Home Currency Research Articles

Infant governments and the fiscal role of tariffs, inflation, and reserve requirements: A welfare analysis

Import duties and inflation taxes generate significant tax revenues for many developing nations. These taxes involve low collection costs relative to income taxes and generate distinct types of distortions, so their use can be reconciled with Ramsey taxation principles. A small open overlapping generations economy is presented in which optimal tariffs and inflation taxes are positive, both when home currency has no good substitutes and when inflation gives rise to currency substitution. Compared with a regime of tariffs and direct taxes on foreign assets, welfare is lower in the optimal inflation-tariff equilibrium.

Foreign exchange management—A strategic approach

Changes in exchange rates affect the value of the firm because of the sensitivity of corporate cash flows to exchange rate fluctuations. Notwithstanding innovation in foreign exchange risk management, there are situations where hedging does not protect the firm against the adverse impact of unanticipated changes in exchange rates. This paper discusses a particular, although very common, case of economic exposure in which firms have continuous contractual cash flows denominated in a foreign currency showing a persistent appreciation or depreciation vis-à-vis the firm's home currency. We present alternative strategic responses when hedging techniques are inadequate.

The Simplest Test of Target Zone Credibility

Under the assumption of no arbitrage, the credibility of an exchange rate target zone is tested by whether domestic interest rates fall within rate-of-return bands between the maximum and minimum home currency rate of return on a foreign investment in the absence of a devaluation. Under the assumption of uncovered interest parity, credibility is tested by whether expected future exchange rates fall within the exchange rate band. These tests are applied on data on the Swedish target zone from January 1987 through August 1990.

Managing the Currency Risk of Non-Dollar Portfolios

With the availability of currency hedging instruments-including futures, forwards and options contracts-foreign exchange risk can be isolated from the price risk of the investment evaluated in its home (non-dollar) currency. Managers can thus choose to regulate their currency exposure as conditions dictate. At one extreme, they may choose to maintain their exchange exposure intact; at the other, they may eliminate it entirely.

International market linkages and optimal monetary policy

The interrelation among portfolio choice and labor supply decisions and real balance effects is examined under flexible exchange rates. On the asset menu are home currency, domestic government bonds and foreign bonds. With commodity market linkages the real balance effect is highlighted as the inefficiency of an economy with positive government bonds is demonstrated, while the additional linkage of interest rates through covered interest parity may transform an economy where only money is useful into an economy in which both money and government bonds are beneficial.

A simple rule for multinational capital budgeting

Multinational capital budgeting has been a topic mired in considerable complexities. Even in its most basic problem where the only source of uncertainty is the possibility of currency fluctuations in alI future periods, the solutions are still far from simple. In the ‘theoretically’ correct approach, an international capital asset pricing has to be derived such that an appropriate discount rate could be calculated (see for example [2]). The model involves the specification of the stochastic processes governing the project cash flows, the exchange rates, and the covariances between the project and the exchange rates, among the exchange rates, and among ail assets. Empirically, estimation of the discount rate requires the world market (or consumption) portfolio, risk aversion parameter, and risk free interest rates in different countries. The approaches in the textbooks, e.g., [1, 4, 6, 8,9], although simpler, still require a substantial amount of forecasted variables. In particular, the approach in which local cash flows are translated into home currency and discounted at the home discount rate requires the manager to forecast the expected spot exchange rates, or their equivalent, the expected inflation rates in both countries e.g., [6], for all time periods during the life of the project t = 1,2,. . . ,T. The purpose of this note is to propose that under certain conditions, there is a much simpler rule for evaluating multinational capital budgeting problem.

The Determinants of the Growth of Multinational Banking Organizations: 1972-86

The paper develops an empirical model to explain growth of total assets of a sample of the world's largest banks. The model was estimated over a period in which U.S. banks' assets grew less rapidly than the assets of large banks headquartered in other industrial countries. The model provides an estimate of the banks' allocation between home currency and foreign currency assets which allows an estimate of the impact of exchange rate exchanges on bank asset growth.The results of the model suggest that no single economic variable explains the faster growth of non-U.S. banks. Changes in real exchange rates were estimated to have had a significant impact on bank asset growth through their impact on the dollar value of banks' home-currency assets. This impact was greater over a shorter time period when exchange rate movements tended to be larger. Over the longer run other factors, such as faster home-country economic growth, an expanding trade and foreign investment sector, and the ability of large banks to retain their share of domestic intermediation, tended to be relatively more important.The model tested whether banks headquartered in particular countries tended to respond in a similar manner to economic variables and could be aggregated into a single behavioral equation. Aggregation was generally indicated for non-U.S. banks and was rejected for American banks. The model overpredicted asset growth for large U.S. and Canadian banks after 1982, suggesting that various factors including pressure by bank regulators to increase capital ratios and asset quality questions may have affected their asset growth sooner than banks headquartered in other countries.

A theory of home currency preference

Eine Theorie der PrAferenz fur die heimische WAhrung. - Das Modell, das in diesem Aufsatz entwickelt wird, bezieht sich auf ein System flexibler Wechselkurse und soll erklAren, warum die heimische WAhrung so stark bevorzugt wird. Die Ergebnisse sind:(i) Die heimische WAhrung wirkt als eine Sicherung dagegen, da\ der Wechselkurs nicht der KaufkraftparitAt folgt,(ii) Letzten Endes bestimmen die PrAferenz-kurve und die Kovarianzen die absolute Hohe der PrAferenz fur die heimische WAhrung,(iii) Die PrAferenz fur die heimische WAhrung nimmt zu, wenn erwartet wird, da\ deren Wert real ansteigt. Une theorie de preference de la monnaie nationale. - Le modele developpe dans cet article se refere e un regime des taux de change flottants et s’occupe de la question pourquoi la monnaie nationale est si preferee. Les resultats sont:(i) La monnaie nationale sert de contrepartie contre le risque que le taux de change ne conforme pas avec sa valeur PPA.(ii) Dans l’analyse finale les preferences et les covariances determinent le niveau absolu de la preference pour la monnaie nationale.(iii) La preference pour la monnaie nationale augmente si l’on attend que la monnaie nationale se revalorise en terme reel. Una teoria de la preferencia por la moneda nacional. - El modelo que se deriva en este trabajo se refiere a un regimen de tipos de cambio flexibles y sirve para explicar la preferencia por la moneda nacional. Se concluye(i) que la moneda nacional actUa como seguro contra el riesgo de que el tipo de cambio no se adhiera a la paridad del poder adquisitivo (PPA),(ii) que las preferencias y las covarianzas determinan el nivel absoluto de la preferencia por la moneda nacional en el analisis final y(iii) que la preferencia por la moneda nacional aumenta con la expectativa de que la misma sera revaluada en terminos reales.

Currency Substitution and the Demand for Money: Some Evidence for Canada

RECENTLY, THE POSSIBILITY THAT foreign and domestic currencies are substitutes has received considerable attention (see [1, 2, 3, 10, 19, 21]). Currency substitution has important implications for the working of flexible exchange rates. If the degree of currency substitution is high, small changes in the money supply would induce large changes in the exchange rate. Furthermore, currency substitution would transmit the effect of monetary disturbances from one country to another. Indeed, significant currency substitution would seriously undermine the ability of flexible exchange rates to provide monetary independence. This paper examines the empirical importance of currency substitution in the framework of the demand function for money. If currency substitution is important, the expected change in the exchange rate should be a significant determinant of the demand for home currency. In section 2, we undertake such a test for the Canadian demand for money during the recent flexible exchange rate period. There is considerable evidence that the forward exchange rate is a good measure of the expected exchange rate. Our own tests confirm these results for Canadian data since 1970.

The Numeraire Problem and Foreign Exchange Risk

TRADITIONAL EXPLANATIONS of foreign exchange exposure have generally suffered from two deficiencies: the failure to place the foreign exchange problem within the context of the firm trying to maximize shareholder wealth, and the attempt to deal with exposure management on a transaction by transaction basis. The first deficiency manifests itself in the assumption or belief that assets denominated in a home or numeraire currency are void of foreign exchange risk. Invoking that assumption ignores the impact of exchange rate changes on the home currency's purchasing power over imported goods. The second weakness is evidenced by the attempt to deal with foreign exchange decisions using a hedge or no-hedge decision rule, thus ignoring portfolio considerations. In a recent article, Makin [7] discusses the hedge-no-hedge strategy and offers an alternative way to analyze foreign currency problems using portfolio theory. Although Makin's approach is a significant improvement on the hedge-no-hedge analysis it still suffers from the first deficiency. Makin's model is dependent upon his assumption that the home currency is a risk-free asset, an assumption that will likely bring about the inclusion in the resulting portfolio of more assets denominated in the home currency than would be the case if risk were correctly specified. The purpose of this paper is to show that the assumption is not generally correct and to suggest an index that more accurately measures exchange risk. The index that is used is one that was developed by Kouri and Braga de Macedo [3]. It is similar in concept to a trade-weighted exchange rate and reflects the impact of exchange rate variation on the purchasing power of a unit of currency. Section I presents a verbal description of exchange risk. The differences between the traditional view and the global view espoused here are highlighted. Section II discusses the Kouri and Braga de Macedo index of value and its applicability to the foreign exchange exposure problem. Section III demonstrates the use of the index in adjusting returns and analytically shows the error in confusing the nominal riskless asset with a real riskless asset. In section IV the characteristics of a real riskless asset are investigated.

Net Foreign Asset Positions and Stability in a World Portfolio Balance Model

Can a flexible exchange rate regime be unstable in the absence of destabilizing speculation? Several writers have suggested that portfolio composition alone can be a source of dynamic instability. When the residents of an open economy have net claims denominated in foreign currency, a depreciation of the home currency reaises teh home currency value of their wealth, thereby increasing their demand for home-currency assets. However, when they have net debts denominated in foreign currency, this conventional stabilizing valuation effect is reversed. A depreciation has the "perverse" effect of lowering the home currency value of wealth, thereby reducing demand for home-currency assets. Furthermore, even if home residents have a positive net foreign asset position, a depreciation of the home currency can have a destabilizing valuatoin effect if foreign residents have a genative net foreing asset position )that is, if they have net debts denominated in the currency of the home country).

The Dynamic Effects of Exchange Market Intervention Policy: Two Extreme Views and a Synthesis

Under a regime of managed floating, one policy instrument available to authorities is exchange market intervention policy, purchases or sales of assets denominated in foreign currency in exchange for assets denominated in home currency. SInce, in general, an economy does not reach its new long-run equilibrium immediately following an exchange market intervention, a complete analysis ofthe effects of this policy must include description of the path followed by the economy as it adjusts to its new long-run equilibrium. This paper is a study of the dynamic effects of the particular type of intervention policy, a purchase of foreign money with home money.

The Influence of Exchange Rate Changes on Prices: A Study of 18 Industrial Countries

A key issue in contemporary economic policy-making concerns the effect of rate changes on prices. The traditional view of rate movements, prevalent up to the 1 960s, took it almost for granted that a devaluation would reduce the foreign currency price of exports and increase the home currency price of imports. The empirical debate centred on the price elasticities of demand for those exports and imports. If the elasticities were sufficiently large, the devaluation would work; i.e., the volume effects (higher exports, lower imports) would outweigh the adverse movement in the terms of trade (cheaper exports, dearer imports) and the trade balance would improve (Robinson, 1947). This classic analysis was essentially static and was attacked on the grounds that it ignored the long-run effect on prices of a parity change. These effects are taken account of by the monetary view of the balance of payments, which stresses the effect of balance of payments disequilibrium on the supply and hence on prices. On this view (summarized in Johnson, 1972) a devaluation may initially create a balance of payments surplus, but this will then increase the supply and set in motion an inflationary process which restores the price level of the devaluing country, measured in foreign currency terms, to its pre-devaluation level. At this point the external surplus disappears and the country is back in its original position, but with a once-for-all increase in its reserves, accumulated while the price adjustment was occurring. The above analysis justifies the claim that the rate, being an essentially monetary phenomenon, can affect only money things (i.e. the general price level) and cannot permanently change the underlying phenomena such as the trade balance or the terms of trade. This view of rate changes can be justified by another line of argument: the tradeable output of each country has a determinate value. In other words, if trade was conducted by barter, a hundred Leyland Minis would be freely exchanged for some definite number of Volkswagen Golfs or Renaults 5s, the real barter rate of exchange of those goods. In equilibrium, UK, French and German prices and rates should be such that the sterling value of the hundred Minis should, when converted into German marks or French francs at the market rate of exchange, exactly purchase the number of Volkswagens or Renaults given by the barter rate of exchange. Clearly, a change in the rate is not going to alter people's preferences for Minis as against Volkswagens or Renaults. Hence, starting from a position in which prices and rates are in equilibrium, any rate change must in the long run be completely offset by price movements which restore the rate at which Minis are exchanged for Volkswagens and Renaults.

The Post-Devaluation Time Profile of Reserves and Prices under Neoclassical Assumptions

The re-introduction of neoclassical assumptions into balance of payments theory was done by Hahn (1959) and Kemp (1962). Both of these writers employed a Patinkin-type model specialized to two countries, two commodities, two individuals and two fiat moneys. By making the assumptions that all goods were gross substitutes and normal, they were able to demonstrate the proposition that in the period in which a small devaluation by the home country takes place, (a) the balance of payments of that country improves; (b) the prices of the two commodities, expressed in home currency, increase but not proportionately with the price of foreign exchange; and (c) the foreign currency prices of the two commodities decrease, but not proportionally with the fall in the price of the home country's currency. In the first years of this decade, a further theorem was discovered which provided the rationale for the Hahn-Kemp results. It is that (1) a devaluation is equivalent, in its effects on the model's real variables and monetary variables expressed in home currency, to an equiproportional increase in the foreign money stock of the same percentage amount as the increase in the price of foreign currency; and (2) a devaluation is equivalent, in its effects on the real variables and the monetary variables expressed in foreign currency, to an equiproportional decrease in the home money stock of the same percentage amount (see e.g., Kemp, 1970; Kuska, 1972). Now (1) implies that the world money stock, measured in home currency, increases but proportionally not by as much as the price of foreign exchange; and (2) implies that the foreign currency value of the world money stock decreases, but not by as much proportionally as the devaluation. Therefore, in the long run, on price-specie-flow considerations, one would expect the Hahn-Kemp results to hold; and that this is so was demonstrated in Kuska (1972, p. 315) for the general case in which there are arbitrary numbers of commodities and individuals in the world economy. The Hahn-Kemp results just state that these long-run properties also hold in the initial post-devaluation period in the two-commodity, two-individual case-if the goods are gross substitutes and normal. Even aside from the fact that the Hahn-Kemp theorem has been demonstrated only for a restricted case, the resulting situation is not entirely satisfactory. We know that, in the long run, providing the system is stable, a devaluation will increase the home country's reserves, and we know what it will do to prices. If we make the Hahn-Kemp assumptions, we also know that qualitatively similar results happen in the initial period for their specialized model. We do not know, however, whether their results hold in the general case; and further, we do not know what occurs in the interim

FLUCTUATING EXCHANGE RATES AND THE PRICING OF EXPORTS

The purpose of this paper is to examine the invoicing decision of an exporter under a system of pegged exchange rates and a system of freely fluctuating rates. With pegged exchange rates, the exporter may equivalently invoice in its home currency or in the currency of its foreign clients, since the two prices are related by the pegged rate. With fluctuating rates, however, the choice of an invoicing strategy is important and will affect the level of trade. The optimal prices with each strategy are compared, and the exporter's responses to governmental policy instruments are characterized.

Adequacy of International Means of Payments

It has been argued recently that the size of the holdings of foreign exchange by commercial banks provides a better measure of the adequacy of international means of payments than the size of official reserves.' At first glance this appears obvious for it is these commercial holdings of foreign exchange which are used directly for financing international exchange while official reserves are used only to finance imbalances in countries' balance of payments which result from the maintenance of relatively exchange The argument becomes less clear, however, when one stops to question what is meant by the adequacy of international means of payments. Within a free market context, what does it mean to say that commercial holdings of foreign exchange are inadequate? The commercial interests involved clearly can not feel that their foreign exchange holdings are inadequate (apart from a desire to have higher wealth positions in general) for otherwise they would simply exchange domestic for foreign currency until their foreign currency holdings were no longer inadequate. In other words, from the point of view of commercial banks and traders, at any point in time would merely mean a temporary disequilibrium situation. traders on both sides of the market felt their foreign currency holdings to be inadequate then they would in effect merely swap currencies with one another (a practice now common between central banks). the size of the desired swaps did not match on each side of the market, then under flexible rates the price of the relatively scarce currency would be bid up until desired holdings equalled actual holdings, i.e., until foreign currency holdings were adequate. As Yeager has put it, If no authority concerned itself with gold and foreign exchange, and if private persons, firms and dealers such as banks, found their holdings inadequate, they would bid for additional amounts, thus depressing the home currency on the exchange market, stimulating exports relative to imports, and making available the quantity of foreign exchange desired at the new level of exchange rates. 2 Under a fixed rate system the increased demand for foreign currency would be reflected in official reserve losses. In either case, observed foreign currency holdings would always reflect desired or adequate holdings except for the effects of transitory disequilibrium. We could, however, meaningfully speak of inadequacy in terms of a discrepancy between desired and actual holdings if a free market does not exist. In other words, where exchange controls, etc. effectively prevent traders from satisfying their demands for foreign balances then we could unambiguously say that observed holdings were inadequate. As is brought out in Heller's figures,3 the rapid expansion of holdings of foreign currencies by banks in industrial Europe as postwar exchange controls were loosened suggests that there was considerable inadequacy at the beginning of the period. one accepts the argument put forward here that one can meaningfully speak of an inadequacy of commercial holdings of foreign exchange only where traders do not face free markets for foreign exchange, then inadequate commercial holdings of foreign exchange are themselves a reflection of an inadequacy of official reserves (at least from the point of view of the country in question). In other words, inadequacy of commercial holdings of foreign exchange is a reflection of impediments placed on the foreign exchange market which in turn reflect that the government of the country in question feels that its official reserve holdings are below their desired level, i.e., that they are inadequate. At first glance Heller's figures would seem to contradict this argument. Over the 1951 to 1966 period the global ratios of official reserves to imports and banks' foreign exchange holdings to imports show quite different trends, the former falling by almost one half while the latter almost tripled. Hence, Heller's conclusion that, while according to