Hailey College of Banking & Finance Lahore

Sep 1 - 7, 2008

The expected volatility of exchange rate movements, resembling stock prices, is by now commonplace. In a comment, Marina Whitman in 1975, characterized exchange rates as being approximately determined by asset market equilibrium. In 1976, Jacob Frenkel and Michael Mussa described the exchange rate as the relative price of national monies. In an important paper in 1981, Frenkel surveyed and extended results that showed that exchange rates fluctuate like stock prices rather than goods prices. The fundamentals model of exchange rate determination in fact shows exchange rates and interest rates being determined by the same set of equilibrium forces.

When we add the expectations layer to the fundamentals model of exchange determination as explained in Text Books of International Finance, the expected volatility of exchange rates becomes more obvious. Forward looking financial markets bring the future consequences of real disturbances into the present. As discussed in Branson (1983), news about the trade balance can be interpreted as a predictor of the future accumulation of the foreign asset position. This will lead the market to anticipate a movement in the real exchange rate, and the rate will jump immediately. As noted earlier, expectations will also bring the consequences of future policy actions into the present. According to an observation the anticipation of a future shift in the budget position resulted in a jump in the real exchange rate in the recent past.

Volatility of exchange rates, following time series processes like stock prices, is thus a normal feature of modern thinking about exchange-rate determination. Considerations of current account balance and purchasing power parity, which were in the center of models of exchange-rate determination in the 1960s, now are part of the longer run equilibration process.

While volatility is a normal feature of the exchange market, its consequences may be more important than stock price volatility, and therefore policy reactions may differ. In an open economy, fluctuations in the exchange rate must emerge as fluctuations either in the prices of tradable goods or in the profits of the firms producing them. Volatility in either may be of concern for policy. If fluctuations in exchange rates cause price fluctuations (as opposed to persistent inflation) this may discomfort consumers if exchange-rate fluctuations are absorbed in profits, the resulting variability increases risk in investment in the tradable goods industry. This may reduce such investment, and raise legitimate policy concerns. Thus the statement that volatility is a normal and expected feature in the exchange market does not imply that it is a good thing, or even acceptable. Policy regarding this volatility is rightly an urgent matter for discussion.

Apart from others there are at least three other explanations for the strength of the dollar that we will consider here, if too briefly. The first is the effect of tax changes in on investment incentives in the U.S., if considered on world wide basis. The second is the "safe haven" argument that we have seen in a shift in international portfolio demands toward the dollar. The third is the effect of financial deregulation pulling foreign funds into the U.S. We will consider each in turn.

The Tax Effect: The increase in the after-tax yield would increase investment demand; the rest would follow, with the U.S. borrowing abroad to finance investment at home. There are three points to make concerning this argument as an "alternative."

First, it is unclear how much changes in the tax laws have actually changed after-tax yields or the cost of capital. In a fairly detailed empirical analysis many macroeconomists have ascribed most of the change in the cost of capital to a reduction in the price of capital goods relative to output. Given the increasing share of imports in expenditure on capital goods, some of this relative price effect probably comes from dollar appreciation.

Second, it is not clear that investment is booming in the U.S., as we would expect particularly after a huge dilemma of sub prime mortgages after which recent recessions have generated a severe slump in investment.

Finally, if we think an investment in the country boom would lead to a rise in real interest rates and real dollar depreciation, we should also believe that a major shift in the structural budget deficit would do the same. In one case the stimulant is investment spending and in the other, it is consumer spending and defense. Both would raise real interest rates and pull in foreign capital. It is clear that the budget deficit has shifted. So the logic of the investment argument should lead one to accept the budget argument as well!

Safe haven effects: The second alternative explanation is a shift in international portfolio preferences toward the dollar, generally called a "safe haven" effect. The safe haven argument is based on a shift in the supply of funds to the U.S.; the shift in the budget deficit moves the demand for funds. Both would result in dollar appreciation in the short run, but the budget deficit delivers the rise in real interest rates. So, while there may well have been some supply shift, the dominant effect must have come from the demand side.

Financial deregulation: The final alternative, more promising than the safe haven argument, is financial deregulation. This would raise deposit rates, drawing funds from abroad. If it signaled an increase in financial competition in the Pakistan, it might draw foreign funds into non-bank lending. This would contribute to downward pressure on bank lending rates, contributing to a narrowing of the spread. As is obvious from the financials of the Financials Institutions that this narrowing has indeed occurred. The inflow would also result in dollar appreciation keeping in view the political uncertainty and international pressures.