On Buying Cheap and Selling Dear: Another Note

Author(s): T. L. Powrie
Source: The Canadian Journal of Economics and Political Science / Revue canadienne
d'Economique et de Science politique, Vol. 31, No. 4 (Nov., 1965), pp. 566-570
Published by: Blackwell Publishing on behalf of Canadian Economics Association
Stable URL: http://www.jstor.org/stable/139832 .
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NOTES
ON BUYING CHEAP AND SELLING DEAR: ANOTHER NOTE*
T. L. POWRIE University of Alberta
How do transactions which resist all movements in a flexible exchange rate
affect the stability of the rate? Professor Eastman has improved the answer
to this question in a recent note.' This note is an extension of the same topic,
in order to show that the effect of official intervention in the market depends
on the behaviour of private short-term capital movements.2 It will be shown
that, to achieve the most efficient stabilization, the type of official inter-
vention chosen must depend on the behaviour of private funds.
Let excess demand in a foreign exchange market be described by
(1) g-hR + k sin
wt-(m,
+
n,)(R-N)-(m,
+
n,)DtR.
R is the exchange rate, and g, h, k, w,
m., ne, ms,
and
n.
are constants, each
not less than zero. The term (g
- hR) describes excess demand in the absence
of fluctuations in the market. Sinusoidal fluctuations in demand are intro-
duced by (k sin wt), where t is time, and k and w are respectively the ampli-
tude and the frequency of the fluctuations. The term
(m,
+
n,)
(R
-
N)
introduces transactions which resist deviations of the exchange rate from its
normal or average value N. The constants
m,
and n, are the strengths with
which private short-term capital movements and official intervention re-
spectively resist (R
-
N). Finally, (mi, + n8)DtR describes transactions which
resist all changes in the exchange rate, with m8 and
n, being the strengths
respectively of private short-term capital movements and of official inter-
vention in this direction. By defining each of
m",
m8,
n.,
and
n,
to be non-
negative, we are in effect excluding any discussion of short-term capital
movements which aggravate exchange rate fluctuations.
*I am much indebted to my colleague Dr. W. Haque, for patient guidance to the mathematics
required for this note.
'H. C. Eastman, "On Buying Cheap and Selling Dear: Professor Powrie's Paradox," this
JOURNAL, XXX, no. 3 (Aug. 1964), 431-5.
2The second last paragraph of Eastman's note is based on the incorrect premise that the
behaviour of private short-term capital has no relevance for the effect of official intervention.
There also seems to be a small ambiguity in Eastman's note, in that his distinction between
the observed, stabilized rate of exchange (call it R) and the rate which would have existed in
the absence of stabilizing influences (call it R*) is not consistently expressed. In paragraph
two, "rates of exchange" must mean R* to be correct; in the next several paragraphs, an
unqualified reference to "the rate" clearly means R; in the third last paragraph there is the
implication that "the rate" meant R* on page 221 of Eastman and Stykolt, "Exchange Stabi-
lization in Canada, 1950-54 " (this JOURNAL, May 1956), for the paragraph does not make
sense otherwise. Such a minor lapse from clarity could pass unnoticed, except that it suggests
a theory to explain an otherwise puzzling point. Eastman's note validates and extends my
discussion of the topic, but attributes to my treatment such features as "unreal distinction"
and "error." The puzzle is, why was he saying I was wrong while he was proving I was right?
The explanatory hypothesis is that where I wrote "the rate," he sometimes read "the rate
that would have existed in the absence of stabilization."
Notes 567
To find the equilibrium exchange rate, set the excess demand function
equal to zero and note that N
=
g/lh.
Then
(2) R =
N +
fkl(h
+
m.
+ ne)
I
sin wt-{
(m.
+ nz)/(h +
m,
+
n,)IDR.
The solution of this differential equation is
(3) R-N + A sin(wt- a)
where
(4)
A
- \k/V{ (h + mc +
n
)2 + (ms + n,)2
W2}
and a is determined by
(5) tan a
=
(min + n8)w/(h + mc + n0).
(The solution also contains a transient term which approaches zero as t in-
creases and which is ignored.)
Let S be the net total sales of foreign currency arising from all private
short-term capital movements and official transactions.
(6) S = mi(R - N) + miDjR +
n,(R
- N) +
n3DgR
(7) = G sin(wt
- a + ,B') + H sin(wt
- a + 3") ... .(by (3))
where
(8)
G =
kV(M n2 +
mi22w2)/\/f
(h + Mc + n,)2 + (Mn, + n,)2
w2}
and
(9) H =
kV\(n.2
+ n,2 w2)/v{ (h + mi, + n)2 + (mi, + n,)2
w2A
and ,B' and p3" are determined by
tan ,3' = m,w/m,, tan p" =
n,w/n,.
An alternative equation for S, which consolidates official and private tran-
sactions into one net expression,
is
(10)
S =
Fsin(wt-a +,)
where
(11)
F =
kV/{(m, + nC)2 +
(m.,
+ n,)2w2/2/{(h + min + n,)2
+ (ms +
ns)2 UP)
and
3
is determined
by
(12)
tan 3 =
(mi, +
n,)w/(m,,
+ n,).
Now we need a measure of the efficiency, as stabilizers of the exchange rate,
of these S transactions. Eastman has provided the conceptual basis for the
measure: "the smallness of the capital flow that achieves a given reduction
in the amplitude of fluctuations in the rate."3 To adapt this concept to the
present problem, first set up a special model x as a standard of efficiency. In
36'On Buying Cheap and Selling Dear," 434.
568
T. L. POWBIE
model x, all short-term capital movements resist deviations of the exchange
rate from its normal value. Excess demand in model x is
(13) g - hR + k sin wt - e(R - N),
where the subscript x identifies the model and e is the strength of short-term
capital movements. The amplitude of Rx is
(14)
Ax
=
k/(h
+
e)
and the amplitude of short-term capital flows in the model is
(15)
F_
=
ke/(h + e).
Now set A (from equation 4) equal to Ax (equation 14) and solve for e to find
(16) e = -/{ (h +
m,
+ nC)2 + (ms + n)2 w2} - h,
which is the value of e required to make A.
= A. Putting this value of e
into equation 15, we get
(17) Fx
=
[kV{ (h + mc + nc)2 + (ms + nf)2 W2} - kh]/{ (h +
m,
+ nf)2
+
(mi
+
ns)2
w2},
which is the value of F, required to make Ax = A. Let the measure of the
efficiency of stabilizing short-term capital movements be
(18) E =
Fx/(G
+ H) =
[N/
(h + mc + nf)2 +
(m,
+ nS)2 w2}
- h]/[V/(mc2 + Min2 w2) +
V(n"2
+ n82 W2)].
Terms G and H come from equations 8 and 9. Their sum is used instead of F
from equation 11 because F conceals a form of inefficiency in the general
model. In the general model, G is the amplitude of net private short-term
transactions and H is the amplitude of net official intervention. Since these
two sets of transactions may have different phasing, they may in part merely
offset each other without affecting the exchange rate. This partial cancellation
of effect is inefficient, but the wasted transactions are not reflected in the size
of F, the net amplitude of all short-term capital flows. To include these wasted
transactions in the measure of efficiency, G + H, the gross amplitude of short-
term capital flows, is used in the measure. (The term "gross amplitude" is
used for want of a better, but note that its components, G and H, are both
net amplitudes.)
The larger is E, the more efficient is the model. In words, efficiency is
greater if exchange rate fluctuations are limited to any given amplitude by
smaller gross short-term capital flows. The index of efficiency E equals one
when all short-term capital flows resist deviations of the exchange rate from
its normal value.
Let m
=
m,
+ Ms, m being the total strength of all private short-term
capital
flows. Similarly,
let n
=
n, + n8,
n being
the total strength
of official
intervention.
Now we can consider a few particular cases of the above general model.
First consider a situation in which all private short-term capital movements
Notes 569
resist (R -
N),
that is, where
m,
= m and m,
=
0. In model 1, let official
transactions also be entirely devoted to resisting (R - N), that is, let n0 =
n
and
n,
=
0. In model 2, let official transactions resist only
DgR,
that is, let
n.
=
n and n0 = 0. The values of A and E can be obtained for each model
simply by putting the appropriate values of m, mi8, nc,
and n8 into equations
4 and 18 (subscript numbers identify the model):
Al
= k/(h + m + n)
E1 =
[V/ (h + m + n)21 -hI/(m + n)
A2 = k/Vt (h + m)2 + n2W2}
E2
=
[V/t(h
+
M)2
+ n2W2I -
h]/(m + nw)
AI
is greater or less than A2 as w2 is greater or less than 1 + 2(h + m)/n.
However, E1 is always greater
than E2 since E1 = 1 and
E2 < 1. Thus, for
any given n, R2 may have a smaller amplitude than R1 if w is large enough,
but stabilization in model 2 can never be as efficient as in model 1. If private
short-term capital movements resist (R - N), achievement of maximum
efficiency requires that official intervention also resist (R - N).
Now turn to another pair of models, 3 and 4. In both of these, all private
short-term capital flows resist DIR. That is
mc
=
0, min = m. In model 3,
nc =
n, n, = 0;
in model 4, n, = 0, n, = n.
A3 =
k/Vf (h + n)2 + M2W2}
E3 = [V/{(h
+
n)2 + M2w21
-
h]/(mw + n)
A4= ki Vt h2 + (m + n)2w2}
E4 =
[V/{h2 + (m + n)2w2}
-
h]/(m + n)w
A3 t A4 as W2 t (2h + n)/(2m + n).
Both E3 and E4 are less than one, but the condition determining which is
larger apparently does not reduce to a simple statement in terms of h, m,
n, and w. Numerical examples
show that either
efficiency may be the greater
one. For instance, if w = 1, E3 t E4 as h i m. The conclusion is, if private
short-term funds resist DIR,
an
efficiency
of
unity
is not possible, but attain-
ment of the highest possible efficiency may require
that official transactions
resist either (R - N) or DIR.
One reason for this conclusion lies in the
problem of minimizing the waste
of official transactions on the cancellation of other stabilizing influences. If
official trading resists (R
-
N), part
of it will be wasted in offsetting some
of the private short-term capital
movements
resisting DIR. On the other hand,
if official trading resists DIR, part of it will be wasted in offsetting some of the
stabilizing effect of the private transactions, described by -hR, which are
related to the absolute level of the exchange rate. In general, the waste will
be minimized if the official trading reinforces whichever is the stronger sort
of stabilizing behaviour in the
private
sector of the market. There is another
possible reason for the above conclusion. Eastman has pointed out that the
most efficient stabilization occurs when all short-term flows resist (R
-
N),
because only then are movements of these funds exactly in phase with fluctua-
tions of the rate which would have existed in the absence of stabilization. In
570 T. L. POWIRE
the present case where private funds resist DIR, their movement is out of
phase with the unstabilized rate. The phase lag, (B - a), of net total short-
term capital flows depends on whether official intervention is related to
(R - N) or to DIR. (See equations 5 and 12.) Depending on the sizes of the
parameters, either kind of official intervention could be more favourable or
less unfavourable with respect to the phasing of short-term capital flows.
In correspondence, Professor Eastman has expressed reservations, which I
share, about the relevance of model 4 as a simplified description of the Canadian
foreign exchange market under a flexible rate. Private short-term capital move-
ments were statistically related to changes in the exchange rate, so one
might suppose that model 4's mDzR is a useful simulation of their behaviour.
However, the real world private capital movements may not have been caused
by changes in the exchange rate. To the extent that they were not so caused,
they must be reflected, in the present model, in the parameter k, not in m. A
model in which m = 0 might be a better approximation of reality than is
model 4. Another important empirical question is the size of h. As h and m
both approach zero, E3 and E4 both approach one,
in which case both forms
of official intervention would be about equally efficient.
FIXED FACTOR PROPORTIONS IN CLASSICAL ECONOMICS:
A NOTE
BRIN BIXLEY University of Toronto
It is common to find in modern critical commentaries of classical economics
the assertion that members of the Classical School assumed "fixed factor pro-
portions." Professor Blaug has claimed that "Ricardo, Mill and Marx treated
all commodities as produced under conditions of constant costs and fixed
technical coefficients."' In a recent article on Mill, Professor Hollander has
written: "I have interpreted Mill's comments on equipment and materials as
referring not merely to the notion that production requires the presence of
inputs in addition to labour, but more specifically to the assumption that
factors must be used in fixed proportions."2
The great contribution of marginal productivity analysis was to make factor
proportions continuously variable in given states of technological knowledge;
indeed, without some such assumption the concept of marginal productivity is
meaningless.3 Tlis is contrasted with supposed classical assumptions:
This formulation of the principle of variation of proportions as a general rule govern-
ing all resources is one of Menger's greatest achievements. ... Classical theory
1M. Blaug, Economic Theory in Retrospect (Homewood, 1962), 277.
2S. Hollander, "Technology and Aggregate Demand in J. S. Mill's Economic System," this
JOURNAL, XXX, no. 2 (May 1964), 177.
3If we are thinking of the marginal productivity of a factor in a particular line of employ-
ment. If alternative occupations are open to the factor then it is possible to derive a marginal
productivity curve (demand curve) for that factor, even though the factor is used in fixed
(but different) proportions in the alternative occupations.