Speculation, Capital Mobility, Price Flexibility, Forward Market Intervention and Exchange Rate Variability: A Simulation Approach
Tseng, Hui-Kuan
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https://hdl.handle.net/2142/72413
Description
Title
Speculation, Capital Mobility, Price Flexibility, Forward Market Intervention and Exchange Rate Variability: A Simulation Approach
Author(s)
Tseng, Hui-Kuan
Issue Date
1988
Department of Study
Economics
Discipline
Economics
Degree Granting Institution
University of Illinois at Urbana-Champaign
Degree Name
Ph.D.
Degree Level
Dissertation
Keyword(s)
Economics, General
Abstract
This study develops a general stochastic disequilibrium model for a small open economy in order to investigate whether under rational expectations hypothesis increased speculation, capital mobility, price flexibility and forward market intervention can dampen fluctuations of spot and forward exchange rates against random disturbances originating in the home country and abroad. The key extension made here is the incorporation of these realistic aspects into the model: (1) foreign goods are imperfect substitutes for domestic goods; (2) foreign assets are imperfect substitutes for domestic assets on a covered basis; and (3) the current forward rate differs from the future spot by a market-determined risk premium. Although domestic goods price is assumed to be sticky, it is not predetermined, as in the literature.
Numerical simulation is performed for the model based on exogenous speculation and for the extensive one based on endogenous speculation respectively to highlight the importance of the Lucas critique. It is found that increased speculation, price flexibility, capital mobility or forward market intervention is not necessarily stabilizing, depending on the origin of random disturbances, the degree of price flexibility and sometimes the degree of exogenous speculative elasticity (or risk aversion) relative to the degree of price flexibility and the degree of capital mobility. It is also observed that if domestic price adjustment is inelastic, the impact of domestic monetary disturbance dominates, and induce the spot rate to be more volatile than this market fundamental in the short run; but if domestic price adjustment is elastic, the impact of domestic absorption disturbance dominates, and results in the similar phenomenon. Spot trade disturbance can give rise to this sort of excessive volatility of the spot rate in the short run only if capital movement across countries is extremely sluggish and risk aversion of speculators is relatively high.
Endogenizing private speculation raise the problems of existence and non-uniqueness of equilibrium. It is shown that the existence problem is absent in our model, but non-uniqueness might occur if such disturbances that initially impinge on spot trade balance are present.
Our conclusions convey the following policy implications. As far as spot rate variability is concerned, forward market intervention is much less desirable especially in the long run when private speculation is endogenously determined. A tax on foreign exchange transactions to deter short-term capital movements, as suggested by Tobin (1978), is not guaranteed to be stabilizing.
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