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Exchange rates.

Exchange Rates

Takatoshi Ito

Since the Plaza Agreement of September 1985, the exchange rates of the major industrial countries have changed dramatically. The dollar depreciated against the yen and the mark by more than 60 percent in the six months following the Plaza Agreement. The dollar's decline continued, although at a slower pace, throughout 1986 and 1987. In 1988, fluctuations in exchange rates decreased significantly but 1989 has been another volatile year.

What kinds of information can trigger large changes in the exchange rate? Why is the volatility apparently clustered in particular periods? How do expectations among traders change when there are large movements in exchange rates, and do their expectations affect the path of the exchange rate? To help answer these questions about exchange rate dynamics, researchers turn to both intradaily data and survey data on exchange rate expectations.

Intradaily Exchange Rate Dynamics: News Announcements, 1980-5

If the foreign exchange market is "efficient," then any movement of the exchange rate should reflect the arrival of new information or "news." For example, an announcement of an unexpected increase in the money supply should affect the exchange rate. In my research, I considered how exchange rates responded to important news about money supply, inflation, and industrial production. Working backward, I also recorded the days (and hours) when large changes in the exchange rate occurred, and then tried to identify the news behind these large jumps.

Because of the time difference between Japan and the United States, the hours of the Tokyo and New York foreign exchange markets do not overlap. Thus, it is possible to distinguish exchange rate movements caused by Tokyo news from those caused by New York news. V. Vance Roley and I exploit this idea by examining the responses of the exchange rate to announcements of the money supply, the inflation rate, and the industrial production index in the United States and Japan.(1) If the market is efficient, there should be a response within minutes after an announcement. We show that when the Federal Reserve pursued a money supply target, from October 1979 to October 1982, the U.S. money supply announcement had a significant effect on the exchange rate. Unexpected increases in the money supply created an expectation that the money supply would be curtailed in the coming months, so that the interest rate, and consequently the dollar, would have to rise. Even after the New York market closed, the exchange rate responded to the money supply announcement, suggesting that it took not just minutes, but hours, for the market to reach an agreement about the meaning of the announcement. After the Fed abandoned the money supply target in October 1982, this announcement effect disappeared.

The Japanese money supply announcement did not have much effect on the yen/dollar exchange rate at any time, suggesting that the market did not believe that the Bank of Japan followed strict money supply targeting. Nor did announcements of the price index or of industrial production in the United States prompt significant responses in the yen/dollar exchange rate.

Although the announcement of the price index in Japan did not affect the exchange rate, announcement of Japan's industrial production index had an impact on the exchange rate for some periods into the future. This suggests that the market believed that Japanese policy would respond to news about economic growth.

Intradaily Exchange Rate Dynamics: After the Plaza Agreement

In examining the sharp appreciation of the yen after the Plaza Agreement, I find that large changes usually, but not always, accompany the arrival of news in the market.(2) For example, the large appreciation in the yen during New York market hours following the Plaza Agreement indicates that the shift in U.S. policy toward more policy cooperation with other countries was responsible. The yen appreciation in late October 1985, mainly during the Tokyo market hours, corresponds to the surprising increase in interest rates engineered by the Bank of Japan at that time. These were both instances when the market-specific news moved the exchange rate during the market hours in that market, but not in other countries.

The reasons for yen appreciation in the first half of 1986 are not as clear-cut. Yen appreciation occurred not only in the Tokyo and New York markets but also in the European market, indicating that some factor, such as the decrease in oil prices, played a role along with monetary news in Tokyo and New York.

Heat Waves versus Meteor Showers

Once the market becomes volatile (that is, undergoes large changes), it stays that way for weeks or months. If volatility clustering reflects the clustering of country-specific news (as in a "heatwave" in one country), then volatility should be correlated only daily in the specific market. However, if the volatility clustering occurs around the clock in many countries (as in a worldwide meteor shower), then it is caused by random policy coordination or by information being digested over a prolonged period.

Robert F. Engle III, Wen-Ling Lin, and I show that volatility clustering is like a meteor shower.(3) Once there is a large jump in one market, the volatility spills over to the next market that opens. This meteor shower volatility existed after the Plaza Agreement, and during the first half of the 1980s, when the policy coordination among the industrialized countries was almost nonexistent. Thus, we conclude that volatility clustering within a day is caused mainly by slow processing of information in the market.

Micro Survey Data

I also analyze panel data from the expectations survey of the Japan Center of International Finance (JCIF) and find that market participants are persistently heterogeneous.(4) Biases among the participants are statistically significant: exporters have a depreciation bias and importers and trading companies have an appreciation bias. Exporters gain from yen appreciation, given that price pass-through is incomplete.

These kinds of "wishful expectations" can be explained either as naive, nonrational behavior or as sophisticated, manipulative behavior. The usual test of rationality (orthogonality of forecast errors from information available at the time of forecast) reveals that many participants have irrational expectations.

A recent appreciation in the yen creates an expectation of a further yen appreciation in the short run (say, one month) and an expectation of depreciation in the long run (six months). I also find that these short- and long-run expectations are not internally consistent in the JCIF dataset and in survey data from the United States and Europe.(5)

(1)T. Ito and V. V. Roley, "News from the United States and Japan: Which Moves the Yen/Dollar Exchange Rate?" NBER Reprint No. 889, August 1987, and Journal of Monetary Economics 19,2 (1987), pp. 255-277. (2)T. Ito, "The Intradaily Exchange Rate Dynamics and Monetary Policies After the Group of Five Agreement," NBER Reprint No. 954, December 1987, and Journal of the Japanese and International Economies 1, 1 (1987). (3)R. F. Engle III, T. Ito, and W.-L. Lin, "Meteor Showers or Heat Waves? Heteroskedastic Intradaily Volatility in the Foreign Exchange Market," NBER Working Paper No. 2609, June 1988, and Econometrica, forthcoming; and "Where Does the Meteor Shower Come From? Capital Control, Stochastic Policy Cordination, or Private Information?" forthcoming as an NBER Working Paper. (4)T.Ito, "Foreign Exchange Rate Expectations: Micro Survey Data," NBER Working Paper No. 2679, August 1988, and American Economic Review, forthcoming. (5)K. A. Froot and T. Ito, "On the Consistency of Short-Run and Long-Run Exchange Rate Expectations," NBER Working Paper No. 2577, April 1988, and Journal of International Finance and Money, forthcoming.
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Author:Ito, Takatoshi
Publication:NBER Reporter
Date:Sep 22, 1989
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