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Towards an asset price theory of 
exchange rates 
Jan Priewe, HTW Berlin – University of Applied Sciences 
Kansas City, 26...
Agenda 
1. Where does orthodox exchange rate theory stand? 
2. Where does Keynesian exchange rate theory stand? 
3. Some n...
1. Where does orthodox exchange rate theory stand? 
Traditional XR determinants: 
st = α Et(yt+1 - yt+1*) + ß Et(PPP* - PP...
2. Where does Keynesian exchange rate theory stand? 
• Keynes: PPP is „truism“ (1923); Keynes did not develop a coherent X...
3. Some new ideas 
1.) Role of „fundamentals“ – key point of disagreement 
• „Fundamentals“ is umbrella term for many dive...
2. Predominance of destabilising speculation 
• Most of the time: speculation of forex trading industry, algorithm trade 
...
3. Boom-bust cycles of appreciation – depreciation 
• Similar to other asset classes: value of currency does not grow infi...
4. The dollar-euro/DM-exchange rate since 1970 
• Since 1970: strong volatility, trend towards nominal appreciation of 
DM...
400 
350 
300 
250 
200 
150 
100 
50 
index, 1973 = 100 
Nominal exchange rates of leading currencies vis à vis US-$, 
19...
0.70 
0.80 
0.90 
1.00 
1.10 
1.20 
1.30 
1.40 
1.50 
1.60 
Jan/ 99 
Aug/ 99 
Mrz/ 00 
Okt/ 00 
Mai/ 01 
Dez/ 01 
Jul/ 02 ...
220 
200 
180 
160 
140 
120 
100 
80 
60 
Nominal and real exchange rate DM/€ for US-dollar and real effective 
exchange ...
1.60 
1.50 
1.40 
1.30 
1.20 
1.10 
1.00 
0.90 
0.80 
8.00 
6.00 
4.00 
2.00 
0.00 
-2.00 
-4.00 
Exchange rate USD/DM-€, ...
30 
20 
10 
0 
-10 
-20 
-30 
-40 
-50 
8.00 
6.00 
4.00 
2.00 
0.00 
-2.00 
-4.00 
-6.00 
Four fundamentals and the DM/€/...
1.90 
1.80 
1.70 
1.60 
1.50 
1.40 
1.30 
1.20 
1.10 
1.00 
0.90 
0.80 
0.70 
Deviation of PPP of select countries 1990-20...
0.40 
0.60 
0.80 
1.00 
1.20 
1.40 
1.60 
1.80 
1/2/1970 
1/2/1972 
1/2/1974 
1/2/1976 
1/2/1978 
1/2/1980 
1/2/1982 
1/2/...
5. Where to go 
• Recommencment of XR theory necessary 
• Reconsideration of Keynes‘s endorsement of PPP (for tradables, a...
collaboration of two leading CBs and reserve currencies 
 remember Keynes 1923: dollar and Sterling blocs should 
coopera...
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An Asset Price Theory of Exchange Rates

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Prices, Exchange Rates and Monetary Reform session at 12th International Conference

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An Asset Price Theory of Exchange Rates

  1. 1. Towards an asset price theory of exchange rates Jan Priewe, HTW Berlin – University of Applied Sciences Kansas City, 26 September 2014 12th International Post Keynesian Conference 1
  2. 2. Agenda 1. Where does orthodox exchange rate theory stand? 2. Where does Keynesian exchange rate theory stand? 3. Some new ideas 4. The dollar-euro/DM-exchange rate since 1970 5. Where to go 2
  3. 3. 1. Where does orthodox exchange rate theory stand? Traditional XR determinants: st = α Et(yt+1 - yt+1*) + ß Et(PPP* - PPPt) + λ Et(πt+1* - πt+1) + γ Et(rt+1 - rt+1*) + εt But: „There is overwhelming empirical evidence that the exchange rates of the most important currencies are unrelated to the fundamentals that economic theory has identified.” (De Grauwe 2000, 353) Most orthodox economists believe in the long-run validity of PPP, admit that in the short-run (1-2 years) deviations from fundamentals occur. They cannot explain the transition from the short-run to the long-run. Exchange rate theory is one of the Achilles heels of mainstream international macroeconomics. 3
  4. 4. 2. Where does Keynesian exchange rate theory stand? • Keynes: PPP is „truism“ (1923); Keynes did not develop a coherent XR theory for flexible XR; speculation not very important for him • Davidson: uncertainty, unanchored expectations  volatility, high XR elasticity of expectations, visible hand necessary on forex markets • Harvey: forex is financial asset; speculation of forex dealers, predominance of chartists relative to fundamentalists; high volatility; in the long-run huge imbalances in BoP; cyclicity not addressed • Kindleberger/Minsky: model of boom-bust cycle of asset prices applicable to forex markets „One place where the model surely applies today is foreign exchange markets, in which prices rise and fall in wide swings, despite sizable interventions in the market by monetary authorities …. “ (Kindleberger, 2000, p. 21) • Behavioral finance (De Grauwe et al.): microeconomic approach; under high uncertainty  search for simple heuristics; Chartists predominate against fundamentalists; rejection of rational expectation theory and efficient market hypotheses; but: „bounded rationality“; rejection of PPP 4
  5. 5. 3. Some new ideas 1.) Role of „fundamentals“ – key point of disagreement • „Fundamentals“ is umbrella term for many diverse determinants – heterogeneity of fundamentals • Fundamentals do play a prime role when it comes to reversals from appreciation to depreciation (change of sign) • Fundamentals often without clear, unambiguous direction • Indicators on fundamentals require interpretation and policy decision • Trade-offs among different fundamentals • „perverted PPP“ can happen: output/employment adjust to misaligned XR, in case over-valued XR industries will shrink or go bust  return to PPP impossible • Natural „trustees“ of fundamentals are/should be central banks/governments • In most modern analyses: PPP-deviation neglected, although very relevant in exuberant episodes 5
  6. 6. 2. Predominance of destabilising speculation • Most of the time: speculation of forex trading industry, algorithm trade (high frequency trade), derivatives abet upward and downward speculation • Short-termism underscores lack of fundamental ingrediences in traders‘ rules • Predominance of destabilising speculation (microeconomically „rational“) , lack of stabilising speculation (see Kindleberger/Minsky) • „rational bubbles“? • Currencies are special asset class; traders deal mostly on their account, detached from goods trade, portfolio or direct foreign investment • Financialised forex markets • Long waves of upward/downward speculation, as long as fundamentalists are weak or inactive 6
  7. 7. 3. Boom-bust cycles of appreciation – depreciation • Similar to other asset classes: value of currency does not grow infinitely • Point and time of reversal unpredictable, no clearly defined floors/ceilings • Reversal episodes in the past idiosynchrati • Important fundamentals strongly „violated“ • PPP must play a role since trade with goods and services becomes extremely distorted; heavy pain for strongly appreciating and depreciating economies • Capital flows also strongly distorted • Risk of recession, balance of payments or financial crisis • Central banks become concerned • Vested interests of many interest groups are at risk • In many reversal episodes of XR, central banks intervened on forex markets 7
  8. 8. 4. The dollar-euro/DM-exchange rate since 1970 • Since 1970: strong volatility, trend towards nominal appreciation of DM/euro • Bilateral real exchange rate appreciated at times by > 100%, and depreciated afterwards excessively • Long-run trend: only little real appreciation of DM/Euro since 1973 • Among all fundamental factors, PPP most strongly violated in phases of extreme misalignments • Problems of measurement of PPP remain (tradables, nontradables; high transaction costs (Rogoff)?) • Varying deviation of PPP cannot be explained by transaction costs • Europe can only „survive“ the roller-coaster XR by stable intra-European XR • In several recessions, the dollar revalued against DM/euro • Prime reserve currency is more resilient than others (not substitutable), can live with XR volatility better than others 8
  9. 9. 400 350 300 250 200 150 100 50 index, 1973 = 100 Nominal exchange rates of leading currencies vis à vis US-$, 1950-2013 - Index 1973=100, annual averages - DM € CHF Yen GBP US-$/DM oder € US-$/Yen US-$/GBP US-$/CHF 9
  10. 10. 0.70 0.80 0.90 1.00 1.10 1.20 1.30 1.40 1.50 1.60 Jan/ 99 Aug/ 99 Mrz/ 00 Okt/ 00 Mai/ 01 Dez/ 01 Jul/ 02 Feb/ 03 Sep/ 03 Apr/ 04 Nov/ 04 Jun/ 05 Jan/ 06 Aug/ 06 Mrz/ 07 Okt/ 07 Mai/ 08 Dez/ 08 Jul/ 09 Feb/ 10 Sep/ 10 Apr/ 11 Nov/ 11 Jun/ 12 Jan/ 13 Aug/ 13 Mrz/ 14 Euro-USD-XR 1999-2014: monthly values and annual values (indirect quotation) 1st of month 10 Annual mean
  11. 11. 220 200 180 160 140 120 100 80 60 Nominal and real exchange rate DM/€ for US-dollar and real effective exchange rate 1973-2013 index 1973 = 100 (annual averages, indirect quotation) real effective XR nominal XR bilateral real XR 1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 11
  12. 12. 1.60 1.50 1.40 1.30 1.20 1.10 1.00 0.90 0.80 8.00 6.00 4.00 2.00 0.00 -2.00 -4.00 Exchange rate USD/DM-€, differential of short-term interest rates and differential of current account balance D/EZ-USA) 1992-2013 (until 1998 Germany, then Eurozone) differential short-term interest rates (D/EZ-US) differential current account balance (% of GDP), D/EZ-US USD per DM/€, rhs 12
  13. 13. 30 20 10 0 -10 -20 -30 -40 -50 8.00 6.00 4.00 2.00 0.00 -2.00 -4.00 -6.00 Four fundamentals and the DM/€/USD exchange rate 1992-2013 (until 1998 Germany, afterwards Eurozone) diffential inflation (US-D/EZ) differential growth (D/EZ - US) differential short-term interest rates (D/EZ-US) change of XR (USD per DM/€), rhs deviation price level from PPP (US-D/EZ), rhs 13
  14. 14. 1.90 1.80 1.70 1.60 1.50 1.40 1.30 1.20 1.10 1.00 0.90 0.80 0.70 Deviation of PPP of select countries 1990-2013 vis à vis the US (= 1)* Germany Japan Italy France US GB Switzerland 14
  15. 15. 0.40 0.60 0.80 1.00 1.20 1.40 1.60 1.80 1/2/1970 1/2/1972 1/2/1974 1/2/1976 1/2/1978 1/2/1980 1/2/1982 1/2/1984 1/2/1986 1/2/1988 1/2/1990 1/2/1992 1/2/1994 1/2/1996 1/2/1998 1/2/2000 1/2/2002 1/2/2004 1/2/2006 1/2/2008 1/2/2010 1/2/2012 1/2/2014 US-$ per DM/€ 1970-2014 (daily values, indirect quotation) 1980 1985 1991 1995 2000 DM Euro 2008 1973 15
  16. 16. 5. Where to go • Recommencment of XR theory necessary • Reconsideration of Keynes‘s endorsement of PPP (for tradables, adjusted for transaction costs) and on his analysis of uncertainty, expectations and speculation • Financialisation of XR in modern flexible rate regimes (unregulatted forex markets, full international capital mobility)  huge volume of transactions, unrelated to fundamentals • Destabilising speculation predominates, one-directional • Reversals unavoidable! • In reversal episodes, fundamentals under strong stress • Crises or central bank interventions have plaid certain roles in the past • Turning points still diffficult to explain; econometric methods fail • Strong overlapping of behavioural finance XR theories and Keynesian ideas 16
  17. 17. collaboration of two leading CBs and reserve currencies  remember Keynes 1923: dollar and Sterling blocs should cooperate, leading to more stable XR worldwide  monetary cooperation Fed/ECB is a cornerstone for global monetary reform Keynes 1923, p. 204: „The best we can do, therefore, is to have two managed currencies, sterling and dollars, with as close a collaboration as possible between the aims and methods of the managements.“ 17

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