1. A behavioural finance model of exchange rate expectations within a stock-flow consistent framework Gauthier Daigle Marc Lavoie

2. Outline Prolegomena Behavioural expectations Baseline model, without expectations Simulations with expectations Conclusion Recent developments in PK modelling, Université de Paris 13, November 2009

3. Origins of the open-economy model: Godley and Lavoie, 2007, chapter 12 Recent developments in PK modelling, Université de Paris 13, November 2009

4. Main features of the model Stock-flow coherence Two-country model Integration of real and financial variables Imperfect asset substitutability (in the tradition of Tobin, Branson and Henderson, Blanchard et al. 2005) Therefore uncovered interest parity does not hold Many endogenous variables: – Import prices, export prices, domestic sales deflator, GDP deflator, exchange rate –Exports, imports, output, consumption, domestic sales, disposable income –Taxes, interest payments, money stock, holdings of bills and money (portfolios), wealth –Trade balance, current account balance, capital account balance Recent developments in PK modelling, Université de Paris 13, November 2009

5. BEHAVIOURAL EXPECTATIONS Recent developments in PK modelling, Université de Paris 13, November 2009

6. Exchange rate expectations In the original 2007 model, expectations about exchange rate changes were set to zero (i.e., the probability of appreciation and of depreciation are balanced). Here we reintroduce expectations, consistent with the claim by several PK authors that exchange rate expectations of portfolio holders play a key role in the determination of exchange rates (Harvey 2003). We reject the mainstream introduction of expectations through the interest parity theorem, which asserts that the forward exchange rate represents the expectations of the market regarding the future value of the spot rate. We support instead reversed causality: the forward exchange rate is simply the spot rate plus the interest rate differential (Coulbois/Prissert 1974, Lavoie 2000, Moosa 2004). Recent developments in PK modelling, Université de Paris 13, November 2009

7. Behavioural exchange rate expectations Based on De Grauwe and Grimaldi (2006) Two types of investors/traders: fundamentalists and chartists The fundamentalists stick to a given exchange rate value. This value, in general, will not however be the long-run « equilibrium » one. The chartists believe that the trend in the evolution of the exchange rate will continue. If the exchange rate is moving upwards, but is still below its « fundamental » value, both chartists and fundamentalists will expect an increase in the exchange rate. Recent developments in PK modelling, Université de Paris 13, November 2009

8. The portfolio equations Recent developments in PK modelling, Université de Paris 13, November 2009

9. Expectations equations Recent developments in PK modelling, Université de Paris 13, November 2009

10. BASELINE MODEL, WITHOUT EXPECTATIONS Recent developments in PK modelling, Université de Paris 13, November 2009

11. Baseline simulation To study the role of expectations, we first run a baseline simulation without expectations. We start off from a full equilibrium (the baseline case), with the trade, current and capital accounts all in balance. We then impose an increase in the propensity to import of the US economy from the UK economy (US imports rise) Recent developments in PK modelling, Université de Paris 13, November 2009

12. The UK trade balance (right axis) is initially in surplus, then in deficit, and the UK exchange rate keeps rising until it reaches a steady level (left axis) Recent developments in PK modelling, Université de Paris 13, November 2009

13. Why does the price of the UK currency rise from a portfolio point of view? This can be explained by the large increase in the supply of US bills to the UK. Higher US imports generate a slowdown in the US economy, lower tax revenues and hence a US government deficit, and thus an increase in the supply of US government bills. This larger supply cannot all be absorbed by the domestic US market and must be unloaded on foreign financial markets, thus generating the depreciation of the US currency and the appreciation of the UK currency. The value of the UK currency moves from 1$ to 1.38$. Recent developments in PK modelling, Université de Paris 13, November 2009

14. SIMULATION WITH EXPECTATIONS Recent developments in PK modelling, Université de Paris 13, November 2009

15. Simulation with stable results We assume the same increase in the propensity to import of the US economy. Fundamentalist investors believe that the « fundamental » value of the UK exchange rate remains at its starting value, 1$. Thus they believe that changes are of a transitional nature. Recent developments in PK modelling, Université de Paris 13, November 2009

16. With expectations, the UK exchange rate converges to a different stationary value, 1.55$ The UK trade surplus is turned into a trade deficit Recent developments in PK modelling, Université de Paris 13, November 2009

17. What happens if the « fundamental » exchange rate value is modified? When the fundamental value of the exchange rate is being under- estimated, the economy tends towards a steady-state value of the exchange rate that is above its fundamental value without expectations; Reciprocally, when the fundamental value of the exchange rate is being over-estimated, the economy converges towards a steady-state value of the exchange rate that is below its fundamental value. When the exchange rate expectations of the fundamentalists correspond to the steady state value of the model without expectations, this steady state value is realized in the model with expectations. Thus, adaptative expectations of the « fundamental » exchange rate value would drive the model towards the stationary state achieved without expectations. Recent developments in PK modelling, Université de Paris 13, November 2009

18. What happens if chartists represent a greater proportion of the exchange rate traders or investors? The stabilizing effects of trade flows and asset supplies are beaten by the destabilizing effects of asset demands Recent developments in PK modelling, Université de Paris 13, November 2009

19. Conclusion: Is there hysteresis with expectations? When a shock is reversed, in the stable case, the economy returns exactly at its starting point. There is no path-dependence, even though there are exchange rate expectations and chartists that act on trends. But there is persistence. With exchange rate expectations, the model takes twice as much time to return to its stationary values compared to the model without expectations. In the unstable case, reversing the shock will not do. Recent developments in PK modelling, Université de Paris 13, November 2009