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Published online by Cambridge University Press: 26 March 2020
In March this year, after a year in which policy appeared to be aimed at achieving stability against EMS currencies, the pound was allowed to rise sharply in response to large capital inflows. As with many fluctuations in exchange rates, this development was puzzling in that the prospects for the balance of payments suggested that the rise in sterling would not prove sustainable. On the other hand, high UK interest rates, particularly in relation to those available in EMS countries, provided some rationale for a temporary rise. This note uses a simple forward-looking equation for the exchange rate to illustrate the implications of alternative paths for interest rates and the balance of payments. A number of simulations are presented to illustrate the key elements of this approach.
I would like to acknowledge comments received from colleagues at the National Institute and in particular the advice of Simon Wren-Lewis, Ray Barrell and Andrew Britton.
(1) This equation was estimated by Bob Anderton.
(2) The estimation looked at a number of different specifications over the two periods 1973 II-1987 II, and 1979 11-1987 II. A more detailed description of this work is available from the author on request.
