Expectations and exchange rate dynamics under managed floating : an asset market approach
This thesis analyses exchange rate dynamics in a managed floating exchange rate regime, under two alternative specifications of private expectations: adaptive expectations and long-run perfect foresight. The whole analysis follows the asset market approach to exchange rate determination. A built-in government reaction function is incorporated in a neoclassical general equilibrium portfolio balance model. The intervention rule employed, reflects both the "reference rate proposal" of Ethier and Bloomfield (1975) and the 3rd guideline of the IMF for the management of floating exchange rates. The government intervenes in the foreign exchange market in order to minimize the discrepancies of the spot exchange rate from the government reference rate (estimate of the long-run exchange rate), at every moment in time. It is shown that the degree of success at which government intervention moderates short-run exchange rate variability depends on the degree of precision with which the government forms its estimate of the long-run exchange rate path. Any prediction errors lead to dynamic instability. A generalisation of the intervention rule leads to a stable long-run equilibrium even if the government uses the wrong estimate of the long-run exchange rate path (competitive exchange rate policies). However, the sustenance of these equilibria creates crises in the balance of payments and the system ultimately returns to the free floating long-run position. Persuance of competitive exchange rate policies increases the degree of reserve use and could lead to intervention at cross purposes, increasing the need for international liquidity. A re-interpretation of our intervention rule to reflect speculative behaviour leads to similar results as government intervention. The liquidation of speculative profits, however, creates additional short-run exchange rate variability, enhancing the non-profit making nature of government intervention.