Exchange Rate Volatility, Trade, and Capital Flows under Alternative Exchange Rate Regimes (Japan-US Center UFJ Bank Monographs on International Financial Markets)

172 Pages·2006·4.3 MB·English

by  Piet Sercu

Exchange Rate Volatility, Trade, and Capital
Flows under Alternative Exchange Rate Regimes
Recent years have seen a substantial increase in the volatility of ex-
change rates. This trend has prompted economists and financial ana-
lysts to question if the observed behavior of exchange rates is consistent
with a rational model. Does that volatility, further, hinder trade? What
are financial markets' effects on countries' investment decisions, and
how would changes in fixed exchange rates affect growth and welfare?
What are the requirements to make such changes feasible? Professors
Sercu and Uppal examine these issues in the context of dynamic general-
equilibrium models, explicitly considering the role of financial markets
while allowing for commodity markets to be segmented across coun-
tries. They show that the theoretical models for exchange rates in this
context are quite different from those put forth by monetary theorists
and proponents of purchasing power parity arguments. The authors also
find that an increase in exchange rate volatility may be associated with
either an increase or decrease in trade, and they conclude by identifying
the particular conditions under which a regime of fixed exchange rates
maximizes welfare.
Piet Sercu is Professor of International Finance at the Catholic Univer-
sity of Leuven. He has also taught at the Flemish Business School in
Brussels and held visiting professorships at Cornell and New York Uni-
versities, the University of British Columbia, and the London Business
School. Professor Sercu served in 1995 as President of the European
Finance Association and was awarded the 1996 Francqui Chair of Eco-
nomics at FUNDP, Namur, Belgium. He has published in journals such
as the Journal of Finance, Journal of Banking and Finance, and Journal of
International Money and Finance and is the coauthor with Raman Uppal
of International Financial Markets and the Firm (1995). His current re-
search focuses on general equilibrium models of exchange rate pricing,
international trade and consumption, and forward and future markets.
Raman Uppal is Associate Professor in the Faculty of Commerce and
Business Administration, University of British Columbia, and has served
as Visiting Professor of Finance at the Catholic University of Leuven
and at the Sloan School of Management, Massachusetts Institute of
Technology. His recent research focuses on understanding how market
imperfections affect the welfare of investors, their optimal portfolios and
hedging strategies, aggregate trade and capital flows, and exchange rate
and other asset prices. He is coauthor with Piet Sercu of the above-named
text, and Professor Uppal's articles have appeared in journals such as the
Journal of Finance, Journal of Financial and Quantitative Analysis, Journal
of International Money and Finance, and Review of Financial Studies.

Japan-U.S. Center Sanwa Monographs on International
Financial Markets
Selection Committee
Ryzuo Sato, New York University (Ex Officio Chairman and Editor)
Akiyoshi Horiuchi, University of Tokyo
Paul Krugman, Massachusetts Institute of Technology
Marti Subrahmanyam, New York University
James Tobin, Yale University
Richard Zeckhauser, Harvard University
The Sanwa Bank has established "The Sanwa Bank Research Endowment
Fund on International Financial Markets" at The Center for Japan-U.S. Busi-
ness and Economic Studies of The Stern School of Business, New York Uni-
versity, to support research on international financial markets. One part of this
endowment is used to offer an award for writing a monograph in this field.
The Sanwa award is made annually on a competitive basis by the Selection
Committee, and the winning published titles and proposals are listed below.
1992, Richard C. Marston, University of Pennsylvania: International
Financial Integration: A Study of Interest Differentials between the
Major Industrial Countries (published 1995; paperback ISBN
0 521 59937 7)
1993, Willem H. Buiter, University of Cambridge, Giancarlo Corsetti,
Yale University, and Paolo A. Pesenti, Federal Reserve Bank of New York:
Financial Markets and European Monetary Cooperation: The Lessons
of the 1992-1993 Exchange Rate Mechanism Crisis (published 1998;
ISBN 0 521 49547 4, paperback ISBN 0 521 79440 4)
1994, Lance E. Davis, California Institute of Technology, and the late Robert
E. Gallman, University of North Carolina, Chapel Hill: Evolving
Financial Markets and International Capital Flows: Britain, the
Americas, and Australia, 1865-1914 (ISBN 0 521 55352 0)
1995, Piet Sercu, Catholic University ofLeuven, and Raman Uppal, University
of British Columbia: Exchange Rate Volatility, Trade, and Capital Flows
under Alternative Exchange Rate Regimes (published 2000;
ISBN 0 521 56294 5)
1996, Robert P. Flood, International Monetary Fund, and Peter M. Garber,
Brown University: Speculative Attacks on Fixed Exchange Rates
1997, Maurice Obstfeld, University of California, Berkeley, and
Alan M. Taylor, University of California, Davis: Global Capital Markets:
Growth and Integration
1998, Pravin Krishna, Brown University: Regional Trading Blocs and
Preferential Trading Systems
1999, Kose John, New York University: Corporate Governance and Agency
Problems: Theory and Empirical Evidence

Exchange Rate Volatility, Trade,
and Capital Flows under
Alternative Exchange
Rate Regimes
Piet Sercu
Catholic University ofLeuven
Raman Uppal
University of British Columbia
CAMBRIDGE
UNIVERSITY PRESS
CAMBRIDGE UNIVERSITY PRESS
Cambridge, New York, Melbourne, Madrid, Cape Town, Singapore, Sao Paulo
Cambridge University Press
The Edinburgh Building, Cambridge CB2 2RU, UK
Published in the United States of America by Cambridge University Press, New York
www.cambridge.org
Information on this title: www.cambridge.org/9780521562942
© Piet Sercu and Raman Uppal 2000
This publication is in copyright. Subject to statutory exception
and to the provisions of relevant collective licensing agreements,
no reproduction of any part may take place without
the written permission of Cambridge University Press.
First published 2000
This digitally printed first paperback version 2006
A catalogue record for this publication is available from the British Library
Library of Congress Cataloguing in Publication data
Sercu, Piet.
Exchange rate volatility, trade, and capital flows under alternative
exchange rate regimes / Piet Sercu, Raman Uppal.
p. cm. — (Japan-U.S. Center Sanwa monographs on international
finance markets)
Includes bibliographical references.
ISBN 0-521-56294-5 (hb)
1. Foreign exchange rates — Mathematical models. I. Title.
II. Series. III. Uppal, Raman.
HG3823 .S465 2000
332.4'5 21 - dc21 99-040246
ISBN-13 978-0-521-56294-2 hardback
ISBN-10 0-521-56294-5 hardback
ISBN-13 978-0-521-03423-4 paperback
ISBN-10 0-521-03423-X paperback
To my parents, Jan Sercu and Therese Reynaert,
and to my wife, Rita Mosselmans
Piet Sercu
To my grandparents, Jaswant Singh and Gobind Kaur
Raman Uppal

Contents
Acknowledgments page xiii
Guide to Notation xv
1 Introduction and Overview 1
1.1 Our Objective and the Contribution of Our Work 1
1.2 Outline of the Monograph and Summary
of Major Results 2
2 Modeling Exchange Rates: A Survey of the Literature 5
2.1 Exchange Rates and National Price Levels 6
2.2 Spot Exchange Rates, Forward Exchange Rates,
and Interest Rates 9
2.3 Exchange Rates and the Balance of Payments 11
2.4 Asset Models of the Exchange Rate 12
2.5 Exchange Rate Models with
Microeconomic Foundations 15
3 A Simple General-Equilibrium Model
of an International Economy 17
3.1 Motivation for the Modeling Assumptions 17
3.1.1 Advantages of the General-Equilibrium
Modeling Approach 17
3.1.2 Modeling the Distinction between Nations 18
3.1.3 Monetary Policy and Exchange Rate Regimes 22
3.1.4 Advantages of the General-Equilibrium
Approach for Empirical Tests 22
3.2 Details of the Basic Model of an Endowment Economy 23
3.3 Extension of the Basic Model to a
Production Economy 29
3.3.1 The Dynamics of the Spot Exchange Rate 32
3.3.2 The Nominal Exchange Rate in the
Production Economy 33
3.4 Other Extensions 34
ix
Contents
4 The Spot Exchange Rate in a Large Class of
General-Equilibrium Models 35
4.1 The Economy and the Equilibrium Exchange Rate 36
4.2 Characterizing the Level of the Exchange Rate 39
4.2.1 The Exchange Rate under Homothetic,
CRRA Utility 39
4.2.2 Purchasing Power Parity 42
4.2.3 Implications of the General Model for
PPP Tests on First-Differenced Data 43
4.3 Empirical Tests of PPP 45
4.3.1 Review of the Empirical Methodology Used
to Test PPP 45
4.3.2 Data 48
4.3.3 ADF and Cointegration Tests of PPP 48
4.4 Empirical Tests of the Model with Homothetic
CRRA Utility 52
4.5 Conclusion 54
5 Forward Exchange Rates in a Model with Segmented
Goods Markets 57
5.1 Related Literature 58
5.2 Implications of General-Equilibrium Model
for UIP in Real Terms 60
5.3 The UIP Relation in Nominal Terms 63
5.4 Conclusion 64
6 International Trade Flows, Exchange Rate Volatility,
and Welfare 66
6.1 Background and Related Literature 67
6.2 The Economy 70
6.3 The Relation between Trade and Exchange Rate Risk 73
6.3.1 The Effect of Output Volatility on Exchange
Risk and Expected Trade 73
6.3.2 The Effect of Segmentation on Exchange
Rate Volatility and Trade 75
6.4 Discussion of the Model and Its Implications
for Empirical Work 76
6.5 Conclusion 78
7 International Capital Flows and Welfare 82
7.1 The Risk-Sharing Gains from Financial-Market
Integration 83
7.2 Other Sources of Gains from Financial-Market
Integration 85