ASSETS MARKETS, THE CURRENT ACCOUNT AND EXCHANGE RATE DETERMINATION: AN EMPIRICAL

MODEL OF THE STERLINGIDOLLAR RATE 197 3 - 1983 ''

COLM KEARNEY and RONALD MACDONALD

University of N e w South Wales University of Aberdeen

I. INTRODUCTION

The asset market approach to explaining the determination of the exchange rate is now firmly established in international macroeconomics. According to this view, the short-run behaviour of the exchange rate is determined by conditions of instantaneous equilibrium in the markets for financial assets. The exchange rate in turn constitutes a principal determinant of the balance of payments on current account which equals the economy's net accumulation of foreign assets. The pioneering work in this area has been performed by Branson (1977), Dornbusch and Fischer (1980) and Rodriguez (1980). Recent theoretical advancements within this approach to exchange rate determination have emphasized t k extent to which developments in the markets for goods and services have important implications for the unfolding of events in the markets for financial assets. The work of Branson and Buiter (1983), Greenwood (1983) and Kawai (1985) has been particularly noteworthy in this regard.

Greenwood (1983) illustrates how unanticipated improvements in current real income which are perceived to be temporary in nature will lead to appreciation of the exchange rate and improved current account balances. If the higher real incomes are expected to persist, however, exchange rate appreciation will be accompanied by worsening current account balances. In a similar vein, Dornbusch and Fischer (1980) show how anticipated disturbances which ultimately depreciate the exchange rate, can initially cause it to appreciate while the current account is in deficit. Related work by Kawai (1985) demonstrates the complexity of adjustment dynamics which govern the responses of income, the current account balance, and the rate of exchange to changes in the stance of fiscal policy. The predications of this work include cyclical adjustment of income t o fiscal policy and the possibility of gradual rather then instantaneous overshooting of the foreign exchange rate. These authors have demonstrated the extent to which the relationship which exists between the current account balance and the rate of exchange depends in a fundamental way on the nature of the disturbances which impinge upon the macroeconomy.

"'This is a revised version of a paper presented to the 15th Conference of Economists, Monash University, Melbourne. We are grateful to the participants who provided many helpful suggestions.

213

214 A U S T R A L I A N E C O N O M I C P A P E R S D E C E M R E R

Empirical analysis of the relationship which exists between the variables under present discussion has not kept pace with the rate of theoretical advancement. The purpose of this paper is to contribute towards redressing this imbalance. The next section formulates a small structural model of an open economy which operates a managed exchange rate regime. The model consists of an asset sector which lies firmly within the spirit of the portfolio balance approach to explaining the determination of the exchange rate, and this is accompanied by a real sector which solves for the current account balance together with income and prices. Unlike the theoretical analyses mentioned above, however, the model presented in this paper pays explicit attention to the authorities’ intervention behaviour in the foreign exchange market. The importance of explicitly incorporating the consequences of interventionist behaviour in models of the determination of the exchange rate has become paramount in recent times insofar as many governments (including those in Australia, Britain, Europe and the US.) have moved away from clearly floating regimes towards greater exchange rate management.

The paper outline is as follows. The next section describes the model formulation which determines the exchange rate, while highlighting the features which distinguish it from the more conventional type of portfolio balance approach. In Section I11 the model is subjected to empirical testing. This is accomplished using quarterly British data over the recent period of managed floating exchange rates from 1973. The move from fixed adjustable to clearly floating exchange rates in Australia during the early 1980s followed by the more recent trend towards sustained market intervention policy has constituted a number of profound policy changes which impedes our ability to estimate the model on data from this country. Nevertheless, the results which are presented in this paper are of interest in their own right as well as being directly relevant for the emerging Australian context. Section IV subjects the estimated model to simulation experiments in order to examine how the important endogenous variables respond to various economic disturbances. The motivation for this examination stems from the theoretical work referred to above which concludes that empirical studies of the current account balance and the exchange rate will not uncover reliable and stable relationships unless the sources of the disturbances which affect these variables are explicitly modelled. Two disturbances are investigated. A domestic policy-induced fiscal expansion which is financed by issuing debt is shown to generate small cyclical output responses coupled with larger cyclical current account and exchange rate responses. An increase in foreign prices induces exchange rate and current account responses which are moderated by the authorities’ intervention behaviour, while non-instantaneous overshooting of the type outlined by I<awai (1985) occurs in both cases. Finally, Section V summarizes the paper and draws conclusions,

11. THE M O D ~ - L

Although the asset market approach to explaining the determination of the exchange rate is now generally accepted, a number of variants of the approach have been adopted which correspond to different views about the substitutability of goods and assets. The flex- price monetary approach developed by Frankel (1976) and Bilson (1979) assumes that domestic and foreign bonds are perfect substitutes and that asset portfolios adjust instanta- neously t o their desired levels. Uncovered interest parity is thus assumed to hold along with conditions of purchasing power parity (PPP). The fixed-price monetary approach developed by Dornbusch (1976), Frankel (1979) and Drisltell (1981) relaxes the

1988 ASSETS MAKKETS, CURRENT ACCOUNT, E X C H A N G E RATE DETERMINATION 2 15

assumption that PPP obtains in the short run. In addition, the portfolio-balance model developed by Branson (1977) and Kauri and De Macedo (1978) relaxes the assumption that non-money assets are perfect substitutes.

Empirical implementations of the various asset market models have, however, yielded mixed degrees of success. Bilson (1979) reports successful estimates of the flex-price monetary approach for the German marl<-US dollar and the German mark-UI< sterling exchange rates. Frankel (1979) and Drisltell (1981) report similarly for the fixed-price monetary approach on the German mark-US dollar and Swiss-franc-US dollar exchange rates. Branson, Haltunen and Mason (1977) report encouraging results from estimating a reduced-form version of the portfolio balance model for a number of exchange rates employing cumulated current account surpluses as proxies for foreign assets. More recent empirical evidence, however, using a longer time span and a greater selection of currencies casts considerable doubt upon the reduced-form, asset-market models of exchange rate determination. Tests by Dornbusch (1979), Franltel (1983), Hacche and Townend (1981) and MacDonald (1983) all conclude that reduced-form, asset-market models have failed to explain recent exchange rate behaviour.

Can we explain the apparently poor empirical performance of these models? There are three main areas in which simple reduced-form, asset-market models of the exchange rate are deficient. First, there has been tendency to ignore the simultaneity that clearly exists in such reduced-form equations. The current experience with floating exchange rates has been one in which monetary authorities have intervened, at times substantially, in foreign exchange markets. Researchers have only recently allowed for the potential simultaneity of the money supply in their exchange rate equations by using instrumental variable estimation techniques. It is more appropriate, however, to allow for the potential simultaneity of all the RHS variables such as real income, prices and interest rates as well as the supply of money. Ignoring such potential endogeneity causes acute problems of simultaneity and spurious correlation. Second, not only are the variables in a reduced- form, asset-market model all potentially endogenous, they are also potentially interrelated. For example, the simple flex-price monetary approach predicts that a one per cent increase in the money supply will depreciate the exchange rate by the same amount. A similar increase in real income (or reduction in the rate of interest) will result in an exchange rate appreciation of one per cent times the income (or interest rate) elasticity. Such inferences are not valid if the relevant variables are causally related, which they undoubtedly are in reality. Thus the effect of a change in the money supply on the rate of exchange may be reinforced or offset by accompanying changes in real income and interest rates and one cannot say which is the more important until a more sophisticated and complete structural model has been properly specified, Finally, most empirically implemented asset market models have ignored the existence of adjustment lags. This does not concur with the evidence which is now persuasive of the non-applicabilityof PPPover short periods of time coupled with the existence of significant adjustment lags in financial asset demand equations.

The model which forms the basis of our econometric analysis is designed to overcome these problems. Table I provides the details. Equations (1)-(3) present the demands for money, domestic bonds and net foreign assets by domestic private residents. The latter is defined as the domestic demand for foreign currency denominated assets net of foreign demand for domestic currency denominated assets (see Branson (1977) and Branson,

216 AUSTRALIAN E C O N O M I C PAPERS

T A n L E I

Structural M o d e l Outline

- -

E ~ = R (- -, -, -, r , r ',. + AS ) s,Fd y y:> A A c' ,_

P P' p" p p:::

R = i (AS , - S , n ) -

A - * S.P': P P

Y = j (APSD, -, Y , r , --)

- w s .p* CUR = k ( Y , Y", - -)

P' P

W P

A W = 1 (--, S.P;':, APE, a )

AP = M (W, S.p", 6)

S.AF = CUR - A R

A = M + B + S.F - fi

M + B = p m - B:: - R - ,ij

M D = M

F D = F

I1 EC E M HE R

Symbols have the following meanings:

M = money defined as currency plus D - L

B = domestic bonds held by domestic residents

D = domestic private sector bank deposits

(B" = domestic bonds held by overseas residents)

(3)

(4)

( 7 )

(9)

1988 ASSETS MARKETS CUIIlIt2N1 ACCOUZ r f Y C H A N G E RATE D t r t K’LIIN ITIOh 217

bank lending to non-bank private sector

other private sector net liabilities

net foreign assets denominated in foreign currency

private sector net financial wealth

domestic income

wages

prices

balance of payments on current account

foreign exchange reserves

outstanding public sector debt

banks’ ‘switched’ position plus their net overseas and nondeposit liabilities

rate of unemployment

spot exchange rate defined as the domestic currency price of a unit of foreign exchange (s = target rate)

yield on domestic bonds

In addition, superscripts ‘D’, ‘e’ and ’ ’ denote respectively the demand for, the expected value of, and the foreign magnitude of a variable while a bar over a variable indicates that it is determined exogenously to the model Details on the sources and derivation of these variables and the model identities from the published statistical tables are provided in the data appendix.

Haltunen and Masson (1977) for theoretical and empirical examples of this specificational procedure). All asset demands are posited in real terms and are hypothesized to depend positively on real income and financial wealth. In addition, the demand functions depend positively on own rates and negatively on cross rates of interest. The net foreign asset is denominated in foreign currency so that its domestic demand is multiplied by the rate of exchange in order to convert it to home currency units.

Equation (4) describes the authorities’ intervention behaviour in the foreign exchange market. The IMF’s “Guidelines for Management of Floating Exchange Rates” recognises the existence of two types of intervention: the so-called ‘leaning against the wind’ option by which the authorities act to resist the influence of market forces on the exchange rate, and smoothing operations which are performed on a daily basis to smooth erratic movements in the rate. It is commonly known that the monetary authorities in many countries including Australia, Canada, Germany and the U.K. have engaged in both of these types of foreign exchange intervention behaviour, and equation (5) is specified in order to capture these effects, More specifically, the first term reflects the design of Wonnacott (1965) to capture ‘leaning against the wind’ behaviour, the second term reflects the design of Artus (1975) to test for the existence of some exchange rate target, (deviations from which lead to

218 AUSTItALIAN ECONOMIC PAPERS DECEMBER

vigorous intervention) while the third term tests for the existence of ‘beggar-your neighbour’ policies. Kearney and MacDonald (1986) provide further evidence on the intervention and sterilization behaviour of the U.K. authorities during the recent period of floating exchange rates.

The income equation (5) is derived from the standard Keynesian specification of goods market equilibrium. The APSD term enters the equation to approximate the government’s fiscal stance, while real wealth and interest rates are expected to impinge upon consumption and investment behaviour in influencing income. In addition, foreign income and the real exchange rate enter the equation which is designed to constitute an improvement over the more usual assumption of exogenously-determined income in empirical implementations of the asset-market model. The absence of a monetary growth term in this equation may be conspicuous, but reflects the results of previous research by Laidler and O’Shea (1980) and Kearney and MacDonald (1985). The balance of payments on current account is described by equation (6). It is determined by relative income, relative prices, domestic wages and the rate of exchange.

The wage price nexus of the model is presented in equations ( 7 ) and (8). There are essentially two theories of the determination of wage inflation. The expectations- augmented Phillips curve approach emphasises the influence of market forces on the rate of wage inflation while the real wage resistance hypothesis asserts the importance of institutional factors in determining wage inflation. We follow Sargan (1980) in specifying an eclectic wage equation in which the intitial specification contains both views of the wage determination process nested within it. Unlike Sargan, however, our equation contains a foreign price term because it seems appropriate to expect wage bargainers who reside in open economies to be sufficiently sophisticated to realise the real wage consequences of fluctuations in foreign prices and in the rate of exchange. The price equation is quite conventional insofar as it follows the contributions of Dicks-Mireux (1961d), Lipsey and Parltin (1972) and Sargan (1980). Prices are accordingly related to wages and import costs with a possible role for the level of unemployment as a pressure variable. This wage-price sector is recognizable as constituting a considerable improvement over the standard purchasing power parity assumption which is common in less sophisticated models of exchange rate determination.

Identities (9)-(13) complete the model specification. The first of these defines the capital account of the balance of payments as the sum of the current account deficit plus the change in official holdings of foreign exchange reserves. The latter would be equal to zero under a freely floating exchange rate regime but is determined by equation (4) in the present analysis. Identity (10) defines the private sector’s net financial wealth as the sum of its assets less its debts. This identity renders one of equations (1)-(3) redundant and we have accordingly dropped the domestic bond equation (2) from the estimation. Identity (1 1) presents the government’s budget constraint which in first difference form explains how the fiscal deficit net of foreign exchange reserves must be financed either by monetary expansion or by the creation of debt.

Equations’ (12) and (13) describe the equilibrium conditions in the markets for domestic money and net foreign assets. Only two of identities (9)-(11) are independent because the sum of global financial wealth is equal to zero. The model therefore consists of eleven independent equations (z.e. equations (l), (3)-(8), two of (9)-( 11) and (12)-( 13)) which

1988 ASSETS MARKETS, C U R I W N T ACCOUNT. E X C H A N G E w m D E T E R M I N A T I O N 219

solve for eleven endogenous variables: three assets ( M , B and F ) , four prices ( W , P , rand S) together with wealth, income, the current account and the level of foreign exchange reserves (W, Y , CUR and R ) .

A general description of the operation of the model is as follows. Wages and prices are determined on a m a r k u p principle subject to foreign prices and the rate of exchange. and these variables work together to determine the current account of the balance ofpayments. The authorities’ intervention equation determines the level of foreign exchange reserves which together with the current balance, determines the capital account as the net domestic acquisition of foreign assets. These variables then impinge upon domestic wealth via identity (10) and the supply of money which is determined by identity (11) in conjunction with a financing decision for the fiscal stance. The model thus incorporates the fact that exchange rate intervention behaviour will have monetary implications unless the authorities act to sterilize these effects by simultaneously pursuing open market operations. It also explicitly accounts for the importance of tightly specifying the inter- dependencies which exist between the various sectors’ financial constraints, as illustrated by Branson (1976) and Eaton and Turnovsky (1983). With income and prices determined, domestic portfolio balancers demand money, bonds and net foreign assets subject to their wealth constraint. If the demand for money does not equal its supply, the short bond interest rate adjusts to clear the market. The exchange rate is determined within the spirit of the asset market approach, it being the variable that moves to clear the foreign asset m a r k t .

The model is simultaneous. With given foreign and domestic policy environments, the authorities react to what they consider to be excessive exchange rate movements by engaging in interventionist behaviour. This changes the level of foreign reserves and the current account balance which in turn influences the supply of money through the balance of official financing, and the level of real incomes through the accumulation of wealth. These linkages reflect the basic interdependencies which exist between the sectorial constraints in the economy. The exchange rate also impinges upon private wealth more directly through the revaluation effect on domestic holdings of foreign-currency denominated assets. It also determines domestic prices which, together with income and wealth, impinge upon the domestic asset demand functions and !,rings the system to its new equilibrium.

Before the model can be empirically estimated, it is necessary to derive appropriate measures for the expectational variables. The difficulties associated with incorporating such variables in the estimation of‘ rational expectations models is widely recognized and described by a number of researchers including McCallum (1976) and Obstfeld (1983). In terms of exchange rate expectations, we follow the procedure adopted by the latter author in assuming that offshore interest rates - the eurodollar or europound rates - are perfect substitutes, whilst onshore assets - U.S. and U.K. treasury bills - are imperfect substitutes. The former assumption allows us to use the forward premium as our measure of the expected change in the exchange rate. By assuming that uncovered interest parity holds for offshore assets, the role of non-diversifiable exchange risk in determining the interest differential between onshore assets and europound deposits is ignored.

220 A U STK A LI A N E C O N 0 M I C PA PE I<S I IECEMBEK

We experimented with a number of proxies for expected inflation in estimating the wage- price sector of the modcl, but none of these proved to be statistically significant. This implies that the wage equation turns out to be supportive of the real wage resistance hypothesis. I t is arguable that the existence of an expectational term in the wage equation should be imposed a pr ior i , but this has not been done for the following reasons. First, although it is crucial to incorporate the role of expectations at the modelling stage of financial asset markets which operate efficiently, the same condition does not apply with equal force in modelling the labour market. The latter does not remotely correspond to an auction market and although expectations are undeniably important, it takes time for these expectations to be incorporated into wage settlements. This does not mean that expectations d o not impinge upon the model’s wage-price sector, rather, they work indirectly through the existence of a real wage target term. In addition, the absence of a direct expectational effect in the wage-price sector is practically important insofar as it considerably simplifies the computations involved in simulating the estimated model.

The model has been fitted to quarterly end-period seasonally unadjusted data over the period 1973( 1)-1983( 1). Seasonality influences are captured by using conventional seasonal dummy variables. The data appendix provides details of variable sources and derivations. All equations were initially estimated using the ordinary least squares procedure. The existence of insufficient degrees of freedom prevented estimation of the model as a full system. As a compromise, the two asset demand equations together with the current account and reserve equations have been estimated using three stage least squares. Since only predetermined variables enter the remaining equations, the only loss which results from this approach is the loss of efficiency from not using the full system-wide variance-covariance matrix. In order to avoid complications at the model simulation stage which are caused by the existence of complicated lag structures due to expectational and adjustment considerations, the asset demand equations employ the framework of partial adjustment. The other equations have been estimated using the general to specific methodology whereby each equation was initially specified as an unrestricted autoregressive distributed lag with up to four lags on each variable. Variables were sequentially dropped using a series of F tests to arrive at the most parsimonious versions which are reported below.

Table I1 presents the estimation results. In estimating the money demand equation, we experimented with a variety of combinations of interest rates. In every case the ‘own’ money rate was completely insignificant and induced bias into the estimates of the other included rates. The best specification is reported as equation (14) in Table I1 and includes two opportunity cost variables; the yield on domestic bonds and the return on foreign assets which is adjusted by the forward premium. Both interest rates are bordering on significance at the 95 per cent level while the real wealth term enters positively but is statistically insignificant. This contrasts with earlier work reported by Grice and Bennet (1984) and by Kearney and MacDonald (1985) in which real wealth was shown to have a significantly positive effect on the demand for sterling M 3 . It is, however, consistent with results which show that the narrower monetary aggregate demand equations are generally less dependent on wealth than their broader counterparts. The partial adjustment term indicates that about 30 per cent of the discrepancy between desired and actual money balances is eliminated in one quarter.

1988 A S S E T S M A R K E T S . C U R R E N T A C C O U N T . E X C H A N G E K A T E U E T E K R . 1 I N A T I O N 221

TARLF. IIA

Model Equation Estimates

MONEY

= 12.16 - 0.02 I' - 0.01 ( P + A S E ) - 1.07 log [j + 0.10 log [$I + (3.6) (1.6) (1.6) (3.2) (0.9)

0.71 log [!!$I + S D

(10.7)

FOREIGN ASSET

= 1.09 + 0.02 (P+ASE) + 0.23 log [:] - 0.57 log [g] + 1.16 log

(0.1) (3.0) (0.2) (0.6) (2.8)

- 1.10 log k] + 0.72 log + S D El RESERVES

R = - 0.14 - 0.88 AS + 0.33 R-1 + S D

(0.3) (2.0) (2.8)

CURRENT ACCOUNT

S, p::: - 4.95 log [g] - 2.21 log -1 + 0.05 Time +

(2.3) (2.0) -1

(1.2) -1

CA = 86.64 - 5.13 log

(2.2) (1.0)

0.58 CA-1 + S D

(4.4)

WAGES

log ( A W ) = - 0.12 - 0.73 log ( U ) - 4 - 0.17 log [;] -4 + 0.09 log (S.P':')-3 + (1.9) (4.3) (2.0) (3.2)

222 A US I R A L I A N ECO N (1 M 1 C PA PE RS

TABLE IIA (Continued)

DE CEM R E R

PRICES

INCOME

+ 0.22 log [g] + 0.22 log [;] -

-1 (1.7)

-1 (2.8)

log [g = 3.95 + 0.48 log

(3.2) (3.3)

s. P>:: 0.25 log [F] - 0.13 log [+] 9.p::: -1 + 0.17 log r7] + S D (20)

-2 (2.0) (2.5) (3.2)

L ’ A - L

EQUATION

(14) Money

(15) Foreign Asset

(16) Reserves

(17) Current Account

(18) Wages

(19) Prices

(20) Income

TABLE IIB

Model Equation Diagnostics

R2 S E R

.90 0.07

.94 0.10

.34 1.26

.60 0.56

.47 0.02

.56 0.01

.93 0.01

DH

.57

.55

.62

.54

.14

.46

.81

Q5

16.1

16.0

14.5

19.5

12.96

13.47

12.22

In the foreign asset equation (15), the foreign interest rate term is correctly signed and statistically significant as are the home and foreign wealth terms. Interestingly, the latter variables are equal in magnitude in absolute terms. Although both the home and foreign income terms are correctly signed in this equation, neither is statistically significant. Again the partial adjustment term indicates that about 30 per cent of the discrepancy between desired and actual foreign asset holdings is eliminated in the first quarter.

In experimenting with estimates of the reserve equation, only the ‘leaning against the wind’ term on the lagged change in reserves proved to be statistically significant. We

1988 ASSETS MARKETS. CURRENT ACCOUNT. EXCHANGE RATE DETERMINATION 223

consequently find no evidence of the U.K. authorities adopting a target exchange rate or ‘beggar-your-neighbour policies’ during the period studied. The equation indicates that every time the pound depreciates by one penny the U.K. authorities sell $80 millions of foreign exchange reserves. This is a similar order of magnitude to the results reported by other researchers for different time periods and currencies (see, for example, Longworth’s (1980) study of the Canadian dollar and Quirk’s (1977) study of the Japanese yen).

The current account equation has the lagged real exchange rate entering with a statistically significant negative coefficient. The lagged current account deficit term enters significantly, although the home and foreign income terms enter with a low level of significance. In common with this equation, the real exchange rate enters the real income equation with a statistically negative coefficient from period t-1 and a significantly positive coefficient from t-2. Lagged home and foreign income aiso have a significant role to play in the determination of domestic real income. Interestingly, all attempts to find a role for the authorities’ fiscal stance in the determination of domestic real income proved to be unsuccessful. This finding of no direct fiscal effects on the determination of domestic output is interesting insofar as it contrasts with the work of Laidler and O’Shea (1980) who found that these effects are significant in explaining the British data during the period of fixed exchange rates prior to 1970. Our findings indicate that the movement from fixed to floating exchange rates weakens the direct influences of fiscal policy initiatives on domestic income. This implies that the indirect transmission mechanisms of fiscal policy which operate through wealth, prices and exchange rates are more important under floating than under fixed exchange rates. The simulations which are reported in the next section are designed to shed further light on this issue.

Our empirical estimates of the wage-price nexus are reported as equations (18) and (19) in the table. Notice that for the wage equation, all variables are correctly signed and statistically significant a t the 95 per cent level except for the lagged wage term. Various proxies for expected inflation were experimented with, including lagged inflation rates and a long term bond rate of interest, without success. This finding concurs with those obtained by Sargan (1980) and other researchers. The wage equation is thus supportive of the real wage resistance hypothesis with real wages entering significantly as an explanatory variable. The estimated price equation noticeably includes the influence of foreign prices in domestic currency terms which is correctly signed and statistically significant.

The Durbin h statistic is presented for all the estimated equations in Table 11 and it indicates the absence of first order autocorrelation. In order to test for the existence of higher order autocorrelation, the Box-Pierce statistics have been computed and these are also reported in the table. All are statistically insignificant a t the 95 per cent level (Q16,95 =

26.30). Further evidence on the absence of higher order autocorrelation was obtained by inspection of the residual correlograms which indicated that the residuals are tolerably white.

Iv. S I M U L A T I O N RESULTS

We begin by describing the ability of the estimated structural model to track the historical data. This subsequently constitutes the base run which is used to evaluate the effects of changes in policy and in the external environments on the domestic macroeconomic variables of interest. All simulations are dynamic in nature with the previous model solution values being used in place of lagged endogenous variables.

224 A U S’IIIA LI A N ECO N 0 M 1 C I’APE RS DECEMBER

Table 111 provides comparisons of the actual and predicted series for the important endog- enous variables in the model. It reports the correlation coefficients and the regression co- efficients of the actual on the predicted series as well as the root mean squared errors and Theil’s inequality coefficients. The latter are then sub-divided to give the fraction of prediction errors which are due to bias, different variation and difference covariation. It is worth emphasizing that although single equation errors have been accounted for, the dynamic nature of the simulation provides a non-trivial test of the model’s ability to capture turning points in the data. The results demonstrate a satisfactory degree of success in this regard with the highest fraction of prediction error being due to difference covaration in most cases.

TARLE I11

Base Run Simulation: Comparison of Actual and Model Prediction Series

Variables Correlation Regression Theil’s Fraction Fraction Fraction Coefficient Coefficient Inequality of error of error of error

Squared of the Coefficient due to due to due to Actual Bias Different Difference on the Variation Covariation

Predicted Series

Money .90

Reserves .95

Current Account .76

Exchange Rate .4 I

Wages .99

Prices .99

Income .99

.96 ,016 .06 .09 .85

.84 .001 .04 .30 .66

.93 ,513 .52 .01 .47

.70 ,619 .43 .o 1 .56

1.02 ,000 .08 .16 .76

1.13 ,000 .3 1 .43 .26

.98 ,000 .67 .o 1 .3 1

In order to cast light upon how the model responds to exogenous disturbances, the following simulations have been conducted: Simulation 1: 1 billion increase in public borrowing financed by issuing debt, while the

Simulation 2: 10 per cent increase in foreign prices, with and without foreign exchange

The result which illustrate the dynamic adjustment of the four endogenously determined ‘prices’, i.e. the exchange rate, domestic interest rates, wages and the consumer price level,

authorities intervene in the foreign exchange market.

market intervention by the authorities.

1988 ASSETS MAKKETS. CUliliENT ACCOUNT. EXCHANGE RATE DIITLRMINATION 225

along with the supply of money, the level of foreign exchange reserves, the current account balance and the level of real income, are shown in Charts 1 and 2 respectively.

Consider simulation 1 firstly. The fiscal expansion is spread over four quarters in accordance with how this policy might be implemented in practice. It is worth noting that the theoretical literature which investigates the effects of expansionary fiscal policy in open economies indicates that the exchange rate may either appreciate or depreciate before adjusting to its long run equilibrium level. Penati (1983) provides a neat survey of the issues which determine which of these cases is liltcly to occur. If the fiscal expansion raises domestic output and prices, an excess demand for money will emerge which induces an appreciation of the exchange rate to clear the money market. This effect is usually confined to the short run because the output effects diminish over time as the current account deteriorates along with the foreign exchange value of the currency. I f domestic and foreign currency denominated assets are imperfectly substitutable, however, bond financed fiscal deficits will induce financial market participants who are concerned about the more general conditions of portfolio balance to diversify their portfolios by moving into foreign assets.

These portfolio balance considerations are important in our model. The fiscal policy initiative raises domestic financial wealth and causes excess supply to emerge in the market for domestic bonds. The higher financial wealth induces market participants to raise their demands for all financial assets. To the extent that the higher demand for domestic bonds falls short of the excess supply, the domestic interest rate begins to rise. This works against the wealth effects by inducing portfolio balances to moderate their demandsfor money and foreign assets. Since the substitution effect in the foreign asset equation is dominated by the wealth effect, the demand for net foreign assets rises and the exchange rate depreciates to clear the market. This causes the current account of the balance of payments to move into deficit, and the authorities intervene in the foreign exchange market to support the ailing currency at the expense of losing foreign reserves. This intervention behaviour has its expected depressing influence on the supply of money which, together with the current account deficit, causes the real side of the economy to contract slightly before expanding.

As time proceeds, however, the rising level of domestic prices curtails the demand for financial assets by reducing real w,ealth. This causes the initial deterioration in the exchange rate and the current account balance to unwind in the manner which is depicted in Chart 1. The authorities use this period to recover their foreign exchange reserves and the money supply returns to its initial equilibrium level. It is noteworthy that the resulting nonmonotonic adjustment dynamics replicate the theoretical predictions of Branson (1977) and Kawai (1985) regarding the response of open economies to fiscal disturbances when exchange rates adjust more rapidly than prices. This condition obtains in our model insofar as the exchange rate moves to clear the foreign asset market while the level of prices is subsequently influenced by the exchange rate with a lag of one quarter. It is noteworthy that the level of real wages remains stable throughout the adjustment process insofar as nominal wage inflation closely follows the rate of general price inflation. This is consistent with the real wage resistance hypothesis which was upheld at the estimation stage. The conclusion which emerges is that expansionary fiscal policy in an open economy which operates a managed floating exchange rate regime will not have significant expansionary effects on the real economy. The indirect transmission mechanisms which operate through wealth, prices and the exchange rate act to dampen the fixed exchange rate responsiveness

226 AUSTKALIAN ECONOMIC PAPERS DECEMBER

of domestic income to fiscal policy initiatives by deteriorating the economy’s performance on current account of the balance of payments. This finding is supportive of that which was obtained at the model estimation stage when no direct effects of fiscal policy were obtained in the domestic income determination equation.

Simulation 2 examines the effects on the domestic economy of a ten per cent increase in foreign prices. This provides a good opportunity to assess the domestic economic implications of the authorities’ foreign exchange market intervention behaviour. Previous work by Kearney and MacDonald (1986) concluded that sterilized intervention behaviour by the U.K. monetary authorities is approximately half as effective as its unsterilized counterpart in influencing the sterling/dollar exchange rate. The present exercise is designed to examine the related issue of how the authorities’ intervention behaviour affects the responses of important domestic macroeconomic variables to economic environmental disturbances. More specifically, this second simulation examines the implications of the authorities’ intervention behaviour for the international transmission of inflation and for the adjustment dynamics of the current account balance.

Chart 2 provides the details. Consider first what happens to the domestic economy when the monetary authorities refrain from any intervention behaviour. The higher foreign price level reduces real foreign wealth and causes excess demand to emerge in the market for net foreign assets which is cleared by depreciation of the exchange rate. The higher foreign price level also depresses foreign real incomes which, together with the higher real exchange rate, has the net effect of moving the current account into deficit. As time proceeds, the foreign inflation is transmitted to the domestic price level which begins to rise. This causes the initial exchange rate effects to unwind by lowering real domestic wealth which reduces the demand for net foreign assets, and the current account performance begins to improve. It is noteworthy, however, that the importation of foreign inflation is incomplete. This is not surprising in an economy whose monetary authorities allow the foreign exchange value of its currency to be market determined. These results support the familiar theoretical prediction that the international mobility of capital reduces the insulation properties of floating exchange rates (see, inter alia, Argy and Porter (1972) and Artis and Currie (1981)). The domestic money supply remains under the control of the authorities in this case insofar as foreign reserves are neither gained nor lost.

It is interesting to compare the outcome just presented with that which occurs when the monetary authorities intervene in the foreign exchange market in order to dampen the effects of higher world prices on the foreign value of the domestic currency. In this case the resulting depreciation is diminished as foreign reserves are off-loaded t o support the ailing currency. The resulting current account deficit is correspondingly smaller and of less duration than that which occurs in the absence of intervention -its size and duration are reduced by two thirds and one half respectively. The authorities are presented with the opportunity to replenish their lost reserves when sterling appreciates, and the monetary consequences of this unsterilized behaviour are clearly visible in the Chart. This illustrates the nature of the problem which exists in an open economy for the economic policymaker who wishes to simultaneously target on monetary aggregates while managing the foreign exchange value of the currency. This problem has been endemic to the Medium Term Financial Strategies of the Thatcher government since the early 1980s. Indeed, it was the exchange rate consequences of tight monetary policy that finally led to the demise of monetary targeting in the British anti-inflation strategy. A similar problem has not arisen in

1988 ASSETS MARKETS. CURRENT ACCOUNT. E X C H A N G E RATE DETERMINATION 227

-025 -

CHART 1 Model Simulation Results of a E l billion

Debt-Financed Fiscal Expansion

Notes: The calibrations on the horizontal axes refer to quarter years.

228 AUSTKALIAN ECONOMIC PAPEKS DECEMBER

CHART I1 Model Simulation Results of a 100/0 Increase in Foreign Prices With and

Without Foreign Exchange Market Intervention

Interest Rate Exchange Rate

%A %A , - -* -8

Notes: The calibrations on the horizontal axes refer to quarter years. The solid lines denote the results which emerge when the authorities engage in intervention ( I ) and the broken lines de-

note the outcomes without intervention ( N o .

1988 ASSETS MARKETS, CURRENT ACCOUNT. EXCHANGE RATE DETERMINATION 229

the recent Australian experience insofar as the monetary targets were abandoned by the Hawlte administration prior to the move towards greater exchange rate management. It is also worth pointing to the higher and more volatile interest rates which are consequent to the monetary implications of foreign exchange market interventionist policies. The overall effect of this policy is to depress the real economy by a fraction of a percentage point relative to that which would obtain in the absence of such intervention behaviour.

V. SUMMARY A N D CONCLUSIONS

Recent theoretical analysis of the relationship which exists between the current account balance and the rate of exchange implies that the nature of the economic disturbances which impinge upon the macroeconomic system must be explicitly modelled in order to obtain reliable empirical evidence. The purpose of this paper has been to investigate this evidence using a macroeconometric model which combines a carefully specified asset market sector with the determination of real output, prices and the current account of the balance of payments. The model was simulated for a number of economic disturbances in order to investigate how the relevant variables are related during the adjustment process.

Amongst the papers’ main findings is the cyclical adjustment of domestic macro- economic variables to fiscal policy and foreign price shocks together with non- instantaneous overshooting of the exchange rate. The current account response to these disturbances comprises strong deficit tendencies prior to subsequent corrective behaviour in a n economy which operates a managed exchange rate regime. This response is dampened by the extent of intervention by the monetary authorities in the foreign exchange market. The evidence presented here also indicates that the transmission mechanisms which operate through wealth, prices and the exchange rate act to dampen the fixed exchange rate responsiveness of domestic income t o fiscal policy initiatives by deteriorating the economy’s performance on current account of the balance of payments. Finally, the evidence presented here also indicates that the international transmission of price disturbances can be mitigated for considerable periods of time by the monetary authorities’ exchange rate management behaviour.

230 AUSTRALIAN ECONOMIC PAPERS DECEMBER

DATA APPENDIX

This appendix describes the data and definitions of variables used in the study. The following abbreviations will be employed: BEQB = Bank of England Quarterly Bulletin; ET = Economic Trends; FRBQR = Federal Reserve Bank Quarterly Report; FS = Financial Statistics; IFS = International Financial Statistics.

M B B :: D L N F

A

A ;3

Y Y W

P P;: CUR RES PSD X

U

S

r r”

broad money defined as currency plus D - L , FS. domestic bonds held by domestic residents, FS.

domestic bonds held by overseas residents, FS. domestic private sector bank depostis, FS. bank lending to non-bank private scctor, FS. other private sector net liabilities, FS. net foreign assets denominated in foreign currency, FS. private sector net financial wealth, FS.

U S . private portfolio wealth, FRBQR. U.K. nominal GDP, IFS. U.S. nominal GDP, IFS. U.K. wage rates, ET. U.K. consumer prices, IFS. U.S. consumer prices, IFS. balance of payments on current account, ET. foreign exchange reserves, FS. outstanding public sector debt, FS.

banks’ ‘switched’ position plus their net overseas and nondeposit liabilities, FS

rate of unemployment, ET. spot sterling/dollar exchange rate, IFS. yield on short government bonds, BEQB. rate of return on 3-month eurodollars, BEQB.

1988 ASSETS MARKETS, CURRENT ACCOUNT, EXCHANGE RATE DETERMINATION 231

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