Journal of Post Keynesian Economics

ISSN: 0160-3477 (Print) 1557-7821 (Online) Journal homepage: http://www.tandfonline.com/loi/mpke20

A Post Keynesian View of Exchange Rate

Determination

John T. Harvey

To cite this article: John T. Harvey (1991) A Post Keynesian View of Exchange
Rate Determination, Journal of Post Keynesian Economics, 14:1, 61-71, DOI:
10.1080/01603477.1991.11489878

To link to this article: http://dx.doi.org/10.1080/01603477.1991.11489878

Published online: 04 Nov 2015.

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 JOHN T. HARVEY

A Post Keynesian view of exchange

rate determination
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Since the final collapse of the Bretton Woods regime in 1973, research
on the determinants of exchange rates has continued at a furious, if not
productive, rate. The most popular alternative, the monetary approach
to exchange rate determination, has performed very poorly in empirical
testing (Wasserfallen, 1989, p. 511). While some version of the mone-
tary approach may show promise in explaining one aspect of exchange
rates during a given time period, that version invariably falls flat when
the search for robustness begins.
Thus, we are left with a system that has not at all performed as expected
and we generally do not know why. Rates have been terribly volatile,
they have been misaligned for extended periods of time, and domestic
monetary authorities find that they do not possess the autonomy that had
been promised (McCulloch, 1986). The level of international macroeco-
nomic policy interdependence has become so great that the nations of
the industrialized world, under various guises (the Group of Five, the
Group of Thirty, etc.), have started trying to coordinate their macroeco-
nomic policies. Oearly, the political realities have outstripped the
economic theorizing.
It is the contention of this author that elements of a theory that can
successfully explain the determination of exchange prices under the
flexible rate system can be developed from the writings of various Post
Keynesian scholars. This paper is intended to provide a rough outline
of that approach and to spur further refinement of the model.

I. Exchange rate behavior since 1973

Not even the most pessimistic pre-1973 predictions of the behavior of
the flexible rate envisioned the level of volatility that has actually
The author is Assistant Professor of Economics at Texas Christian University, Fort
Worth, Texas. He would like to thank C. Richard Waits for his considerable help and
guidance, and would also like to thank William Milberg and an anonymous referee
for their helpful comments. Any remaining errors are the author's responsibility.
Journal o/Post Keynesian Economics I Fall 1991, Vol. 14, No.1 61
 62 JOURNAL OF POST KEYNESIAN ECONOMICS

occurred. Furthermore, those movements have been largely unpredict-

able and much more variable than national price levels, and have
included both the real and the nominal exchange rate (Marrinan, 1989,
p. 41). The longer-term exchange rates have been a mystery too. Clear
misalignments have existed for very long periods of time and they show
little predictable trend (Dornbusch, 1987, pp. 1-2). Daniel Gros sum-
marizes the state of economic theory:
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The highly erratic behaviour of floating exchange rates since the break-
down of the fixed exchange rate system has been a puzzle for many
observers. Some claim that the degree of volatility exhibited by exchange
rates is excessive. and thus undesirable; others claim that an efficient
foreign exchange market is a better, or more efficient, outlet for many
underlying disturbances, rather than markets that might not be able to
react as swiftly. Another aspect of this problem is that there seem to be
tranquil and turbulent periods in the foreign exchange markets, that is
the degree of volatility of rates varies over time without corresponding
changes in the behaviour of the fundamentals. It is widely claimed that
the degree of this volatility is due to the volatility of the underlying
policies-a claim which has not, as yet been substantiated. [Gros, 1989,
p.273]
Schulmeister has further observed that the rates in the short run tend
to move in "a series of upward or downward price runs interrupted by
some erratic fluctuations" but that in the medium run they fluctuate
around purchasing power parity (although they show no tendency to
settle there) (1988, p. 343).
Thus, a successful theory of exchange rate determination must account
for short-term volatility in the form of upward and downward runs, the
apparent separation of short-term movements (and possibly the me-
dium-term movements as well) from the influence of the "fundamen-
tals," and the persistence of balance-of-payments imbalances in the
short and medium terms.! It is by these criteria that the model outlined
here will be judged.

II. Previous work

While domestic macroeconomics seems to be the preferred domain of
most Post Keynesian scholars, there are those who have written in the
! "Medium-tenn" and "medium-run" are used throughout this paper instead of
"long-tenn" and "long-run" so that it might be consistent with Schulmeister's (1988)
work. As far as the author can tell, there is no marked difference between
Schulmeister's "medium" and other scholars' "long."
 EXCHANGE RATE DETERMINATION 63

area of international finance. Most important to this paper are Miles and
Davidson (1979), Davidson (1982), and Schulmeister (1988).2
Davidson has emphasized the role of changing expectations in an
environment of uncertainty as the key to volatility. Using the concept
of currency substitution (Miles and Davidson, 1979), combined with
Hicks's elasticity of expectations and classificatory scheme for holding
assets in an uncertain world (Davidson, 1982), Davidson shows how,
especially under a flexible exchange rate regime, foreign currencies
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become the object of considerable speculation.

Schulmeister's work fills many of the voids left by Davidson. In
particular, the institution of exchange trading is examined. Most impor-
tant is Schulmeister's contention that those creating the bulk of the
demand for foreign exchange are not those needing liquidity for inter-
national merchandise trade and investment, but instead the bank trading
desks themselves. 3 Furthermore, those trading desks make frequent use
of trading rules. These rules contribute to bandwagon and cash-in
effects, and the consistent profits thus earned are generally accumulated
at the expense of
all those market participants who buy or sell foreign exchange for other
reasons than short-term profit maximization from foreign exchange
dealing itself (including central banks), particularly traders of goods and
services who perceive and use foreign exchange for international pay-
ments rather than as a financial asset. [Schulmeister, 1988, p. 356]
Last, Schulmeister explains that traders maintain two sets of expecta-
tions about future exchange rate movements, short- and medium-term,
and he explains how these interrelate.
These works form the basis of the more general model developed
below.

ll. Exchange rate determination

The role of currency trading in the world economy has changed consid-
erably in the last twenty years. Once a market operating primarily to

2 Weintraub (1981) and Zis (1989) have made important contributions, although
their works tend to be more descriptive and add little in terms of formal theory. H.
Peter Gray has also contributed a great deal to the literature, but his work tends to em-
phasize trade rather than exchange rates (Gray, 1974, 1987; Gray and Gray, 1988-
89).
3 In fact, bank respondents to a recent survey reported that only 11.5 percent of their
total foreign exchange activity was customer business (Schulmeister, 1988, p. 344).
 64 JOURNAL OF POST KEYNESIAN ECONOMICS

grease the wheels of commerce, now outright speculation, by traders at

banks, multinationals, and other unlikely agents, has come to dominate
(Marsh, 1982; The Economist, 1987). As partial evidence, Schulmeister
emphasizes that the daily volume of the foreign exchange market
exceeds trade flows by a factor of around forty, and portfolio investment
by a factor of sixty: "One can therefore conclude that foreign exchange
dealing has largely emancipated itself from the direct forces implied by
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market fundamentals" (Schulmeister, 1988, p. 346).4

So, rates are set almost solely by foreign exchange dealers holding
currency for the reasons suggested by Hicks's classificatory scheme. As
suggested above, dealers maintain two sets of expectations, short-term
and medium-term. While the short-term are affected primarily by polit-
ical and economic (especially monetary) news, the medium-term are
more likely to be influenced by such economic fundamentals as balance
of payments, interest differentials, relative rates of inflation, and growth
rates. In general, the present exchange rate (spot or forward) can be
expressed in the functional form
(1) E, =f[(Eet+n-Et-l)' (E e t+m-Et-l)] ,
(+) (+)
where Ee'+n is the expected medium-term exchange rate and Et+m is the
expected short-term exchange rate. Since Et-l will already be known, it
remains only to determine E,+" and E'+m'
Medium-term expectations
Medium-term expectations are likely to dominate the decision making
of those economic agents whose demand for foreign currency is derived
solely from their desire for activities such as trading, portfolio invest-
ment, and direct investment. In tum, those concerned primarily with
speculative profits, even though they plan no long-term commitment to
a particular currency, will watch the fundamentals as a sign of the
inherent strength of a currency. It was precisely these sorts of demand
that led floating rate proponents to suggest that exchange movements
would be gradual if market forces were allowed free reign (Zis, 1989,
pp.2-5).

4 One may ask why these changes have taken place. In large part, the globalization
of international capital markets through technological innovation is to blame. Further-
more, declining profit rates and increasing competition among banks has made turn-
ing a profit at the exchange desk a priority (The Economist, 1987).
 EXCHANGE RATE DETERMINATION 65

The variables that are important in the determination of medium-term

expectations are
(2) E e,+" =f[BOCA" BOCA'" (r,-r,), (P,-p,'), (g,-g',)]
(-) (+) (-) (+) (-)
where E et+" is the current expectation of the medium-term value of the
exchange rate (domestic currency units per foreign currency unit) n time
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periods from the present; BOCA is the balance on current account; r is

the nominal interest rate; p is the rate of price inflation; g is the rate of
growth of aggregate output; and "*,, indicates "foreign. ,.5 The sign below
each determinant indicates whether a rise in that variable will cause a
domestic currency appreciation (-) or depreciation (+). All the signs are
fairly standard and self-explanatory, with the possible exception of the
last one. In this model it is assumed that the effect of a rising rate of
growth in a country-a likely characteristic of a healthy, vibrant econ-
om y-will have a greater effect on exchange rates through international
investment than through trade, and will thus attract more demand for
the home currency than cause supply.6
Equation (2) is a simplification in one very important respect. It implies
that the determinants of the expected exchange rate are the actual levels
and rates at time period t, when, in fact, the variables determining
medium-term exchange rate expectations would be the expected values
of the determinants at time period t. In that case, the independent
variables speCified in equation (2) are actually derived from other

5 Empirical support for all of the variables is provided by Hardouvelis (1988). In

general, however, price levels and price inflation do not perform well in exchange
rate models (Koch, Rosensweig, and Whitt, 1988; Hakkio and Pearce, 1985), and nei-
ther do growth rates and other measures of the business cycle. On the other hand,
these studies tend to be short run, so there may be no harm in including these vari-
ables at this stage.
6 Coincidentally, the monetary approach to exchange rate determination would also
suggest that a faster-growing economy might find its currency appreciating. There,
however, the mechanism is the rising transactions demand for money which, if not
met by the domestic monetary authorities, will be satisfied by the increased exports
and decreased imports of the domestic residents (in other words, their increased de-
mand for money causes them to "hoard"). On the other hand, a Keynesian analysis,
based usually on the assumption that the majority of currency trading would be for
import/export facilitation, would suggest that rising income will raise the demand for
imports and thus the demand for foreign currency. This, in turn, causes a domestic
currency depreciation. The latter has clearly not been the case (Zis, 1989, p. 4), and
the monetarist approach has enough problems in explaining the domestic macroeco-
nomy to make this explanation suspect (Davidson and Weintraub, 1973).
 66 JOURNAL OF POST KEYNESIAN ECONOMICS

values. This is shown by:

(3)
where XM represents the expected values of the set of determinants of
medium-term exchange rate expectations (the independent variables in
equation (2)); and YM is any information that might cause agents to
reevaluate the expected values of the variables represented by XM (YM
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includes the current known values of XM ). Equation (3), therefore,

reflects the effects of the often-cited "news" in exchange rate determi-
nation (Frenkel, 1981; Hakkio and Pearce, 1985; and Hardouvelis,
1988).7
An example of YM might be a public comment by the Federal Reserve
that they are biased against lowering interest rates over the next year.
This would imply that, if the United States is the domestic country and
Germany is the foreign, we can expect any r > ,. that may exist at the
present, in the absence of action by the Bundesbank, to remain over the
next year. On the other hand, news from the Fed that they fear recession
would signal that r > ,. may soon be reduced or eliminated. A less
straightforward example of YM would be the recent fall of the Berlin
Wall. This has presumably cued investors to the possiblility that, given
West Germany's position to exploit the liberalization in the Eastern
Bloc, g < g* (where West Germany is "foreign") may occur over the
long run. This partially explains the recent upward tendency of the
deutsche mark.8

Short-term expectations
Over the short-term it is possible for most of those agents using the
exchange rate as a means to an end to hedge against any possible adverse
movements. 9 Furthermore, those involved in portfolio investment, and
especially direct foreign investment and trade, will find that contracts
and physical circumstances make it difficult to shift from one country
to another, regardless of their expectations. Their movement will take
place only over the medium run.
7 Actually, the role of "news" is usually associated with the short-term volatility of
rates. While this will be held to be true later in this paper, in this instance short-term
volatility is not the object of analysis.
8 Schulmeister uses only the balance on current account and real interest rate differ-
ences in explaining medium-term movements, but arrives at very interesting results
nonetheless (Schulmeister, 1988, pp. 358-363).
9 Even then, it can be expensive (Horton, 1986).
 EXCHANGE RATE DETERMINATION 67

This leaves short-term movements to be determined by reserve asset

holdings and speculators. The determinants themselves are largely the
same as those outlined above:
(4)
E e I+m =f[BOCA t , BOCA * t' (rt-'t)' (Pt-P*t),(gt-g*t)' RULE, RUN],
(-) (+) (-) (+) (-) (?) (-)
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where E't+m is the expected value of the exchange rate m periods from
the present (m < n); RULE is the buy or sell signal given by the various
technical trading rules; and RUN is the number of consecutive time
periods E has moved in the same direction (the number is positive if E
has been rising, negative if it has been falling).lo Also, as above, these
determinants are really expected values:
(5)
where the subscript S denotes short run. Despite apparent similarities
between equations (2) and (4) with respect to those determinants they
have in common, there is a general tendency for the responsiveness of
the dependent variable to be greater in equation (4).11 In Davidson's
terms, the elasticity of expectations is higher.
Technical trading rules in foreign exchange trading (R ULE in equation
(4)) are both widespread and consistently profitable. Their effect on the
exchange rate is to make upturns and downturns more substantial than
they otherwise might be. Specifically, they contribute to the "band-
wagon effect" (Schulmeister, 1988, pp. 347-350). Consider the follow-
ing sequence of events:

"news" - . upward ~ buy DM ---. trigger ----.. buy DM

favorable revision "buy DM"
to DM of E't+m programs

Here, some event in the market causes market participants to expect a

rise in the value of the deutsche mark. For this example, let us say that

10 It was pointed out in note 8 that the support for including price and growth rates
may be a bit weak. Since the evidence is derived from models specified in different
ways from the present one. however. final judgment should be reserved until the pres-
ent theory is tested.
II In other words. the value of the partial derivative of the dependent variable with re-
spect to the common independent variables is greater in absolute value terms in equa-
tion (3) than in equation (1).
 68 JOURNAL OF POST KEYNESIAN ECONOMICS

the Bundesbank announces that ithas decided to attack Gennan inflation

vigorously, causing traders to expect higher interest rates. Depending
on the expected timing of the Gennan action, equations (3) and (5) (and
therefore equations (2) and (4» will be reevaluated, and the DM will be
expected to rise. This spurs traders to buy DM and therefore raises its
value (equation (1». As the DM appreciates, it may begin to pass those
levels at which technical trading programs indicate "buy." If they do
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buy, then more traders jump on the bandwagon and the DM soars even
higher. This force can work to increase depreciation as well.
Finally, RUN represents the cash-in effect (Schulmeister, 1988, p.
346). As the DM rises in the above example, for instance, the temptation
to sell will rise. Thus, as the DM appreciates, it can be expected that
negative "news" will carry more and more weight with traders, while
the impact of positive news will decline.
With both F:'+n and F:'+m defined, the model is complete. Recalling
equation (1), changes in F:t+n and F:t+m (since Et-l cannot change once
time period t-1 is past) will cause a change in the exchange rate. In
practice, most rate changes are likely to be the result of traders , reeval-
uation of F:t+m' while F:'+n provides a medium-run trend, dampening
movements away from F:'+n and magnifying those toward it (Schulmeis-
ter, 1988, p. 346).

Short-term volatility
It still remains to be explained why exchange rates are so volatile in the
short run. In tenns of the above equations, any volatility would be likely
explained by rapid reevaluation of the exchange rate expectations asso-
ciated with equations (4) and (5). Such rapid reevaluation is very likely
in an environment of uncertainty, historical time, and irreversible deci-
sion making.
Uncertainty implies that, given the multitude of detenninants that are
represented by Ys' only a small subset is ever known. Furthennore,
neither the relative importance of the known determinants nor the total
number of all determinants (if, indeed, such a concept is relevant) is
known. Combine this with the relative irreversibility of taking action,
which eliminates recontracting and helps put the model in historical
time, and the purchase and sale of foreign currency is seen in a new light.
Now, given the importance of making a decision (spurred by animal
spirits)-an irreversible one at that-and the guesswork involved in
detennining which decision to make, the stage is set for economic agents
 EXCHANGE RATE DETERMINATION 69

to attribute to each new piece of news much more weight than it would
deserve in a world of perfect certainty. As new information becomes
known, expectations are rapidly reviewed and altered, and actions soon
follow. Expectations are volatile, therefore actions are volatile, therefore
economic variables are volatile.

Medium-term misalignment
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One last feature of the international monetary system that has not been
properly addressed is the medium-term misalignment of exchange rates.
Typically, calling an exchange rate "misaligned" means that the country in
question has a persistent current account imbalance. Of course, the balance
on current account is only one of many factors considered as important by
traders. The term "misalignment" itself is a holdover from exchange
theories that assumed, either implicitly or explicitly, that the main demand
for foreign currency was trade-related. Were that true, then of course
persistent balance-of-payments disequilibria would correct themselves.
Another factor that may be at work is the passage of historical time, a
concept very familiar to Post Keynesian macroeconomists. Benninga
and Protopapadakis (1988) have found that modeling trade outside a
general equilibrium framework can, by itself, produce price and ex-
change rate movements that show no systematic tendency toward pur-
chasing power parity.

III. Conclusions
This model can explain all the salient features of the post-Bretton Woods
float, especially short-run volatility and medium-run misalignment. It
makes use of uncertainty, historical time, and irreversible decision making,
and shows these to be important features of the real world.
But one element is lacking: empirical verification. While the nature of
the short-run determinants may be such that they do not lend themselves
to statistical testing, it may be possible to examine the medium-run
determinants. Until this work is begun, however, perhaps the above
model offers a starting point for a Post Keynesian theory of exchange
rate determination.

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