Conditions under which Exchange Rate May Overshoot Even in the Presence of Rational Expectations - Research Paper Example

Conditions under which Exchange Rate may overshoot Even in the Presence of Rational Expectations Introduction This paper’s objective is to assess and throw light on the conditions under which the exchange rate may shoot up, even in the presence of Rational Expectations. For the very objective of the paper, it becomes crucial to look into the theory of rational expectations besides critically evaluating the meaning of the term in context of its practicality and its theory format. The paper focuses on the term rational expectations and also aims to sort out how easily it can be executed or how difficult it is to execute it in real life instances. John F. Muth of Indiana University coined the theory of rational expectations in the early sixties. He used the term to describe economic situations under which, the outcome depends on peoples’ expectations. For example as discussed by Sargent J. Thomas (Rational Expectations) “The price of an agricultural commodity depends on how many acres farmers plant, which in turn depends on the price that farmers expect to realize when they harvest and sell their crops”. The theory greatly applies to the stock markets around the world, as, if investors expect the price of common stock of a particular company to come down they go on a selling spree and the result is obvious, and when they expect it to go up they buy heavily and hence, the prices spirally. To conclude the cornerstone of the theory, we can suggest that, people behave or take decisions in order to maximize the value of an outcome and they keep getting feedback from the transactions, as to what they expected and what they actually received. In this way there expectations over a period of time tend to stabilize because of the result of the past outcomes. In other words, their expectations become rational. To put the theory in mathematical perspective, let us assume that P* is the equilibrium price (a price at which demand equals supply) in a market, then according to the rational expectations theory (Pe) will be the function of P* + e, where (Pe) is the expected price and e is the random error term, which is independent of P*. (Sargent J. Thomas, Rational Expectations). The Theory of Rational Expectations in Practice Rational Expectations in Practice The thoery of rational expectations is often put into practice in many economic as well as finance models. One such execution of the model is related to The Efficient Markets Theory of Stock Prices, which states that there are three forms of the efficient-market hypothesis, namely, weak form, semi strong form, and strong form (Fischer Donald and Jordan Ronald 540). Weak form, which is also known as the Random-walk theory suggests that there is no purpose of examining the charts as the share pieces fully reflect the historical sequences. Semi-strong form on the other hand suggests that current market prices not only reflect the historical chart patterns, but also reflect all the publicly available knowledge, so this kind of information is almost always useless for the analysts and the investors. The theory maintains that as soon as the information is made public, the price plays a catch-up and soon starts to reflect the new announcement. Finally strong form suggests that not only publicly available information is useless, but also all the information concerning the company is useless, as that will have no impact over the stock price. Rational expectations relates to the efficient market theory as investors, based on their expectations, value a stock, for example if they think earnings visibility is good, they bid the prices higher, and if perceive earnings visibility to be low, they bid prices to be low and this is reflected in the stock prices, so their estimates or expectations are reflected in the stock prices. (Sargent J. Thomas, Rational Expectations). Talking of the critisism faced by the theory, we can argue that the theory of efficient market itself suggests that all the announcements and news about the company are already fully refelected in the price, so expectations do not drive the result and hence investors’ expectations have nothing to do with the future market price. Also the theory is based on future, (predicting the earnings),which can nor be predicted Another application of the theory pertains to The Permanent Income Theory of Consumption, which states that there is a direct positive relationship between the people’s consumption and their income. Friedman believed that people not only consume depending upon their current income, but also considering their future income. (Qtd in Rational Expectations). Ananlysis of future income in his work is due to the expectations that people have about their future, so the concept directly relates to the rational expectations theory. The specific model of consumption and income has been tested time and again and results have varied greatly, as the studies show that the model works, but imperfectly. It can be argued to overpower the above mentioned point that many people have certain consumption habits and if they stick to their habits, it becomes literally improbable for them to care about their resources and income. Many such cases happen with addicts or people who abuse drugs or alcohol. Rational expectations theory can also be applied to the Expectational Error Models of the Business Cycle, which states that errors in people’s forecasts are a major cause of business fluctuations. Phillips curve shows the inverse relationship between unemployment and inflation. (Phillips Curve), where Nairu stands for non-accelerating inflation rate of unemployment. The PC, which is the long red line, changes in the long run because of the change in expectations and thus only a single rate of unemployment was consistent with the inflation rate. If the unemployment rate stays behind the red line inflationary expectations will rise, which will tale the short term PC upwards as indicated by B. Economists attribute this inverse correlation to the errors that people made while forecasting price levels. These forecasting errors of public were manipulated by the economists to generate better performance of economy. As discussed by Hall Robert on the next page: The benefits of inflation derive from the use of expansionary policy to trick economic agents into behaving in socially preferable ways even though their behavior is not in their own interest.... The gap between actual and expected inflation measures the extent of the trickery.... The optimal policy is not nearly as expansionary [inflationary] when expectations adjust rapidly, and most of the effect of an inflationary policy is dissipated in costly anticipated inflation. (Qtd in Rational Expectations) So it is made evident that policymakers could use public’s false expectations to regulate the economy, but with rational expectations it is not possible to for the economists to do so. So this model is many a time used to make policies ineffective. The theory, however, can be contradicted by asserting that there are only a few government policies that will be affected by rational expectations and most of the policies will not be affected, as they primarily deal with incentives or margins. Overshooting of Exchange Rate To have a deeper look into the reasons why exchange rates overshoot, there is a need to look into the monetary policy and the way interest rates are formed. Any government has the power to regulate the economy of the country and not only does it regulate the economy, it has a vital role to ensure that the economic condition remains stable. It is the responsibility of the government to ensure that all the aspects of economy maintain a stable level so that the country can grow and expand. Government regulates many things in an economy including inflation, exports and imports, prices of many vital commodities, and many important economic aspects. Let us take the example of Bank of England to understand the whole concept of interest rates and inflation. Government of England has entrusted the job of determining the monetary policy, in the hands of Bank of England. Bank of England looks into many other big issues. One of the most important issues is that of ensuring monetary stability in the economy, which can be achieved through a combination of stable prices of goods and services across the economy coupled with a low inflation level and level of confidence of the investors in the currency of the country. The Bank comes out with the monetary policy in order to ensure a certain key objectives like, delivering price stability with a low inflation level coupled with an objective to support the Government’s economic objectives of growth and employment. Price stability is taken care of, by the Government’s usual inflation target of 2%. There is a need to contemplate the crucial and critical role played by price stability in achieving the aforesaid economic stability, and in providing just the right conditions for a sustainable and longer living growth in output and employment. Chancellor of the Exchequer announces the Government’s inflation target every year in the annual Budget statement. Though The 1998 Bank of England Act enables it to set interest rates independently, however, The Bank does hold accountability to the parliament and the wider public, which can not be refrained from. The legislation provides the government the power to instruct the bank on the interest rates issues for a limited period of time during emergency, for the sake of national interests. (How Monetary Policy Works) The inflation target of 2% depicts the target in terms of an annual rate of inflation based on the Consumer Prices Index (CPI). The government’s intention is definitely not to achieve the lowest possible inflation rate, as a low inflation is supposed to be equally bad as a high one and for that matter inflation below the target of 2% is judged to be as worse as inflation above the predefined target. The inflation target is therefore very symmetrical. (How Monetary Policy Works) If the Bank misses the target just by a margin of more than 1 percentage points on any side, be it up or down, the Governor of the Bank is required to write an open letter to the Chancellor explaining all the reasons as to why it happened and why inflation increased or fell to such an extent and what are the proposals to ensure that inflation comes back to the target and is retained, however, A target of 2% does in no way mean that inflation will be held at this rate constantly. That would be neither possible nor in any way desirable. Interest rates would be changing all the times, causing unnecessary volatility in the economy. Even then it would neither be possible nor feasible to keep inflation at any predetermined level, say 2% in each and every month continuously. Instead, the committee aims to set interest rates so that inflation can be brought back to target within a reasonable and imaginable span of time without creating undue instability and volatility in the economy. The Committee has its own way of functioning and it entrusts the job of taking all interest rate decision with a nine member committee. The committee’s predominantly focuses on meeting the inflation target by setting an interest rate. (How Monetary Policy Works) Role of Government in Regulating Inflation and Exchange Rate The Bank of England has a monetary policy and it uses the same to regulate mechanism of the economy. Like when it decides to change the interest rate, the government is trying to check the overall expenditure of the economy. A change in interest rates is mostly used to contain inflation, which is the result of lavish expenditure by the country. The bank sets a fixed interest rate at which it lends money to financial institutions and depending on this interest rate, individual banks and other financial institutions set up their own interest rates, which apply to the whole economy. The point to be noted here is that, this interest rate set by the Bank of England is so effective and powerful that it chips in greatly to regulate the whole economy. It affects the stock and bond prices and also influences the asset prices through out the country. This interest rate also regulated the savings in an economy, which eventually results in capital formation and reinvestment. It is note that when interest rates are high, people prefer to invest money in government deposits that are less risky in nature than the stock markets and similarly high interest rates boost up the savings. Lower interest rates make asset and real estate prices go up, as people start ignoring conventional saving instruments and make use of the high growth ventures like shares and houses, which pushes up their prices. Interest rate change also affects exchange rates, as an increase in the interest rate in UK will yield better returns to the investors compared to their overseas ventures. The diagram given below explains better The above diagram explains the concept of system regulation. It shows that the official rate, which is set by the Bank of England, influences many parts of an economy such as market rates, asset prices including the house prices, expectations, and exchange rate. This gives rise to demand, which is the sum total of domestic plus external demand, which in turn gives rise to inflationary pressure resulting in inflation, another important point shown, which deserves a mention is the relationship between the exchange rate and import prices, or the price paid for imports. As explained above, the stronger the exchange rate the lesser the price paid for imports and the weaker the currency the higher the price paid for imports. (How Monetary Policy Works) Talking of the exchange rates, exchange rates can be highly volatile due to an immature monetary policy. As discussed by Rogoff S. Kenneth as under: If domestic monetary policies are unpredictable, then so, too, will be domestic inflation differentials. Ergo, the exchange rate must be volatile because, in the very long run, there has to be a tight link between national inflation differentials and exchange rates. (At least, this is what we have all believed since Swedish economist Gustav Cassel championed his theory of "purchasing power parity"—that exchange rates adjust to reflect differences in consumer price levels—as the way to reset world exchange rates after the system broke down during World War I.) (Why Are G-3 Exchange Rates So Fickle) Another important factor that contributes to the overshooting of the exchange rates is that the real exchange rate of fast growing economies tends to grow at a faster pace due to the fact that the growth happening in the economy bids up the prices of non traded goods. (Why Are G-3 Exchange Rates So Fickle) The Dornbusch's model The ‘overshooting’ model with perfect capital mobility was originally studied by Dornbusch [1976]. The model reinstates that the prices are to be fixed in the short run and not the long run, which is also called the macro- economic disequilibrium approach. The interest rate is taken to be the endogenous variable for the model and also the assumption of purchasing power parity is relaxed. The price of non-traded goods slowly changes towards their new equilibrium after a disturbance, while the prices of traded goods increase in proportion to the money supply. So, the overall price level eventually increases lesser than the money supply, leaving the demand for money lower than the supply. In these circumstances, the exchange rate generally goes beyond a new equilibrium before coming back. In the meanwhile, the excess of money causes increased spending specially in goods and bonds. Eventually, the excess supply of money is eliminated due to rising prices of non-traded goods. (Exchange Rate Theory: A review) The major assumptions are, firstly, there is full employment, secondly, sticky goods prices, thirdly, flexible interest rates as well as exchange rates. The main result does confirm the link between interest rates and exchange rates that is looked into in a foreign exchange event. A key role in this analysis goes to the sluggish adjustment of prices when compared to the asset market. In the short run, however, the effects of monetary expansion are completely dominated by the asset market or by and expectations or capital mobility for that matter. (Exchange Rate Theory: A review) Works Cited “Exchange Rate Theory” Library Ucla 06 Apr. 2007 http://www.library.ucla.edu/libraries/url/colls/asia/papers/ph/exchange.pdf Fischer Donald and Jordan Ronald, Security Analysis and Portfolio Management. Pearson Education, 2004. “How Monetary Policy Works” bankofengland. 06Apr.2007. Bank of England. http://www.bankofengland.co.uk/monetarypolicy/how.htm “Phillips Curve” Wikipedia 06 Apr. 2007. Encyclopedia Wikipedia. 6 Apr. 2007 http://en.wikipedia.org/wiki/Phillips_curve Sargent J. Thomas, “Rational Expectations” The Library Of Economics And Liberty. 6 Apr.2007 The Library Of Economics And Liberty. http://www.econlib.org/library/enc/RationalExpectations.html Kenneth S. Rogoff “Why Are G-3 Exchange Rates So Fickle?” imf 06 Apr 2007 International Monetary Fund http://www.imf.org/external/pubs/ft/fandd/2002/06/rogoff.htm Read More