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An Integrated Theory of Exchange Rate Equilibrium

Published online by Cambridge University Press:  19 October 2009

Ian H. Giddy
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Extract

This brief paper will show that (a) a theoretical equilibrium state of the world exists in the absence of capital controls and trade barriers when prices for the same goods in different markets are equal, after translation at the spot exchange rate; (b) differences in rates of aggregate price change in different markets eventually cause offsetting exchange rate changes which restore condition (a); (c) returns on equivalent securities denominated in different currencies but covered in the forward market are almost instantaneously equalized; (d) the market's expected rate of change of the exchange rate equals, to a close approximation, the control-free interest rate differential between the two currencies; (e) in the absence of predictable exchange market intervention by central banks, the interest rate differential is the best possible forecaster of the future spot rate; and (f) the forward rate also provides the best forecast of the future spot rate. A final corollary identifies a relationship between inflation rates and international interest rate differentials.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 11 , Issue 5 , December 1976 , pp. 883 - 892
Copyright
Copyright © School of Business Administration, University of Washington 1976

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References

1 A similar approach is taken by Robert Z. Aliber in an unpublished manuscript entitled The Short Guide to Corporate International Finances (1974). See also Aliber, Robert Z. and Stickney, Clyde P., “Accounting Measures of Foreign Exchange Exposure: The Long and Short of It,” The Accounting Review, Vol. 50 (January 1975), pp. 44–57.Google Scholar

2 The purchasing power parity theorem was first proposed and tested by Cassel, Gustav in “The Present Situation of the Foreign Exchanges,” Economic Journal, Vol. 26 (1916), pp. 62–65CrossRefGoogle Scholar, 319–23, and in subsequent articles and books. More recent expositions may be found in Balassa, Bela, “The Purchasing Power Parity Doctrine: A Reappraisal,” Journal of Political Economy, Vol. 72 (December 1964), pp. 584–596CrossRefGoogle Scholar, and in Holmes, James M., “The Purchasing Power Parity Theory: In Defense of Gustav Cassel as a Modern Theorist,” Journal of Political Economy, Vol. 75 (October 1967), pp. 686–695.CrossRefGoogle Scholar

3 For recent tests of the purchasing power parity theorem see Aliber, and Stickney, , “Accounting Measures, Balassa, “Purchasing Power, Leland B. Yeager,” A Rehabilitation of Purchasing Power Parity,” Journal of Political Economy, Vol. 66 (December 1958), pp. 516–530Google Scholar, and Galliot, Henry J., “Purchasing Power Parity As An Explanation of Long-Term Changes in Exchange Rates,” Journal of Money, Credit and Banking, Vol. 2 (August 1971), pp. 348–357.CrossRefGoogle Scholar

4 On the interest rate parity theorem see any recent international finance textbook. See also: Officer, Lawrence H. and Willett, Thomas D., “The Covered-Arbitrage Schedule: A Critical Survey of Recent Developments,” Journal of Money, Credit, and Banking, Vol. 2 (May 1970), pp. 247—257CrossRefGoogle Scholar; Aliber, Robert Z., “The Interest Rate Parity Theorem: A Reinterpretation,” Journal of Political Economy, Vol. 81 (December 1973), pp. 1451–1459CrossRefGoogle Scholar; Marston, Richard C., “Interest Arbitrage in the Eurocurrency Markets,” Discussion Paper No. 259 (The Wharton School, University of Pennsylvania, 1974)Google Scholar; Herring, Richard J. and Marston, Richard C., “The Forward Market and Interest Rate Determination in the Eurocurrency and National Money Markets,” unpublished working paper (University of Pennsylvania, 1974)Google Scholar; and Agmon, Tamir and Bronfeld, Saul, “International Mobility of Short Term Covered Arbitrage Capital,” Journal of Business Finance and Accounting, Vol. 2 (Spring 1975).CrossRefGoogle Scholar

5 See Giddy, Ian H. and Dufey, Gunter, “The Random Behavior of Flexible Exchange Rates: Implications for Forecasting,” Journal of International Busines Studies, Vol. 6 (Spring 1975)Google Scholar; also: Aliber, The Short Guide, Chapter 6, for long-run tests of this theory.

6 Solnik, Bruno H., European Capital Markets (Lexington, Mass.: Lexington Books, 1973), p. 37.Google Scholar

7 Levich, Richard M., “Tests of Foreign Exchange Forecasting Models and Market Efficiency—A Preliminary Report,” Working Paper No. 75–88 (New York University Graduate School of Business Administration, November 1975).Google Scholar

8 A concise exposition of this notion may be found in Kaufman, George G., Money, the Financial System, and the Economy (Chicago: Rand McNally, 1973), pp. 136–143Google Scholar. For a rare example of an empirical test see Fama, Eugene F., “Short-Term Interest Rates as Predictors of Inflation,” American Economic Review, Vol. 65, No. 3 (June 1975), pp. 269–282.Google Scholar

9 Fisher, Irving, The Theory of Interest (New York: Macmillan, 1930), p. 69.Google Scholar