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Exchange Rates and International Finance.

By Laurence S. Copeland, LReading MA: Addison-Wesley Publishing Company, 1989, Pp. 340, $21.50.

THE THEME of Exchange Rates and International Finance is that, even though exchange rate theory may provide some insight into broad exchange rate movements, it cannot explain exchange rate volatility. Economists who find this distinction and other aspects of exchange rate theory difficult to unravel will want to read this textbook. Dr. Copeland has minimized the technical level of exchange rate theory while preserving its basic insights. Therefore, he has achieved his goal of writing a book accessible to as wide an audience as possible. Beginning students of international finance will find enlightening the emphasis of intuition over rigor; academicians will find adequate references to explore the theory more thoroughly; and business economists who need a basic reference on exchange rate determination will find the book a useful addition to their library. The target audience for this book, undergraduate and MBA students in International Economics, International Finance and Business, and Financial Economics, will also appreciate his references to the existing empirical results as he develops the theory.

Dr. Copeland uses the introduction to define the essentials for any international economist: exchange rates, exchange rate markets, balance of payments, and a brief history of currency markets since World War II. Although he briefly discusses the European Monetary System, it is disappointing that, as a British economist, he did not give it a more thorough treatment.

In Part I, Dr. Copeland discusses the conditions under which one might expect the "law of one price" to hold in an open economy context and the implications of aggregating this "law" into the theory of purchasing power parity (PPP). Then he provides ample evidence that the PPP theory does not seem to hold even in the long run and that a better model of exchange rate determination is needed. He also covers the theoretical relationships among expected future spot exchange rates, forward exchange rates, and efficient markets, while leaving the empirical observations to Part III. The final chapter of Part I provides the reader with a comprehensible graphical approach to simple open economy macroeconomics. Using this approach, Dr. Copeland is able to take the reader through the short, medium and long-run effects of a shock to aggregate demand.

In Part II, Dr. Copeland presents the core economic models of exchange rate determination, the flexible-price monetary model, the fixed-price Mundell-Fleming model, and the sticky-price Dornbusch model. As Dr. Copeland points out, Dornbusch's significant innovation is in the observation that financial markets adjust quickly while goods markets adjust slowly. Dr. Copeland shows that both the Dornbusch model (in the long run) and the monetary model predict that a domestic currency will depreciate in response to a domestic monetary expansion. Further, he intuitively derives the Dornbusch result that the immediate effect of the monetary expansion will be to cause the currency to overshoot its long-run value and appreciate during the adjustment process. As Dr. Copeland summarizes, this overshooting is one possible explanation of exchange rate volatility. Though Dr. Copeland demonstrates a useful practical application of the Dornbusch model to the impact of North Sea oil revenue on the United Kingdom, he could have enhanced the application by comparing the predictions of the theory with actual U. K. exchange rate movements.

In the remaining two chapters of Part II, Dr. Copeland presents the portfolio balance model and the currency substitution model where assets markets are explicitly included in the analysis. An important result of these models, as in the Dornbusch model above, is that, in the short-run, exchange rates can overshoot their ultimate long-run equilibrium values. Dr. Copeland discusses this overshooting result but understates its powerful contribution to the understanding of exchange rate volatility.

In Part III, Dr. Copeland addresses a variety of important issues under the heading of exchange rate uncertainty. In his chapter on rational expectations, he provides evidence that spot exchange rates predict changes in forward exchange rates but not vice versa. He points out that this result contradicts the rational expectations result that forward exchange rates should be unbiased predictors of future spot exchange rates. In his chapter on the "news" approach to exchange rate determination, he presents a model in which unexpected changes in spot exchange rates are directly related to unexpected changes in fundamental variables. Dr. Copeland argues that, even though this approach has had a qualified success, it is still inadequate because exchange rate volatility is excessive when compared against the volatility of the fundamental variables. Finally, Dr. Copeland includes a chapter that describes the existence of a risk premium, a necessary component of the portfolio balance model. This chapter will be difficult reading for those lacking a background in microeconomics and statistics.

Given that this book emphasizes the fact that economic theory cannot completely explain exchange rate volatility, a potential drawback of it is that the reader may miss important insights that exchange rate theory can provide. This criticism aside, this book is a useful introductory text for economists, particularly business economists who need to educate themselves quickly on exchange rate determination. Not only is the theoretical presentation clear and nontechnical, but the corresponding empirical results outlined provide useful additional insights.
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Author:Browning, William H.
Publication:Business Economics
Article Type:Book Review
Date:Oct 1, 1990
Words:864
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