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Money and exchange rates, 1974-79

  • Economics
  • Political Science


=EDERAL RESERVE BANK :JF SAN FRANCISCO ECONOMIC REVIEW SPRING 1878 Michael W. Keran* Why has the international value of the dollar declined over the past year and a half? There is a popular impression (sometimes reinforced by the rhetoric of government officials) that the dollar has been driven down by speculators who have a vested interest in seeing an undervalued dollar. According to this view, the magnitude of the decline is unrelated to economic fundamentals and represents the irrational behavior of spec- ulators. Most economists have difficulty with this explanation. A considerable body of evidence shows that speculation tends to drive the value of a currency towards the long-run equilibrium value; i.e., value determined by economic fun- damentals. Those who misjudge fundamentals and attempt to drive the dollar away from its long-run equilibrium value will tend to lose money. On the average they will buy when the market value is high and sell when the market value is low. Those speculators who most clearly perceive the underlying fundamentals and ac- cordingly take a position in the exchange market will, on average, make the most profits. What this means is that stabilizing speculation will tend to be profitable and destabilizing specu- lation to be unprofitable. 2 The self-selection process of unsuccessful speculators leaving the market to the successful speculators has impor- tant implications for the exchange markets. In particular, the observed value of the dollar would not deviate significantly from the level consistent with economic fundamentals for more than a short period of time. Two types of economic factors affect the * Senior Vice President and Director of Research, Federal Reserve Bank of San Francisco. Research assistance for this article was provided by Stephen Zeldes. 19 exchange rate-real factors and monetary fac- tors. The real factors have to do with the relative attractiveness of any two countries' goods, i.e., how many bushels of U.S. wheat are exc

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