8.4Alternative views of forex markets

Sadly for this view, however, empirical evidence tends to reject all of the international

parity conditions with the exception of covered interest rate parity. This leaves open

the question of how forex markets do, in practice, operate.

Three broad alternative approaches can be distinguished. The rst retains the

assumption of rational behaviour but through either assumptions of price rigidities or

the incorporation of some non-rational elements within a rational framework pro-

duces models in which exchange rates are subject to large swings and considerable

volatility. The second goes further and denies entirely the usefulness of economic

models in forecasting the behaviour of exchange rates and instead bases predictions

on past exchange rate trends and patterns. This is sometimes known as technical

analysis. The third approach stresses the psychology of markets and market particip-

ants and distinguishes among different types of participant in the market.

One example of attempts to make use of a standard economic model to explain

the highly volatile exchange rates observed in practice is overshooting exchange

rate models. These continue to assume the existence of long-run equilibrium rates

of exchange and incorporate both uncovered interest rate parity and purchasing

power parity. These models also typically assume rational expectations. Market par-

ticipants are assumed to make the best available use of all relevant information

and to employ the best available model for forecasting future exchange rates. They

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8.4 Alternative views of forex markets

are assumed to know what the long-run equilibrium exchange rate is. Nonetheless,

exchange rates are held to overshoot their long-run equilibrium positions. That is,

when the exchange rate is above its equilibrium, it will fall well below the equilib-

rium rate before once again rising towards equilibrium. Equally, a rising exchange

rate will rise above the equilibrium rate before falling back towards it. This result

is achieved by assuming that different elements in the model adjust at different

speeds. The best known such model was developed by the American economist

Rudiger Dornbusch (in 1976). It assumes that goods market prices adjust only slowly

in response to changes in demand and supply conditions (goods prices are said to be

sticky) while asset markets adjust instantaneously and can be assumed to be always

in equilibrium.

Then the effects of an increase in the domestic money supply can be traced.

Everyone knows that in the long run equilibrium prices will be higher and the value

of the currency lower, to reect purchasing power parity. However, initially prices

do not adjust and with no price changes, interest rates must fall by a long way to

restore equilibrium in the money market. Capital ows out of the country and the

exchange rate falls dramatically, well past the long-run equilibrium position. It con-

tinues to do so until agents can see that the loss of income from holding funds in

the country due to lower interest rates will be offset by a future rise in the exchange

rate back to equilibrium. At this point, we reach a temporary equilibrium in which

aggregate demand is greater than aggregate supply but in which prices remain at.

The pressure of demand on supply then slowly pushes prices up, the demand for

money increases as a result, and both interest rates and the exchange rate are pushed

back up towards their long-run equilibrium position. This and other similar models

are of interest to economists, but empirical tests do not provide strong support for

them. A rather different set of models attempts to account for ‘bubbles’ – sudden and

apparently inexplicable jumps in the value of a currency – while continuing to argue

that the market is characterised by rational behaviour.

Yet other models reject the notion of rational behaviour and argue that much

trading in forex markets is based on ‘noise’ and that this results in excessive volatility.

Another possibility is to assume that different types of participants behave in differ-

ent ways. For instance, a model developed by Frankel and Froot (in 1990) divides

forecasters into fundamentalists and chartists. Chartists are people who make use of

technical analysis – attempting to forecast on the basis of past trends and patterns

which they identify in the charts of exchange rate movements that they construct.

Box 8.4 indicates some of the features of exchange rate behaviour of interest to

chartists and the extent to which market practitioners often combine fundamentalism

and chartism.

Another approach divides speculators into those who think short term (which in

this context refers to one week or less) and those with long-run horizons (up to three

months). It is then suggested that the short-termers hold extrapolative expectations

(assuming that an exchange rate will continue in the direction in which it is currently

moving) while the long-termers have regressive expectations (assuming that an

over-valued/under-valued currency will fall/rise back to its equilibrium level). Much

then depends on which group dominates the market at any particular time.

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Chapter 8 • Foreign exchange markets

Box 8.4Forecasting foreign exchange rates with the use of charts

Forecasters who make use of charts of past foreign exchange rates are attempting only

to forecast the very short term. This assumes that current demand and supply condi-

tions can best be understood by examining the way exchange rates have been moving.

Forecasting is based principally upon three elements in the charts:

(a) Trends

Whether an exchange rate has been rising or falling and the gradient of the trend – relatively

at trends are regarded as being more sustainable, steep trends as more volatile and sub-

ject to change. Trends can be established by constructing a channel of two parallel lines

which encompass all the exchange rate movements. If an exchange rate then breaks out

of its current channel there is a suggestion that the present trend is about to be reversed.

Analysis of trends can be supplemented by calculation of moving averages.

(b) Support and resistance levels

A support level is a rate at which the currency appears to be strongly demanded. Thus,

it is difcult for the exchange rate to fall below this level. A resistance level is the reverse

– a rate that it is difcult for the currency to rise above. Support and resistance levels thus

establish the width of the current channel in which the currency is trading. It is usually

felt that if support or resistance levels are breached, the currency will fall sharply below

the previous support level or rise sharply above the prior resistance level.

(c) Pattern recognition

This is just the recognition of visual patterns in the chart – either continuation patterns

(including ‘ags’ and ‘triangles’) which suggest that the rate will continue to follow its

current overall tendencies, or reversal patterns (such as ‘head and shoulders’). In addi-

tion, chartists make use of information on momentum(the speed at which exchange

rates change) and velocity(the rate of change of moving averages of exchange rates).

The following examples of nancial journalism show how fundamentalism and chartism

may be combined:

(i)

Marc Chandler at HSBC said technicals1 supported the dollar’s move after the euro closed on Monday below trend-line support drawn through the December and January euro lows. Mr Chandler added that news of Moody’s2 decision to downgrade South Korea’s outlook to neg- ative later weighed on the dollar. FT Financial Times, 12 February 2003

(ii)

The euro saw a urry of excitement after unexpectedly weak US consumer condence numbers sent the dollar sharply lower. It reached $1.082 but the rise was brief as comments by Hans Blix, chief United Nations weapons inspector, lifted the dollar once more. The euro stood at $1.078 by midsession in New York, consistent with its levels ahead of the data. Mr Blix allayed fears of imminent war when he said Baghdad was complying with UN requests. However, despite the day’s excitement, the pair remained in a range, a trend analysts said was likely to continue. FT Financial Times, 26 February 2003

¹Technicals are those who follow technical analysis.

²Moody’s is a major risk assessment rm. Here it had changed its rating of investments in

South Korea, suggesting that they were riskier than had previously been indicated.

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		8.5 Fixed exchange rate systems
8.5	Fixed exchange rate systems

One way of attempting to overcome the problems associated with volatile exchange

rates is for governments to enter into xed exchange rate systems in which central

rates or parities are established for each country’s currency and each central bank

has an obligation to buy or sell its own currency in order to maintain its exchange

rate within a band of agreed width around its central rate. A xed exchange rate

system will normally contain some provision for adjustment of central parities if

exchange rates are believed to have moved out of line with economic realities. Clearly,

however, exchange rates can be regarded as xed only if such adjustments of central

rates occur relatively infrequently.

Since parities can change, xed exchange rate systems do not remove the possibility

of speculation. Indeed, it is often argued that life is made much easier for speculators

since a weak currency can only remain unchanged or be devalued. Speculation against

a currency carries little risk of loss. The debate over xed versus exible exchange

rates has many elements and belongs properly in an international economics textbook.

However, Box 8.5 summarises the principal points on both sides.

Box 8.5

Fixed versus oating exchange rates

Points in favour of oating exchange rates

lThey allow continuous adjustment to change in the relative real strengths of economies.

lThey allow countries to retain control over their own monetary policy.

l	Hence, a oating exchange rate system reduces the number of policy targets govern-ments are attempting to achieve and improves the balance between targets and instruments.

l	With oating rates, the country is insulated against external shocks of all kinds.
l	There will be less need for a country to hold international reserves.

l	With xed exchange rates, there is the problem of the rate at which it is xed. As withany other form of government intervention, incorrect decisions regarding the exchangerate impose heavy costs on the economy.

l	Floating rates will tend towards long-run equilibrium and be relatively stable. Speculationis assumed to be stabilising.

l	Fixed exchange rate systems are asymmetrical in the sense that they force action on decit countries, which are likely to respond with barriers to trade, interfering with comparative advantage as the basis for trade, lowering efciency of resource use and lowering rates of economic growth.

Points in favour of xed exchange rates

l	Changes in exchange rates are not a good way to overcome balance of payments problems.

l	Fixed rates of exchange enforce a discipline on domestic economic policies.

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Chapter 8 • Foreign exchange markets

l	Floating rate systems have an inationary bias because there is an asymmetrical effect between countries with depreciating and appreciating currencies.

l	Speculation may be destabilising.

l	Thus, oating exchange rate systems are likely to be unstable and produce a great deal of uncertainty for traders.

l	If falling exchange rates do not work to solve balance of payments problems quickly, reserves will still be needed in a oating system.

l	The market exchange rate will be determined by the whole balance of payments (capital and current accounts) but this may not be in the long-term interest of the economy.

l	Floating exchange rates allow manipulation of exchange rates in a country’s own interests and this leads to competitive devaluations and attempts to export unemploy- ment to other countries.

l	Fixed exchange rates lead to reduced uncertainty regarding goods prices and lower risk premiums on interest rates. This, in turn, leads to better investment decisions abroad.

One step beyond a xed exchange rate system is a monetary union in which a

number of independent countries adopt a single currency. Monetary unions have

existed in the past and modern examples can be found among former French colonies

in Africa. However, by far the most important so far established is the monetary

union that began operating among eleven of the fteen members of the European

Union on 1 January 1999, providing the second element of EMU (Economic and

Monetary Union) in Europe. Greece became the twelfth member in January 2001.