Exchange Rate Economics: Theories and Evidence

Introduction 19
foreign rate adjusted for the expected change in the exchange rate (or to put it
slightly differently international portfolios adjust instantly). On this basis equation
(1.14) may be taken as a representation of perfect capital mobility. Equation (1.12)
may not,however,be taken as a measure of perfect capital mobility since,as we
have seen,bonds may not be regarded as perfect substitutes if risk is important;
that is,there may be a risk premium over and above the expected change in the
exchange rate. Other factors,in addition to exchange risk factors,which make
bonds imperfect substitutes are: political risk,default risk,differential tax risk and
liquidity considerations. Capital may also be imperfectly mobile if portfolios take
time to adjust. The definition of perfect capital mobility used here accords with
the general usage of the term in the international finance literature (see, inter alia,
Fleming 1962; Dornbusch 1976; Frenkel and Rodriguez 1982),but contrasts with
the definition given by, inter alia,Dornbusch and Krugman (1978) and Frankel
(1979). The latter take perfect capital mobility simply to mean the instantaneous
adjustment of portfolios. 10
Since we shall be considering in future chapters circumstances where
capital is less than perfectly mobile,it will prove useful to define a capital flow
function:
CAP = β[i t − i ∗ t − s e t+k − s t],(1.17)
where CAP represents a net capital inflow (capital account surplus) and β represents
the speed of adjustment in capital markets. Hence if β =∞capital is perfectly
mobile,since any change in the uncovered interest differential will lead to a potentially
infinite capital movement and clearly (1.14) holds continuously. If,however,
β lies between 0 and ∞ capital is less than perfectly mobile and net yield differentials
are not continuously arbitraged away. With β = 0 capital will clearly be
completely immobile.
Open or uncovered interest parity relates,as we have seen,to international
interest differentials. Closed interest parity,or the Fisher condition,hypothesises
that a country’s nominal interest rate can be decomposed into a real interest rate
plus the expected inflation rate:
i t = r e t + p e t+k ,(1.18)
where rt e is the ex ante real rate of interest,which is often assumed constant,and
pt+k e is the expected change in the log price level or the expected inflation rate.
These measures of interest parity are nominal in nature (i.e. nominal interest
rates and exchange rates). In Chapter 8 we consider the real interest rate parity
condition.
1.8 Some stylised facts about exchange rate behaviour
In this section we consider some stylised facts about exchange rate behaviour. In
particular,we consider the time series properties of the first and second moments