A behavioural finance model of exchange rate expectations within a stock-flow consistent framework

1
A behavioural finance model of exchange rate
expectations within a stock-flow consistent
framework

• Gauthier Daigle
• Marc Lavoie

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Outline

• Prolegomena
• Behavioural expectations
• Baseline model, without expectations
• Simulations with expectations
• Conclusion

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Origins of the open-economy model Godley and
Lavoie, 2007, chapter 12
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Main features of the model

• Stock-flow coherence
• Two-country model
• Integration of real and financial variables
• Imperfect asset substitutability (in the
  tradition of Tobin, Branson and Henderson,
  Blanchard et al. 2005)
• Therefore uncovered interest parity does not hold
• Many endogenous variables
• Import prices, export prices, domestic sales
  deflator, GDP deflator, exchange rate
• Exports, imports, output, consumption, domestic
  sales, disposable income
• Taxes, interest payments, money stock, holdings
  of bills and money (portfolios), wealth
• Trade balance, current account balance, capital
  account balance

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Behavioural expectations
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Exchange rate expectations

• In the original 2007 model, expectations about
  exchange rate changes were set to zero (i.e., the
  probability of appreciation and of depreciation
  are balanced).
• Here we reintroduce expectations, consistent with
  the claim by several PK authors that exchange
  rate expectations of portfolio holders play a key
  role in the determination of exchange rates
  (Harvey 2003).
• We reject the mainstream introduction of
  expectations through the interest parity theorem,
  which asserts that the forward exchange rate
  represents the expectations of the market
  regarding the future value of the spot rate.
• We support instead reversed causality the
  forward exchange rate is simply the spot rate
  plus the interest rate differential
  (Coulbois/Prissert 1974, Lavoie 2000, Moosa
  2004).

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Behavioural exchange rate expectations

• Based on De Grauwe and Grimaldi (2006)
• Two types of investors/traders fundamentalists
  and chartists
• The fundamentalists stick to a given exchange
  rate value. This value, in general, will not
  however be the long-run  equilibrium  one.
• The chartists believe that the trend in the
  evolution of the exchange rate will continue.
• If the exchange rate is moving upwards, but is
  still below its  fundamental  value, both
  chartists and fundamentalists will expect an
  increase in the exchange rate.

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The portfolio equations
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Expectations equations
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Baseline model, without expectations
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Baseline simulation

• To study the role of expectations, we first run a
  baseline simulation without expectations.
• We start off from a full equilibrium (the
  baseline case), with the trade, current and
  capital accounts all in balance.
• We then impose an increase in the propensity to
  import of the US economy from the UK economy (US
  imports rise)

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The UK trade balance (right axis) is initially in
surplus, then in deficit, and the UK exchange
rate keeps rising until it reaches a steady level
(left axis)
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Why does the price of the UK currency rise from a
portfolio point of view?

• This can be explained by the large increase in
  the supply of US bills to the UK.
• Higher US imports generate a slowdown in the US
  economy, lower tax revenues and hence a US
  government deficit, and thus an increase in the
  supply of US government bills.
• This larger supply cannot all be absorbed by the
  domestic US market and must be unloaded on
  foreign financial markets, thus generating the
  depreciation of the US currency and the
  appreciation of the UK currency.
• The value of the UK currency moves from 1 to
  1.38.

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Simulation with expectations
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Simulation with stable results

• We assume the same increase in the propensity to
  import of the US economy.
• Fundamentalist investors believe that the
   fundamental  value of the UK exchange rate
  remains at its starting value, 1.
• Thus they believe that changes are of a
  transitional nature.

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With expectations, the UK exchange rate converges
to a different stationary value, 1.55The UK
trade surplus is turned into a trade deficit
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What happens if the  fundamental  exchange rate
value is modified?

• When the fundamental value of the exchange rate
  is being under-estimated, the economy tends
  towards a steady-state value of the exchange rate
  that is above its fundamental value without
  expectations
• Reciprocally, when the fundamental value of the
  exchange rate is being over-estimated, the
  economy converges towards a steady-state value of
  the exchange rate that is below its fundamental
  value.
• When the exchange rate expectations of the
  fundamentalists correspond to the steady state
  value of the model without expectations, this
  steady state value is realized in the model with
  expectations.
• Thus, adaptative expectations of the
   fundamental  exchange rate value would drive
  the model towards the stationary state achieved
  without expectations.

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What happens if chartists represent a greater
proportion of the exchange rate traders or
investors?The stabilizing effects of trade flows
and asset supplies are beaten by the
destabilizing effects of asset demands
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Conclusion Is there hysteresis with expectations?

• When a shock is reversed, in the stable case, the
  economy returns exactly at its starting point.
  There is no path-dependence, even though there
  are exchange rate expectations and chartists that
  act on trends.
• But there is persistence. With exchange rate
  expectations, the model takes twice as much time
  to return to its stationary values compared to
  the model without expectations.
• In the unstable case, reversing the shock will
  not do.