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D E E C O N O M I S T 129, N R .

3, 1981

E X C H A N G E R A T E D E T E R M I N A T I O N AND THE BALANCE


OF PAYMENTS, A T H E O R E T I C A L F R A M E W O R K

BY

P.B. D E R I D D E R *

1 INTRODUCTION

In the early 1970s, the Bretton Woods system of fLxed parities collapsed and
exchange rates began to float. Since then, many publications have drawn
attention to the issue of how exchange rates are to be determined in a world
with floating rates.
Purchasing power parity theory, portfolio analysis applied to international
capital flows, and the monetary approach to the problem of floating
exchange rates are the mainstreams in exchange rate literature. The work of
Lybeck and J/irnh~dl [9], Bflson [4] and the Optica Report [10] of the EC
Secretariat are examples of the purchasing power parity approach. In fact, the
monetary approach to the exchange rate is also based on the purchasing
power identity. Among others, Frenkel [6], Tullio [13], and again Bilson
[4] have found empirical evidence for this view on the causes for exchange
rate variability. Finally Armington [1], Brillembourg and Schadler [3] and
Artus [2] developed exchange rate models inspired by the theory of optimal
portfolio selection.
It would go beyond the scope of this paper to review all these articles. 1
The main purpose is to formulate a synthesis between the theory of optimal
portfolio selection and the purchasing power parity analysis. Therefore, a
model for the balance of payments is constructed in which the current
balance is distinguished next to the capital account. For the sake of
argument, a rather high level of abstraction is chosen and no attention has
been paid to the dynamic properties of the model.
In Section 2, the current account model is described. In Section 3, the
determinants of capital imports and exports are considered, while Section

* Formerly, Central Planning Bureau, The Hague.

1 Recently Bilson [5] published an excellent survey on the subject.


374 P.B. DE RIDDER

4 deals with the integration of both models. Finally in Section 5 some con-
cluding remarks are made.

2 THE CURRENT ACCOUNT AND THE EXCHANGE RATE

The current account model provides a description of exports and imports of


goods and services. Another equation defines the change in international
reserves held by the central bank. As stated before, the model is kept static,
which in this case means that adjustment processes are instantaneous. 2

B=8.1 +81(8+8) exports in current prices (2.1)


M = M. 1 -I- M.1 (Pn -I- /~l - ~ ¢ ) imports in current prices (2.2)
SL =B-M current balance (2.3)
Z, = 1 + volume of exports (2.4)
= + + volume of imports (2.5)
AIR = SL change in official reserves (2.6)

where,

p = domestic price level


pl = foreign price level
k = exchange rate
mw = world trade
v = total expenditure

With world trade, relative prices, and total expenditure being exogenous, the
model seems to be underdetermined. However, it depends on what system Of
exchange rate determination is assumed whether the change in official re-
serves or the rate of exchange is an endogenous variable. In a system of fixed
parities, the change in international reserves is completely determined by the
balance of exports and imports. Under these circumstances any surplus or
deficit on current account will be absorbed or financed by the monetary
authorities. If, on the other hand, exchange rates are permitted to float
without any limits, the change in international reserves will be zero. In other

2 All variables refer to levels, except those with a dot, which refer to relative first differ-
ences. Capital symbols refer to values, small symbols to volumes or prices.
EXCHANGE R A T E D E T E R M I N A T I O N 375

words, foreign exchange market equilibrium, which in that case is identical


with equilibrium on current account, will be accomplished by exchange rate
movements only.
Finally, the model also provides a description of managed floating. In that
case, both official intervention by the central bank, i.e., exogenous changes in
official reserves, and endogenous changes in the exchange rate bring about
equilibrium in the exchange market. In these circumstances, however, equili-
brium does not necessarily imply that the current account is in balance too.
In order to see what the fundamental sources of exchange rate variability
are in an economy lacking substantial exports and imports of capital, the
model is solved for the exchange rate:
1
= -(~_b 1) + [(m°w-~) +
a+~-I
SL - 1 AIR
l (2.7)
B-1 B-1

Looking at eq. (2.7), three sources of exchange rate variability can be distin-
guished. First, let us consider official intervention. It is not surprising, of
course, that an increase in international reserves, that is to say an increased
demand for foreign currencies, will cause a depreciation. From eq. (2.7), how-
ever, it can be seen that a policy of exchange rate stabilisation through direct
intervention becomes harder to implement the higher the price elasticities of
exports and imports (a +/~) are.
Apart from changes in international reserves, two other kinds of deter-
minants of exchange rate variability can be distinguished. 3 One is the so-
called "real source of exchange rate movements." If, for instance, inter-
national demand falls relative to domestic demand, i.e., an ex ante deficit
on current account, the currency in question will tend to depreciate relative
to others. Another example is the exploitation of natural resources such as oil
and gas. Under these circumstances, an ex ante surplus on current account
will occur, followed by appreciation.
Finally, it is also possible to distinguish pure nominal exchange rate
changes. These arise when the rate of inflation differs between countries.
For instance, if the rate of inflation in the Netherlands is below that of its
trading partners, the guilder will appreciate vis ?tvis those trading partners.
The reason why in these circumstances an appreciation of the guilder occurs

3 For an analogous way in treating the various sources for exchange rate variability, see
also Korteweg, [7] and [8].
376 P.B. DE RIDDER

is obvious. Due to a lower rate of inflation, the competitive position of Dutch


industry improves, which in turn leads to a rise in exports, a fall in imports
and thus to an improvement of the current account. With no intervention
of monetary authorities such as ex ante surplus, i.e., an excess demand for
guilders, involves an upward-moving exchange rate in order to achieve a new
current account equilibrium.

3 PRIVATE CAPITAL FLOWS AND THE ECHANGE RATE

In this section a theoretical model is constructed according to the analysis of


portfolio management. Only private capital flows are considered, implying
that monetary authorities are assumed to have full control over foreign
activities of the banking system.
Let us consider an economic agent seeking to invest his wealth in two
kinds of assets, foreign and domestic. The utility he gets back from those
assets depends not only on its possession, but also on the fact that they are
capable of supplying the investor with an income. Therefore the utility func-
tion is of the following shape 4:
k
U = (~.(1 + r*) 1¢ip + ( 1 - ~ ) ( 1 + r~)~,W~ p yl/p
-1 <p <0 (3.1)

where,

U = utility
W1 = domestic assets of residents
W2 = foreign assets of residents
r* = expected rate of return
k* = expected exchange rate
k = spot rate.

For a given period of time the investor wishes to maximize his utility sub-
ject to the following constraint:

W = W1 + W2 total wealth. (3.2)

4 A same type o f CES-function can be found in Steinhauer and Chang [12] and PaUada
[11].
EXCHANGE RATE DETERMINATION 377

The first order condition for a maximum states:

1 -X 1 + r2* k }l/O+p) W1 (3.3)


W2 = { "- -
X 1 +r~ /~
Substitution of eq. 3.2 in eq. 3.3 and taking first difference leads to an ex-
pression for capital exports:
W2 1 W~
AW2 = { A ( r ~ - r { ' ) + Ic-~c*)+ ' AW (3.4)
W1 1 + p Wt
It is obvious that capital imports can be treated in the same way, so that the
balance of imports and exports of capital may be taken as:
X W2 1
SK--aX2-zxw : (.2.. +
-X + W
)
l+p
{A(r -rD

X2
+ (--~- A X - - ~ AW}, (3.5)

where,

SK = capffal account
AX2 = capital imports
x2= domestic assets of non-residents
.X = total wealth of non-residents

From eq. (3.5) it appears that a rise in domestic interest rates leads to net
Capital imports, as does an anticipiated appreciation. In both cases, an ex-
pected improvement in future revenue causes a slfift towards domestic assets.
A rise in the spot rate, on the other hand, will initiate net capital exports, be-
cause asset holders expect to realize some capital gains. Finally, one can also
see from eq. (3.5) that a difference in the rate of wealth accumulation may be a
source of imbalance.
In the same way as in Section 2, the model is completed by the assump-
tion that in principle any surplus or deficit on capital account will be offset
by a change in international reserves. Taking the two equations together,
assuming equal rates of wealth accumulation at home and abroad, an expres-
sion for the exchange rate can be obtained:
X W
= ~* + A (r~ - r~) - (1 + p ) ( +~ ) AIR (3.6)
X2 W~
378 P.B. DE RIDDER

Without any official intervention, eq. (3.6) defines the well-known interest-
parity rule, which is common knowledge in forward exchange practice. If,
for instance, market participants expect an appreciation of the currency,
i.e., to* > 0, they will buy assets denominated in that currency in order to
realize some capital gains. This increased demand in turn drives up the spot
rate, until it equals the expected exchange rate again. In that case, no incen-
tive is left for further speculation, so that exchange market equilibrium is
restored. It goes without saying that along the same lines changes in interest
rate differentials will be absorbed by the economy through adaption of the
exchange rate.
Finally eq. 3.6 shows that official intervention is an instrument through
which the spot rate can be managed. The extent to which this occurs de-
pends, apart from the available quantity of international reserves, on the
degree of capital mobility. The latter is determined by the elasticity of sub-
sitution (1/1 + t9) and the degree of international integration of capital
(X2 /X and W2/W). Insofar as direct intervention is considered, exchange rates
become less manageable when capital mobility increases, that is to say when
the elasticity of substitution and the degree of international integration of
capital become higher.

4 THE BALANCE OF PAYMENTS AND THE EXCHANGE RATE

In the foregoing two sections, attention has been focussed on the separate
relationships between the exchange rate on the one hand and trade and
capital flows on the other. In this section those pieces are put together into
one simultaneous model.
Summing up the relevant equations, we get:

SL = SL. 1 + ~ (rnw - v ) - ~ (or + [J- 1 ) 6 - p 1 + It) (4.1) 5

SK = 7{A (r~' --r~) + ~c* -- Ic} (4.2) 6

A I R = SL + SK (4.3)

5 6 = B. 1 ~- M_ 1

X2 W2 1
6 ~¢= ( - - + - - ) . - -
X W l+p
EXCHANGE RATEDETERMINATION 379

In the case of managed floating, i.e., of exogenous international reserves,


this model yields a reduced form equation for the exchange rate:
1
k = [- A I R + SL_ 1 + ~ (17~w - ~ ) ) -
+ t -l) + v
- 5 (or + /~- 1)(/~-/~ 1) +

+ v (A(r - + ] (4.4)

A closer look at this expression shows that linking both models leads to the
same qualitative conclusions as derived separately in the foregoing sections.
The relationship between the exchange rate and its determinants, however,
has become more stable. That is to say: the exchange rate has become less
sensitive to chan~es in its determinants. This may be demonstrated by
comparing, for instance, the first derivative of ~c with respect to/3 in eq. (2.7)
with the one in eq. (4.4). From eq. (2.7) it follows:
al
a/~ - 1, (4.5)

where from eq. (4.4) one can compute a first derivative which is less than
unity:

o = - > - 1 (4.6)
3p 5(a + ¢/-1) + 7
More important, however, than this increased stability is the general conclu-
sion which can be drawn from the integration of both models. In theory, it
seems possible to explain exchange rates simultaneously by purchasing power
parity theory and by the theory of optimal portfolio selection.

5 SUMMARY AND CONCLUDING REMARKS

This paper demonstrates the construction of a theoretical model for the


balance of payments, with special attention to the exchange rate. It seems
possible, ignoring for the sake of argument the dynamic characteristics of
foreign trade and international capital flows, to integrate purchasing power
parity theory with portfolio analysis into one theoretical framework. From
this, it follows that the variability Of exchange rates depends on real pheno-
mena, like international differences in economic growth and exploitation of
natural resources, as well as on nominal phenomena, i.e., changes in relative
380 P.B. DE R I D D E R

prices of internationally tradeable goods and services. Apart from these,


monetary sources of exchange rate variability should also be distinguished:
that is to say, changes in interest rate differentials as well as in exchange rate
expectations.
Finally it may be noticed that, apart from other (monetary) policy
measures, excess demand or supply of a currency can be sterilized by a
countervailing change in international reserves. In other words, official inter-
vention is one, but not the only, instrument to cope with undesired exchange
rate changes.

REFERENCES

[ 1] Armington, P., A Multilateral Dynamic Model of Exchange Rates and Short-term


Interest Rates, Paper presented at the VIth International Conference of Applied
Econometrics, Rome, 1979.
[2] Artus, J.R., "Exchange Rate Stability and Managed Floating: The Experience of
the Federal Republic of Germany," IMF-StaffPapers, XXIII (1976).
[3] Brillembourg, A. and S.M. Scliadler, A Model of Currency Substitution in Ex-
change Rate Determination, 19 73-19 78, Paper presented at the VIth International
Conference of Applied Econometrics, Rome, 1979.
[4] Bilson, J.F.O., "The Monetary Approach to the Exchange Rate: Some Empirical
Evidence," IMF-StaffPapers, XXV (1978).
[5 ] - - "Recent Developments in Monetary Models of Exchange Rate Determina-
tion," IMF- Staff Papers, XXVI (1979).
[6] Frenkel, J.A., "A Monetary Approach to the Exchange Rate: Doctrinal Aspects
and Empricat Evidence," Scandinavian Journal of Economics, 78 (1976).
[7] Korteweg, P., "The European Monetary System - Will It Really Bring More
Monetary Stability for Europe," De Economist, 128 (1980), pp. 15-49.
[8] - - Exchange Rate Policy, Monetary Policy and Real Exchange Rate Varia-
bility, Paper presented at the Conference on Exchange Rate Policy, London,
1980.
[9] Lybeck, J.A. and B. J~/rnh~ll, A Simultaneous Model o f Capital Flows, Exchange
Rates, Interest Rates and Prices o f Traded Goods: Theoretical Considerations and
Estimations by Alternative Techniques, Paper presented at the Vlth International
Conference of Applied Econometrics, Rome, 1979.
[10] Optica Report, Inflation and Exchange Rates: Evidence and Policy Guidelines
for the European Community, Brussels, EC Commission, 1976.
[11] PaUada, F.W.M., De substitutie tussen monetaire vermogenscomponenten, Occa-
sional Paper no. 21, Central Planning Bureau, 1980.
[12] Steinhauer, L. and J. Chang, "On Measuring the Nearness of Near-moneys: Com-
ment," American Economic Review, 62 (1972).
[13] Tullio, G., "The Fluctuations of the Price of Italian Banknotes in Zurich: An
Econometric Analysis," Kyklos, 31 (1978).
EXCHANGE RATE DETERMINATION 381

Summary
EXCHANGE RATE DETERMINATION AND THE BALANCE OF PAYMENTS,
A THEORETICAL FRAMEWORK

In order to distinguish the more fundamental determinants of the exchange rate, a static
model for the balance of payments is constructed. From this theoretical exercise it
follows that the exchange rate is determined by three kinds of phenomena: first, real
phenomena such as exploitation of natural resources and the relative level of economic
activity; second, nominal phenomena such as relative prices; and finally, monetary
phenomena such as interest rate differentials, exchange rate expectations and official
intervention.