Table Of ContentFLEXIBLE EXCHANGE RATES AND
STABILIZATION POLICY
FLEXIBLE
EXCHANGE RATES
AND STABILIZATION
POLICY
Edited by
JAN HERIN, ASSAR LINDBECK
AND JOHAN MYHRMAN
Originally published in
THE SCANDINAVIAN JOURNAL OF ECOXOMICS
©The Scandinavian Journal of Economics 1976, 1977
Softcover reprint of the hardcover 1st edition 1977 978-0-333-21839-6
All rights reserved. No part of this publication may be
reproduced or transmitted, in any form or by any means,
without permission
These proceedings were originally published in
The Scandinavian Journal of Economics, Vol. 78, No.2, 1976
First published in book form 19 77
Reprinted 1980
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CONTENTS
Preface vii
Approaches to Exchange Rate Analysis-An Introduction Assar
Lindheck
Monetary Theory and Policy in an Open Economy Ricoord N. Cooper 14
Comment by Per Meinich 32
Comment by Stanley W. Black 34
Experiences of Flexible Exchange Rates in Earlier Periods: Theories,
Evidence and a New View Jolw,n Myhrman 37
Comment by David Laidler 65
A Monetary Approach to the Exchange Rate: Doctrinal Aspects and
Empirical Evidence Jacob A. Frenkel 68
Comment by Giorgio Basevi 93
The Exchange Rate, the Balance of Payments and Monetary and Fiscal
Policy under a Regime of Controlled Floating M iclw,el M ussa 97
Comment by Michael Parkin 117
The Theory of Flexible Exchange Rate Regimes and Macroeconomic
Policy Rudiger Dornbusch 123
Comment by Stanley Fischer 144
The Exchange Rate and the Balance of Payments in the Short Run and in
the Long Run: A Monetary Approach Pentti J. K. Kouri 148
Comment by Alexander K. Swoboda 173
The Firm under Pegged and Floating Exchange Rates Robert Z. Aliber 177
Comment by Dwight M. Jaffee 191
Exchange-rate Flexibility and Reserve Use John Williamson 195
Comment by Stanley W. Black 208
World Inflation under Flexible Exchange Rates Emil-Maria Claassen 214
Comment by Hans Genberg 234
Inflation and the Exchange Rate Regime W. Max Gorden 238
Comment by Ephraim Kleiman 252
General Discussion. Edited by Lars Calmfors and Clas W ihlborg
Participants: Stanley W. Black, Rudiger Dornbusch, France Modigliani,
Robert Mundell, William H. Branson, Ronald McKinnon, W. Max
Gorden, Ephraim Kleiman, David Laidler, J0rgen Gelting, Alexander
Swoboda, Dwight M. Jaffee, Marcus Fleming, Robert Z. Aliber, Michael
Mussa, Assar Lindbeck 254
PREFACE
The shift to greater exchange-rate fiexibity during the early 1970s has created
a need to strengthen the theory of flexible exchange rates and to improve its
integration with macro theory and stabilization policy analyis.
This volume consists of the papers, comments and, in summary form, the
discussion at a conference on "Flexible Exchange Rates and Stabilization
Policy", held at Saltsjiibaden, Stockholm, August 26-27, 1975. The con
ference was organized by the Institute for International Economic Studies at
the University of Stockholm, and arrangements and financing were carried
out by the Bank of Sweden Tercentenary Foundation, under the guidance
of its Director, Dr. Nils-Eric Svensson. A special committee, appointed by the
Foundation, was formed to plan the conference. The members of the committee
were Ragnar Bentzel, Erik Lundberg, Assar Lindbeck (Chairman) and Nils
Eric Svensson. Birgitta Eliason of the Institute for International Economic
Studies carried the main burden of organization during the conference.
These proceedings were originally published in The Scandiru:wian Journal of
Economics, Vol. 78, No.2, 1976.
Institute for International Economic Studies
Stockholm Jan Herin
Assar Lindbeck
Johan Myhrman
APPROACHES TO EXCHANGE RATE
ANALYSIS-AN JNTRODUCTION
Assar Lindbeck
Institute for International Economic Studies, Stockholm, Sweden
It is the fate of social scientists to shoot at moving targets. At about the time
when macro economists started to understand the operations of a world econ
omy with fixed exchange rates, or adjustable pegs, the system was replaced
with a regime with considerable exchange rate flexibility, occasionally even
floating rates. As a consequence, prevailing "embryos" to a theory of the
balance of payments for a regime of flexible rates-as formulated by Milton
Friedman, James Meade, Egon Sohmen and others-were suddenly put into
empirical test and found to be in need of some modification. The same can be
said about theoretical suggestions concerning the performance of stabilization
policy under alternative exchange rate regimes, as formulated inter alia by
Marcus Fleming and Robert Mundell.
When approaching the theory of the balance of payments, exchange rates
and stabilization policy, it is easy to agree that the analysis ideally should be
pursued in the context of a complete macro model with full consideration to
the interaction of various markets, i.e. by way of a general equilibrium, or a
"general disequilibrium" (without market-clearing) model. In practical applica
tions, drastic simplifcations are, of course, necessary both to make the analy
sis manageable and to reach unambiguous conclusions. It is about the choice
of such simplifications and shortcuts that the analytical controversies rage.
This is evident also from most of the papers in this conference volume.
Among the various controversies, a rather technical one concerns the cele
brated issue of (I) the choice between stock and flow formulations for the
financial markets. A more fundamental controversy refers to (II) the choice
between partial and total equilibrium analysis, or rather the degree of "partial
ity", as well as the related issues of the specification of endogenous and exoge
nous variables, and the length of the time perspective (short-run versus long
run analysis). A third basic controversy concerns (III) the relative speed of
reaction and market-clearing in various markets.
The purpose of this introductory paper is to take a brief look at these three,
highly interrelated issues, and then to try relating some of the major contribu
tions of the conference to earlier and contemporary doctrinal development of
those issues.
2 A. Lindbeck
I. Stocks versus Flows
Perhaps the main advances in theoretical and empirical analysis of the balance
of payments and exchange rates in recent years have been (1) an increased
understanding of the analytical advantages of formulating the financial mar
kets in terms of demand and supply of stocks of assets in various currency
denominations, and not just the flow of funds; and (2) a realization that
expectations about the variables which influence asset behavior should be a
crucial consideration in the analysis.
These points are developed in several of the papers in this volume. More
specifically, the exchange rate is seen as a consequence of the requirements of
equilibrium in the market of financial assets with different currency denomina
tions. Moreover, changes in the stock-supply and stock-demand of assets are
regarded as an important part of the adjustments of the balance of payments
and the exchange rate over time.1
It is well known from the celebrated controversy about the loanable funds
and the liquidity preference approaches to interest rate theory that "flow
models" and "stock models" under certain conditions can be formulated in
such a way that the two approaches may be regarded as consistent, or perhaps
even equivalent. However, as in the case of interest rate analysis, an explicit
formulation of the financial markets in stock-terms has obvious advantages
as compared to flow formulations only. In the case of exchange-rate and
balance-of-payments analysis, perhaps three advantages of a stock formula
tion are particularly worth emphasizing:
(1) A stock formulation reminds us that flows can fruitfully be seen as adjust
ments to desired stocks, and that the flows become zero when desired stocks
have been reached (if net wealth is constant). Thereby a stock formulation
helps to clarify when a flow is temporary and permanent, respectively. Then
we can also easily dispel the theoretically dubious, but rather usual, assump
tion that capital movements (rather than desired stocks of foreign assets) are
functions of interest rate differentials between nations.
(2) An explicit asset approach also helps us realize that even a rather moder
ate percentage change in stock-demand or stock-supply may generate a large
percentage change in the flow of funds because of the large size of stocks rela
tive to flows during a short period (for instance a few months).
(3) Moreover, an explicit introduction of both stocks and flows (of financial
and monetary variables) helps focus on the basic macroeconomic adjustment
mechanism, which may otherwise easily be "forgotten", by highlighting changes
1 Harry Johnson made a rather prophetic statement some ten years ago about the likely
"future" role of asset (portfolio) considerations in exchange-rate and balance-of-payments
analysis, when commenting on a pioneering article in this field by Ronald McKinnon:
"I should not be surprised if in ten years time most of us will be talking McKinnon's
language (i.e. portfolio analysis) as a matter of course." Monetary Problems of the Inter
national Economy, ed. by R. A. Mundell and A. K. Swoboda, University of Chicago Press,
1969, p. 399.
Introduction: Approaches to exchange rate analysis 3
in net wealth via the flow of saving through a surplus (or deficit) in the current
account of the balance of payments or in the government budget. We are thus
reminded that a full (stationary) equilibrium, ceteris paribus, is not reached
until the sum of the current account and the government budget is zero.1
(This argument implicitly assumes that the private sector does not regard
the capital value of future taxes, needed to finance the public debt, as a lia
bility of the private sector.)
II. Partial versus Total Analysis
If we choose a continuous treatment of time in our model, it follows as an
"analytical triviality" that the exchange rate at every movement of time is
determined only by the conditions of instantaneous stock equilibrium-with
out any influence whatsoever from the rate of the flow on the current account
(except in the sense that the rate of the flow of the current account may influ
ence expectations and hence stock-demand for assets).
Controversies start when we choose a discrete treatment of time, as in
empirical studies. In a very short-run time perspective, such as a few weeks,
an isolated partial equilibrium stock analysis, without explicit connections to
the flows in the current account, may often be quite appropriate as a rough
analysis of the balance of payments and/or exchange rates. The reason is, of
course, the short-run "stickiness" of the flows on the current account, and the
often dominating influence of portfolio shifts upon the exchange rate (un
related to the development on the current account) in the short run, for in
stance in response to changes in interest rate differentials, exchange rate expec
tations or political circumstances.
1 Some other often asserted "advantages" of a stock approach are more doubtful, as they
do not logically seem to be tied more to stock formulations than to flow formulations.
For instance, it is sometimes claimed that the emphasis on portfolio behavior quite auto
matically leads us to assign a crucial role to expectations. However, there is hardly any
reason why expectations should play a more important role in an analysis built on stock
formulations than in analyses in terms of flows.
Another alleged advantaged of stock formulations is that the correlation between the
size of flows during a period (ex post) and actual or expected exchange rate changes is
weak. The reason would be that financial flows are largely a function of the dispersion
and accuracy of exchange rate expectations rather than of the size of the actual or ("on
the average") expected change in the rate. However, this correct observation by itself is
no ground for preferring "stock formulations" to "flow formulations", as the same weak
correlation holds between exchange rate changes and stock-demand shifts (ex post). The
point is rather that it is important to distinguish between, on the one hand, desired flows
and stocks (ex ante) and, on the other hand, actual flows and stocks (ex post), and that
exchange rate changes should be explained by the former types of variable rather than the
latter.
For instance, if everybody operating in the market for assets correctly expects the ex
change rate to shift by ex percent, a given (ex post) change in the spot rate may take place
with rather small shifts in assets, and hence with rather small financial flows, even though
desired (ex ante) asset holdings and flows may have changed quite a lot. If, by contrast,
some people expect large exchange rate changes whereas others expect small ones, or even
changes in the opposite direction, large reshufflings of assets, and hence large financial
flows, will usually take place ex post.
4 A. Lindbeck
The reason for the words "usually" and "as a rough analysis" in these
formulations is that actual and expected changes in the current account
may occasionally have quite strong effects even in a rather short time perspec
tive, such as a few months. For instance, a sudden dramatic change in the
terms of trade may within a rather short period. of time considerably influence
both the supply and demand side of assets via the actual and expected flows
on the current account. An illustration is probably provided by the events in
the world economy during the 1973-75 period, in connection with violent
changes in the price of oil and certain other raw materials. In cases like these,
some useful information is lost-even in a rather short-run perspective-if
stock equilibrium in the asset markets is analyzed without considering the
influence from, and perhaps also the interaction with, the actual and expected
future current account. Moreover, for large countries for which the exchange
rate influences world market prices-with a feedback on the exchange rate
via the value of the current account-"stickiness" of the volume of trade
(during perhaps several months) is no reason to neglect the interdependence
between the exchange rate and the value of the current account, even in a
rather short-run analysis.
It should perhaps be added that the current account has an important
information value "by itself" for policy purposes, as many governments
seem to be much concerned with the composition of the balance of payments,
and not just its total value (at fixed rates) or the exchange rate (at floating
rates).
In spite of these reservations, and without ambitions to deal with the
composition of the balance of payments, it is probably reasonable to argue, as
Michael Mussa does, that in a short-run perspective (a few weeks or perhaps
even a few months) "the proximate determination of exchange rates and the
balance of payments are the demand and supply of various monies". However,
then the term "monies" has to be liberally interpreted as "financial assets"
rather than "money" in the literal sense. For there is hardly any theoretical
presumption that shifts in the market for money are "more important" (for
the exchange rate andfor the balance of payments) than shifts in the markets
for interest-bearing financial assets. Empirical evidence in recent years suggest,
in fact, that portfolio shifts have often taken place between earning assets
of different denominations (bonds, bills and time deposits of various types)
rather than just money. Thus, there is hardly any reason to turn an "asset
theory" (of the balance of payments and exchange rates) into a "monetary
theory". I understand that the emphasis on a "monetary approach" to the
balance of payments and exchange rates in some of the papers in this volume
such as the papers by Michael Mussa, Rudiger Dornbusch and Pentti Kouri
is simply a "pedagogical simplification" of what is basicallyanassetapproach.
"Money" should tnen perhaps be read "financial assets" in all.these papers.
As soon as the time perspective is lengthened (over several months or
