A post Keynesian framework of exchange rate determination: a Minskyan approach

Abstract

This paper proposes a general framework to analyze exchange rate determination from a post Keynesian perspective based on chapter 17 of the General Theory. The paper shows that this framework accounts for both the importance of context and time-specific expectations put forward by existing post Keynesian exchange rate theory, and for the hierarchic and structured nature of the international monetary system that is crucial to understanding exchange rate movements in developing and emerging countries (DECs). To analyze these currency hierarchies, the paper presents a novel Minskyan approach that emphasizes the structural determinants of these hierarchies and currency positions in international debtor–creditor relations. This approach can better account for DECs’ continued monetary subordination and points to the endogenous and self-perpetuating nature of international monetary hierarchies.

Key words:

• developing and emerging countries
• exchange rate determination
• international currency hierarchies
• Minsky

JEL classifications:

• B5
• F31
• F34

Notes

¹Harvey points out that even in neoclassical economics the real nature of these fundamentals remains vague and ill-defined. Most generally they seem to refer to “that set of variables guaranteeing the efficient operation of the foreign currency market,” where efficient generally means long-run balanced trade and optimal allocation of resources (Harvey, 2001, p. 4).

²The only other contributions that explicitly make use of all elements of Keynes’s “own rate of interest” equation are Kaltenbrunner (2008) and Prates and Andrade (2013). The latter authors focus exclusively on DECs and do not propose chapter 17 as a general framework.

³It is important to note though that although both neoclassical and post Keynesian authors refer to Keynes’s CIP theorem, their interpretations of the workings of the foreign exchange market differ fundamentally. Whereas for neoclassical authors the forward rate is a reflection of rational exchange rate expectations, post Keynesian authors consider the forward rate a simple markup over the spot rate given the existing interest rate differential. Thus, at the level of the individual transaction, CIP holds by definition as banks formulaically charge a forward rate on the basis of their “input values,” that is the spot rate and the interest rate differential. This also means that rather than in the forward rate (as in neoclassical economics), exchange rate expectations are reflected directly in either the current spot rate (Lavoie 2000, 2002–3; Smithin 2002–3) or the interest rate (Carvalho, 1992; Kregel, 1982; Taylor, 2004). While the latter assume a structuralist position, Lavoie and Smithin adopt a more horizontalist stance, where, even in the open economy, interest rates continue to be set exogenously by the central bank.

⁴Although Keynes’s “own rate of interest” evokes an equilibrium concept, it is not guaranteed that this eilibrium is ever achieved. Changes in returns and demand for assets will set forces in motion that, by themselves, change the same returns, keeping things in steady motion (Carvalho, 1992). In addition, the emphasis on expectations under uncertainty and social conventions (and the confidence with which these conventions are held) also means that there is no equilibrium level toward which the economy will converge (Carvalho, 1984–85).

⁵Given that this is a model of asset choice under uncertainty it is predominantly investors’ expectations about a currency’s return, rather than the actual values, that matter for exchange rate movements.

⁶It is important to note, however, that exchange rate expectations do not necessarily need to be formed endogenously to Equation (2). In post Keynesian economics, exchange rate expectations are an autonomous variable, which, as will be discussed below, can be driven by social and psychological factors. In this case, one of the other variables of Equation (2) needs to adjust in order to maintain demand for the domestic currency.

⁷Davidson (1999) uses this element of the “own rate of interest” equation to motivate speculative exchange rate expectations in his analysis of the Tobin tax.

⁸In line with Keynes’s assumption for the closed economy, carry costs are considered negligible for money and short-term financial instruments.

⁹The manner in which this is accomplished is an immediate depreciation. As the world-reserve currency becomes more popular, capital will flow there. This will appreciate the world currency and depreciate the domestic currency. In other words, it is not that an increase in the reserve currency’s liquidity premium causes people to think that the domestic currency will be worth more in the future, it is that they cause it to be worth less today. I am very thankful to the referee for this observation.

¹⁰Many post Keynesian authors have pointed to the importance of short-term financial returns for exchange rate determination (Harvey, 1998, 2002, 2009; Lavoie, 2000). Keynes’s “own rate of interest” equation accounts for these returns theoretically as money’s yield in the open economy.

¹¹Just like money in the closed economy, the leading currency can offer the lowest yield. Moreover, as “money rules the roost” its yield will act as a reference point for all other currencies in the system.

¹²For example, the Brazilian real appreciated from nearly 4R$/US$ at the end of 2003 to 1.5R$/US$ in August 2008, to then lose around 60 percent of its value during the global financial crisis. In a similar vein, the Colombian peso and Korean won both lost 13 percent in a month during the international financial crisis, largely independent of domestic economic conditions (Arduini et al., 2012).

¹³The current impact of quantitative easing (and its potential withdrawal) on DECs’ exchange rates is just one example of this continued monetary subordination.

¹⁴It is important to note that in the Minskyan framework presented here a currency’s ability to act as international store of value remains a crucial element of its international liquidity premium. It is, however, its inability to act as international medium of contractual settlement that undermines this function in the first place.

¹⁵Smithin (2002–3), Smithin and Kam (2004), and Paraskevopolous et al. (1996) endogenize a currency’s liquidity premium according to its country’s ratio of foreign debt to gross domestic product. A similar approach is adopted by Minsky himself, who incorporates a unit’s liability structure in Keynes’s “own rate of interest” by interpreting carrying costs as the payment commitments set up by its liabilities. GMKs also place a strong emphasis on a country’s foreign currency debtor status as both a manifestation and determinant of a currency’s position in the international monetary hierarchy. However, they do not see it as the main causal factor as in the Minskyan view adopted in this paper.

¹⁶For a certain amount of time, these foreign commitments can be met with new capital flows. However, in line with Minsky’s famous classification of financing structures, this makes a country effectively a fragile Ponzi unit which can only meet its outstanding obligations through incurring new debt.

¹⁷A similar view is presented by De Conti (2011), who distinguishes between the liquidity of a currency and “market” liquidity.

¹⁸Their role as international funding currencies is arguably also what maintains the position of the Japanese yen and Swiss franc in the international monetary hierarchy.

¹⁹This also shows the continued importance of the second and third Minskyan elements of currencies’ international liquidity premia. As to the former, any type of foreign investment will generate payment commitments, which—if funded in foreign currency—require the country to generate the necessary foreign exchange to meet them. A currency’s institutional liquidity, in turn, becomes even more important in the face of foreign investment in short-term domestic currency assets. The returns on these investments are often constituted by capital gains, which fundamentally depend on the ability to “make positions” (Kaltenbrunner, 2010).

Additional information

Notes on contributors

Annina Kaltenbrunner

Annina Kaltenbrunner is Lecturer in the Economics Division, University of Leeds Business School (LUBS).