of course not what happened, confirmation if such were needed that PPPcan be distorted by “temporary” factors. Between 1993 and 1995, the dollar–yen exchangerate fell sharply from around 120 to a record low of 79.85, a decline of some 33%. A rise inthe yen against the US dollar should push Japanese export prices higher in US dollar terms.As Japanese domestic prices are substantially higher than those tolerated in the US, such anappreciation in the yen’s value would merely compound an existing problem. Our Japanesemanufacturer would face the dilemma of either maintaining the Japanese domestic price inthe US and thus losing market share – and pleasing the US trade negotiator – or cutting theUS dollar price sharply, sacrificing its margin on the alters of sales and market share. In thefirst case, one would assume US consumers would not tolerate Japanese domestic prices, thatJapanese exports would fall as a result and that if PPP holds the yen would fall to the extent thatJapanese export production becomes competitive once more. In the second case, the Japanesemanufacturer could either cut its US price to the extent it attracted US consumers or else to theextent it believed the perception of superior quality would offset a price differential relative toits competitors. The natural inclination would be the latter, in which case PPP would again bedistorted because price would be “distorted” by the influence of consumer taste. Hence, froman exchange rate perspective, one would not expect the dollar–yen exchange rate to move tooffset the price differential. Indeed, if anything it might actually move in favour of the yenif there were a US preference for Japanese autos that offset price considerations, until yenappreciation put the manufacturer’s US dollar prices under such upward pressure that it wasforced to raise them.For such a dramatic move in the dollar–yen exchange rate, there is of course a third alternativefor our Japanese auto manufacturer, which is in the face of inexorable yen appreciation, to moveproduction out of Japan to the US. This is indeed what happened in specific cases and to anextent how the two sides found some degree of compromise. From the perspective of PPP,this did not end the issue because the newly US-made auto would still be cheaper than itscounterpart made back in Japan. However, it would no longer be exactly the same auto, taking
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Currency Strategy
into account differences in quality, cost and so forth, thus one could argue that the law ofhomogeneity no longer applies. This is splitting hairs. The important thing is to demonstratehow PPP plays a part in the real world of merchandise trade and corporate pricing strategy.Thus, care needs to be taken with PPP as it can be distorted by a wide variety of factors,particularly over the short term. Over the long run, however, PPP serves as an extremely usefulbenchmark. Indeed, another example should hopefully put the PPP model in a better light.Example 2The Economist newspaper uses a well-known method of monitoring PPP levels, the “Big MacIndex”. This model of “burger-nomics” examines the domestic price of a McDonalds Big Macin a range of countries, translates that into US dollars and seeks to measure the disparity betweenthe price of a Big Mac in the US and that in other countries as a reflection of medium-termunder- or overvaluation.To some, this may seem a jovial if spurious exercise, but it is PPP in its simplest and purestform, not least because a Big Mac is a homogeneous product – it is the same wherever yougo. This is exactly what you need for PPP analysis in order to avoid distortions. Moreover, theBig Mac Index actually has an impressive record of forecasting exchange rate trends over longperiods of time and as a result has been the subject of several academic research papers. Forinstance, when the Euro came into being in January 1999, most currency forecasters predictedthe Euro–dollar exchange rate would appreciate over time – that is, the Euro would appreciateagainst the dollar – based on anticipation of capital flows and the view that the new singlecurrency was undervalued. The fact that most currency forecasters in turn got this predictionentirely wrong shows the danger and the limitation of valuation considerations. You can belooking at the wrong measure of valuation, and even if you are looking at the right one you canget the wrong time horizon. To be fair to my fellow currency forecasters in the industry, theEuro–dollar exchange rate did rise initially, reaching a high of 1.1885. From then, however, itfell like a stone, grinding lower remorselessly, greatly disappointing not only the expectationsof the market, but also those of European Union officials. One must give credit where it’s due,however. In early 1999, not everyone was a raging bull on the Euro. On January 7 of that year,The Economist published the latest readings of its Big Mac Index, suggesting the Euro wasnot undervalued, but actually overvalued by some 13%! In order to calculate the Big Mac PPPfor the Euro–dollar exchange rate, you simply translate the Euro price of a Big Mac into USdollars at the prevailing exchange rate and divide that by the US dollar price of a Big Mac inthe US. Clearly, if you had followed that forecast and run your position over the next two years,you could have made a lot of money. The usefulness of PPP applies not just with industrialcountry currencies but also with those of the emerging markets.In order to give a slightly more up-to-date edition of this entertaining – and informative –variation on the theory of PPP equilibrium theory, I include Table 1.1 from The Economistas of April 19, 2001. At the time, these results would have suggested a number of interestingpossibilities for currency valuation, some of which have proved largely accurate, others thathave yet to show such accuracy. Within the industrialized world, these results suggested at thetime that the Euro was still undervalued by around 11% as of mid-April 2001, estimating thePPP level for the Euro–dollar exchange rate at 0.99. In addition, it suggested that the Japaneseyen was around 6% undervalued against the dollar, implying a PPP rate for dollar–yen of around116. Subsequently, it should indeed be remembered that since then the Euro–dollar exchange
Fundamental Analysis: The Strengths and Weaknesses of Traditional Exchange Rate Models
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Table 1.1 McParityBig Mac pricesLocal currencypriceUnited StatesArgentinaAustraliaBrazilBritainCanadaChileChinaCzech RepublicDenmarkEuro areaHong KongHungaryIndonesiaJapanMalaysiaMexicoNew ZealandPhilippinesPolandRussiaSingaporeSouth AfricaSouth KoreaSwedenSwitzerlandTaiwanThailand
USD2.54ARS2.50AUD3.00BRL3.60£1.99CAD3.33CLP1260CNY9.90CZK56.00DKK24.75EUR2.57HKD10.70HUF399IDR14,700JPY294MYR4.52MXN21.9NZD3.60PHP59.00PLN5.90RUB35.00SGD3.30ZAR9.70KRW3000SEK24.0CHF6.30TWD70.0THB55.0
USD price
Implied PPP ofthe USD
2.542.501.521.642.852.142.101.201.432.932.271.371.321.352.381.192.361.461.171.461.211.821.192.272.333.652.131.21
—0.981.181.421.281.314963.9022.09.740.994.2115757871161.788.621.4223.22.3213.81.303.8211819.452.4827.621.7
Actual USDexchange rate(17/04/01)—1.001.982.191.431.566018.2839.08.460.887.8030310,8551243.809.292.4750.34.0328.91.818.13132510.281.7332.945.5
Undervaluation(−)/overvaluation(+) against theUSD (%)—−2−40−35+12−16−17−53−44+15−11−46−48−47−6−53−7−43−54−42−52−28−53−11−8+44−16−52
c The Economist Newspaper Limited, London.Source: The Economist (April 19, 2001). 
rate has indeed appreciated from 0.88 through 1.00. Meanwhile, the dollar–yen exchange ratefell from 124 to 116. Readers will no doubt claim that a plethora of factors could have been atwork, irrespective of goods’ price differentials and undoubtedly that was the case. That said,there is no getting away from the fact that the Big Mac Index in this case showed the way interms of the forthcoming trend for these exchange rates.As with every model, there are also cases where it has not worked so well and there areindeed cases of that in Table 1.1 (e.g. the South African rand was undervalued by 53%). Inresponse, I would say that broadly speaking any type of PPP model should only be viewedfrom a long-term perspective. In addition, it has to be acknowledged that PPP can be distortedfor substantial periods of time. Thus it may have differing levels of importance and relevancedepending on the type of currency market practitioner. For instance, a corporation that is lookingto hedge out a year’s worth of receivables may find PPP a very useful valuation considerationcome January. That said, an investor would most likely not be able to wait that long. For a
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Currency Strategy
trader, medium-term valuation considerations such as PPP cannot be afforded in a world ofsplit-second timing.In the Big Mac example, “McParity” can be significantly distorted by cultural and religiousconsiderations, notably in India and Israel. That said, while some in the market like to ridiculePPP measures such as but not exclusive to this, the beauty of it is in its simplicity and transparency. Furthermore, its results have been impressive, certainly to the extent that it should betaken seriously.1.1.4 PPP and the Real Exchange RateThe real exchange rate is a function of the price or inflation differential and the nominal exchange rate. The relationship between the concept of PPP and the “real exchange rate” – orthe nominal exchange rate adjusted for price differentials – is of necessity a close and important one. In line with this relationship is the core idea that if PPP is seen to hold over thelong term, then the real exchange rate should remain constant. This is the case because ifPPP holds relative price differentials between two countries will over the long term be offsetby an appropriate nominal exchange rate adjustment. Granted, the real exchange rate mayfluctuate significantly over the short term, with the result that such fluctuations can have potentially important economic impact, however, it should revert to mean over time assuming PPPholds.When the real exchange rate is constant, the international price competitiveness of a country’stradable goods is maintained. Another way of expressing this is to say that when a countryexperiences high inflation, its tradable goods become proportionally uncompetitive. In orderto restore price competitiveness, there has to be a depreciation of the nominal exchange rate.In order to gain competitiveness, a country needs a real depreciation, not simply depreciationin the nominal value of the exchange rate.The behaviour of the real exchange rate and its components can be broken down into thatexisting under fixed and floating exchange rate regimes. Under a fixed exchange rate regime,the nominal exchange rate’s ability to move is of necessity limited, hence changes in the realexchange rate must be a direct function of the change in the inflation differential, and this isindeed what we find empirically. By contrast, under a floating exchange rate regime, boththe nominal exchange rate and the inflation differential can change or “adjust” in economists’jargon. Thus, the relationship between the real and the nominal exchange rates is considerablycloser. Indeed, because inflation differentials adjust relatively slowly in floating exchange rateregimes, most of the adjustment to the real exchange rate comes from an adjustment in thenominal exchange rate. Hence, the same cautions of applying PPP to nominal exchange ratevaluation should also apply to real exchange rate techniques.To summarize this concept of PPP or the law of one price, it is a poor predictor of short-termexchange rate moves. However, it is considerably more accurate on a multi-month or multiyearbasis. Note that in the case of the Euro–dollar forecasts, the 13% overvaluation noted in January1999 and the 11% undervaluation noted in April 2001 was a multi-month guide to the futurenominal exchange rate. Thus, a corporate Treasury department or a long-term strategic investorcan find a PPP model highly useful in terms of providing a directional framework for mediumto long-term currency forecasting. A “macro” hedge fund or leveraged investor might alsofind this highly useful for spotting disparities between fundamental valuation and marketperception. On the other hand, this is clearly less so for short-term traders whose perspectiveis measured in days or weeks.
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Some final points to note with regard to PPP:
r PPP provides a useful medium- to long-term perspective of currency valuationr If PPP holds, the real exchange rate remains stable over the long termr There can however be substantial short-term divergences from PPPr PPP may thus be particularly useful in currency forecasting for corporations, long-terminvestors and also leveraged investors, but much less so for short-term traders
1.2 THE MONETARY APPROACHLinked in with the concept of Purchasing Power Parity is the second type of long-term equilibrium model we will look at, the Monetary Approach to determining or forecasting exchangerates. In this, there are two transmission mechanisms, the first through the price, the secondthrough interest rates.According to classical theory, a country’s price level is a function of the quantity of money.However, according to PPP, exchange rates adjust to equalize domestic tradable goods pricesbetween countries. Thus, if monetary factors determine prices, they also play a part in determining exchange rates. The transmission mechanism for this would be as follows:(i) Change in money supply → Change in price → Change in exchange rate(ii) Change in money supply → Change in interest rate → Change in exchange rateFor instance, if money supply was rising, one would presume this was due to relatively loosemonetary policy from the central bank. That rising money supply would in time lead to risingprices as too much money chases too few goods. PPP suggests that under the law of one price,the price of freely tradable goods must be the same everywhere over time and that the exchangerate must adjust to achieve that. Hence, as prices rise in a country relative to prices for thesame goods elsewhere, so the currency must depreciate to restore equilibrium.Similarly, a rise in money supply should lead to a reduction in interest rates. Money supplyis presumed to be known and a function of central bank activity. Money demand is somewhatmore complex and is determined by interest rates, real income and prices. A decrease in interestrates should logically cause an investor to increase their portfolio weighting in money/cashand decrease it in interest-bearing securities.The basic premise behind this is that a change in money supply will eventually be offset by asimilar change in money demand to restore balance. Within this, the point at which real moneysupply is equal to real money demand should logically equate to an “equilibrium” interest rate.Given that the Monetary Approach is focused on determining exchange rates, this point shouldsimultaneously reflect the equilibrium exchange rate. However, it should come as no surprisethat this point where money supply and demand equate is rarely if ever achieved. Indeed, likeany “equilibrium” level, it is a moving target, which is why central banks can get monetarypolicy “wrong”, and the fact that it can change is clearly a factor in interest rate and currencymarket volatility.Looking at it logically, it is all about incentive. As interest rates rise above this supposedequilibrium level at which real money supply and demand equate, money demand should fallas the incentive to hold interest rate-bearing securities should rise relative to the incentive tohold non-interest-bearing money. Here, “money” refers to cash, which is assumed to have no
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Currency Strategy
interest-bearing component. Thus, reduced money demand should eventually reduce moneysupply. Equally, as interest rates fall below the equilibrium level, so the incentive to holdinterest-bearing securities falls and the incentive to hold money rises. Rising money demandtherefore should eventually cause rising money supply.Within this premise however, and indeed within the Monetary Approach as a whole, is theidea that the transmission mechanism from monetary impulse through prices to the exchangerate is perfect and immediate. In the real world, this is simply not the case. There can besignificant lags between the monetary impulse and the change in the exchange rate, not leastbecause the prices of tradable goods do not necessarily respond immediately to changes in thedynamics that affect them. This is the idea of prices being “sticky”, which is the economists’response to the apparent disparity between what should happen according to the standardmonetary flexible price model and what actually does happen. Thus, instead of the theoreticaltransmission mechanism, we get something more akin to:Change in money supply → Delayed price change → Delayed exchange rate changeEventually, the same transmission mechanism takes place, but the model by itself does not tellus when the exchange rate changes in response to a change in money supply or to what extent. Inan attempt to deal with these practical issues, there have been a significant number of variationson the original Monetary Approach to exchange rates, most of them involving a blizzard offormulae. Given this book’s practical emphasis, we do not go through these here. This effortto determine exchange rates using the Monetary Approach owes much to the brilliant workof Rudiger Dornbusch, Jeffrey Frankel and Paul Krugman.1 However, despite this effort, theMonetary Approach is far from a complete predictor of exchange rates. This failure to be ableto predict accurately short-term exchange rate moves can logically be ascribed to one of twothings, either that the transmission mechanism is significantly delayed and allowing for suchdelays improves the results, or rather the Monetary Approach does not predict exchange ratesbecause exchange rates do not respond to monetary impulses in the way economists believe –in other words that the theory does not work.While the results of the Monetary Approach to trying to predict exchange rates have beenfar from satisfactory, we cannot reject it out of hand, not least because we know that mostof the building blocks of the theory are correct. Rising supply will eventually meet risingdemand of any commodity. The key lies in the transmission mechanism. We know that thereare delays, but why is that so? The usual component of the model that is blamed is PPP, whichmakes sense given that we know that PPP itself involves delays. However, this is not the wholestory. After all, if none other than the Federal Reserve accepts that recent changes within thefinancial system, notably the much greater public involvement in the equity market, mean thatmoney supply data can no longer be relied on as an inflationary indicator, then why should wesuppose that changes in money supply can be used to predict exchange rates? In 2001, moneysupply growth exploded, with no adverse impact on the US dollar, which in fact had anotherstellar year in the face of the worst recession in the US for at least 30 years. At present, thebest answer we can come up with is that the transmission mechanism will work, but it takes1Readers who are interested in delving deeper into their work on exchange rates may care to read some or all of Rudiger Dornbusch,Exchange Rates and Inflation, MIT, 1992; Jeffrey Frankel, On Exchange Rates, MIT, 1993; Paul Krugman, Currencies and Crises,MIT, 1992.
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time. Whatever such changes, rising money supply (of a currency) should eventually lead to adepreciation of that currency until such time as that rising money supply creates rising moneydemand, at which point the currency should stabilize and recover lost ground.As with any market, an exchange rate is a function of supply and demand. In a freely floatingexchange rate regime, the market sets both the prevailing and the equilibrium exchange ratelevels. In a fixed exchange rate regime, however, a central bank determines the prevailing levelof the exchange rate. In committing to a fixed exchange rate regime, the central bank most likelywould seek to commit to an exchange rate value that mirrors the equilibrium level at whichexchange rate supply and demand meet. However, we know that equilibrium levels themselvescan and do fluctuate. Therefore, it should be safe to assume that at some point the prevailingexchange rate level and the equilibrium level will not match. Indeed, this is likely to be the casethe majority of the time. As a result, one should also assume an excess of demand or supply forthe local currency to be the norm. The central bank has to offset that excess supply or demandby buying or selling its own currency. If there is excess demand for the currency within a fixedexchange rate regime, this forces market interest rates higher than they otherwise would be,obliging the central bank to “sterilize” the effect of excess money demand by injecting moneysupply into the system. Equally, if there is excess supply of the local currency, the authoritiesmust drain that excess. The ability of a central bank to achieve either of these goals is limited.In the first case, if there is excess local currency demand, its ability to sell local currency islimited by its willingness to print that local currency. To do so could be inflationary, whichmight necessitate higher interest rates, yet higher interest rates might result in even higherlevels of local currency demand. Thus, maybe it should cut interest rates in order to reduce theattractiveness of its currency? Yet, if it does that, it might spark inflation. The ability to copewith massive capital inflows – excess demand for the local currency – is an issue that is veryfamiliar to many emerging market countries.Equally, if there is an excess supply of local currency within a fixed exchange rate regime,this forces market interest rates lower than they otherwise should be, obliging the centralbank to drain that excess local currency supply and force interest rates back up – in otherwords to conduct unsterilized intervention. This time, its ability to achieve this is limitedby the extent of its foreign exchange reserves and its willingness to tolerate sharply higherinterest rates. When a central bank runs out of reserves in its attempt to offset excess localcurrency supply, de-pegging and flotation (devaluation) become inevitable. The general rulefor this is that the longer the central bank tries to defend a fixed exchange rate regime thatis experiencing an excess supply of local currency, the greater the degree of local currencydevaluation and “overshooting” relative to that equilibrium once it is de-pegged and floated.This is one of the reasons why emerging market currencies such as the Indonesian rupiah, Thaibaht, Korean won, Russian rouble and Brazilian real substantially overshot any approximationof their equilibrium level using a monetary approach before finally recovering some ground.Thus, while the Monetary Approach may not be able to make accurate short-term exchangerate forecasts, it should be able to provide insight into future exchange rate “events”, such asthe de-pegging and devaluation of a fixed exchange rate regime.1.2.1 Mundell–FlemingThanks to the work of Robert Mundell and J. Marcus Fleming we know that certain combinations of monetary and fiscal policy create specific exchange rate conditions. The Mundell–Fleming model illustrates how specific combinations of monetary and fiscal policy changes
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Currency Strategy
can cause temporary changes in the balance of payments relative to an equilibrium level. Theexchange rate therefore becomes the transmission mechanism by which equilibrium is restoredto the balance of payments. It must be noted within this that the degree of capital mobility iscrucially important.In an economy with high capital mobility, suppose that a central bank decides to loosenmonetary policy by cutting interest rates. One must assume that it does this because of weakgrowth conditions and benign inflation. As we saw before when looking at money demand,lowering interest rates reduces the incentive to hold interest-bearing securities, thus on a relativebasis increasing the incentive to hold money or cash. This increase in money demand can beput to work buying goods and should reflect a future rise in national income and growth. Thestandard monetary model thinks of this in terms of rising demand causing price increases,which in turn causes the exchange rate to depreciate via the concept of PPP. Looking at itanother way, rising domestic demand will cause rising import demand, which should meandeterioration in the trade balance. This in turn should eventually lead to depreciation in theexchange rate to allow the trade balance to revert back towards an equilibrium level. Anotherway of expressing the same thing is that lower interest rates cause capital outflows, which inturn cause depreciation in the exchange rate. Conversely, the basic assumption is that tightermonetary policy through higher interest rates should lead either to weaker domestic demandand a positive swing in the trade balance, or capital inflows, both of which should causeexchange rate appreciation.On the fiscal side, much depends on whether trade or capital flows dominate. On the onehand, looser fiscal policy, either through tax cuts or spending increases, should cause risingdomestic demand, which in turn should cause deterioration in the trade balance. On the otherhand, looser fiscal policy causes higher domestic interest rates, which in turn attract capitalinflows. If trade flows dominate, then the exchange rate should depreciate. However, if capitalflows dominate, then the exchange rate should appreciate.Conversely, tighter fiscal policy should, according to Mundell–Fleming, lead to weakerdomestic demand. On the trade flow side, this should result in reduced import demand, causinga positive swing in the trade balance. On the capital flow side, tighter fiscal policy should leadto lower interest rates, which in turn lead to capital outflows. Here, if trade flows dominate, theexchange rate should appreciate, whereas if capital flows dominate, the exchange rate shoulddepreciate. In a world of perfect or at least high capital mobility, it is assumed that capital flowsdominate over trade flows. Therefore, we can express the likely impact on exchange rates viaspecific combinations of monetary and fiscal policies through Table 1.2.This model can be used for developed economies and the leading emerging market economieswhich have deregulated and liberalized barriers to trade and more importantly capital. Theclassic example of this used in text books is that of the US dollar in 1980–1985, when it appreciated dramatically as the Reagan administration’s military spending programme dramaticallyboosted the budget deficit, while the Volcker-led Federal Reserve waged war against inflation(caused at least in part by those budget deficits). The Plaza Accord of 1985, which helped tobring down the value of the US dollar, worked only because it was accompanied by significantpolicy changes. In the 1993–1995 period, the US had a somewhat different problem to 1980–1985. While the new US government was moving towards the idea of balancing the budget,and thus tightening fiscal policy, the Federal Reserve was in 1993 keeping a relatively loosemonetary policy. Indeed, one could argue that the Fed maintained an inappropriately loosemonetary policy for much of 1994 up until its tightening of November 1994, before policy wasseen as appropriately tight. Perhaps not coincidentally, in 1994 the US Treasury market had
Fundamental Analysis: The Strengths and Weaknesses of Traditional Exchange Rate Models
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Table 1.2 The policy mix impact on exchange rates in an economy with high capital mobility
Loose fiscal policyTight fiscal policy
Loose monetary policy
Tight monetary policy
Offsetting impactExchange rate depreciation
Exchange rate appreciationOffsetting impact
Table 1.3 The policy mix impact on exchange rates in an economy with low capital mobility
Loose fiscal policyTight fiscal policy
Loose monetary policy
Tight monetary policy
Exchange rate depreciationOffsetting impact
Offsetting impactExchange rate appreciation
its worst year on record. In line with this, the US dollar weakened up until November of thatyear.The above model and examples assume either perfect or high capital mobility. However,not all economies are like this. While the move towards liberalization of trade and capital hasbroadly increased capital mobility, there remain specific countries in the emerging marketswhere capital mobility remains low (e.g. China). In this case, therefore, one must assume thattrade flows dominate over capital flows. Thus, the results are altered as in Table 1.3.The Mundell–Fleming model has done much to explain how combinations of monetary andfiscal policy should affect exchange rates. Indeed, their model is the standard for this kind ofwork.1.2.2 Theory vs. PracticeHowever, as ever with exchange rate models, in an open economy with high capital mobilitythere remains the issue of delay in the transmission mechanism. Monetary models suggest thatan increase in interest rates should lead to an increase in the investor’s weighting of interestbearing securities and a corresponding reduction in the weighting of money/cash. This in turnshould lead to a reduction in the demand for and therefore the price of goods, which accordingto PPP should result in an offsetting appreciation of the nominal exchange rate in order torestore equilibrium.In practice, it may not take place exactly like this, at least in the short term. Say you arean investor in US Treasuries and the Federal Reserve tightens monetary policy by increasinginterest rates. Depending on what were market expectations for Fed policy prior to that andalso depending on where you were positioned on the US yield curve, you may be facing losseson your position due to the simple inverse relationship between bond yields and bond prices.Eventually, the incentive to hold interest-bearing securities will rise as interest rates rise, butonly at the point where the investor believes interest rates have stopped rising. Until that time,the investor may in practice do the opposite of what the model suggests, by reducing theirposition in interest-bearing securities and reverting to money/cash in order to preserve capital.Theoretically, the investor will have more money/cash to spend on goods and this should pushup prices, which in turn should lead to depreciation – rather than appreciation – of the exchangerate according to PPP to restore equilibrium.
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Equally, the natural reaction of our US Treasury investor to a fall in interest rates is notnecessarily to reduce the position, given that falling yields equal rising prices. Eventually, thereduction in income will not be offset by the capital gain, at which point the investor willindeed reduce the position in favour of other assets such as money/cash. Before that, they maywell maintain or even increase the position in interest-bearing securities in order to reap thecapital gains impact. Thus, a reduction of interest rates may at least initially lead to an actualreduction in money/cash within portfolios, in turn causing money demand and prices to falland the currency to appreciate according to PPP to restore equilibrium. I suspect that the verysuggestion that a reduction in interest rates may lead to a reduction rather than an increase inmoney/cash may cause one or two economists reading this to foam at the mouth. The point isa serious one however, and it is this – the assumption that a change in monetary policy leadsdirectly and automatically to a parallel change in the exchange rate is flawed for the followingreasons:
r There may be a delay in the transmission mechanismr The initial exchange rate reaction may be the exact opposite of what standard models assume
This is not in any way to reduce the importance of the original work. Rather, it is to bring it intothe context of modern-day trading and investing conditions. Over the medium to long term, theMundell–Fleming model of policy combinations is an invaluable guide to future exchangerate direction. In the short term, however, as I have tried to show, there may be delays anddistortions, which at least put off the anticipated