Exchange Rate Economics: Theories and Evidence

12 Introduction
likely that the relevant elasticities in (1.9) will be highly inelastic (simply because it
takes time for existing contracts to be fulfilled and therefore domestic residents cannot
instantly buy import-competing goods and foreigners cannot instantly switch
towards our cheaper export goods – see,for example,Goldstein and Khan 1985).
In the case where the current account worsens in the short term and improves
only slowly over time. This pattern of current account behaviour is labelled the
J-curve effect.
As we have seen,underlying the demand for foreign currency in Figure 1.1 is the
demand and supply of imports and exports of goods and services. But as was noted
in the previous chapter,perhaps the most dominant component of day-to-day
transactions in foreign exchange markets are (short-term) capital account items.
As will be shown in some detail in future chapters,short-term capital movements
respond essentially to interest differentials. Thus an increase in the foreign interest
rate relative to the domestic rate, ceteris paribus,would be expected to lead to a flow
of capital to the foreign country,as investors increase their demand for the more
profitable foreign interest-bearing assets and decrease their demand for the less
profitable home asset(s). In so doing there will clearly be an increased demand for
the foreign currency. In terms of Figure 1.1,if the demand and supply schedules
underlying the DD and SS curves are the total demand for goods,services and
financial assets then the interest differential in favour of the foreign country (Japan
in our previous example) would lead to an increased demand for yen represented
by the rightward shift in the DD curve to DD ′ and a depreciation of the exchange
rate from S 0 to S 1 . Note therefore that in terms of the balance of payments view of
the determination of the exchange rate that an interest differential in favour of the
foreign country is associated in the home country with a capital outflow and an
exchange rate depreciation. This will be discussed in more detail in later chapters.
1.6 Tsiang’s trichotomyof the capital account and
covered interest rate parity
Tsiang (1959) proposed analysing the capital account in terms of the behaviour
of three different groups of agents: commercial traders,interest arbitrageurs and
speculators. Although this approach has not been fashionable for some time,we
believe it is,nonetheless,a useful way of integrating the determination of the
forward exchange with the determination of the spot exchange rate. 8
Consider,first,the role of so-called interest arbitrageurs and the concept of
interest arbitrage. The object of interest arbitrage is to allocate funds between
financial centres in order to realize the highest possible rate of return,subject to
the least possible risk. Thus,say,a UK individual had £1000 to invest for 1 year
and the current spot exchange rate is £0.60/$1. She may consider buying a UK
treasury bill yielding a 4% rate of interest per annum. Alternatively,the funds
could be invested in a similar US treasury bill at a 5% interest rate (the numbers
here are taken purely for illustrative purposes). On the face of it,one would expect
the investor to put her funds into the US investment since it appears to offer the
higher return but is this in fact correct? By investing in the UK the investor would