TOWARDS A POST-KEYNESIAN EXCHANGE RATE MODELING

TOWARDS A POST-KEYNESIAN EXCHANGE RATE MODELING

References:

Marc Lavoie Introduction to Post-Keynesian Economics, Chapter 1, 2006.

John T. Harvey Currencies, Capital Flows and Crises, Chapter 3 and 5, 2010.

John Maynard Keynes The General Theory of Employment, “The Quarterly Journal of Economics”, February 1937.

John Maynard Keynes Treatise of Probability, 1921, CW VIII

Amos Tversky and Daniel Kahneman, Judgment under Uncertainty: Heuristics and Biases, “Science” Vol. 185, No. 4157, Sep. 27, 1974.

Prof. Stefano Lucarelli – Università di Bergamo

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The failure of orthodox economists to formulate a satisfactory explanation of exchange rate determination is related primarily to their predilection with the idea that “fundamental”forces must be responsible for currency price determination.


Paradigm

Free marketsState interventionPolitical core

Exchange, scarcityProduction, growthEconomic core

Hyper rationalityOptimizing agent

Reasonable rationality

Rationality

IndividualismHolism, organicismOntology/Method

InstrumentalismRealismEpistemology

Mainstream or Neoclassical

schools

Heterodox schoolsPresupposition

Presuppositions of the heterodox programmevs those of the mainstream


Macro-economics

Heterodoxauthors

Neoclassical school

MarxistsCambridgeKeynesians

OldKeynesians

Monetarists

New Keynesians

New Classicals

RadicalsFrench

RegulationSchool

Post-Keynesians

KEYNES



In Neoclassical view currency market participants’expectations have no impact on the actual outcome.

Aggregate market expectations are bound to be rational at least in the long run, because either all participants are individually rational.

The portion of the market that is irrational will be driven out of business.



Features of the Post-Keynesian alternative:

1. Equilibrium trade imbalances

2. Less-than-full employment

3. Endogenous money

4. Exchanges rates marked by volatility

5. Bandwagon effects

6. Market participants’ forecasts: expectations are guided by a mental model that is shaped by social forces.


The Post-Keynesian economics Post-Keynesian economics is when uncertainty and money

are taken seriously

It penetrates economic decision making and behaviour at all levels – micro/macro and short or long run.

Hence, uncertainty and money are inescapable phenomena in macroeconomics

We know this from e.g.

Liquidity preference theory

The theory of effective demand

The fall of the apple …


The pseudo-analogy with the physical sciences leads directly counter to the habit of mind which is most important for an economist proper to acquire. I also want to emphasise strongly the point about economics being a moral science. I mentioned before that it deals with introspection and with values. I might have added that it deals with motives, expectations, psychological uncertainties. One has to be constantly on guard against treating the material as constant and homogeneous in the same way that the material of the other sciences, in spite of its complexity, is constant and homogeneous. It is as though the fall of the apple to the ground depended on the apple's motives, on whether it is worth while falling to the ground, and whether the ground wanted the apple to fall, and on mistaken calculations on the part of the apple as to how far it was from the centre of the earth.

J.M. Keyenes, Letter to R. Harrod, July 1938.


WHOLESALE

Interbank Market two-way offers very small spreads

RETAIL

Banks, Restaurants, Hotels, Currency Kiosks

COMMERCIAL

Import/Export, Direct Investment,

Portfolio Investment

Foreign currency market structure


Currency Market Participants’ Roles

The question “what determines the exchange rates?” becomes “what determines the relative demand for currency?”

Wholesaling, retailing and commercial demands


Currency Market Participants’ Roles

Demands for

foreign currency

arise from:

1. Imports

2. Direct foreign

investment abroad

3. Portfolio

Investment abroad

It is not their goal to engage in currency speculation! They act in response to changes that have taken place (or that they anticipate) at the commercial level.

Merely intermediate between commercial actors and wholesalers, charging a mark-up in the process

CommercialWholesalingRetailing


What drives commercial activity and exchange rates?

Trade flows tend to be price inelastic but income elastic => large changes in exchange rates have only a small and delayed effect on trade flows, while fluctuations in overall economic activity has a big impact.

DFI: 1. horizontal (at the same stage of production) tend to be attracted to high income nations and similar tastes to those in the source country; 2. vertical (along the stages of production of a given product) is typically resource-seeking and moves to nations with cheap supplies of those resources;=> both a rise in national income, that tends to attract horizontal DFI, or a fall in factor costs, that tends to attractvertical DFI, => domestic currency appreciation



What drives commercial activity and exchange rates?

Portfolio capital flow (and in particular flow in search of short-term, capital gains) dominate the foreign exchange market (Schulmeister 1987; Krause 1991).

The factors driving financial flows are many (see Keynes 1936, ch. 17):

1. the greater the yield an agent expect to earn, the grater the demand for asset;

2. the greater the default risk, the less enthusiastic an agent is to buy;

3. the easier one suspects it will be liquidate the asset, the more attractive it will be.


Nations whose assets are perceived to be offering a higher yield, lower chance of default and greater liquidity will experience appreciating currencies as agents rush to buy those assets, creating net capital inflows.

If portfolio investors expected a nation’s income to rise, then they would eventually drive down the value of the currency and thus the value of assets issued by that country, market participants immediately sell those assets. The outflow of portfolio investors would then cause the very depreciation agents feared!

Self-fulfilling prophecy


Self-fulfilling prophecy


Psychology & decision-making in the foreign exchange market

If the flows into a country are expected to increase then nation’s currency can be expected to appreciate, then it is safe to assume that will, ceteris paribus, attract portfolio capital.

Today’s expectations of future currency price movements play the most important role in determining the current foreign exchange rate.

Agents are not forecasting an event that is independent of their actions. They are creating the event.


Psychology and decision-making in the foreign exchange market

The forecast creates the realized values.

In this context, “bias” does not mean forecast error: it is the unreasonable influence of some factor in the formation of the forecast.

The unreasonable influence, if widely shared, does not lead to a mistake: it becomes part of the realized price!


Keynes on forecasting and decision making

By ‘uncertain’ knowledge, let me explain, I do not mean merely to distinguish what is known for certain from what is only probable. The game of roulette is not subject, in this sense, touncertainty; nor is the prospect of a Victory bond being drawn. Or, again, the expectation of life is only slightly uncertain. Even the weather is only moderately uncertain. The sense in which I am using the term is that in which the prospect of an European war is uncertain, or the price of copper and the rate of interest twenty years hence, or the obsolescence of a new invention, or the position of private wealth-owners in the social system in 1970. About these matters there is no scientific basis on which to form any calculable probability whatever. We simply do not know.


Nevertheless, the necessity for action and for decision compels us as practical men to do our best to overlook this awkward fact and to behave exactly as we should if we had behind us a good Benthamitecalculation of a series of prospective advantages and disadvantages, each multiplied by its appropriate probability, waiting to be summed. How do we manage in such circumstances to behave in a manner which saves our faces as rational, economic men? We have devised for the purpose a variety of techniques, of which much the most important are the three following:


(1) We assume that the present is a much more serviceable guide to the future than a candid examination of past experience would show it to have been hitherto. In other words we largely ignore the prospect of future changes about the actual character of which we know nothing.

(2) We assume that the existing state of opinion as expressed inprices and the character of existing output is based on a correct summing up of future prospects, so that we can accept it as suchunless and until something new and relevant comes into the picture.

(3) Knowing that our individual judgment is worthless, we endeavourto fall back on the judgment of the rest of the world which is perhaps better informed. That is, we endeavor to conform with the behaviour of the majority or the average. The psychology of a society of individuals each of whom is endeavouring to copy the others lead to what we may strictly term a conventional judgment.


Now a practical theory of the future based on these three principles has certain marked characteristics. In particular, being based on so flimsy a foundation, it is subject to sudden and violent changes. The practice of calmness and immobility, of certainty and security, suddenly breaks down. New fears and hopes will, without warning, take charge of human conduct. The forces of disillusion may suddenly impose a new conventional basis of valuation. All these pretty, polite techniques, made for a well-panelled board room and a nicely regulated market, are liable to collapse. At all times the vague panic fears and equally vague and unreasoned hopes are not really lulled, and lie but a little waybelow the surface. Perhaps the reader feels that this general, philosophical disquisition on the behaviour of mankind is somewhat remote from the economic theory under discussion. But I think not.


Though this is how we behave in the market place, the theory we devise in the study of how we behave in the market place should not itself submit to market-place idols. I accuse the classical economic theory of being itself one of these pretty, polite techniques which tries to deal with the present by abstracting from the fact that we know very little about the future. I daresay that a classical economist would readily admit this. But, even so, I think he has overlooked the precise nature of the difference which his abstraction makes between theory and practice, and the character of the fallacies into which he is likely to be led. This is particularly the case in his treatment

of money and interest.


Stages of decision making

Post-Keynesians see agents’ expectations as key determinants of foreign currency prices. Explaining expectations will require reference to the work of psychologists.

Humans rely on a limited number of heuristic principles which reduce the complex tasks of assessing probabilities and predicting values to simpler judgmental operations (Tversky & Kahneman 1974).


Stages of decision making

1. Eventuality Analysis

2. Choice and Consequence Definition

3. Decision Weight Assignment

4. Choice

5. Post-event Assessment


Eventuality Analysis

ProfitLossSell Euros

LossProfitBuy Euros

Euro Depreciation

Euro Appreciation


Belief

Is our expectation of rain, when we start out for a walk, always more likely than not, or less likely than not, or as likely as not? I am prepared to argue that on some occasions none of these alternatives hold, and that it will be an arbitrary matter to decide for or against an umbrella. If the barometer is high, but the clouds are black, it is not always rational that one should prevail over the other in our minds, or even that we should balance them…

(J.M. Keynes, Treatise of Probability, 1921, CW VIII, p. 32).


1. O represents impossibility, I certainty, and A a numerically measurable probability intermediate between O and I;

2. U, V, W, X, Y, Z are non-numerical probabilities, of which, however, V is less than the numerical probability A, and is also less than W, X and Y. X and Y are both greater than W, and greater than V, but are not comparable with one another, or with A.

3. V and Z are both less than W, X, and Y, but are not comparable with one another, U is not quantitatively comparable with any of the probabilities V, W, X, Y, Z (J.M. Keynes 1921, CW VIII, p. 42).


Weight of Arguments

As the relevant evidence at our disposal increases, the magnitude of the probability of the argument may either decrease or increase, according as the new knowledge strengthens the unfavourable or the favourable evidence; but something seems to have increased in either case, - we have more substantial basis upon which to rest our conclusion. I express this by saying that an accession of new evidence increases the weight of argument



Weight of Arguments: an example

…in the first case we know that the urn contains black and white in equal proportions; in the second case the proportion of each colour is unknown, and each ball is as likely to be black as white. It is evident that in either case the probability of drawing a white ball is 1/2, but that the weight of the argument in favour of this conclusion is greater in the first case.



Decision Weight Assignment

IgnorantLuckyAgainst Conventional Logic

UnluckyRationalWith Conventional Logic

Incorrect Decision

Correct Decision


Salient Market Characteristics

Forecast construction bias

Volatility

Bandwagons

Technical analysis

Trading limits and cash in

Mental model


Forecast construction bias

Availability

Representativeness

Anchoring

Tendency to expect favorable events

Tendency to ignore events that do not fit preconceptions


Volatility

Uncertainty

Availability

Representativeness

Anchoring

Desire for quick results

Animal Spirits

Convention


BANDWAGONS


Technical AnalysisStock charts tell us a lot about what companies are doing, what they will be doing and what the market thinks of it all. However, we have to learn how to read stock charts. At the most basic level, there are some important concepts that should be kept in mind: 1. Uptrends are characterized by rising bottoms on the stock chart and can be described as periods of optimism 2. Downtrends are characterized by falling tops on the stock chart, and can be described as periods of pessimism 3. Abnormal trading activity often signal significant fundamental change in the company's business 4. Support is a floor price that the market has shown an unwillingness to trade under in the past 5. Resistance is a ceiling price that the market has shown an unwillingness to above in the past

stockscores.com



Technical Analysis

Neoclassical economists argue that reliance on such a tool is futile since past price movements are available to everyone. If they contained valuable information then the market would already reflect this.

Why would such simple method be employed by so many professionals?

From the Post Keynesian perspective, trading rules are profitable, and it is because bandwagon effects make them so


TRADING LIMITS AND CASH IN

When agents feel they are in a losing situation they will tend to choose more risky options.

When agents are winning, they tend to become risk averse. => when a currency appreciates, those holding it become increasingly anxious about realizing what have been up to now only paper profits (Schulmeister 1988)


MENTAL MODEL

Currency market participants are members of a particular subculture (education, colleagues, family, friends, professional scholarly literature…)

Mimic the behavior of various role models.


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TOWARDS A POST-KEYNESIAN EXCHANGE RATE MODELING