Exchange Rate Economics: Theories and Evidence

Notes
1 Introduction: some basic concepts and stylised facts and
the case for (and against) floating exchange rates
1 The weights used in our examples of the construction of a NEER and REER are
arithmetic. In practice,however,geometric weights are often preferred because a geometric
average treats increases and decreases in exchange rates symmetrically and is
not affected by the choice of base year.
2 For a more complete analysis of the MABP and,in particular,the assumptions
underlying the approach see Hallwood and MacDonald (2000).
3 A lucid account of this view is given in Johnson (1977). For some empirical estimates
see Genberg (1978).
4 Also notice from equation (1.3) that even if D = 0 the money supply may still be
changing if reserves are changing due,perhaps,to excessive domestic credit expansions
in other countries. By having a freely floating exchange rate the home country would
effectively insulate itself from such foreign monetary impulses.
5 In the Classical Gold standard period participating countries defined their currencies
in terms of one ounce of gold which,in turn,meant the bilateral exchange rate of the
two countries was fixed. However,the costs (both direct and indirect) of shipping gold
between countries defined the gold points,which were effectively the upper and lower
limits within which the exchange rate could move without generating arbitrage. In other
words,the gold points defined a kind of neutral band within which it was not profitable
to ship gold between countries.
6 The classic discussion of equilibria is to be found in Marshall (1923) in the context of
his treatment of reciprocal demand or offer curves.
7 More precisely,the Marshall-Lerner condition is predicated on the following assumptions:
there is assumed to be only one export and one import good; the elasticity of
supply of exports and imports are infinite; trade is initially balanced; the home country
is at full employment. For some empirical evidence supportive of the J-curve effect see
Artus and Young (1979). For further information on the Marshall-Lerner condition see
Hallwood and MacDonald (2000).
8 One problem,however,with the Tsiang analysis lies in its compartmentalization of the
different activities of traders. In the real world the hypothetical agents we deal with in the
next section are liable to indulge in all three roles simultaneously. For present purposes
it will prove useful to trade-off this added realism for greater simplicity and clarity.
9 Operating in the spot market a speculator requires access to the funds for speculation
more or less immediately. Operating in the forward market,however,he only requires
to fulfil any margin requirements imposed by his broker (which may,for example,be
10% of his total transaction). The opportunity cost therefore of operating in the forward
market is much less than the cost of spot market operations.