n t h e same d i r e c t i o n :

31 = z - l % ( t - l ) - z l - m(t) (45)

Ru = z + I B ( t - 1 ) - z J + m(t) (46)

where m ( t ) = A - BIR(t-1) - z ] f o r t h e s i m p l e v e r s i o n

= A - BIR(t-1) -zl - CT f o r t h e amended v e r s i o n (47)

a n d where A , B and C a r e p o l i c y p a r a m e t e r s , 1 R (t-1)-zf m e a s u r e s

t h e c u r r e n t d e v i a t i o n f r o n t a r g e t and T m e a s u r e s t h e e x c e s s

time, o v e r a n d above t h e rainireurn, t h a t r e s e r v e s h a v e s p e n t on

o n e s i d e or t h e other of t a r g e t ,

The r u l e a l l o w s any r e s e r v e c h a n g e s u f f i c i e n t t o f i x t h e

e x c h a n g e rate, so l o n g a s i t d o e s n o t take r e s e r v e l e v e l s

o u t s i d e t h e s e bounds, C a l l t h e c u r r e n t r e s e r v e l e v e l which would

----------------- 2 The p l a c e m e n t o f l i m i t s a r o u n d z, r a t h e r t h a n B (t-1) , as su tnes t h a t t h e r e is ex p o s t a d j u s t m e n t of t h e e x a n t e rule d u r i n g t h e period- S e e t h e d i s c u s s i o n i n t h e first s e c t i o n of C h a p t e r 3.

b e c o n s i s t e n t w i t h no change i n e x c h a n g e ra tes R e . 3 T h e rule

t h e n s p e c i f i e s t h a t t h e c u r r e n t r e s e r v e l e v e l s h o u l d be

R = P* = R 1 i f R e is less t h a n B 1 Bn i f R e is g r e a t e r t h a n Ru R e o t h e r w i s e

In t h e above g e n e r a l form, t h e s e t t i n g F(t) =F*-Gt {t-1) c a n t h e n

It r e m a i n s t o s p e c i f y v a l u e s f o r t h e p o l i c y ' p a r a m e t e r s A, B

and C, C h a p t e r 3 d e r i v e d e x p r e s s i o n s f o r these as f u n c t i o n s o f

t h e t a r g e t r e s e r v e l e v e l z, t h e u p p e r l i m i t on f e a s i b l e r . e s e r v e

l e v e l s h and t h e l e n g t h o f the a u t h o r i t y ' s own p l a n n i n g hori 'zon

H, The c h o i c e o f v a l u e s for 2, h a n d H is noas d e s c r i b e d ,

One p u r p o s e of t h e s i n u l a t i o n e x p e r i m e n t s i s t o see

whether , under v a r i o u s exogenous s h o c k s , t h e s i m p l e and amended

v e r s i o n s of t h e r u l e produce exchange r a t e b e h a v i o u s which

d i f f e r s s y s t e m a t i c a l l y from t h a t p roauced were r e s e r v e s f i x e d a t

t a r g e t and t h e exchange r a t e free t o f l o a t , A s is e x p l a i n e d

s h o r t l y , t h e s e s i m l a t i o n s beg in w i t h a l l t h e exogenous '

v a r i a b l e s t a k i n g t h e v a l u e s t h e y had i n Canada i n March 1979,

t h e first p e r i o d beyond t h e estimation i n t e r v a l , Under f l e x i b l e

exchange r a t e s , r e s e r v e s r emain a t t h i s l e v e l , s o t h a t is t h e

v a l u e chosen f o r t h e t a r g e t r e s e r v e l e v e l z, T h i s v a l u e of ---------------- 3 R e ( t ) is f o u n d b y s e t t i n g e ( t ) = e ( t - 1 ) i n t h e p r i v a t e sector b e h a v i o u r a l e q u a t i o n ,

4 It was n o t e d i n C h a p t e r 3 t h a t w h i l e c a l c u l a t i o n of t h e r e s e r v e l i m i t s d o e s n o t r e q u i r e p r i o r knowledge o f R e , i m p l e a e n t a t i o n w i t h o u t t h i s knowledge does impose p r a c t i c a l d i f f i c u l t i e s , Here it is assumed t h a t l e a n i n g a g a i n s t t h e wind o c c u r s i n an i d e a l i z e d f a s h i o n , e s s e n t i a l l y by assuming t h a t t h e f o r e i g n exchange a u t h o r i t y d o e s know B e a h e a d of t i n e .

8(US)4.55 b i l l i o n is a l s o * r e p r e s e n t a t i v e t , i n t h e s e n s e of

b e i n g v e r y c l o s e t o t h e a v e r a g e r e s e r v e l e v e l , $(US)4,75

b i l l i o n , m a i n t a i n e d i n Canada o v e r t h e p e r i o d J u l y 1970 t o March

I n C h a p t e r 3, it was s u g g e s t e d t h a t i f t h e t a r g e t r e s e r v e

l e v e l were i t se l f a n o b j e c t of c h o i c e , t h e n it would be set

midway be tween t h e u p p e r bound h a n d lower bound. z e r o o n

f e a s i b l e r e s e r v e l e v e l s , However, i t was a l s o s u g g e s t e d t h a t t h e

upper a n d lower b o u n d s c o u l d be r e s c a l e d s o t h a t t h e y .

r e p r e s e n t e d r e s e r v e l e v e l s close t o , b u t j u s t s h o r t of, t h o s e

wh ich would c a u s e r e a l p o l i t i c a l or economic r u i n , T h e s e two

p r o p o s i t i o n s a r e a c c e p t e d i n t h i s c h a p t e r . The r e s u l t is t h a t

t h e term z(h-z) , which a p p e a r s i n t h e e x p r e s s i o n s f o r A a n d C,

i s r e p l a c e d by t h e term (2-b) 2, where (2-b) m e a s u r e s t h e

d i s t a n c e from t a r g e t t o e i t h e r of t h e r e s c a f e d bounds. It a l s o

means t h a t A/B e q u a l s (2-b), which, u n d e r t h e s i m p l e r u l e ,

becomes the maximu m c u m u l a t i v e d e v i a t i o n in r e s e r v e s f rom t a r g e t

t h a t is a l l o w e d b e f o r e a free f l o a t i s i n s t i t u t e d . Choos ing a

v a l u e for h now b e c o n e s a q u e s t i o n of c h o o s i n g a v a l u e f o r

fz-b) , The v a l u e c h o s e n is $(US) 3.32 b i l l i o n , T h i s i n t u r n

i m p l i e s a v a l u e $ ( U S ) 1.23 b i l l i o n for t h e lower bound, and

5{US)7.87 b i l l i o n f o r t h e u p p e r bound, B h i l e t h e s e bounds allow

w i d e r f l u c t u a t i o n s i n r e s e r v e l e v e l s t h a n t h o s e e x p e r i e n c e d i n

Canada d u r i n g t h e 1 9 7 0 s [ S (US) 2,955- 65 b i l l i o n ] , t h e y e n s u r e

t h a t r e s e r v e s are s t o p p e d s h o r t of c o m p l e t e d e p l e t i o n .

F i n a l l y , a v a l u e for t h e l e n g t h o f t h e p l a n n i n g h o r i z o n H

is r e q u i r e d , B h i l e it is o b v i o u s l y d i f f i c u l t t o o b t a i n a d i r e c t

e s t i m a t e o f t h i s parameter , t h e v a l u e c h o s e n is a t l e a s t

c o n s i s t e n t w i t h obse rved r e s e r v e b e h a v i o u r i n ' c a n a a a d u r i n g t h e

1970s. T h e c h o i c e o f H w i l l d e t e r m i n e t h e maximum of p e r m i s s i b l e

period- by-period c h a n g e s i n reserve l e v e l s , as r e f l e c t e d i n the

s i z e o f t h e p o l i c y p a r a m e t e r A, I n terms of F i g u r e I i n C h a p t e r

3, it w i l l d e t e r m i n e t h e h e i g h t o f t h e p o i n t K, A t f irst s i g h t ,

i t would seem r e a s o n a b l e t o a s sume t h a t H t a k e s t h e v a l u e o f an

e l e c t o r a l term - 48 months, Houever, s u c h a v a l u e , when combined

w i t h t h e above a s s u m p t i o n s a b o u t z and (z-b) , i m p l i e s a maxiaum

p e r ~ i s s i b l e pe r iod-by-per iod change t h a t is f a r s m a l l e r t h a n t h e

~ a x i m u m o f t h e monthly c h a n g e s e x p e r i e n c e d i n Canada o v e r t h e

last t e n y e a r s , However, a v a l u e H=3, t o g e t h e r wi th t h e v a l u e s

j u s t chosen f o r z and (2-b) ,5 i m p l y t h a t t h e maxiraum of

p e r m i s s i b l e per iod-by-per iod c h a n g e s is $ ( U S ) 0.41 b i l l i o n , T h i s

v a l u e is a p p r o x i m a t e l y one s t a n d a r d d e v i a t i o n above t h e mean

monthly reserve c h a n g e i n Canada i n t h e 1970s,*

A second p u r p o s e of t h e s i m u l a t i o n e x p e r i a e n t s is t o

examine t h e effects o f a l t e r n a t i v e p o l i c y p a r a m e t e r s e t t i n g s , --- -------------- 5 These v a l u e s f o r z, (2-b) a n d H p r o d u c e v a l u e s f o r A, B a n d C o f A=415-427, B=0,125 and C=51-928, However, t h e v a l u e fo r B a c t u a l l y used d u r i n g s i m u l a t i o n was 0,10825, and r e s u l t e d from a h e u r i s t i c s o l u t i o n for ~i t h a t was s l i g h t l y d i f f e r e n t from t h a t p r e s e n t e d i n Appendix I,

, 6 T h e monthly c h a n g e s i n r e s e r v e l e v e l s i n Canada between J u l y 1970 and Plarch 1979 h a d a mean of $(US) 0.17 b i l l i o n and a s t a n d a r d d e v i a t i o n of $ ( U S ) 0- 24 b i l l i o n , However, t h e r e were o n l y 9 changes d u r i n g t h i s p e r i o d t h a t were l a r g e r t h a n $ (US) 0.4 1 b i l l i on ,

d e r i v e d f r o m a l t e r n a t i v e v a l u e s f o r z , (z-b) and H, The p l a n n i n g

h o r i z o n H is assumed t o be an i n t e r n a l d e c i s i o n parameter, n o t

s u b j e c t t o amendment, The t a r g e t r e s e r v e l e v e l z and t h e

d i s t a n c e (2-b) t o t h e u p p e r a n d l o v e r bounds i o g e t h e r d e t e r m i n e

t h e s ize o f t h e r e s e r v e p o o l ( o r r e s e r v o i r , i n t h e l a n g u a g e of

C h a p t e r 3) a v a i l a b l e t o t h e f o r e i g n e x c h a n g e a u t h o r i t y , When z

i s v a r i e d , t h e a s s u m p t i o n t h a t it l i e s midway between t h e u p p e r

a n d l o v e r bounds i s a l s o m a i n t a i n e d , A l t h o u g h t h e u p p e r a n d

l o v e r b o u n d s are a l s o resealed, t h e y are n o t changed

e q n i p r o p o r t i o n a t e l y w i t h z, s o t h a t l a r g e r v a l u e s o f z t r u l y

i i q l y a l a r g e r r e s e r v e p o o l , The o p t i a a l r u l e s a r e t h e n

s i a n l a t e d n s i n g v a l u e s f o r z t h a t a re h a l f , one-and-a-half a n d

twice t h e s i z e c h o s e n above.7 T h e s e r e s u l t s a re t h e n compared

w i t h t h o s e o b t a i n e d were r e s e r v e s f i x e d a t t h e s e a l t e r n a t i v e

t a r g e t l e v e l s a n d t h e e x c h a n g e r a t e free t o f l o a t ,

N o w t u r n t o t h e time p r o f i l e s of t h e exogenous v a r i a b l e s ,

I n C h a p t e r 3, i t was a r g u e d t h a t t h e p e r f o r m a n c e of t h e r u l e s

woald depend o n t h e r e l a t i v e s i ze a n d s t r u c t u r e o f t h e

s y s t e a a t i c a n d u n s y s t e l n a t i c c o m p o n e n t s of the exogenous s h o c k s ,

I n a s i m l a t i o n c o n t e x t , t h e s h o c k s are i n t r o d u c e d t h r o n g h t h e

exogenous v a r i a b l e s , S i n c e t h e r e are two t y p e s of e x o g e n o u s

v a r i a b l e i n t h e model, nomina l and r e a l , s h o c k s are i n t r o d u c e d

----------------- 7 Phen z=$ ( U S ) 2-28 b i l l i o n a n d (z-b) =$ (US) 1.66 b i l l i o n , t h e n A=207,714 a n d C=25.964, Hhen z=$(US) 6-83 b i l l i o n and (2-b) =$ ( U S ) 4.99 b i l l i o n , t h e n A=623, l4l a n d C=77-893. Vhen z=$ ( U S ) 9. 10 b i l l i o n and (z-b) =$(US) 6 - 6 5 b i l l i o n , t h e n A=83O, 855 a n d C=103-857, B d e p e n d s o n l y on H a n d is u n a f f e c t e d by t h e s e changes.

t o e a c h s e p a r a t e l y t o see w h e t h e r r u l e p e r f o r m a n c e is d e p e n d e n t

on t h e s o u r c e of t h e s h o c k - F o r e a c h s o u r c e of shock , b o t h a

s y s t e m a t i c a n d u n s y s t e m a t i c componen t t o its movement o v e r time

is s p e c i f i e d , T h r e e t y p e s of s y s t e a a t i c movenent and t h r e e t y p e s

of u n s y s t e m a t i c movement a r e h y p o t h e s i z e d , a n d f o r e a c h s o u r c e ,

t h e s e are t r i e d i n d i f f e r e n t c o m b i n a t i o n , T h e s i z e o f e a c h

component, however , i s c h o s e n so as t o be r o u g h l y c o n s i s t e n t

w i t h Canad ian e x p e r i e n c e d u r i n g t h e 1970s, T h u s t h e s a c c h a r i n e

syndrome is avo ided .8 The s t r u c t u r e of t h e e x o g e n o u s s h o c k s is

nou d e s c r i b e d i n n o r e d e t a i l ,

The t h r e e t y p e s of s y s t e m a t i c movement are n o change ,

o n c e - f o r - a l l c h a n g e a n d c o n t i n u o u s change , The t h r e e t y p e s of

u n s y s t e m a t i c # e r r o r a s u p e r i m p o s e d o n t h e s e are i n d e p e n d e n t ,

a u t o c o r r e l a t e d and random walk errors, The time p r o f i l e of a n

exogenous s h o c k i s g e n e r a t e d a c c o r d i n g t o

x ( t ) = xo + v u d ( t ) + v l t + v 2 u ( t ) 149)

where u ( t ) = Q n ( t -1) + B V (t) (50)

Xo is some i n i t i a l or c o n s t a n t l e v e l f o r t h e a s s o c i a t e d

exogenous v a r i a b l e X, The v a r i a b l e d ( t ) is a 0-1 dunny v a r i a b l e

which al lows t h e i n t r o d u c t i o n of a once-f o r - a l l change , a n d t is

a t i m e t r e n d which a l l o w s t h e i n t r o d u c t i o n of c o n t i n u o u s change ,

The s c a l i n g p a r a m e t e r s vO and v l d e t e r m i n e t h e s i z e of t h e s e

s y s t e m a t i c c h a n g e s - The u n s y s t e m a t i c component is i n t r o d u c e d

t h r o u g h t h e v a r i a b l e u ( t ) , which is g e n e r a t e d i n t u r n by t h e

8 Anyth ing would be c a r c i n o g e n i c i f consumed a t t h e r a t e of 5 0 t o n s a d a y f o r 30 y e a r s ,

s t a n d a r d n o r m a l r a n d o n v a r i a b l e BV- A v a l u e f o r of z e r o t h e n ? g i v e s s e r i a l l y i n d e p e n d e n t errors, ?=Om 5 is c h o s e n t o g e n e r a t e

a u t o c o r r e l a t e d e r r o r s and t=1.0 g e n e r a t e s random u a l k errors.

The s c a l i n g p a r a a e t e r v2 d e t e r m i n e s t h e s i z e d f t h i s

u n s y s t e m a t i c movement,

V a l u e s f o r t h e scaling p a r a m e t e r s vO, v l and v2 are c h o s e n

f r o m C a n a d i a n e x p e r i e n c e a s f o l l o w s :

(i) Nominal D i s t u r b a n c e s , ,

T h e f irst k i n d of d i s t u r b a n c e is o n e t o t h e d o m e s t i c

component of t h e C a n a d i a n mone ta ry base D, Ove r t h e p e r i o d J u l y

1970 t o Harch 1979, its b e h a v i o u r c a n r o u g h l y b e d e s c r i b e d a s

v a r i a t i o n a r o u n d a n upward t r e n d , A r e g r e s s i o n of D on a

c o n s t a n t term and a t i n e t r e n d t o v e r t h i s p e r i o d g i v e s t h e

f o l l o w i n g r e s u l t s :

82 = 0-96 D R = 0-26 SEB = 628-928

T h e r e f o r e , v 1=98,63 f i x e s t h e size of a n o m i n a l t r e n d .

O n c e - f o r - a l l n o m i n a l c h a n g e i s set b y v0=1297-25, t h e maximum

c h a n g e i n D i n Canada o v e r t h e p e r i o d J u l y 1970 t o Harch 1979,

No s y s t e n a t i c c h a n g e o c c u r s when vO a n d v l are zero,

The s i z e o f a n o ~ i n a l i n d e p e n d e n t error term is set by

v2=628,928, t h e s t a n d a r d error of t h e a b o v e r e g r e s s i o n . F o r

a u t o c o r r e l a t e d n o m i n a l errors, a v a l u e v2=544-668 e n s u r e s t h a t

t h e i r error v a r i a n c e is t h e s a m e a s f o r t h e i n d e p e n d e n t 'errors-9

Al though t h e e r r o r v a r i a n c e is u n d e f i n e d f o r random v a l k e r r o r s ,

t h e i r # s i z e @ i s s e t b y v2=226,432, t h e a v e r a g e s i z e of c h a n g e s

i n D i n Canada o v e r t h e p e r i o d July 1970 t o n a r c h 1979,

( i i ) R e a l D i s t u r b a n c e s ,

The i n t e r e s t r a t e v a r i a b l e s r a n d r*, t h e r e a l income

v a r i a b l e s y a n d y* a n d t h e f o r e i g n r ea l Isoney s u p p l y v a r i a b l e

H*/P* e n t e r t h e model i n e x a c t l y t h e same way - c h a n g e s i n e a c h

a p p e a r l i n e a r l y i n t h e p r i v a t e sector b e h a v i o u r a l e q u a t i o . n , l o

T h e r e f o r e , f o r a given d i s t u r b a n c e i n a n y o n e of these exogenous

v a r i a b l e s , t h e r e is a n e q u i v a l e n t d i s t u r b a n c e i n a n y o n e of t h e

o t h e r s which would h a v e t h e same i m p a c t o n t h e d e p e n d e n t

v a r i a b l e o f t h a t e q u a t i o n , I n terms of e x a m i n i n g t h e effects of

d i f f e r e n t s o u r c e s of d i s t u r k a n c e , i t d o e s n o t m a t t e r which of

t h e s e v a r i a b l e s is chosen , T h e i r effects are e q u i v a l e n t , i n t h e

s e n s e j u s t d e s c r i b e d , and c a n l o o s e l y be c a l l e d ' r e a l '

effects, 1 1 For s i m u l a t i o n p u r p o s e s , t h e d o m e s t i c r e a l income

v a r i a b l e is c h o s e n a s t h e v e h i c l e f o r d i s t u r b a n c e s , The c h o i c e ,

w h i l e a r b i t r a r y , reflects a t r a d i t i o n of c o n c e r n w i t h t h e

effects o f *a h a r v e s t f a i l u r e , s t r i k e s o r war, 112 Never t h e l e s s ,

----------- ------ 9 T h i s c a l c n l a t i o n uses t h e r e l a t i o n s h i p V{u) = V (38)/(1-Q*) - l o The f o r e i g n p r i c e l e v e l P* a l s o a p p e a r s i n t h e p u r c h a s i n g p o v e r p a r i t y c o n d i t i o n , b u t c h a n g e s i n !!*/P* c a n be h y p o t h e s i z e d t h a t are i n d e p e n d e n t of c h a n g e s i n P*-

1 1 w h i l e t h e i n t e r e s t ra te v a r i a b l e s are i n nomina l terms, t h e d i f f e r e n c e be tween them c a n b e r e g a r d e d a s h a v i n g a r e a l effect-

1 2 See B u n d e l l (1973,P,115),

t h e s c a l i n g p a r a m e t e r s a r e chosen s o t h a t t h e s i z e of v a r i a t i o n . i n y is t h e s a n e a s t h a t o b t a i n e d by combin ing a l l t h e - 0 0 * h i s t o r i c a l v a r i a t i o n i n t h e real v a r i a b l e s y*. r, r* and

d/d t (B*/P*) , a s suming a t t h e same time that these s e p a r a t e

i n f l u e n c e s a r e a l w a y s r e i n f o r c i n g .

T h e r e f o r e , v l = Zlbiki/b6 = 0,042082 f i x e s t h e s i z e of a

r e a l t r e n d , where k i is t h e a v e r a g e c h a n g e i n e a c h o f t h e s e

v a r i a b l e s o v e r t h e p e r i o d J u l y 1970 t o Barch 3979, and b i is its

a s s o c i a t e d r e g r e s s i o n c o e f f i c i e n t , B o n c e - f o r - a l l r e a l ch.ange is

se t by v0=16,75624, c a l c u l a t e d i n t h e same way but where k i now

r e p r e s e n t s t h e maximum change i n e a c h v a r i a b l e - No s y s t e m a t i c

r ea l change occurs *hen YO and v l are zero-

The s i z e o f a r e a l i n d e p e n d e n t e r r o r t e r a i s set by

v2=3,925, c a l c u l a t e d as above b u t where k i r e p r e s e n t s t h e

s t a n d a r d d e v i a t i o n of changes i n e a c h v a r i a b l e , F o r

a u t o c o r r e l a t e d r e a l e r r o r s , a v a l u e v2=3,399 e n s u r e s t h a t t h e i r

error var iance is t h e sane as f o r t h e i n d e p e n d e n t e r r o r s , Again,

t h e e r r o r v a r i a n c e is undef ined f o r random wa lk e r r o r s , b u t

t h e i r ' s i z e ' is d e t e r m i n e d by v2=0,1, a v a l u e which g i v e s

r o u g h l y t h e same exchange r a t e v a r i a n c e as w i t h t h e o t h e r t y p e s

of error, g i v e n t h e sample set of o b s e r v a t i o n s o n BV-

With t h i s s i m u l a t i o n e n v i r o n m e n t , e a c h r u l e is s i m u l a t e d

nnder e v e r y p o s s i b l e c o m b i n a t i o n of s y s t e m a t i c a n d u n s y s t e m a t i c \

d i s t u r b a n c e , Each s imula t i o n is g i v e n t h e same s t a s t i n g p o i n t ,

w i t h t h e exogenous v a r i a b l e s t a k i n g t h e v a l u e s t h e y had i n

Canada i n March 1979, I n s u b s e q u e n t p e r i o d s , t h e s o u r c e o f t h e

d i s t u r b a n c e t a k e s t h e v a l n e s j u s t d e s c r i b e d , w h i l e a l l t h e o t h e r

exogenous v a r i a b l e s remain a t t h e i r s t a r t i n g va lues , These

v a l u e s a r e :

D = D o = $(Can) 8838.37 m i l l i o n

fl* = B*o = $(US) 142.4 b i l l i o n

r = r o = O where r = 0,8674 * * r* = r*o = 0 where r* = 0,7415 . . y = y o = O where y = 120.6 - . y* = y+o = 0 where y* = 129-9

The same s e q u e n c e of o b s e r v a t i o n s on RV is used i n a l l

s i m u l a t i o n s a n d h a s a mean o f -0,0295 and a s t a n d a r d d e v i a t i o n

o f 0.9537, Each s i m u l a t i o n p r o c e e d s f o r j u s t ove r t e n y e a r s , a

p e r i o d which, f o r c o n c r e t e n e s s , is c a l l e d A p r i l 1979 t o J u n e

1989, a n d g e n e r a t e s 123 monthly o b s e r v a t i o n s on t h e endogenous

v a r i a b l e s ,

F i n a l l y , i n o r d e r t o compare t h e r e s e r v e management rules

with Bank o f Canada p o l i c i e s d u r i n g t h e 1970s, e a c h laanagement

r u l e is s i m n l a t e d when t h e exogenous v a r i a b l e s t a k e t h e i r a c t u a l

v a l u e s from t h e p e r i o d J u l y 1970 t o Harch 1979, The r e s u l t i n g

s i m u l a t i o n s g e n e r a t e 105 monthly o b s e r v a t i o n s on t h e endogenous

v a r i a b l e s .

The S i m u l a t i o n R e s u l t s - ---- --- T h i s s e c t i o n compares t h e p e r f o r m a n c e of t h e r e s e r v e

management r u l e s , b o t h a l o n e a n d r e l a t i v e t o Bank o f Canada

a c t i o n s , a c c o r d i n g t o t h r e e c o n c e r n s - e n h a n c e b e n t o f

p r e d i c t a b i l i t y , t r a c k i n g a b i l i t y , a n d p e r f o r m a n c e u n d e r

a l t e r n a t i v e t a r g e t r e s e r v e l e v e l s ,

(i) Enhancement of P r e d i c t a b i l i t y ,

Rou much of t h e t o t a l i m p a c t of t h e i n t e r v e n t i o n r u l e s

f a l l s on t h e u n s y s t e m a t i c componen t of e x c h a n g e rate b e h a v i o u r ?

I n p a r t i c u l a r , do t h e r e s e r v e management r u l e s p r o d u c e

u n s y s t e m a t i c e x c h a n g e rate v a r i a t i o n t h a t is s i g n i f i c a n t l y l o w e r

t h a n t h a t p r o d u c e d u n d e r a free f l o a t , g i v e n t h e wide v a r i e t y of

d i s t u r b a n c e s ?

To a n s w e r t h e s e q n e s t i o n s , a m e a s u r e of u n s y s t e m a t i c

e x c h a n g e r a t e v a r i a t i o n is r e q u i r e d , The v a r i a n c e o f t h e

e x c h a n g e r a t e is i n a p p r o p r i a t e b e c a u s e it m e a s u r e s t o t a l

v a r i a t i o n , n o t u n s y s t e m a t i c v a r i a t i o n . 1 3 A t t h e v e r y leas t , a n y

t r e n d component ~ u s t be s c r e e n e d o u t b e f o r e u n s y s t e m a t i c

v a r i a t i o n c a n be measured, T h e r e f ore, t h e v a r i a n c e of e x c h a n g e

r a t e c h a n q e s is u s e d as a c r u d e measu re of u n s y s t e m a t i c

v a r i a t i o n , T h i s by d e f i n i t i o n is a m e a s u r e of v a r i a t i o n a r o u n d

t h e mean e x c h a n g e r a t e c h a n g e - t h a t is, a r o u n d t h e t r e n d ,

A s t a n d a r d F - t e s t on e q u a l i t y of v a r i a n c e s is t h e n ,

p e r f o r m e d t o compare t h e u n s y s t e m a t i c v a r i a t i o n p roduced by e a c h

---------------- 1 3 A s T a y l o r (1982) n o t e s , a l a r g e v a r i a n c e need n o t be i n c o n s i s t e n t w i t h some n o t i o n s of s t a b i l i t y ,

i n t e r v e n t i o n r u l e wi th t h a t p roduced under a f r e e f l o a t - 1 4 The

r e s u l t i n g P s t a t i s t i c s a r e r e p o r t e d i n T a b l e 11 f o r b o t h t h e

v a r i o u s k i n d s o f h y p o t h e s i z e d d i s t u r b a n c e and f o r t h e

d i s t u r b a n c e s a c t u a l l y e x p e r i e n c e d i n Canada d k i n g 1970-79, I n

e a c h c a s e , t h o s e i n s t a n c e s are f l a g g e d where t h e rules produce

u n s y s t e m a t i c v a r i a t i o n t h a t i s got s i g n i f i c a n t l y s m a l l e r t h a n

under a free f l o a t ,

T a b l e 11 shows t h a t i n a l m o s t a l l c a s e s , b o t h v e r s i o n s of

t h e r e s e r v e management r u l e s i g n i f i c a n t l y r e d u c e t h e

u n s y s t e m a t i c v a r i a t i o n t h a t would o t h e r w i s e occur , w i t h t h e

s i m p l e r u l e o o t p e r f o r m i n g t h e amended v e r s i o n on t h i s s c o r e -

Fur thermore , a n argument c a n b e made t o d i s m i s s t h e f i v e

e x c e p t i o n s on e m p i r i c a l grounds ,

It was a r g u e d a p r i o r i i n C h a p t e r 3 t h a t t h e r u l e s ' s u c c e s s

c o u l d b e expect ,ed t o depend on t h e r e l a t i v e s i z e s o f s y s t e n a k i c

and u n s y s t e m a t i c v a r i a t i o n i n t h e d i s t u r b a n c e , B o w i n t h e above

c a s e s w h e r e t h e ru les perform p o o r l y , t h e s i z e o f u n s y s t e m a t i c

v a r i a t i o n i n t h e u n d e r l y i n g h y p o t h e t i c a l d i s t u r b a n c e is

s i g n i f i c a n t l y s m a l l e r t h a n t h a t e x p e r i e n c e d i n Canada d u r i n g t h e

1970s. and i n t h a t s e n s e u n r e a l i s t i c . However, i n o t h e r

i n s t a n c e s where t h e h y p o t h e t i c a l u n s y s t e m a t i c v a r i a t i o n is

----------------- 1 4 T h i s t es t assumes t h e s i m u l a t e d sample v a r i a n c e s a r e independen t , Now t h e same set of o b s e r v a t i o n s on RV is used i n e a c h s i m u l a t i o n s o a s t o f a c i l i t a t e v i s u a l comparison- Dependence between s o u r c e s of d i s t u r b a n c e does n o t e n s u r e dependence between v a r i a n c e s , however, since t h e b a s i c d i s t u r b a n c e i s run th rough d i f f e r e n t filters, T h e issue of independence is t h u s d i f f i c u l t t o e s t a b l i s h w i t h o u t a n a n a l y t i c a 1 s o l u t i o n ,

T a b l e II - C o g p a r i s o n of U n s y s t e m a t i c Exchanqe R a t e V a r i a t i o n

F - t e s t on E q u a l i t y of V a r i a n c e s Between I n t e r v e n t i o n and F r e e F l o a t

S i m u l a t e d D i s t u r b a n c e I n t e r v e n t i o n R u l e

S o u r c e S y s t e m a t i c U n s y s t e m a t i c S i m p l e Antended Component Component R u l e R u l e

Nominal C o n s t a n t I n d e p e n d e n t A a t o c o r r ,

Randoa Walk T r e n d I n d e p e n d e n t

A u t o c o r r . Randoa Walk

Step I n d e p e n d e n t A u t o c o r r ,

Random Q a l k

Real Constant I n d e p e n d e n t Au tocor r -

Random Balk T r e n d I n d e p e n d e n t

A u t o c o r r , Random Walk

Step I n d e p e n d e n t Autocorr-

Random Salk

H i s t o r i c a l 1970-79*** 17-26 3.25

* Not s i g n i f i c a n t l y d i f f e r e n t f rom z e r o a t t h e 5% l e v e l ** F - s t a t i s t i c v e r y l a r g e *** Bank of Canada po1 icy :ove r t h i s p e r i o d , a s embodied i n

a c t u a l e x c h a n g e rate b e h a v i o u r , produced F=7,28

s m a l l e r t h a n h i s t o r i c a l e x p e r i e n c e , b o t h v e r s i o n s o f t h e r u l e

s i g n i f i e a n t l y r e d u c e t h a t v a r i a t i o n . T h e r e f o r e , t h e r e i s a

margin of s a f e t y w i t h i n which t h e r u l e s p e r f o r m w e l l , d e s p i t e

s m a l l u n s y s t e m a t i c v a r i a t i o n , 1s

Somewhat a s a n a s i d e , t h e f i v e e x c e p t i o n s j u s t d i s m i s s e d on

e m p i r i c a l g r o u n d s are a l l a s s o c i a t e d w i t h real d i s t u r b a n c e s , One

d i f f e r e n c e be tween t h e r e a l a n d n o m i n a l s h o c k s 3s t h a t l e v e l s

have been p r e s p e c i f l e d f o r t h e nominal v a r i a b l e , b u t c h a n g e s f o r

t h e r e a l v a r i a b l e , The real d i s t u r b a n c e t h e r e f o r e h a s a n .

a d d i t i o n a l , i n b u i l t e l e m e n t o f a u t o c o r r e l a t i o n - C o n s i d e r a t i o n of

b o t h t y p e s of s h o c k p r o v i d e s a r i c h e r v a r i e t y of exchange r a t e

p a t t e r n s on which t o b a s e c o n c l u s i o n s . However, t h e real s h o c k s

a l o n e i n v a r i a b l y p r o d u c e u n s y s t e m a t i c exchange ra te v a r i a t i o n

t h a t is u n r e a l i s t i c a l l y smal l . 1 6 By c o n t r a s t , t h e noniinal

d i s t u r b a n c e s a l o n e c a n produce a r a n g e of u n s y s t e m a t i c exchange

r a t e v a r i a t i o n i n t h e ne ighbourhood o f h i s t o r i c a l exper ience .

There fo re , o n l y t h e l a t t e r k i n d of d i s t u r b a n c e is u s e d when

examining a l t e r n a t i v e t a r g e t r e s e r v e l e v e l s ,

--------------- 15 T h e compar ison o f h y p o t h e t i c a l and h i s t o r i c a l u n s y s t e m a t i c s h o c k s is performed u s i n g F - t e s t s on t h e u n s y s t e m a t i c v a r i a t i o n t h e r e b y produced i n a f r e e l y f l o a t i n g exchange rate- F o r t h e f i v e e x c e p t i o n s , F statistics i n t h e r a n g e 15-32 t o 2147.00 are o b t a i n e d , showing t h e u n s y s t e m a t i c v a r i a t i o n i n t h e s i m u l a t e d d i s t u r b a n c e s t o b e s i g n i f i c a n t l y s m a l l e r t h a n h i s t o r i c a l e x p e r i e n c e . I n t h e o t h e r c a s e s o f s ~ a l l v a r i a t i o n , P s k a t i s t i c s i n t h e r a n g e 2.97 t o 76-61 are o b t a i n e d , s u g g e s t i n g some margin o f s a f e t y w i t h i n which t h e rules c a n p e r f o r a w e l l -

1 6 Using t h e above ~ e t h o d of compar i son , F - s t a t i s t i c s i n t h e r a n g e 9-18 t o 2147-00 are produced by t h e real d i s t u r b a n c e s -

F i n a l l y , t h o s e r e s u l t s o b t a i n e d i n t h e face of t h e

d i s t u r b a n c e s e x p e r i e n c e d i n Canada i n t h e 1970s show t h a t Bank

o f Canada p o l i c i e s , a s embodied i n t h e a c t o a l e x c h a n g e rate

b e h a v i o u r o v e r t h e p e r i o d , p roduced e x c h a n g e s a t e s which were

s i g n i f i c a n t l y s m o o t h e r t h a n t h e f r e e l y f l o a t i n g e x c h a n g e r a t e ,

However, t h e s i m p l e , t hough n o t t h e amended v e r s i o n of t h e

o p t i m a l r u l e would h a v e o u t p e r f o r m e d t h e Bank of Canada on t h i s

s c o r e ,

( i i ) T r a c k i n g A b i l i t y ,

The q u e s t i o n h e r e is w h e t h e r t h e r e s e r v e management r u l e s

p r o d u c e e x c h a n g e r a t e b e h a v i o u r t h a t differs s y s t e m a t i c a l l y from

a free f l o a t ,

T h i s q u e s t i o n is answered a s follows, A s e q u e n c e o f

o b s e r v a t i o n s is c a l c u l a t e d on t h e d i f f e r e n c e be tween a f r e e l y

f l o a t i n g e x c h a n g e ra te and t h a t rate p r o d u c e d by t h e

i n t e r v e n t i o n r u l e s . A t - test is t h e n pe r fo rmed t o see i f t h e

a v e r a g e of t h i s s e q u e n c e is s i g n i f i c a n t l y d i f f e r e n t from z e r o -

The associated t s ta t is t ics a re r e p o r t e d i n T a b l e 111, fo r b o t h

t h e v a r i o u s k i n d s of h y p o t h e s i z e d d i s t u r b a n c e and f o r t h e

i i i s t u r b a n c e s a c t u a l l y e x p e r i e n c e d i n Canada d a r i n g 1970-79, In

e a c h c a s e , t h o s e i n s t a n c e s are f l a g g e d where t h e r u l e s are

s i g n i f i c a n t l y d i f f e r e n t f r o i ~ a free f l o a t ,

T a b l e 111 shows t h a t i n many i n s t a n c e s , t h e r e s e r v e

man agemen t r u l e s p r o d n c e e x c h a n g e r a t e b e h a v i o u r t h a t i s

s i g n i f i c a n t l y d i f f e r e n t f r o a t h a t u n d e r a f see f l o a t , a l t h o u g h

t h e amended v e r s i o n t r a c k s better t h a n t h e s i m p l e v e r s i o n .

Table III - Compar i son of m t e r n a t i c Exchanqe Rate V a r i a t i o n

t-test on S i g n i f i c a n c e of Average Exchange Rate D i f f e r e n c e be tween I n t e r v e n t i o n a n d F r e e F l o a t

S i m u l a t e d D i s t u r b a n c e

S o u r c e S y s t e a a t i c O n s y s t e m a t i c S i m p l e Amended Component Component R u l e Rule

Nominal C o n s t a n t I n d e p e n d e n t B u t o c o r r ,

Random Walk Trend I n d e p e n d e n t

Au toco r r , Random Walk

S t e p I n d ~ p e n d e n t A u t o c o r r -

Randoot Walk

Real C o n s t a n t I n d e p e n d e n t Ao t o c o r r .

Random Balk Trend I n d e p e n d e n t

Autocor r . Random Walk

S t e p I n d e p e n d e n t Au toco r r ,

Random Valk

H i s t o r i c a l 1970-79**

* Not s i g n i f i c a n t l y d i f f e r e n t from zero a t t h e 5% l e v e l , ** Bank o f Canada p o l i c y o v e r t h i s p e r i o d , a s embodied i n

a c t u a l e x c h a n g e rate b e h a v i o u r , p roduced t = 1 2 - 8 4

Houever, t h e q u e s t i o n of d i v e r g e n c e c a n n o t be answered by

t h i s s t a t i s t i c a l t e s t a l o n e , I n t h e first i n s t a n c e , t h e t

s t a t i s t i c s a r e s e n s i t i v e t o t h e d i r e c t i o n , as well a s t o t h e

s i z e of d i v e r g e n c e , Thus a minu te b u t persisteht d i f f e r e n c e i n

t h e exchange rate from a free f l o a t may show a s s i g n i f i c a n t ,

s imply b e c a u s e t h e s i z e of t h e d i f f e r e n c e , a l t h o u g h s m a l l , is

l a r g e r e l a t i v e t o t h e d e g r e e o f v a r i a t i o n i n t h e . d i f f e r e n c e .

Secondly , t h e q u e s t i o n of d i v e r g e n c e h i n g e s o n t h e c o s t s o f

d i v e r g e n c e r e l a t i v e t o the b e n e f i t s o b t a i n e d by t h e r e d u c f i o n i n

u n s y s t e m a t i c exchange r a t e v a r i a t i o n , a s was argued i n t h e

i n t r o d u c t i o n t o t h i s c h a p t e r ,

N e v e r t h e l e s s , this a p p a r e n t i n c o n c l u s i v e n e s s can b e p u t i n

p e r s p e c t i v e by c o n s i d e r i n g whether t h e r u l e s outperfor ia t h e

i n t e r v e n t i o n p o l i c y a c t u a l l y f o l l o w e d by t h e Bank of Canada

d u r i n g t h e 1970s- T a b l e I11 n o t e s t h a t o v e r t h i s p e r i o d , t h e r e

was s u b s t a n t i a l d i v e r g e n c e between t h e a c t u a l rate and t h a t

which would h a v e o c c u r r e d had t h e e x c h a n g e r a t e f l o a t e d f r e e l y -

By compar ison, b o t h t h e s i u i p l e and amended v e r s i o n s of t h e

r e s e r v e management r u l e t r a c k t h e f r e e l y f l o a t i n g r a t e much more

c l o s e l y ,

(ii i) A l t e r n a t i v e T a r g e t B e s e r v e L e v e l s ,

T h e q u e s t i o n h e r e is whe the r success i n r e d u c i n g

u n s y s t e m a t i c exchange r a t e v a r i a t i o n is s e n s i t i v e t o t h e c h o i c e

of t a r g e t r e s e r v e l e v e l .

T a b l e IV r e p o r t s t h e u n s y s t e m a t i c exchange r a t e v a r i a t i o n

produced using d i f f e r e n t t a r g e t r e s e r v e s e t t i n g s f o r t h e o p t i m a l

r u l e s . T a b l e V r e p o r t s t h e P s t a t i s t i c s which show t h i s

u n s y s t e m a t i c e x c h a n g e ra te v a r i a t i o n , r e l a t i v e t o t h a t p roduced

were r e s e r v e s f i x e d a t t h e a l t e r n a t i v e l e v e l s and t h e e x c h a n g e

ra te free t o f l o a t . J . 7 The t a r g e t r e s e r v e l e v e l ' n s e d t o g e n e r a t e

t h e r e s o l t s a b o v e is d e n o t e d b y z. T h i s v a l u e of $(US)4.55

b i l l i o n is close t o t h e a v e r a g e r e s e r v e l e v e l m a i n t a i n e d i n

Canada o v e r t h e p e r i o d J u l y 1970 t o Harch 1979. A l t e r n a t i v e

t a r g e t r e s e r v e l e v e l s are d e n o t e d r e l a t i v e t o t h i s benchinark.

The r e s u l t s are p roduced u n d e r v a r i o u s h y p o t h e t i ca l nomina l

d i s t u r b a n c e s , a s w e l l as u n d e r t h o s e d i s t u r b a n c e s e x p e r i e n c e d i n

Canada o v e r t h e p e r i o d J u l p 1970 t o Harch 1979-

T a b l e s IV and V show t h a t t h e a b i l i t y of e a c h v e r s i o n t o

r e d u c e u n s y s t e m a t i c e x c h a n g e r a t e v a r i a t i o n i n i t i a l l y i n c r e a s e s ,

t h e l a r g e r is t h e t a r g e t r e s e r v e l e v e l - t h a t is, t h e l a r g e r is

t h e r e s e r v e p o o l w i t h which t o p e r f o r m the smoothing. However,

beyond a c e r t a i n r e s e r v e l e v e l , e a c h v e r s i o n * s pe r fo rmance a g a i n

d e t e r i o r a t e s . f o r v a r i o u s d i s t o r b a n c e s , t h e si trrple rule u s u a l l y

p e r f o r m s bes t a t a t a r g e t r e s e r v e l e v e l of 1,5z, w h i l e t h e

amended r u l e performs b e s t a t a t a r g e t r e s e r v e l e v e l o f e i t h e r z

or 1 . 5 ~ . Assuming c o n t i n u i t y , i t c a n t h u s be c l a i m e d t h a t t h e

o p t i i s a l t a r g e t r e s e r v e l e v e l lies somewhere be tween z=$ (US) 4 -55 ------------------ 1 7 R e l a t i v e a s w e l l a s a b s o l u t e r e d u c t i o n is r e p o r t e d b e c a u s e t h e a b s o l u t e f i g u r e s are n o t s t r i c t l y c o m p a r a b l e a c r o s s t a r g e t r e s e r v e f e v e l s . D e s p i t e t h e same d i s t u r b a n c e s , t h e t o t a l u n s y s t e m a t i c v a r i a t i o n t o b e . r e d n c e d d e c r e a s e s s l i g h t l y a s t h e t a r g e t r e s e r v e l e v e l i n c r e a s e s . The l a r g e r t h e t a r g e t r e s e r v e l e v e l , t h e l a r g e r t h e a v e r a g e n o m i n a l money s u p p l y , t h e s m a l l e r t h e p e r c e n t a g e c h a n g e i n t h e money s u p p l y t h a t a g i v e n d i s t u r b a n c e r e p r e s e n t s , a n d t h e smaller t h e e x c h a n g e r a t e a d j u s t m e n t r e q u i r e d t o compensa t e ,

T a b l e I V - T a r q e t R e s e r v e s A b s o l u t e I a r i a t i o q R e d u c t i o n

S t d - D e v i a t i o n of Exchange Rate Changes x 1000

S i m u l a t e d D i s t a r b a n c e T a r g e t R e s e r v e L e v e l +

S y s t e m a t i c U n s y s t e m a t i c 0- 5 2 z 1-52 2 2 Corn pone n t Component

S i m p l e R u l e -- C o n s t a n t I n d e p e n d e n t

A u t o c o r r - Random P a l k

Trend I n d e p e n d e n t Au toco r r ,

Randota Walk - S t e p I n d e p e n d e n t

A u t o c o r r - Random Ualk

H i s t o r i c a l 1970-79

Amended R u l e - C o n s t a n t I n d e p e n d e n t

A u t o c o r r - Random Salk

Trend I n d e p e n d e n t Au toco r r .

Random Walk S t e p I n d e p e n d e n t

A u t o c o r r - Random P a l k

Historical 1970-79

7,50* 4.43*

0 * 16- 00* l1,36* 5,92* 9,51* 7,14* 0.86 8-32

+ z = $ (US)4-55 b i l l i o n * liinimurn u n s y s t e m a t i c e x c h a n g e r a t e v a r i a t i o n

T a b l e V - Target R e s e r v e s and R e l a t i v e V a r i a t i o n Reduction

F - t e s t on E q u a l i t y o f V a r i a n c e s Between I n t e r v e n t i o n and F r e e F l o a t

S imula ted D i s t u r b a n c e T a r g e t Rese rve Leve l+

S y s t e a a t i c U n s y s t e m a t i c 0.52 z 1-52 .2 z Component Component

S imple R u l e

C o n s t a n t I n d e p e n d e n t Antocorr.

Banaom Balk Trend I ndependen t

Autocor r , Random Valk -

Step I n d e p e n d e n t Autocor r ,

Randoa Walk Historical 1970-79

Anended B u l e ----- C o n s t a n t I n d e p e n d e n t

Autocor r , Random Balk

Trend I n d e p e n d e n t Autocor r ,

Bandoat Ralk S t e p I n d e p e n d e n t

A u t o c o r r , Random Halk

H i s t o r i c a l 1970-79

+ 2 = $ ( U S ) 4.55 b i l l i o n * Haximum r e d u c t i o n i n u n s y s t e m a t i c exchange r a t e

v a r i a t i o n - ** F - s t a t i s t i c very l a r g e

b i l l i o n a n d 1- 5z=$ ( U S ) 6 - 8 3 b i l l i o n , w i t h t h e optimum p e r h a p s

b e i n g s m a l l e r f o r t h e amended v e r s i o n t h a n f o r t h e s i m p l e

v e r s i o n .

The e x p l a n a t i o n for t h i s r e s u l t l i e s i n t h e way t h e ru les

o p e r a t e , T h e r e is a n i n h e r e n t c o n f l i c t be tween t h e d e s i r e t o

minimize e x c h a n g e rate v a r i a t i o n a n d t h u s a a x i m i z e r e s e r v e l e v e l

v a r i a t i o n , a n d t h e r e q u i r e m e n t t h a t r e s e r v e s r e m a i n w i t h i n t h e

l i m i t s s e t by r e s e r v e a v a i l a b i l i t y , T h e l a r g e r t h e p o o l of

a v a i l a b l e r e s e r v e s , t h e v i d e r t h o s e lilaits, s o t h a t more .of a n y

g i v e n s h o c k c a n b e a b s o r b e d by r e s e r v e movement when r e s e r v e s

are close t o t a r g e t e d l e v e l s , With v i d e r l i m i t s , however,

r e s e r v e s c a n move f u r t h e r a v a p from t a r g e t and r e m a i n away f o r

l o n g e r p e r i o d s , Yhen t h i s o c c u r s , e x c h a n g e r a t e a d j u s t m e n t mus t

b e g i n t o s u b s t i t u t e f o r r e s e r v e a d j u s t m e n t - l a

The s i m u l a t i o n r e s u l t s t h e r e f o r e s u g g e s t t h a t f o r t a r g e t

r e s e r v e l e v e l s l a r g e r t h a n $(US) 4-55-6.83 bill i o n , t h e s e

c o u n t e r v a i l i n g f o r c e s begin t o d o m i n a t e , Beyond t h i s r a n g e ,

t h e r e a r e n e g a t i v e r e t u r n s t o a d d i t i o n a l r e s e r v e h o l d i n g , The

r e s u l t s a l s o confirm t h a t b e c a u s e t h e amended v e r s i o n

i n c o r p o r a t e s s t r o n g e r c o u n t e r v a i l i n g forces t h a n t h e s i m p l e

v e r s i o n , its n e g a t i v e r e t u r n s o c c u r earlier,

--- -------------- , 1 8 The s i m p l e v e r s i o n sets t h e c u r r e n t p e r m i s s i b l e r e s e r v e c h a n g e a* a c c o r d i n g t o A-BX, v h e r e X is t h e d e v i a t i o n i n r e s e r v e s from t a r g e t . F roa C h a p t e r 3, t h e p a r t i a l d e r i v a t i v e of IR* w i t h respect t o z i s p o s i t i v e when t h e a s s u a p t i o n h=2z is m a i n t a i n e d , However, dX/dz (and dT/dz) may e x p o s t be n e g a t i v e ,

s i m u l a t i o n

R e s u l t Summary and P o l i c y c o n c l u s i o n s -- Appendix I V d e p i c t s g r a p h i c a l l y t h e

o b t a i n e d f o r a g i v e n t a r g e t r e s e r v e l e v e

r e s u l t s

1- I n t h a t Appendix,

F i g u r e s V t o XXII show t h e exchange r a t e b e h a v i o u r p rodaced b y

t h e r e s e r v e management r u l e s w i t h e a c h h y p o t h e t i c a l s o u r c e a n d

s t r u c t u r e of d i s t u r b a n c e , 19 a n d F i g u r e XXIII shows t h e r e s u l t s

o b t a i n e d i n t h e face o f t h o s e d i s t u r b a n c e s e x p e r i e n c e d i n Canada

o v e r t h e p e r i o d J u l y 1970 t o March 1979. his l a s t f i g u r e a l s o

shows Bank o f Canada pe r fo rmance , a s embod ied i n a c t u a l e x c h a n g e

r a t e b e h a v i o u r , o v e r t h a t p e r i o d ,

The s i m p l e v e r s i o n of t h e r e s e r v e management r u l e p r o d u c e s

exchange r a t e b e h a v i o u r which a p p e a r s , by c a s u a l o b s e r v a t i o n , t o

be smoo the r t h a n t h a t u n d e r a free f loa t , Both v e r s i o n s o p e r a t e

by p l a c i n g ( v a r i a b l e ) upper a n d l o w e r bounds on r e s e r v e

aovements , S o l ong a s t h e d i s t u r b a n c e i s s m a l l enough t o k e e p

r e s e r v e s w i t h i n t h e s e bounds, t h e e x c h a n g e r a t e r e m a i n s f i x e d ,

When t h e b o u n d s a r e h i t , t h e s i m p l e v e r s i o n l e a n s a g a i n s t t h e

wind - it allows a n e x c h a n g e rate a d j u s t m e n t , b u t o n e smaller

t h a n which wou ld o c c u r u n d e r a f r e e l y f l o a t i n g r e g i m e - F i n a l l y ,

b o t h v e r s i o n s allow t h e p o s s i b i l i t y of a free f l o a t i n t h e f a c e

of l a r g e o r p e r s i s t e n t d i s t u r b a n c e s . 2 0 I n t h i s way, t h e s i a p l e ----------------- 19 An i n t e r e s t i n g p o i n t is t h a t a o n c e - f o r - a l l r e a l c h a n g e is n o t d i s t i n g u i s h a b l e from t h e v a r i a t i o n a r o u n d t h a t change , T h i s c o n f i r m s t h e earlier judge ment on t h e d e s i r a b i l i t y of d e s i g n i n g a r u l e which d o e s n o t presume a n a b i l i t y t o d i s t i n g u i s h d i f f e r e n t k i n d s of shock , The r e s u l t s s u g g e s t t h a t t h i s may be d i f f i c u l t .

2oIn no case d i d t h e s i m p l e v e r s i o n a c t u a l l y p r o d u c e a free f l o a t , a l t h o u g h F i g u r e X V I shows a c a s e where it came v e r y close t o d o i n g s o ,

v e r s i o n r e d u c e s b o t h t h e s i ze a n d t h e number of e x c h a n g e r a t e

s h o c k s , T h e r e s u l t s of t h e p r e v i o u s s e c t i o n c o n f i r m t h a t t h i s

r e d u c t i o n i n u n s y s t e m a t i c e x c h a n g e r a t e v a r i a t i o n is

s t a t i s t i c a l l y s i g n i f i c a n t , a t l eas t fo r d i s t u r b a n c e s i n a wide

r a n g e a r o u n d t h o s e e x p e r i e n c e d i n Canada d u r i n g t h e 1970s-

The amended v e r s i o n of t h e r u l e a l so a p p e a r s t o smooth

e x c h a n g e r a t e v a r i a t i o n , e v e n t h o u g h i t d o e s n o t . a l w a y s l e a n

a g a i n s t t h e wind, I f r e s e r v e s r e m a i n away from t a r g e t f o r

p r o l o n g e d p e r i o d s of time, t h e n t h i s v e r s i o n e v e n t u a l l y f o r c e s

them back , i n d e p e n d e n t of t h e c u r r e n t shock , E x p o s t , t h e

a u t h o r i t y may b e t w i t h , r a t h e r t h a n a g a i n s t , t h e marke t and

e x a c e r b a t e a s i n g l e e x c h a n g e r a t e a d j u s t m e n t . B u t a s t h e r e s u l t s

show, t h i s need n o t b e i n c o n s i s t e n t w i t h s t a b i l i t y or s m o o t h n e s s

o v e r t h e l o n g e r term, The r e s u l t s o f t h e p r e v i o u s s e c t i o n

c o n f i r m t h a t t h e r e d u c t i o n i n u n s y s t e m a t i c e x c h a n g e r a t e

v a r i a t i o n is s t a t i s t i c a l l y s i g n i f i c a n t , a t l ea s t f o r

d i s t u r b a n c e s i n a wide r a n g e a r o u n d h i s t o r i c a l e x p e r i e n c e ,

However, the r e s u l t s a l s o show t h a t , b e c a u s e t h i s v e r s i o n p l a c e s

an a d d i t i o n a l c o n s t r a i n t on r e s e r v e movement, it c a n n o t r e d u c e

u n s y s t e m a t i c e x c h a n g e rate v a r i a t i o n a s s u c c e s s f n l l y a s t h e

s i m p l e v e r s i o n ,

Both v e r s i o n s o f t h e r e s e r v e management rule h a v e a d e g r e e i

o f i n b a i l t asymmetry , which allows s y s t e m a t i c e x c h a n g e rate

a d j u s t m e n t i n t h e face of a t r e n d i n t h e u n d e r l y i n g d i s t u r b a n c e ,

Because r e s e r v e s a re k e p t w i t h i n some r a n g e a r o u n d t a r g e t ,

e x c h a n g e r a t e a d j u s t m e n t must e v e n t u a l l y s u b s t i t u t e f o r r e s e r v e

a d j u s t m e n t . 2 1 The amended v e r s i o n sets n a r r o w e r l i m i t s on

r e s e r v e s , wh ich e x p l a i n s why it a p p e a r s t o t r a c k t h e s y s t e m a t i c

a d j u s t ~ e n t o f a f r e e l y f l o a t i n g e x c h a n g e rate b e t t e r t h a n i ts

s i m p l e c o u n t e r p a r t , P e v e r t h e l e s s , t h e r e s u l t s of t h e p r e v i o u s

s e c t i o n show t h a t e i t h e r v e r s i o n c a n p r o d u c e d e v i a t i o n s from a

free f l o a t t h a t a re s t a t i s t i c a l l y s i g n i f i c a n t .

From a p o l i c y p e r s p e c t i v e , however , s u c h d e v i a t i o n s matter

o n l y i f t h e y i m p o s e cos ts which m i g h t o u t w e i g h t h e b e n e f i t s

o b t a i n e d frorn t h e r e d u c t i o n i n u n s y s t e m a t i c e x c h a n g e r a t e .

v a r i a t i o n , w i t h i ts a s s o c i a t e d i n c r e a s e i n e x c h a n g e r a t e

p r e d i c t a b i l i t y , T h i s i n t n r n d e p e n d s on t h e t r a d e o f f between

s m o o t h i n g a n d t r a c k i n g a b i l i t y , I n t h i s r e g a r d , t h e s i m u l a t i o n

r e s u l t s c a n be s u ~ m a r i z e d by F i g u r e 111. T h i s gives t h e t r a d e o f f

p r o d u c e d i n t h e f a c e of t h o s e d i s t u r b a n c e s e x p e r i e n c e d i n Canada

d u r i n g t h e 1970s. T h i s c a s e t y p i f i e s t h e r e s u l t s p roduced u n d e r

a w i d e v a r i e t y of h y p o t h e t i c a l d i s t u r b a n c e s , and also a l l o w s a

c o m p a r i s o n w i t h Bank o f Canada p o l i c i e s o v e r t h e p e r i o d ,

On t h e h o r i z o n t a l axis is a measu re of u n s y s t e n a t i c

e x c h a n g e r a t e v a r i a t i o n , n o r m a l i z e d so t h a t the v a r i a t i o n

p roduced by a f r e e l y f b a t i n g e x c h a n g e r a t e g i v e s a v a l u e of

--we-----------

21 It a p p e a r s from Appendix IV t h a t t h e g r e a t e r t h e d e g r e e of s e r i a l c o r r e l a t i o n i n the u n s y s t e m a t i c component of t h e u n d e r l y i n g d i s t u r b a n c e , t h e worse t h e t r a c k i n g a b i l i t y of e i t h e r v e r s i o n . T h i s is b e c a u s e p o s i t i v e s e r i a l c o r r e l a t i o n l e a d s t o s h o r t term c y c l e s , w i t h i n which r e s e r v e s can p e r s i s t e n t l y l i e o n o n e side or t h e o t h e r of t a r g e t and t h u s r e i n f o r c e a n y s u c h t e n d e n c y a l r e a d y i a p l i c i t i n t h e s y s t e m a t i c component of t h e exogenous s h o c k ,

Figure I11 - T r a c k i n q A b i l i t p and Enhancement of E x c h a n q e

Rate P r e d i c t a b i l i t v -- 1_1__-

S y s t e m a t i c D e v i a t i o n

from F r e e Float

U n s y s t e m a t i c E x c h a n g e Bate Variation

un i ty .22 On t h e v e r t i c a l a x i s is a measu re of the s y s t e m a t i c

d e v i a t i o n from a f r e e l y f l o a t i n g e x c h a n g e rate-23 I n t h e f a c e of

t h o s e d i s t u r b a n c e s e x p e r i e n c e d i n Canada d u r i n g the Igi'Os, e a c h

v e r s i o n of t h e r e s e r v e aanagemen t r n l e would hLave p roduced a

c e r t a i n c o m b i n a t i o n o f u n s y s t e m a t i c v a r i a t i o n a n d s y s t e m a t i c

d e v i a t i o n , as shown b y t h e p o i n t s B a n d C, T y p i c a l l y , t h e s i m p l e

v e r s i o n e n h a n c e s e x c h a n g e rate p r e d i c t a b i l i t y more s u c c e s s f u l l y

t h a n t h e amended v e r s i o n , b u t p r o d u c e s more d i v e r g e n c e from a

f r e e l y f l o a t i n g e x c h a n g e rate, T h e p o i n t A i s o b v i o u s l y .

a s s o c i a t e d w i t h f r e e l y f l o a t i n g e x c h a n g e rates- The p o i n t D is

t h e p o i n t p roduced b y Bank of Canada p o l i c i e s , a s embodied i n

a c t u a l e x c h a n g e r a t e b e h a v i o u r , o v e r t h e p e r i o d -

The l i n e A-B-C d e f i n e s t h e t r a d e o f f be tween smoo th ing and

t r a c k i n g a b i l i t y made a v a i l a b l e by d i f f e r e n t v e r s i o n s o f t h e

r e s e r v e management r u l e , T h e l i n e 8 - D d e f i n e s t h e t r a d e o f f

p r o a u c e d by Bank of Canada a c t i o n s d a r i n g t h e 1970s- Given t h a t

a f o r e i g n e x c h a n g e a u t h o r i t y would p r e f e r t o be a s close t o t h e

o r i g i n a s p o s s i b l e , t h e s i m p l e and amended v e r s i o n s of t h e

o p t i m a l r n l e c l e a r l y p r o d u c e a more e f f i c i e n t t r a d e o f f t h a n d o e s

Bank of Canada p o l i c y , The c h o i c e b e t v e e n v e r s i o n s , however ,

d e p e n d s o n the e x a c t s h a p e of t h e a u t h o r i t y ' s i n d i f f e r e n c e map,

T h i s d e p e n d s i n t u r n on t h e b e n e f i t s t h e a u t h o r i t y i m p u t e s t o

enhancemen t o f e x c h a n g e r a t e p r e d i c t a b i l i t y , r e l a t i v e t o t h e

2 2 T h i s m e a s u r e i s t h e i n v e r s e of t h e f - s t a t i s t i c s r e p o r t e d i n T a b l e 111,

23 T h i s m e a s u r e is t h e t - s ta t i s t ic from T a b l e 111,

c o s t s i t i m p u t e s t o d i v e r g e n c e f r o m a f r e e l y f l o a t i n g e x c h a n g e

r a t e ,

The p r i m a r y o b j e c t i v e of t h e o p t i m a l r e s e r v e management

ru le was t h e enhancemen t of e x c h a n g e r a t e p r e d k c t a b i l i t p , The

a b o v e r e s u l t s i n d i c a t e t h a t , w i t h i n t h e g e n e r a l f rainework o f t h e

r u l e , t h e f o r e i g n exchange a u t h o r i t y h a s a marg in o f c h o i c e b y

which i t c a n meet a n a d d i t i o n a l c o n c e r n , By c h o o s i n g be tween

v e r s i o n s of t h e r u l e , it c a n t a k e a c c o u n t of t h e c o s t s it

i m p u t e s to p r o l o n g e d d i v e r g e n c e from a f r e e l y f l o a t i n g e x c h a n g e

r a te ,

A s e c o n d q u e s t i o n is w h e t h e r , w i t h i n t h e g e n e r a l f r a m e u o r k ,

it h a s a marg in o f c h o i c e b y which i t c a n t a k e a c c o u n t of t h e 1

costs of t h e i m p l i e d a v e r a g e r e s e r v e h o l d i n g , T h i s c a n be

a n s w e r e d by c o n s i d e r i n g how a l t e r n a t i v e t a r g e t r e s e r v e l e v e l s

affect r n l e p e r f o r m a n c e ,

f i g u r e I V shows s c h e m a t i c a l l y t h e s i m n l a t i o n r e s u l t s

o b t a i n e d u n d e r a l t e r n a t i v e t a r g e t r e s e r v e l e v e l s , The h o r i z o n t a l

a x i s shows a l t e r n a t i v e t a r g e t r e s e r v e l e v e l s , ineasured i n

m u l t i p l e s of $ ( U S ) 4-55 b i l l i o n , a f i g u r e v e r y close t o t h e

a v e r a g e r e s e r v e l e v e l m a i n t a i n e d i n Canada d u r i n g t h e 1970s. The

v e r t i c a l a x i s m e a s u r e s u n s y s t e m a t i c e x c h a n g e rate v a r i a t i o n .

F i g u r e IB shows t h a t u p t o a p o i n t , a l a r g e r r e s e r v e p o o l

c a n e n h a n c e t h e p e r f o r m a n c e of t h e o p t i m a l i n t e r v e n t i o n r u l e s .

Beyond t h a t p o i n t , t h e r e a r e n e g a t i v e r e t u r n s t o a d d i t i o n a l

r e s e r v e h o l d i n g , T h i s r e s u l t reflects t h e i n h e r e n t c o n f l i c t

be tween t h e desire to minimize e x c h a n g e ra te v a r i a t i o n , a n d t h e

Figure IV - Target Beserve L e v e l s and Enhancement of

E x c h a m Rate P r e d i c t a b i l i t y -7

Unsystemat ic Exchange Rate

V a r i a t i o n

A mended V e r s i o n

Vers ion

Target R e s e r v e Levels f n u l t i p l e s of $(US)4,55 b i l l i o n )

r e q u i r e m e n t t h a t r e s e r v e s r e m a i n u i t h i n t h e l i m i t s s e t by

r e s e r v e a v a i l a b i l i t y . The l a r g e r t h e p o o l of a v a i l a b l e r e s e r v e s ,

t h e wider t h o s e l i m i t s , s o t h e more a g i v e n s h o c k c a n b e

a b s o r b e d by r e s e r v e movement when r e s e r v e s a rd c l o s e t o t a r g e t e d

l e v e l s . However, t h e w i d e r t h e l i m i t s , t h e f u r t h e r r e s e r v e s c a n

move away from t h e i r t a r g e t e d l e v e l s a n d when t h i s o c c u r s ,

exchange r a k e a d j u s t m e n t mus t b e g i n t o s u b s t i t u t e f o r r e s e r v e

movement.

Hose f u n d a n e n t a l l y , t h e e x i s t e n c e of n e g a t i v e r e t u r n s t o

a d a i t i o n a l r e s e r v e h o l d i n g c a n be t r a c e d t o t h e i n f o r m a t i o n

a s s u m p t i o n s e n b o d i e d i n t h e o p t i m a l r u l e s , As was d i s c u s s e d i n

t h e i n t r o d u c t i o n t o t h i s t h e s i s , o n e o f t h e major f l a w s of t h e

B r e t t o n Roods s y s t e m Mas t h e d i f f i c u l t y of a p p l y i n g t h e c l a u s e

on I f undamen ta l d i s e q u i l i b r i u m ' , V i t h o u t p e r f e c t knowledge or

f o r e s i g h t , au t h o s i t i e s had d i f f i c n l t y d i s t i n g u i s h i n g a

d i s e q u i l i b r i u m t h a t was t r u l y p e r m a n e n t and f u n d a m e n t a l from o n e

t h a t a r o s e t h r o u g h t e m p o r a r y c h a n g e s a n d woold be s u b s e q u e n t l y

c o r r e c t e d w i t h o u t f u r t h e r a c t i o n , T h e r e s e r v e management r u l e s

d o n o t r e q u i r e t h a t t h e f o r e i g n e x c h a n g e a u t h o r i t y make t h i s

d i s t i n c t i o n - D e s p i t e t h i s , t h e e x c h a n g e rate c o u l d still b e

smoothed c o m p l e t e l y a n d i n d e f i n i t e l y , mere r e s e r v e s i n f i n i t e -

Y it h a n y t h i n g less t h a n i n f i n i t e r e s e r v e s , t h e p o s s i b i l i t y of

r e s e r v e d e p l e t i o n o r e x c e s s i v e a c c u m u l a t i o n must be c o n s i d e r e d ,

S u c c e s s f u l s m o o t h i n g of u n s y s t e m a t i c , r e v e r s i b l e e x c h a n g e r a t e

movement t h e r e f o r e r e q u i r e s , n o t just t h a t r e s e r v e s be l a r g e ,

b u t t h a t t h e y b e l a r g e enouqh t o f u l l y accommodate t h e s h o c k

be•’ o r e t h e l i m i t s of r e s e r v e d e p l e t i o n o r e x c e s s i v e a c c u m u l a t i o n

are reached ,

With p e r f e c t i n f o r m a t i o n a b o u t t h e f u t u r e , p a r t o f t h e

c h o i c e of o p t i m a l t a r g e t r e s e r v e l e v e l s would ^ i n v o l v e

c o n s i d e r a t i o n of t h e q u a n t i t y r e q u i r e d t o smooth t h e e x c h a n g e

r a t e a t r e n d is r e v e r s e d , I n t h i s case, t h e r e would n o t b e

n e g a t i v e r e t u r n s t o a d d i t i o n a l r e s e r v e h o l d i n g , g i t h o u t p e r f e c t

i n f o r m a t i o n , i t c a n n o t b e known if o r when a t r e n d w i l l be

r e v e r s e d , However, t h e c o n s t a n t risk of r e s e r v e d e p l e t i o q causes

t h e r e s e r v e management r u l e s t o o p e r a t e o n t h e s i d e o f

c o n s e r v a t i s r e . Exchange rate a d j u s t m e n t is sometimes a l l o w e d

which, i n h i n d s i g h t , could be s e e n t o be u n n e c e s s a r y .

F u r t h e r m o r e , l a r g e r t a r g e t r e s e r v e l e v e l s allow s t r o n g e r

r e s i s t a n c e t o e x c h a n g e r a t e a d j u s t m e n t i n i t i a l l y , b u t when

e v e n t u a l e x c h a n g e rate a d j u s t m e n t o c c u r s , i t must be l a r g e r a n d

Bore d i s r u p t i v e t h a n w i t h smaller t a r g e t r e s e r v e l e v e l s a n d more

f r e q u e n t , g r a d u a l e x c h a n g e ra te adjustment- With t h e l o n g e r v i ew

p r o v i d e d by t h e s i e n l a t i o n e x p e r i m e n t s , i t c a n b e s e e n t h a t

t h e s e c o n s i d e r a t i o n s e v e n t u a l l y domina te , T h e r e f ore, i n t h e

a b s e n c e of p e r f e c t f u t u r e i n f o r m a t i o n , t h e r e a re e v e n t u a l l y

n e g a t i v e r e t u r n s t o a d d i t i o n a l r e s e r v e h o l d i n g .

From a p o l i c y p e r s p e c t i v e , however , t h e e x i s t e n c e of

n e g a t i v e r e t u r n s n e e d o n l y b e a t h e o r e t i c a l c u r i o s i t y , F o r t h e \

same r e a s o n t h a t a p r o f i t max imiz ing firm s i l l n e v e r c h o o s e t o

o p e r a t e where m a r g i n a l p r o d u c t i v i t y i s n e g a t i v e , a n a u t h o r i t y

t h a t w i s h e s t o maxizuize soc ia l w e l f a r e w i l l n e v e r c h o o s e a

t a r g e t r e s e r v e l e v e l which p r o v i d e s a n e g a t i v e m a r g i n a l r e t u r n ,

The e x a c t c h o i c e of t a r g e t r e s e r v e l e v e l s is g o v e r n e d b y a

we igh ing of t h e b e a e f its irapu t e d t o e n h a n c e m e n t of e x c h a n g e f a t e

p r e d i c t a b i l i t y , r e l a t i v e t o t h e costs o f a c q u i r i n g a n d h o l d i n g

r e s e r v e s . By h o l d i n g r e s e r v e s f o r i n t e r v e n t i o n p u r p o s e s , t h e

a u t h o r i t y i s f o r e g o i n g t h e r ea l r e t u r n o b t a i n e d had t h e y been

i n v e s t e d i n p r o d n c t i v e a c t i v i t y , The a u t h o r i t 1 s h o u l d c h o o s e

t h a t t a r g e t r e s e r v e l e v e l f o r which t h e i m p u t e d m a r g i n a l b e n e f i t

e q u a l s t h e marginal cost - t h a t is, t h e rea l i n t e r e s t r a t e - 2 4 A t

t h i s p o i n t , t h e r e t u r n s t o a d d i t i o n a l r e s e r v e h o l d i n g a r e still

p o s i t i v e ,

2 4 T h i s a r g u m e n t i s d e v e l o p e d more f u l l y i n t h e l i t e r a t u r e o n t h e demand for r e s e r v e s , See, f o r example , Clark (1970) a n d G r u be1 (1973). (1 977)-

VI- SL??IHABY AND POLICY COBCLUSIOES

S i n c e t h e breakdown o f t h e B r e t t o n Woods a g r e e m e n t i n 1971,

t h e i n t e r n a t i o n a l monetary s y s t e m h a s been c h a r a c t e r i z e d b y

managed f l o a t i n g . T h i s s y s t e m is n o t the r e s u l t of a f o r m a l

i n t e r n a t i o n a l a g r e e m e n t - I n s t e a d it h a s e v o l v e d a s e a c h c o u n t r y

h a s made its d e c i s i c n c o n c e r n i n g t h e e x c h a n g e r a t e r e g i m e it

would adop t . The c h o i c e o f managed f l o a t i n g o v e r f u l l

f l e x i b i l i t y is c o n s i s t e n t w i t h r e c e n t t h e o r e t i c a l f i n d i n g s ,

which r a i s e se r ious q u e s t i o n s a b o u t t h e s u p p o s e d a e s i r a b i l i t y of

f r e e l y f l o a t i n g e x c h a n g e rates, However, r e c e n t e x p e r i e n c e w i t h

managed f l o a t i n g h a s also r a i s e d q u e s t i o n s a b o u t t h e u s e f u l n e s s

of t h o s e a p p r o a c h e s t o o p t i m a l e x c h a n g e m a r k e t i n t e r v e n t i o n

which are based o n i n a p p r o p r i a t e o b j e c t i v e & , o r which i g n o r e t h e

o p e r a t i n g c o n s t r a i n t s imposed, f o r example , by f i n i t e r e s e r v e

l e v e l s , I n s t e a d , r e c e n t e x p e r i e n c e s u g g e s t s t h a t many of t h e

q u e s t i o n s raised a t t h e time of t h e Bretton Woods breakdown now

d e s e r v e a n s u e r s , T h i s a r g u e s s t r o n g l y f o r a c o m p r e h e n s i v e s t n d g

of e x c h a n g e market i n t e r v e n t i o n , i n terms of i ts j u s t i f i c a t i o n ,

a n d i n t h e c o n t e x t o f methods w h i c h r e c o g n i s e t h e o p e r a t i n g

c o n s t r a i n t s . T h i s t h e s i s p r o v i d e s s u c h a s t u d y ,

T h e e x a m i n a t i o n begins i n C h a p t e r 2 w i t h a r e v i e w o f

a r g u m e n t s u s e d to j u s t i f y e x ~ h a n g e n a r k e t i n t e r v e n t i o n - Bost

r e c e n t l i t e r a t u r e h a s a r g u e d fo r i n t e r v e n t i o n as a way of

d i r e c t i n g e i t h e r real income o r real c o n s u m p t i o n t o w a r d s some

d e s i r e d g o a l , However, a c a r e f u l e x a m i n a t i o n of t h e w e l f a r e

economic f o u n d a t i o n s of t h e s e a r g u m e n t s s h o w s t h a t it is

g e n e r a l l y some assumed p r i c e r i g i d i t y o r m a r k e t f a i l u r e which i s

r e s p o n s i b l e for t h e o r i g i n a l d i v e r g e n c e i n r ea l

income/consumpt ion from its g o a l , Thus e x c h a n g e m a r k e t

i n t e r v e n t i o n on t h e s e g r o u n d s c o n s t i t u t e s a s e c o n d b e s t

s o l u t i o n .

The s t r o n g e s t a rgumen t f o r i n t e r v e n t i o n , a n d t h e o n e

a d o p t e d h e r e , is o n e i n which i n t e r v e n t i o n r e p r e s e n t s , n o t a

s e c o n d b e s t s o l u t i o n , b u t a n e s s e n t i a l i n g r e d i e n t t o m a r k e t

e f f i c i e n c y , I n t e r v e n t i o n which s m o o t h e s v a r i a t i o n a n d i n c r e a s e s

p r e d i c t a b i l i t y of exchange r a t e a n d p r i c e l e v e l s has a p o s i t i v e

p r i v a t e a n d s o c i a l v a l u e b e c a u s e it c o n t r i b o t e s t o t h e

u s e f u l n e s s o r ' q u a l i t y ' of a c o u n t r y ' s money, E f f i c i e n c y

t h e r e f o r e demands some l e v e l of e x p e n d i t u r e by t h e s u p p l i e r ( s )

of money on q u a l i t y -producing i n t e r v e n t i o n a c t i v i t y ,

I n t e r v e n t i o n is t h u s j u s t i f i e d b e c a u s e it e n s u r e s e f f i c i e n c y a t

a marg in u s u a l l y i g n o r e d b y t h e p r o p o n e n t s of freely f l o a t i n g

e x c h a n g e ra tes - t h e demand f o r and s u p p l y of noney-

Here f o r e i g n e x c h a n g e r e s e r v e s a v a i l a b l e i n u n l i m i t e d

q u a n t i t i e s , s u c h e x c h a n g e rate a n d p r i c e l e v e l v a r i a t i o n c o u l d

b e r educed , a n d i n d e e d e l i m i n a t e d , by f i x i n g t h e e x c h a n g e ra te

c o m p l e t e l y - It is a n o n - t r i v i a l problem, however , t o d e s i g n a

r e s e r v e managenent r u l e which c a n min imize a a s y s t e n a t i c o r

u n p r e d i c t a b l e e x c h a n g e rate f l u c t n a t i o n w i t h o u t v i o l a t i n g t h e

c o n s t r a i n t imposed by r e s e r v e a v a i l a b i l i t y , T h e problem i s

s i m i l a r t o o n e of h y d r o e l e c t r i c power g e n e r a t i o n , With w a t e r

f l o w i n g i n t o a r e s e r v o i r a t a f l u c t u a t i n g rate, what r u l e o n

r e s e r v o i r l e v e l s s h o u l d t h e a u t h o r i t y f o l l a w so as to m i n i m i z e

v a r i a t i o n i n e l e c t r i c i t y g e n e r a t i o n w i t h o u t v i o l a t i n g t h e

r e s e r v o i r ' s p h y s i c a l c a p a c i t y ? A p r i o r i , i t i s o b v i o u s t h a t i n

o r d e r t o a v o i d r e s e r v e d e p l e t i o n o r e x c e s s i v e a c c u m u l a t i o n , some

s y s t e m a t i c e x c h a n g e r a t e / e l e c t r i c i t y s u p p l y a d j u s t m e n t m u s t o n

o c c a s i o n b e a l l o w e d t o t a k e p l a c e . The p rob lem i s f u r t h e r

c o m p l i c a t e d , however , when t h e a u t h o r i t y c a n n o t d i s t i n g u i s h

a h e a d of time a s h o c k t h a t r e p r e s e n t s s y s t e m a t i c movement from

o n e t h a t r e p r e s e n t s u n s y s t e m a t i c v a r i a t i o n a r o u n d t h a t movement.

The a p p r o a c h a d o p t e d i n C h a p t e r 3 is t o b e g i n b y making a

s p e c i f i c s i m p l i f y i n g a s s u m p t i o n a b o u t t h e s t o c h a s t i c b e h a v i o u r

o f r e s e r v e l e v e l s i n t h e a b s e n c e o f o p t i m a l i n t e r v e n t i o n , and t o

d e r i v e a n o p t i n a a l r e s e r v e management r u l e b a s e d on t h i s

assumpt ion . T h e r e s u l t i s a r u l e wh ich s p e c i f i e s t h e r e s e r v e

b e h a v i o u r d e s i r e d ex a n t e by t h e f o r e i g n e x c h a n g e a u t h o r i t y i n

terms of o p t i m a l l i m i t s on ex p o s t r e s e r v e movements. T h e s e

littlits are set a c c o r d i n g t o how f a r r e s e r v e s have a l r e a d y

d e v i a t e d from some t a r g e t e d l o n g r u n a v e r a g e l e v e l . The f u r t h e r

r e s e r v e s a r e from t a r g e t , t h e less a g i v e n s h o c k c a n be a b s o r b e d

by f u r t h e r r e s e r v e movement, s o t h e more i t n u s t be a b s o r b e d by

exchange r a t e a d j u s t m e n t , The r u l e does n o t presume, however,

t h a t t h e f o r e i g n e x c h a n g e a u t h o r i t y knows a h e a d of t i m e v h a t t h e

c u r r e n t s h o c k w i l l be, n o r t h a t it knows how t h a t p r i v a t e sector

w i l l r e s p o n d t o t h a t shock , It t h e r e f o r e i m p o s e s mini taal

i n f o r a a t i o n r e q u i r e m e n t s .

C h a p t e r 3 a lso c o n s i d e r s s i t u a t i o n s v h e r e t h e s i m p l i f y i n g

a s s u m p t i o n b e h i n d t h e rule's d e r i v a t i o n i s n o t met.

C o n s i d e r a t i o n of o n e p a r t i c u l a r a l t e r n a t i v e s c e n a r i o l e a d s t o an

amended v e r s i o n of the s i m p l e r u l e , The s i m p l e v e r s i o n r u l e s o u t

r e s e r v e d e p l e t i o n or e x c e s s i v e a c c n m u l a t i o n , b u t d o e s n o t r u l e

o u t l e n g t h y d e v i a t i o n s i n r e s e r v e l e v e l s o n o n e s i d e o r t h e

o t h e r of t a r g e t , I t d o e s n o t , t h e r e f o r e , r u l e o u t l e n g t h y

d i v e r g e n c e from a f r e e l y f l o a t i n g e x c h a n g e rate, The amended

v e r s i o n l i m i t s t h e d u r a t i o n of s u c h d e v i a t i o n s ,

The p r i m a r y o b j e c t i v e of t h e s e r e s e r v e management r u l e s is

t h e enhancemen t o f e x c h a n g e rate p r e d i c t a b i l i t y , However, t h e

f o r e i g n e x c h a n g e a u t h o r i t y Itlay h a v e a d d i t i o n a l c o n c e r n s , o n e

b e i n g t h e c o s t ( s ) of w h a t e v e r d i v e r g e n c e f rola a f r e e l p f l o a t i n g

e x c h a n g e r a t e s u c h i n t e r v e n t i o n a c t i v i t y p r o d u c e s - A s e c o n d

p o s s i b l e c o n c e r n i s t h e c o s t of a c q u i r i n g and h o l d i n g foreign

e x c h a n g e r e s e r v e s f o r i n t e r v e n t i o n p u r p o s e s , The s t u d y e x a m i n e s

how t h e f o r e i g n e x c h a n g e a u t h o r i t y can , b y e x e r c i s i n g i ts c h o i c e

o v e r v e r s i o n s of t h e r u l e and o v e r t h e t a r g e t r e s e r v e l e v e l o n

which b o t h depend , i n f l u e n c e t h e ou tcome w i t h r e s p e c t t o t h e s e

a d d i t i o n a l c o n c e r n s , However, t h e i a p l i c a t i o n s o f s u c h c h o i c e s

f o r e x p o s t e x c h a n g e r a t e and r e s e r v e b e h a v i o u r c a n n o t be

d e t e r m i n e d a n a l y t i c a l l y i n a l l s i t u a t i o n s , T h e s e q u e s t i o n s a r e

t h e r e f o r e examined e m p i r i c a l l y , u s i n g s i m u l a t i o n t e c h n i q u e s . The

s i m u l a t i o n e n v i r o n m e n t is d e s c r i b e d i n C h a p t e r 4 and t h e first

s e c t i o n of C h a p t e r 5, a n d is c h o s e n t o reflect C a n a d i a n economic

c o n d i t i o n s i n t h e 7970s.

The s i m u l a t i o n r e s u l t s i n t h e r e m a i n d e r o f C h a p t e r 5 show

r u l e p e r f o r m a n c e i n t h e f a c e o f a v i d e v a r i e t y o f e x o g e n o u s

shocks . The r e s u l t s c o n f i r a t h a t i n t h e s e s i t u a t i o n s , b o t h

v e k s i o n s of t h e r u l e s i g n i f i c a n t l y r e d u c e e x c h a n g e r a t e

v a r i a t i o n a n d e n h a n c e p r e d i c t a b i l i t y , w i t h i n t h e c o n s t r a i n t

imposed by r e s e r v e a v a i l a b i l i t y ,

A s e c o n d , r e l a t e d c o n c e r n is t h e p o s s i b l e c o s t ( s )

a s s o c i a t e d w i t h w h a t e v e r d i v e r g e n c e from a f r e e l y f l o a t i n g

e x c h a n g e r a t e r e m a i n s , The r e s u l t s s h o v t h a t t h e a u t h o r i t y c a n

meet t h i s c o n c e r n by c h o o s i n g be tween v e r s i o n s of t h e r u l e ,

T y p i c a l l y , t h e s i m p l e v e r s i o n e n h a n c e s e x c h a n g e r a t e

p r e d i c t a b i l i t y more s u c c e s s f u l l y t h a n t h e amended v e r s i o n , b u t

p r o d u c e s more d i v e r g e n c e from t h e s y s t e m a t i c a d j u s t m e n t o f a

f r e e l y f l o a t i n g e x c h a n g e r a t e , T h e p r e c i s e c h o i c e of v e r s i o n ,

t h e r e f o r e , is g o v e r n e d by a w e i g h i n g of t h e b e n e f i t s impu ted t o

enhancemen t of e x c h a n g e r a te p r e d i c t a b i l i t y , r e l a t i v e t o t h e

c o s t s imputed t o d i v e r g e n c e from a freely f h a t i n g e x c h a n g e

r a t e ,

A n o t h e r p o s s i b l e c o n c e r n of t h e f o r e i g n e x c h a n g e a n t h o r i t y

is t h e cost of t h e i m ~ l i e d a v e r a g e r e s e r v e h o l d i n g . Bore

s p e c i f i c a l l y , t h e a u t h o r i t y must c h o o s e a t a r g e t r e s e r v e l e v e l

w i t h u h i c h t o o p e r a t e its c h o s e n v e r s i o n of t h e rule. However,

r e s e r v e s a re c o s t l y t o a c q u i r e a n d h o l d , The r e s u l t s s h o v t h a t \

i n t h e a b s e n c e of p e r f e c t f u t u r e i n f o r n a t i o n , t h e m a r g i n a l

b e n e f i t s of a d d i t i o n a l r e s e r v e h o l d i n g , i n terms of i n c r e a s e d

exchange rate p r e d i c t a b i l i t y , d i m i n i s h a n d may e v e n t u a l l y become

n e g a t i v e . T h u s t h e c h o i c e of t a r g e t r e s e r v e l e v e l s i s g o v e r n e d

by a w e i g h i n g of t h e b e n e f i t s i m p u t e d t o e x c h a n g e ra te

p r e d i c t a b i l i t y , r e l a t i v e t o t h e costs o f a c q u i r i n g a n d h o l d i n g

r e s e r v e s , By h o l d i n g r e s e r v e s f o r i n t e r v e n t i o d p u r p o s e s , t h e

a u t h o r i t y is f o r e g o i n g t h e rea l r e t u r n o b t a i n e d had t h e y b e e n

i n v e s t e d i n p r o d u c t i v e a c t i v i t y , The a u t h o r i t y s h o u l d t h e r e f o r e

c h o o s e a t a r g e t l e v e l f o r which t h e m a r g i n a l b e n e f i t e q u a l s t h e

m a r g i n a l cost, namely, t h e rea l i n t e r e s t rate,

A f i n a l q u e s t i o n is w h e t h e r t h e o p t i m a l r e s e r v e management

ru les c o a l d h a v e o u t p e r f o r m e d t h e i n t e r v e n t i o n p o l i c y a c t u a l l y

u s e d by t h e Bank o f Canada d u r i n g t h e 1970s. It is n o t clear

e x a c t l y what t h e aims of Bank of Canada i n t e r v e n t i o n were o v e r

t h i s p e r i o d , N e v e r t h e l e s s , p a s t e x p e r i e n c e of l e a n i n g a g a i n s t

t h e wind h a s been c h a r a c t e r i z e d by T a y l o r (1982). among o t h e r s ,

a s one of

, .. r e s i s t i n g e x c h a n g e r a t e c h a n g e s , I n some c a s e s , t h i s h a s l e a d t o p e g g i n g t h e e x i s t i n g e x c h a n g e ra te when its e g u i l i b r i u m l e v e l changes . The a u t h o r i t i e s are able t o h o l d o u t f o r a l i m i t e d t i m e b u t a r e e v e n t n a l l y f o r c e d t o . allow t h e a d j u s t m e n t t o t a k e p l a c e , a n d lose s u b s t a n t i a l sums i n t h e p r o c e s s ,

T a y l o r a r g u e s t h a t t h i s c h a r a c t e r i z a t i o n c e r t a i n l y fits t h e

C a n a d i a n e x p e r i e n c e , a l t h o n g h t h e e v e n t u a l a d j u s t m e n t , a p p a r e n t

f r o m e a r l y 1977, h a d a s anch t o d o w i t h a c h a n g e of mone ta ry

p o l i c y d i r e c t i o n a s a n y t h i n g else,

T h e a b o v e v i ew sees l e a n i n g a g a i n s t t h e wind a s a way of

r e s i s t i n g l o n g t e r m t r e n d s , By c o m p a r i s o n , t h e i n t e r v e n t i o n

r u l e s d e v e l o p e d h e r e a r e a imed a t r e s i s t i n g s h o r t term

f l u c t u a t i o n , w h i l e a l l o w i n g l o n g t e r m t r e n d a d j u s t m e n t t o t a k e

p l a c e , T h i s is a more a m b i t i o u s aim, e s p e c i a l l y s i n c e t h e r u l e s

d o n o t a s sume t h e a u t h o r i t y h a s p r i o r knowledge o f t h e t r u e

t r e n d ,

C a n a d i a n e x p e r i e n c e s u b s e q u e n t t o 1979 s i g g e s t s t h a t the

Bank of Canada is more w i l l i n g t h a n p r e v i o u s l y t o a l l o w

s y s t e m a t i c l o n g term a d j u s t a e n t i n t h e C a n a d i a n e x c h a n g e r a t e ,

However, t h e results show t h a t i n t h e 1970s t h e r e was

s u b s t a n t i a l d i v e r g e n c e be tween t h e a c t u a l rate a n d t h a t v h i c h

would h a v e o c c u r r e d had t h e e x c h a n g e r a t e f l o a t e d f r e e l y , By

c o a p a r i s o n , t h e s i m p l e a n d amended v e r s i o n s of t h e r e s e r v e

management r u l e c o u l d have smoothed e x c h a n g e rate v a r i a t i o n t o

r o u g h l y t h e same e x t e n t , v h i l e t r a c k i n g t h e g e n e r a l t r e n d s i n a

f r e e l y f l o a t i n g e x c h a n g e r a t e much more c l o s e l y - They t h e r e f ore

p r o v i d e a more e f f i c i e n t t r a d e o f f be tween s m o o t h i n g a n d t r a c k i n g

a b i l i t y t h a n d o t h e a c t u a l p o l i c i e s of t h e p e r i o d . T h e r e f o r e , i f

t h e Bank of Canada w i s h e s t o allow s y s t e m a t i c a d j a s t m e n t , v h i l e

still s m o o t h i n g u n s y s t e m a t i c v a r i a t i o n a n d t h u s p r o n o t i n g t h e

q u a l i t y or usefulness of i t s money, t h e n t h e r e s e r v e management

r u l e s d e v e l ~ p e d h e r e will o u t p e r f o r m i ts p o l i c i e s of t h e r e c e n t

p a s t w i t h o u t i m p o s i n g o n e r o u s i n • ’ orma t i o n r e q a i r e a e n t s ,

APPENDIX I

T h i s append ix g i v e s t h e d e r i v a t i o n of b o t h t h e s i m p l e and

amenaed v e r s i o n s of the o p t i m a l r e s e r v e management ru le .

The s i m p l e v e r s i o n is d e r i v e d from

m (t) = [ z (h-z)/ ( ~ + t ) 342 (1- 1)

where i t was a r g u e d t h a t t s h o u l d measure, n o t r e a l time, b u t

the minimum time r e q u i r e d t o a c h i e v e any p a r t i c u l a r s i z e d

a e v i a t i o n i n r e s e r v e s from t a r g e t , A r e l a t i o n s h i p is t h e r e f o r e

r e q u i r e d which g i v e s t h e minirauo t i m e t f o r a g i v e n d e v i a . t i o n i n

r e s e r v e s from t a r g e t 1 B(t-1)-z / , o r , e q u i v a l e n t l y , t h e maximum

d e v i a t i o n froa t a r g e t for a g i v e n t i m e t,

Mow t h e a a g n i t u d e of t h e c u r r e n t d e v i a t i o n i n r e s e r v e s f rom

t a r g e t is d e t e r m i n e d by t h e s u m of p a s t r e s e r v e changes- Since

m(t) is, by d e f i n i t i o n , e q u a l t o jR( t ) -R( t -1) 1 , and s i n c e

R (O)=z, t h e n

w i t h t h e e x a c t e q u a l i t y h o l d i n g when a l l r e s e r v e changes m h a v e

been i n t h e same d i r e c t i o n , The s o m e a t i o n t h e r e f o r e g i v e s t h e

aaxintum d e v i a t i o n f o r a g i v e n t i m e t, The summation is d i f f i c u l t

t o e v a l u a t e as an e x p l i c i t f u n c t i o n of t, b u t t h e r e s u l t

can b e used t o p l a c e a l o w e r bound o n t h e ~ a x i m u m d e v i a t i o n f o r

a g i v e n time, S i n c e t h e maxinula d e v i a t i o n will b e an i n c r e a s i n g

f u n c t i o n of time, t h i s a p p r o x i m a t i o n w i l l t h e r e f o r e a l s o p l a c e a

l o w e r bound on t h e miniaum time t f o r a g i v e n d e v i a t i o n

l R ( t - l ) - z l . -

P r o c e e d i n g w i t h t h e i n t e g r a t i o n , w h i l e s i m p l i f y i n g t h e

n o t a t i o n by d e n o t i n g t h e maximum d e v i a t i o n 1 R ( t - 1)-z l b y X , t h e n

x = 2~i(h-z)j[j~+tj; (1 -4)

= 2\I=j[JiiZ - JX] (1-5)

T h i s can be s o l v e d f o r time i n terms of t h e maximum d e v i a t i o n i n

r e s e r v e s f rom t a r g e t X a s f o l l o w s :

H+t = ---- 42 (h-z)

s u b s t i t a t i o n of t h i s e x p r e s s i o n fo r t i n t o m(t) g i v e s

This c a n be e x p r e s s e d as a n a p p r o x i m a t e l y l i n e a r f u n c t i o n of X

by t a k i n g a T a y l o r series e x p a n s i o n a r o u n d X=O- F o r t h i s

p u r p o s e ,

T h e ref o r e ,

D* (X) A - B X where A=m* (X=O) a n d B=&u*/aX,(X=O),

It was noted i n C h a p t e r 3, h o u e v e r , t h a t t h e method of

p i e c e w i s e s t a t i c o p t i ~ i z a t i o n which l i e s b e h i n d t h i s d e r i v a t i o n

i n some s e n s e i g n o r e s t h e p a s t h i s t o r y of r e s e r v e c h a n g e s , a n d

t h a t t h e r u l e t h e r e f o r e r e q u i r e s t h e i m p o s i t i o n o f some c u t o f f

t o e n s u r e t h a t m*=O when t h e b o u n d a r i e s a re r e a c h e d , The

n e c e s s i t y f o r t h i s c a n be seen from e q u a t i o n (1-9) which, a s it

s t a n d s , w i l l n o t e n s u r e t h a t m* (X) =O f o r any v'diue of X, W h i l e

t h e l i n e a r i z e d v e r s i o n i n (1-13) a t l e a s t e n s u r e s t h a t m*(X)=O

when X=B/B, t h e e x p r e s s i o n s f o r A a n d B g i v e n i n (1-70) a n d

(1.12) still d o n o t e n s u r e t h a t t h i s d e v i a t i o n A/B i s less t h a n

t h a t which i m p l i e s r e s e r v e d e p l e t i o n o r e x c e s s i v e a c c u m u l a t i o n ,

T h e r e f o r e , c u t o f f c a n be imposed by amending t h e f o r m u l a s f o r A,

or B, o r b o t h ,

T h e e s s e n c e of t h e r u l e is t a k e n t o be t h e f e a t u r e t h a t m*

d e c r e a s e s a s X i n c r e a s e s , a s reflected i n t h e c o e f f i c i e n t B,

T h e r e f o r e , cutoff is imposed by r e s c a l i n g A, F u r t h e r i a o r e , i t can

b e s e e n f r o m (1-1) t h a t i f z were a l s o a n o b j e c t o f c h o i c e , a

t a r g e t r a t h e r t h a n a n a r b i t r a r y s t a r t i n g p o i n t , t h e n t h e v a l u e

of z which would make m as l a r g e a s p o s s i b l e , sub j ec t t o t h e

c o n d i t i o n EDkEf, would b e a v a l u e z=h/2, I n t h i s c a s e , z=h-z, a s

i s assumed i n l a t e r c h a p t e r s , a n d A must t h e r e f o r e b e s e t so

t h a t la* ( X ) = O when X = A/B = z = h-z, A a u s t t h e r e f o r e e q u a l

Before t u r n i n g t o t h e amended v e r s i o n of t h e r u l e , t h e

c l o s e e q u i v a l e n c e , a t l e a s t when z=h/2, be tween t h i s v e r s i o n of

t h e rule and t h a t d e r i v e d fram t h e a l t e r n a t i v e method of

p i e c e w i s e s t a t i c o p t i m i z a t i o n w i l l be d e m o n s t r a t e d , The

a l t e r n a t i v e v i ew l e d t o

T h i s can be r e s t a t e d d i r e c t l y i n terms. of d e v i a t i o n s from t a r g e t

a s f o l l o w s :

w h e r e t h e d e v i a t i o n s X' are not i n a b s o l u t e v a l u e form. I f

z=h/2, t h e n

and i n t h i s c a s e , rag (X*) =O when ) X m I =z, a s i s r e q u i r e d to a v o i d

r e s e r v e d e p l e t i o n o r e x c e s s i v e accumula t ion , Taking a s e c o n d

o r d e r T a y l o r series a p p r o x i m a t i o n a r o u n d X * = 0 yields

m ( X ) + A m - B * X 1 2 where A @ = z / ~ and 38=1/42z\lil) (1- 19)

But once a g a i n , s i n c e t h e a p p r o x i m a t i o n is t a k e n around X m = O ,

some f n r t h e r a d j u s t m e n t t o A ' i s r e q u i r e d t o e n s u r e t h a t t h e

c u t o f f c o n d i t i o n B'/Bm=z still h o l d s , However, t h e c l o s e

e q u i v a l e n c e between t h i s a n d the p r e v i o u s approach can be s e e n

by c o n s i d e r i n g t h e par t ia l derivatives of is or m m w i t h r e s p e c t

t o X o r 8'. Prom e q u a t i o n (1.13),

and from e q u a t i o n (1.19).

aav/ax' = -x'/[zJZ] (1-21) ,

A t l e a s t f o r mediala s i z e d deviations i n r e s e r v e s frora t a r g e t ,

sap i n t h e o r d e r of X1=z/2, t h e s e p a r t i a l derivatives have

s i a i l a r o r d e r s of magnitude.

Now t u r n t o t h e amended v e r s i o n of t h e i o t e r v e n t i o n r u l e

which was p r e s e n t e d i n t h e second s e c t i o n of C h a p t e r 3, The

amended v e r s i o n is d e r i v e d from

m ( t ,T) = [z (h -z ) / (H+t+T) 142 (1 - 22)

where t s h o u l d measure t h e minimum time r e q u i r e d t o a c h i e v e a

g i v e n d e v i a t i o n X from t a r g e t , a s before, a n d T is t h e e x c e s s

time, o v e r and a b o v e t h i s minimum, t h a t a dev ia t . ion o n one s i d e

or t h e o t h e r of t a r g e t has p e r s i s t e d ,

A r e l a t i o n s h i p between minimum time t a n d d e v i a t i o n s X c a n

be o b t a i n e d as before :

= 2 J-) [ jmt

T h i s c a n be s o l v e d f o r t

from t a r g e t X and e x c e s s

i n terms of t h e d e v i a t i o n i n r e s e r v e s

time T:

Bow t h e minimum time t o a c h i e v e a g i v e n d e v i a t i o n i n r e s e r v e s

from t a r g e t occurs, by d e f i n i t i o n , when T=O, T h e r e f o r e , t h e

minimum time i s g i v e n by t ( X , O ) and a n o b s e r v a b l e measure of

e x c e s s time c a n now be d e f i n e d :

where To is t h e t o t a l number of p e r i o d s t h a t r e s e r v e s h a v e s p e n t

on o n e s i d e o r t h e o t h e r of t a r g e t ,

S u b s t i t a t i o n o f t h e above e x p r e s s i o n for t (X, 0) i n t o m ( t ,T)

g i v e s

m*(X,T) = J ~ [ H + T + 1 + X X* 1-#2(1-30) I + -4z (h-z) ]

This c a n be e x p r e s s e d a s a n a p p r o x i m a t e l y l i n e a r f u n c t i o n o f X

and T b y t a k i n g a T a y l o r series e x p a n s i o n a round X=O, T=O, F o r

t h i s purpose,

T h e r e f o r e ,

w h e r e A=m* (0,O) . B=am*/aX (0,O) a n d C=am*/aT (OaO) . However, a s i n t h e s i m p l e c a s e , t h e i n t e r c e p t p a r a m e t e r A

laust be r e s c a l e d s o as t o e n s u r e t h a t t h e cutoff c o n d i t i o n fo r X

is met. T h i s c o n d i t i o n r e q u i r e s A t o b e se t so t h a t r a * ( X , O ) = O

when X = B / B = z , A mnst t h e r e f o r e b e

a s before . However, a c u t o f f c o n d i t i o n for T mnst a l s o be

imposed t o e n s u r e t h a t r e s e r v e s a r e e v e n t u a l l y b r o u g h t back t o

t a r g e t . E q u a t i o n (1-30) , - a s i t s t a n d s , w i l l n o t e n s u r e m*=O f o r

aqg v a l u e of T, A c u t o f f o f t h i s s o r t would imply t h a t ,

e v e n t u a l l y , a g i v e n d e v i a t i o n i n r e s e r v e s f rom t a r g e t cou ld n o t

become any l a r g e r , However, t h e r e q u i r e m e n t t h a t t h i s d e v i a t i o n

b e e v e n t u a l l y e l i m i n a t e d is a s t r o n g e r requi rement . I t r e q u i r e s ,

e s s e n t i a l l y , t h a t t h e c r i t i c a l b o u n d a r i e s d e f i n i n g r u i n be

b r o u g h t closer t o t a r g e t , s o t h a t a g i v e n d e v i a t i o n w i l l

e v e n t u a l l y l i e o u t s i d e t h o s e boundar ies , The f o r e i g n exchange

a u t h o r i t y t h e n bas no c h o i c e a s t o t h e d i r e c t i o n of i n t e r v e n t i o n

- i t m u s t a d j u s t i t s r e s e r v e s i n t h e d i r e c t i o n t h a t w i l l .bring

them back t o w a r d s t h e new c r i t i c a l boundar ies , T h e l i n e a r i z e d

v e r s i o n i n (1.36) a l l o w s t h i s vhen T is l a r g e enough s o t h a t tn*

i s n e g a t i v e f o r a g i v e n X , and i n t e r v e n t i o n i n t h a t p e r i o d is

t h e n i n a d i r e c t i o n o p p o s i t e t o X, R e s e r v e s will be b r o u g h t

f u l l y back t o t a r g e t vhen m*(O,T)=O, or when T=A/C-

T h e r e s c a l i n g of A t h e r e f o r e has i m p l i c a t i o n s f o r t h i s

i m p l i c i t c u t o f f c o n d i t i o n on T, If , however, b o t h B and C are

r e s c a l e d by the same f a c t o r , t h e n t h i s c u t o f f c o n d i t i o n for T

w i l l r e m a i n unchanged, Roughly s p e a k i n g , t h i s means t h a t t h e

c u t o f f whikh e n s u r e s r e s e r v e d e p l e t i o n is r u l e d o u t d o e s n o t

a f f e c t t h e l e n g t h of time t h a t s m a l l d e v i a t i o n s a r e a l lowed t o

p e r s i s t , T h e r e f o r e , C is a l s o r e s c a l e d so t h a t

f i n a l l y , t h e method o f p i e c e w i s e s t a t i c o p t i m i z a t i o n which

l i e s b e h i n d t h i s d e r i v a t i o n makes e x p l i c i t t h e way i n which

d e v i a t i o n s X depend on time, I n t h e a l t e r n a t i v e approach o f

- e q u a t i o n (1, 17) , t h e dependence of X on t i m e is o n l y i m p l i c i t l y

recognised, s o t h a t there is no obvious g e n e r a l i z a t i o n to a

n o t i o n of excess time,

APPENDIX 11

T h i s appendix d e r i v e s a r a t i o n a l e x p e c t a t i o n s s o l u t i o n t o t h e

s i m p l e n o d e l of exchange r a t e d e t e r m i n a t i o n - 1

P r i v a t e s e c t o r b e h a v i o u r is i m p l i c i t l y g i v e n by t h e s y s t e m

of e q u a t i o n s (6) t o (9) from C h a p t e r 3, By combining t h e s e

e q u a t i o n s , one o b t a i n s

R = P * f (x) - D / e = g ( x ) - D / e (2-1)

where t h e f o r e i g n p r i c e l e v e l P* has been snbsureed i n t o t h e

v e c t o r o f exogenous v a r i a b l e s x, T i m e d i f f e r e n t i a t i o n y i e l d s . . 0 0

R = g 1 (x) x - D / e + ( D / e 2 ) e (2-2) * 0 0

T h e r e f o r e , B i s p o s i t i v e l y r e l a t e d t o x and e, a n d n e g a t i v e l y . r e l a t e d t o D,

I n t h e ne ighbourhood o f some p o i n t x=xo, e=eo, where e o is

the p e r man e a t

be w r i t t e n i n

Now behav iour

a c t u a l change

f u t u r e change

v a l u e of t h e exchange r a t e , 2 t h i s r e l a t i o n s h i p c a n

t h e a p p r o x i m a t e l y l i n e a r form - 0

I l x - &D (2-3)

i n t h e ~ r i v a t e s e c t o r d e p e n d s n o t simp11 on t h e ,

i n t h e exchange r a t e e, b u t r a t h e r on t h e e x p e c t e d

a. T h e r e f o r e

where a = E t e ( t + l ) - e(t) (2-5)

a n d where b o t h e ( t ) and e (t+l) now measure d e v i a t i o n s i n t h e

exchange r a t e around its permanen t value, Hrit ing a i n t h i s form , ------------------

1 T h e f o l l o w i n g a n a l y s i s d raws h e a v i l y on Hussa (1976) - 2 L a t e r d i s c u s s i o n examines whe the r s u c h a permanent v a l u e exists.

assumes t h a t t h e exchange r a t e is c u r r e n t l y knoun,

T h e r e s e r v e management r u l e c a n be w r i t t e n i n a form

whereby p e r m i s s i b l e r e s e r v e c h a n g e s are some f r a c t i o n 4 of t h e i r

v a l u e under f i x e d exchange r a t e s , Under f i x e d *exchange r a t e s ,

a=O s o t h a t

T h e r e f o r e , a r e s e r v e - b a s e d i n t e r v e n t i o n r u l e cas be w r i t t e n a s 0 - 0

B = + [ l x - GI)] (2- 7)

S u b s t i t u t i o n o f t h i s e x p r e s s i o n i n t o t h e p r i v a t e s e c t o r .

b e h a v i o u r a l e q u a t i o n and c o n v e r s i o n t o d i s c r e t e time n o t a t i o n

y i e l d s

w h e r e Z (t) = 71[x(tj-x (t-1) ] - 6 [D (t)-D ( t - I ) ] (2- 9)

By assumiog t h a t e x p e c t a t i o n s are f o r k e d r a t i o n a l l y and

o s i n g t h e t e c h n i g u e of s u c c e s s i v e s u b s t i t u t i o n , i t c a n be shown

t h a t

A t t h i s s t a g e , t h e c o n d i t i o n s c a n be examined u n d e r which

1 exchange r a t e bubb les1 , o r d e s t a b i l i z i n g e x p e c t a t i o n s , a r e

r u l e d o u t , As Flood a n d Garber (1980) p o i n t o u t , a r a t i o n a l

s o l n t i o n of t h e above form assumes t h a t

l i m EtZ ( t + n ) = 0 n-00 ,

If t h i s c o n d i t i o n is n o t m e t , t h e n r a t i o n a l e x p e c t a t i o n s will be

d e s t a b i l i z i n g . Given t h e d e f i n i t i o n of Z ( t ) , t h i s c o n d i t i o n c a n

b e i n t e r p r e t e d a s r e q u i r i n g t h a t t h e b e h a v i o u r of t h e d o m e s t i c

component of t h e mone ta ry base D b e n o t ' t o o f a r1 o u t of l i n e

w i t h t h e u n d e r l y i n g forces x which d e t e r m i n e t h e p r i v a t e

sector's u i l l i n g n e s s t o h o l d money, o t h e r w i s e , a s y s t e m a t i c

divergence v o n l d r e q u i r e s y s t e m a t i c e x c h a n g e r a te a d j ~ s t m e n t i n

a l l f u t u r e p e r i o d s , T h i s mould t h e n b e r e f l e c t e d , t h r o u g h t h e

fo rward l o o k i n g n a t u r e o f r a t i o n a l e x p e c t a t i o n s , i n a n

i n f i n i t e l y l a r g e d e v i a t i o n i n t h e c u r r e n t e x c h a n g e r a t e from its

permanent v a l u e - 3

I n o r d e r t o o b t a i n an expression for the u n a n t i c i p a t e d

coanponent of e x c h a n g e rate b e h a v i o u r i n terms of t h e

i n t e r v e n t i o n p a r a m e t e r +, a s t o c h a s t i c p r o c e s s f o r Z a u s t be

s p e c i f i e d , Suppose t h a t Z follows a n a u t o r e g r e s s i v e scheme:

Z(t) = u ( t ) (2-12)

where u (t) = pu (t- I ) + v (t) (2-13)

and w h e r e v ( t ) is a s e r i a l l y u n c o r r e l a t e d random v a r i a b l e w i t h a

mean o f z e r o a n d p e o p l e are assumed t o know t h e s t r u c t u r e of t h e

d i s t u r b a n c e s . The r e q u i r e m e n t t h a t P be s t r i c t l y less t h a n o n e

is s u f f i c i e n t t o e n s u r e t h a t c o n d i t i o n (2, 7 1 ) is s a t i s f i e d - B i t h

Z ( t ) of t h i s form, t h e r a t i o n a l s o l u t i o n f o r e x p e c t a t i o n s

becomes

s o t h a t t h e r a t i o n a l s o l u t i o n f o r d e v i a t i o n s i n t h e e x c h a n g e

r a t e from its p e r m a n e n t v a l u e becomes

----------------- A l t e r n a t i v e l y , no s i n q l e p e r m a n e n t v a l u e would e x i s t .

T h e r e f o r e , e v e n when e x p e c t a t i o n s a r e r a t i o n a l , t h e e x a n t e

u n p r e d i c t a b l e component o f exchange r a t e b e h a p i o u r d e p e n d s on

( I - + ) , a s b e f o r e ,

F i n a l l y , t h e s t r e n g t h of t h e i n f l u e n c e of i n t e r v e n t i o n on

t h i s u n p r e d i c t a b l e cotriporient i n t u r n depends on f i r s t l y , when

p=O a n d d i s t u r b a n c e s a r e e x p e c t e d t o l a s t f o r o n l y one p e r i o d ,

t h e n t h e r e s e r v e m a n a g e ~ e n t r u l e is a t its most e f f e c t i v e . A s

i n c r e a s e s , t h e d i s t u r b a n c e s a r e e x p e c t e d to las t f o r l o n g e r

p e r i o d s of t i m e . I n t h e a b s e n c e of i n t e r v e n t i o n , t h i s would be

r e f l e c t e d i n l a r g e r d e v i a t i o n s i n t h e c u r r e n t exchange r a t e from

i ts permanent v a l u e , and t h e i n f l u e n c e of i n t e r v e n t i o n is

t h e r e b y d i l u t e d ,

F i n a l l y , i n the simple model p r e s e n t e d be re , t h e c a s e ? = I

has been r u l e d out b e c a u s e it l e a d s t o d e s t a b i l i z i n g

e x p e c t a t i o n s , Fur the rmore , when Q=l t h e exogenous d i s t u r b a n c e s

f o l l o w a random walk. Here, however, a random walk h a s d i f f e r e n t

i m p l i c a t i o n s from t h o s e i n t h e first s e c t i o n of C h a p t e r 3, T h e r e

i t was used a s a way of showing, i n t h e s t r o n g e s t p o s s i b l e way,

t h a t r a n d o m e s s of r e s e r v e b e h a v i o u r d o e s n o t r u l e o u t

c u m u l a t i v e r e s e r v e movement i n the same d i r e c t i o n . Here, t h e

i m p l i c a t i o n is t h a t when p e o p l e know t h e g e n e r a l stracture o f

the d i s t u r b a n c e s and when t k s e d o f o l l o w a random walk, t h e n

any c u r r e n t d i s t o r b a n c e , once it h i t s , is e x p e c t e d t o l a s t

f o r e v e r . This s i m ~ l e model is n o t r i c h enough t o a l l o w a

- d i s t i n c t i o n t o be drawn b e t u e e n those d i s t u r b a n c e s which c a u s e

v a r i a t i o n i n t h e e x c h a n g e r a te a r o u n d its pe rmanen t v a l u e ( ? < I ) ,

a s opposed t o t h o s e which c a u s e a n a d j u s t m e n t i n t h a t p e r m a n e n t

v a l u e itself ( ~ = 1 ) . I n t h i s s e n s e , t h e s o l u t i o n presented h e r e

h a s t h e same l i m i t a t i o n s a s d i d t h e d i s c u s s i o i i n t h e f i r s t

s e c t i o n of C h a p t e r 3, However, it c a n b e a r g u e d t h a t , ic

p r a c t i c a l terms, t h e d i s t i n c t i o n b e u t e e n a s h o c k t h a t lasts f o r

1000 y e a r s a n d a shock t h a t l a s t s f o r e v e r is a n ' a n n e c e s s a r i l y

f i n e one.

APPENDIX I I X

I n C h a p t e r 4, t h e reduced e x p r e s s i o n r e f l e c t i n g i n d i v i d u a l

s a v i n g s a n d p o r t f o l i o a d j u s t m e n t b e h a v i o u r was g i v e n a s . . 0 , - . d eR = - d D + b l d B* + b 2 r + b3r* + b4a + b5p + b6y*(3,1) - - - - - d t P d t P dtP*

where t h e d o t n o t a t i o n r e p r e s e n t s time d e r i v a t i v e s ,

Here e x p r e s s i o n s f o r t h e b i c o e f f i c i e n t s are o b t a i n e d i n

terms o f t h e u n d e r l y i n g income, i n t e r e s t etc, s e n i t i v i t i e s of

goods and a s s e t demands,

A s e x p f a i n e a i n C h a p t e r 4 , t h i s e x p r e s s i o n is d e r i v e d from

t h e n a r k e t c l e a r i n g c o n d i t i o n s r e f l e c t i n g wor ld (f low) goods

e q u i l i b r i u m a n d world ( s tock) e q n i l i b r i u m f o r d o m e s t i c and

f o r e i g n money, These c o n d i t i o n s a r e

eR/P + D/P = md + md* (3- 3 )

Pi*/P* = af + mf* (3- 4)

The d o m e s t i c a n d f o r e i g n goods and money demand f u n c t i o n s a r e

g i v e n by

mf = m(r,r*,a,y,w) m f * = m*(r,r*,a,y*,w*)

T i m e d i f f e r e n t i a t i o n o f a l l t h e s e c o n d i t i o n s w i t h r e s p e c t t o

time y i e l d s . .I - . c + c * = y + y *

0 * d e R + d g = md + ad* - - d t P d t P

0 - d bl: = m f + a f * - dtP*

. * . - . . ma* = l l * r + 12*r* + 13*a + 14*y* + 15*w* . (3.17) * . - . . 0

m f = ~alr + m2r* + m3a + n4y + m5w (3- 18) . * - 0 . - m f * = a l * r + a2*r* + m3*a + mi)*y* + n5*u* . (3- 19)

S u b s t i t u t i o n of e q u a t i o n s (3.76) and (3.17) i n t o equat ion (3.12)

Now t h e w and w* terms can b e e l i m i n a t e d from t h i s

expression by using e q u a t i o n s (3, I t ) , (3 . 13) , (3 .14 ) . (3.15).

(3 -18) and ( 3 - 1 9 ) - S u b s t i t u t i o n of (3-14) and (3.15) i n t o (3-11)

and rearrangement yields

S u b s t i t u t i o n of (3.10) and (3-19) i n t o (3.13) and rearrangement

y i e l d s

How e q u a t i o n s (3.21) and 13-22) can be s o l v e d s i m u l t a n e o u s l y t o 0 . . 0 0 - e

o b t a i n e x p r e s s i o n s for u and v* i n teras of r, r*, a, y, y* and

d/dt[B*/P*]. These e x p r e s s i o n s are

where X = m5c5* - c5m5*, - 9

S u b s t i t u t i o n of t h e s e expressions for u and w * into

equat ion ( 3 . 2 0 ) gives, upon simplif ication, an e q u a t i o n of the

where b l = (15c5* - c5S*) /X (3.. 2 6 )

b2 = ( 1 + 1 1 * ) - (ml+nl*) b l + (cf +c1*) P (3- 27)

where b l is given above and Y = (15iaS*-m515*)/X

APPENDIX IB

F i g u r e s V t o X X I I I on s u b s e q u e n t p a g e s show the exchange r a t e

b e h a v i o u r produced by s i m u l a t i n g t h e effects of t h e o p t i ~ a l

reserve management rule, Each f i g u r e shows t h e ' exchange rate

p a t h s p roduced by t h e two v e r s i o n s of the rule, t o g e t h e r w i t h

t h e p a t h prodaced were r e s e r v e l e v e l s f i x e d a t t a r g e t and t h e

exchange r a t e free t o f l o a t , fo r a p a r t i c u l a r s o u r c e and

s t r u c t u r e o f exogenous shocks , I n F i g u r e s V t o X X I I , t h e s e

s o u r c e s a r e e i t h e r r ea l o r nominal , T h e i r a s s o c i a t e d s t r u c t u r e

is g i v e n by a s y s t e m a t i c component, d e s c r i b e d a s e i t h e r

c o n s t a n t , t r e n d o r s t e p , a n d a n u n s y s t e m a t i c component,

describes as e i t h e r a n i n d e p e n d e n t , a u t o c o r r e l a t e d o r random

walk e r r o r term, I n F i g u r e XXIII, t h e exogenous s h o c k s a r e t h o s e

which h i t t h e Canadian dollar d u r i n g t h e 1970s-

with R

m Wdlk

--.-.-.---.-.-.-

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