John T. Harvey

The Nature of Expectations in the Foreign Exchange Market: A Test of Competing Theories

In a 1982-83 article, Paul Davidson argues that rational expectations are a poor guide to real-world economic behavior. He supports this contention with a number of points, relying especially on the argument that entrepreneurs focus on exactly the sort of activity least likely to fit the RE mold: crucial decisions. Crucial decisions, once made, may forever change the circumstances surrounding future choices. As a consequence, ergodicity is violated and rational expectations cannot hold. A related question arising from this debate is whether or not economic agents passively forecast events or actually cause them. According to Davidson, rational expectations assume the former, though a realistic analysis would suggest the latter. This last point is the focus of the current paper. The Post Keynesian approach implies that expectations guide actions, and that those actions create the real world. This dynamic process tends to change the parameters affecting future decisions in the manner discussed above. Expectations are therefore causal. The rational expectations approach posits a world in which economic agents simply react, making forecasts of events that are driven by some independent and relatively stable stochastic process. In this context, expectations do not affect the objective variable. It is the purpose of this paper to perform an empirical test of these rival views. In particular, I examine the relationship between expectations and foreign exchange rates (using the forecast surveys published by Money Market Services). In the rational expectations model, where predictions and outcomes are expected to be correlated but not causal,

Post Keynesian versus neoclassical explanations of exchange rate movements: a short look at the long run

In this paper, a series of empirical tests are conducted comparing the explanatory power of the neoclassical approach (in particular, purchasing power parity and the monetary model) with that of a long-run exchange rate model based on Post Keynesian premises (the tests use annual data for the dollar- deutsche mark and the dollar-yen from 1975 through 1998). It is shown that, despite the shift in time horizon and the biasing of the tests in favor of the neoclassical approach, the Post Keynesian approach still shows a much tighter fit to the historical facts.

Foundations of international economics : post Keynesian perspectives

Part I Foreign trade: international trade and mobile technology a dynamic model of absolute advantage. Part II Open economy macroeconomics: a Kaleckian macro model for an open economy aggregate supply and demand in an open-economy framework the balance of payments and growth. Part III International payments systems: global full employment and the reform of the international monetary system the development and reform of the modern international financial system. Part IV Exchange rates determination: exchange rate and expectations. Part V Development: industrialization in the periphery: the case of the EU and NAFTA international liquidity preference and endogenous credit creation marketing mexico: the contradiction of financing development with portfolio investment.

Underdevelopment in Jamaica: An Institutionalist Perspective

Despite constant postwar efforts to decipher the development process, it appears that little practical progress has been made. Many theories have been proposed (some leading directly to policy), but very few countries have succeeded in breaking the bonds of underdevelopment. This characterization fits Latin American and Caribbean (LAC) countries especially well. In LAC countries, the prescription most aggressively pursued has been industrialization. The assumption underlying this approach is that a declining sectoral share of agriculture and agricultural employment will lead to rising per capita income. For the most part, significant structural transformation was achieved, and today it is not uncommon to find LAC nations exhibiting high degrees of industrialization and a labor force that is divorced from the agricultural sector. In Jamaica, for example, between 1930 and 1990, the share of agricultural employment fell from an average of 60 percent to 11 percent, a decline that proceeded over 125 years in many of the currently developed nations. Yet, the expectation of consequent high wages and full employment has proved unfulfilled. Two kinds of explanations have emerged from this frustration: those based on free market principles and those focused on specific social, historical, or political phenomena as the culprit. Using Jamaica as our subject, we take a somewhat different approach. Our argument is that the islands lack of development is a reflection of powerful institutional forces acting to shift economic activity away from democratic problem solving and toward invidious distinction and conspicuous consump-

Psychological and Institutional Forces and the Determination of Exchange Rates

Neoclassical economists have, by their own admission, had a terrible time explaining foreign- currency prices. Not only have they been unable to develop models that explain the past time series of foreign exchange rates with any regularity but their premises lead to conclusions about the character of the market that are inconsistent with many of its salient features. Mainstream approaches cannot, for example, account for exchange rate volatility, nonrational expectations, or the popularity of technical analysis. It is my contention that neoclassicists’ failure can be traced in large part to their assumption that economic behavior is independent of social, psychological, and cultural influences and is instead driven by rational and presumably natural free market impulses. The purpose of this paper is to show that an explanation of exchange rate determination that places the activity in its psychosocial context yields results superior to those of one based on traditional neoclassical principles. In particular, it will be shown that if agents’ behavior is modeled as being a function of their socialization in the capitalist system (and subsequent molding within the subculture of portfolio investors) and if their forecasting and decision-making processes are assumed to be driven by the same factors as theorized by psychologists (rather than economists), then the picture that emerges is one wherein bandwagon effects are common, periods of volatility are to be expected, and predictions can contain persistent bias.

Modeling financial crises: a schematic approach

John Maynard Keynes argued that crises were systemic and that, unless serious reforms were implemented, they would tend to grow in frequency and severity. The paper sets out to build a Keynes-style model of crises that captures both the unique characteristics of each type and their common roots. A schematic method is employed that traces the processes in time and shows how events become interrelated and mutually causal. This permits us, as much as possible, to see everything at once—a necessity when the buildup to a crisis may manifest itself in so many places.

The determinants of currency market forecasts: an empirical study

Empirical studies using surveys of exchange rate expectations have become very popular in the literature. The majority have concluded that short-term currency market activity appears to be inconsistent with the standard neoclassical characterization and that, as a consequence, economists should shift their attention to the long run. This paper, rather than using foreign exchange surveys as an argument for ignoring the short run, treats them as a means of understanding it. To that end, an empirical test is conducted in which the survey results serve as the dependent variable. The results indicate that the expectational variables are not random, but exhibit a pattern. It is further shown that psychological factors play an important role in determining expectations, thus offering support for the Post Keynesian view of currency markets.

International Capital and Mexican Development: A System-Dynamics Model

The proper role of portfolio capital in the development process is currently the subject of vigorous debate among both scholars and policy makers. One of the core elements of the disagreement is whether or not unregulated financial markets represent a more efficient means of allocating capital (especially in terms of attracting funds to the capital-scarce third world) or if in fact they add unnecessary instability to already weak economies and tend to promote policies and outcomes detrimental to the poorest members of those societies. It is the latter view, as argued by institutionalists (and especially Ilene Grabel [1999, 1996a, 1996b, 1995a, 1995b]), that we shall examine here. The existing institutionalist research is primarily theoretical or descriptive. Our goal is to take these approaches to a new level by combining and formalizing their insights in a system dynamics model. In particular, we will highlight the impact of deregulated capital markets on income distribution in Mexico. Building such a model will not only allow us to present a more detailed and comprehensive view but also permit us to undertake some limited experiments by altering the historical inputs. This will, we hope, provide another avenue by which the current debate may be resolved. The paper is organized as follows. In the next section, a brief survey of the work of institutionalist authors in this area is offered. Next, system dynamics modeling is explained. Then the model is specified and some brief policy experiments are conducted. Conclusions follow.

Modeling Interest Rate Parity: A System Dynamics Approach

The purpose of this paper is to show the superiority of Keynes’ approach by comparing three system dynamics models of the relationship among interest and exchange rates: one based on traditional uncovered interest rate parity, one with risk, and one with forecast confidence. It will be demonstrated that only the last produces patterns consistent with those observed in the real world.

The International Monetary System and Exchange Rate Determination: 1945 to the Present

Increasingly, the foreign exchange market has become a focus for pecuniary pursuits at the expense of trade and direct investment. Two of the side effects of the increased use of exchange market operations for pecuniary gain have been rate volatility and chronic payments imbalances. While it is fairly clear that the problems of today have their roots in the tremendous growth of the international money market, it remains to explain the nature and causes of that growth. It is the purpose of this paper to summarize the developments responsible for making the foreign currency market the planets only worldwide, 24-hour casino.