loans and money

This is a particularly useful concept because it deals with that frustrating delay between the change in the exchange rate and the adjustment to the economy. Equally, it deals with both trade and capital flows. Suppose international investors have been buying the equity and fixed income securities of an emerging market economy such as Korea. For some reason, those investors “lose confidence” in the Korean economic story and as a result the Korean won. What does that mean? In practice it means that international investors all try to sell at the same time. However, if investors all try and sell at the same time, chances are their orders will not be filled. The Korean won will fall like a stone, but on very little actual volume.
Classic economic theory suggests that a fall in the nominal exchange rate should lead to a reduction in the current account deficit by making imports more expensive and exports cheaper. However, this assumes that the transmission mechanism from the exchange rate to export and import prices is immediate. We know however that this is not the case. Corporations tend to take a wait-and-see attitude in times of market distress, delaying major price changes until financial and economic conditions become clearer. In economist jargon, as we saw in the monetary approach to exchange rates, prices are “sticky”. Thus, in our example the Korean won may fall without any immediate benefit to the trade and current account balances. This is not completely a hypothetical example because this is exactly what we saw during the Asian currency crisis of 1997–98. Then, a crisis in Thailand focused investor concerns on much of the rest of Asia, triggering a general loss of confidence in Asian assets and currencies. Asian currencies collapsed but on far smaller volumes than the extent of their declines might have suggested. The Korean won collapsed along with the Thai baht, Indonesian rupiah, Philippine peso and at least initially the Malaysian ringgit. Despite this, there was no immediate reduction of Asian trade and current account deficits. Analysts of the Asian crisis will no doubt suggest that other factors were also at work, notably the high importer content within Asian exports. While this was undoubtedly the case, it does not detract from the fact that there was a clear and marked delay between the exchange rate move and the adjustment to the trade balance. For whatever reasons, Korean corporations delayed their price increases.
We can also see this at work from the angle of the exchange rate rather than the trade balance. As an exchange rate appreciates, it causes exports to become more expensive in the currency to which these exports are going and imports from that country to become cheaper. The initial reaction in the trade balance is not negative however. As the exchange rate appreciates, it causes export prices to rise and import prices to fall. This in turn causes the value of exports to rise vs. imports, thus the initial reaction in the J-curve is that the trade balance actually improves. While this is happening, however, the impact of higher export prices reduces demand for those exports, causing falling export volumes. In turn, falling export volumes eventually lead to a fall in the value of exports and thus to a deterioration in the trade balance. The delay between the fall in export volumes and export values and the subsequent impact on the exchange rate is reflected by the concept of the J-curve. That delay factor varies between exchange rates depending on specific export price sensitivity to changes in the exchange rate.

So far in this blog, the focus has been on trying to create new exchange rate models based on capital flows to try to improve forecasting accuracy. As necessary as this is, it does not mean we abandon the traditional exchange rate models. Classical economic theory has provided the foundations for exchange rate analysis. The purpose of establishing a framework known as currency economics is to be able to combine the new with the exchange rate models and use both in a more targeted and focused way. Any major differences between this framework of currency economics and classical economics are more methodological than ideological. The traditional exchange rate models, focusing as they do on such factors as trade, productivity, prices, money supply and the current account balance, help provide the long-term exchange rate view. Capital flow-based models are considerably more helpful and accurate in terms of predicting short-term exchange rate moves.
However, these two types of exchange rate model should not necessarily be viewed as polar opposites. The very purpose of establishing a specific framework known as currency economics is to create an integrated approach to exchange rate analysis, which is capable of answering the riddles of short-, medium- and long-term exchange rate moves. The two sides do have some common ground, and it should be no surprise that this common ground is to be found in the balance of payments model — given that it focuses both on trade and capital flows. Within this, there are three specific analytical tools which should be of use to currency market practitioners in bridging the gap between short- and long-term exchange rate analysis:
The standard accounting identity for economic adjustment
The J-curve
The REER

As with the supposed efficiency of markets, which does not actually work in practice, so there is the idea that supply and demand are completely independent of one another. If this were so, price trends could not exist because markets would instantly work to eliminate any supply or demand imbalances. The fact that this does not happen and that price trends do occur suggests that there are lags, sometimes substantial lags, before such imbalances can be eliminated. In addition, supply and demand are not completely objective concepts. Rather, at least in part, they reflect the views expressed by those market participants that make up that supply and demand. In other words, supply and demand are both cause and effect.
So much for the theory, what does this mean in practice? Actually, to a market practitioner, these ideas are relatively obvious. Currency interbank dealers know full well that particular flows will have more effect than others and thus will materially affect the supply/demand dynamics. Say a large multinational corporation transacts an end-of-quarter hedge in the Euro–dollar exchange rate. Granted, this is the most liquid currency pair in the world, but if the flow is large enough it may affect both current market pricing and future market thinking. Of course the term “future” means different things to different people. To the multinational, it means months at least if not years. To the interbank dealer transacting the flow in the market place it means minutes or hours at most. Currency markets are essentially flow-driven over short time frames, and therefore it is vital to understand the relationship between supply and demand dynamics.
Just as supply and demand are not independent of one another and are both cause and effect, so the relationship between “speculation” and economic fundamentals is also not just one-way. Economic theory requires that markets eliminate “speculative excess”, thus restoring equilibrium. However, we have already established that “equilibrium” is actually a moving target. If the “speculative excess” is the extent to which markets diverge from equilibrium, then that “speculative excess” is also a moving target. Finally, the presumption of economists is that economic fundamentals drive market pricing and thus to an extent speculative excess. Even if we accept this, it has also to be acknowledged that speculative excess can in turn affect economic fundamentals. This is best proven by example.