3. Austrians and two selected mainstream theories
3.2 Austrians and Simple Portfolio Balance Model (PBM)
equilibrium exchange rate that serves as the basis for overshooting or undershooting. Rather it is the expected future exchange rate.
Three addendums are to be made in the end of this section. First, it was its task to put both approaches against each other – Austrian and Dornbuschian, and contrast the mutual differences springing from their causal point of view, on the one hand, and deterministic point of view, on the other hand. Second, it was showed that despite of the undisputable differences, it is still possible to enrich one approach thanks to reasoning of the other. Third, the supposed reconciliation that was brought above in the previous paragraph should be understood as the beginning, not the end, of the chain of problems. It just represents an important insight worth of considering for an Austrian economist. Elaboration of the set of springing additional problems has to be dealt with at the other place83.
attractive compared to the state before. Specificities of these demands are to be presented in the following paragraphs.
Demand for M moves in the opposite direction in respect with interest rate (r)89.
Demand for Bp is positively related with increases in wealth and also with movements in r – the later due to the fact that price of Bp changes inversely to changes in r90.
Demand for eFp is negatively related to r, because its increases (decreases) represent higher (lower) attractiveness of Bp as one of eFp‘s substitutes and consequently decrease (increase) demand for eFp91.
In order to make later comparative-static framework more accessible, one could take total differentials of the relationships ascribed above92:
dM = mr dr + mw(dM + dB + Fp de + edFp) (1)
dBp = br dr + bw(dM + dB + Fpde + edFp) (2)
d(eFp)= fr dr + fw(dM + dB + Fpde + edFp) (3)
The equilibrium is attained when all three markets are in equilibrium with respective r and e.
At this place the short-run behavior will be dealt with resulting from the policies of monetary authorities – foreign exchange operations (FXO) and open market operations (OMO).
In case of expansionary FXO93, authority increases M by purchases of F: dM =- edFp = edFa. This is possible only if domestic price of F, edFp, increases. Since price of F is given abroad, the increase could happen only through increase in e. Moreover, as a consequence, of
89 In other words: M = m(r, E , W); mr<0, m <0, my>0, mw>0; mr, m , mw standing for partial derivatives.
E represents expected rate of depreciation of the domestic currency. Since it is assumed to be equal 0 in the model (Pilbeam (1998, p. 195), it is of no use for our present purposes.
e& e& e&
e&
90 Bp = b(r, Ee&, W); br > 0, b < 0, be& w > 0; br, be&, bw standing for partial derivatives.
91 eFp = f(r, Ee&, W); fr < 0, f > 0, fe& w>0.
92 See Pilbeam (1998, pp. 194-195). It should be noted that since Ee = 0, we have put this variable out of the
picture. &
93 Pilbeam (1998, pp. 195-196).
increased M and rising prices of F for holders of M, r decreases, that is B is bought for additional M, until people are willing to keep additional M in their cash balances.
Restrictionary FXO, on the other hand, ends up with just the opposite results – domestic currency appreciation and increase in r.
When performing OMO94, the authority increases M by purchasing B: dM =- dBp = dBa. Again, r declines as price of B increases and exchange rate rises in order to keep additional money in cash balances and to substitute for more expensive B. In OMO leading to the negative change in M, the opposite takes place – increase in the interest rate and decrease in the exchange rate.
Now, the crucial question comes to one’s mind: Is the proposed theory in some way reconcilable with the Austrian tenets? In course of the answer, two points of the model above are to be highlighted in the beginning: first, the implicit assumption of existence of only three goods in the short-run – M, F and B. Second, the notion that these goods are to be held in a given proportion in regards with W. If the aim of this model is explanation of the real world phenomenon95, for an Austrian, it is determined to fail. Other goods that represent substitutes to three assets above exist even in the short run and they do perform an important effect on relevant variables of the PBM. The second point concerning the proportion of held assets in regard with W could not find any support in general axioms of action either. An Austrian hailing freedom of humans’ choice could hardly accept such an assumption as a fundamental basis of an economic model. Our next task will be devoted to pointing out impacts of the absence of these and others “Austrian-unfriendly” assumptions for the mechanics of the PBM in the previously discussed cases of FXO and OMO.
Let us look at the problem of FXO first. The expansionary policy is considered again, however, under different conditions96. First, whole array of other goods that could be bought in the economy in the short run, including the foreign currency itself, is added to the previous
94 Pilbeam (1998, pp. 198-199).
95 For the present discussion we are leaving out the problem of assumed out expectations concerning future exchange rate changes. These were omitted form PBM only for the sake of simplicity and not for the reason that they would be untenable within the tenets of the model – Branson (1984), for example, undertakes analysis on basis of their existence.
96 However, expectations concerning future changes in the exchange rate are retained to be 0, since this point is not vital as it was suggested before.
three-good world – there is no fundamental reason for an Austrian economist why all other goods should be omitted. Second, the strict proportionality of goods on W is assumed out.
Now, the very FXO could be approached. Here, the question of tradability of F arises. If the number of domestically held F is assumed to be constant in the short-run97 and if the foreign currency is independently bought and sold at the same time for the domestic currency, than, with Ee=0, the short-run e could be in no direct way influenced by changes in the domestic prices of F. There is no chain of action linked with the current increase in the domestic price of F and selling of the domestic currency that leads to higher money income than otherwise – foreign F could not be, by the assumption, sold at home and received domestic currency could not be then exchanged for the foreign currency and the net arbitrage gain could not be received. In other words, domestic currency could not depreciate as a direct result of the increased demand for the domestically held F. With E =0, only step-by-step changes caused by increased amount of money could influence e in a way explained above. However, when and to what extent will this influence come into being is a question of concrete situation.
&
e&
On the other hand, if F is assumed to be internationally arbitrageable in the short-run of our concern, this might lead to direct chains of actions suggested above that will result in depreciation. However, after the desired amount of money is sold by the authority and as soon as the domestic price of F is fully arbitraged, there is no reason why e have some particular value in comparison with its state before the actual intervention. Since the proportion of held assets and goods is in no strict way given, and the spendings of current holders of new cash balances might go in any direction, the state of e is not predictable for that point of time.
Concerning expansionary OMO under the assumptions of more than three goods and non-proportionality of assets on W, short-run changes in the exchange rate are even less predictable when compared to the case of FXO. Increase in the amount of money and decrease in the rate of interest in no way leads to the immediate depreciation of the currency – it is a question of preference of people who receive the additional M. There are many other ways of getting rid of the additional cash balance and many of these chains of actions might lead to the foreign exchange market only after a long temporal lag.
97 Pilbeam (1998, pp. 202-203).
In the end of this section, three important points are to be raised. First, the above problems of the PBM form the Austrian viewpoint holding for expansionary policies, hold in case of restrictionary policies as well. It is the mechanism of influence of e and not its specific direction that was regarded as problematic. Second, it should be clear that the analysis above represents only a glimpse of a potential controversy between the two theories. The PBM presented at this place is one of its most simplified versions, moreover, applied only for the short-run, and it would require much more space to fully develop and put against each other both argumentation lines. However, and third, despite of the second point, the most fundamental difference between both theories were presented – namely the difference in the assumptions concerning the scope of choice of acting people in the short run. In the PBM, this choice is highly restricted and this very restriction represents its necessary core. Austrian approach could not from its basic tenets accept this kind of restriction. As a consequence, it is clear that no fundamental reconciliation between the two approaches is feasible.
Conclusion
There are two broad topics that should be mentioned in the end of this undertaking. The first one is related with the very theory of the Austrian economics. The second one is related with the broader issue of Austrian economics and the theory of economic mainstream.
In respect with the former point, one might, to some extent, rightfully argue that the present thesis has brought about more questions than answers. On the one hand, it is true; the conceptualizing framework of means and ends was brought into the picture. On the other hand, however, resulting implications related with the topics of complementarity, price differentials, or non-neutrality of money brought about new concepts, effects and phenomena.
These are to be confronted with the real world situation to assess their relevance for the analysis and as well as it is important to contrast them with the overall picture of the Austrian theoretical system. These tasks, however, are beyond the reach of the present thesis.
In respect with the latter point, it should be noted that the purpose of the present thesis was not to be “normative” from the point of view of economist choosing the correct economic theory. The point was rather to broaden the overview of the reader – whether from the mainstream circles or from the Austrian circles and to clarify the arguments of both sides of the “scientific barricade” by bringing some “positive” overview. That this barricade is present is without doubts and the present paper brings strong evidence of its support: causal
relationships versus mutual determinationism, concepts based on the theory of human action versus holistic apriori concepts, step-by-step analysis versus equilibrium concepts…
However, despite of all these facts, it was showed that there is a possibility of transmission of knowledge between both systems. They could be compared to each other, moreover, sometimes, as was suggested in case of the overshooting model, they could even enrich one another.
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List of Figures
Figure 1: Chain of individual’s actions ... 6
Figure 2: Chain of individual’s actions: dollars ... 8
Figure 3: Chain of individual’s pounds... 8
Figure 4: Chains of individual’s actions: valuation ... 9
Figure 5: Chain of individual’s actions: foreign exchange market ... 10
Figure 6: Chain of individual’s actions: valuation at the foreign exchange market ... 10
Figure 7: Chain of individual’s actions: foreign exchange market ... 11
Figure 8: Chain of individual’s actions: valuation at the foreign exchange market and particular ends ... 15
Figure 9: Curve representing demand for pounds of Mr. Smith ... 16
Figure 10: Background of the sequence of the preference scale of Mr. Smith ... 17
Figure 11: Chain of individual’s actions: valuation at the foreign exchange market ... 19
Figure 12: Change in the demand schedule of Mr. Smith as a consequence of the change in valuation of his ends... 20
Figure 13: Curve representing supply of pounds by Mr. Brown ... 21
Figure 14: Mr. Brown and Mr. Smith: individual supply and individual demand... 23
Figure 15: Aggregated supply and aggregated demand at the foreign exchange market... 24
Figure 16: Changes in the demand for pounds... 25
Figure 17: Changes in the supply of pounds ... 26
Figure 18: Chain of individual’s actions: exchange rate and prices ... 27
Figure 19: Chains of actions and price differentials ... 45
Figure 20: Price differentials and exchange rates, scenario number 1... 46
Figure 21: Price differentials and exchange rates, scenario number 2... 49
Figure 22: Part of the economy before increase in the money supply ... 54
Figure 23: Part of the economy after the increase in the money supply ... 55
Figure 24: Austrian theory of exchange rates and overshooting... 68
List of Tables
Table 1: The preference scale of Mr. Smith and corresponding demand schedule... 16
Table 2: Change in the demand schedule of Mr. Smith as a consequence of the change in valuation of his ends... 20
Table 3: The preference scale of Mr. Brown and corresponding supply schedule ... 21
Table 4: Two individuals at the foreign exchange market: supply schedule and demand schedule... 22
Table 5: Change the price of individual foreign good and changes in monetary outlays related with this good ... 28
Table 6: Change the price of individual foreign good in the overall context of choice... 32
Table 7: Increase in the price of individual foreign good and potential results for quantities of pounds demanded... 33
Table 8: Decrease in the price of individual foreign good and potential results for quantities of pounds demanded... 33
Table 9: Illustration of the fact that relationship of two goods is dependent on the actual value of the price change ... 34
Table 10: Initial situation of Mr. Strange... 37
Table 11: Increase in price of M, keeping the exchange rate “constant”... 37
Table 12: Mr. Smith and change in the exchange rate ... 38
Table 13: Increase in the price of M under changed exchange rate... 39
Table 14: Increase in the price of individual domestic good and potential results for quantities of pounds demanded... 41
Table 15: Decrease in the price of individual foreign good and potential results for quantities of pounds demanded... 42
Table 16: Increase in the price of individual foreign good and potential results for quantities of pounds supplied ... 43
Table 17: Decrease in the price of individual foreign good and potential results for quantities of pounds supplied ... 43
Table 18: Increase in the price of individual domestic good and potential results for quantities of pounds supplied ... 44
Table 19: Decrease in the price of individual foreign good and potential results for quantities of pounds supplied ... 44
Table 20: Price differentials and changes in quantities of pounds supplied and demanded, scenario number 1 ... 48 Table 21: Price differentials and changes in quantities of pounds supplied and demanded,
scenario number 2 ... 49
Executive Summary
The scope of the present thesis is four-fold. First, to clarify and explain the means-ends framework and step-by-step analysis of the Austrian school. Second, to apply this framework to the Austrian theory of exchange rates. Third, to link the framework with most of the existing Austrian research related with the exchange rate theory and discuss this research.
And fourth, to confront the Austrian economics with two mainstream approaches - Dornbusch’s overshooting model and short-run portfolio balance model. Message springing from this confrontation is twofold. First, the fundamental differences between present-day mainstream methods are envisaged. And second, the fact of possibility of mutual enrichment of both approaches from each other despite of completely different methodological backgrounds is suggested.
Key Words: Austrian school of economics, causality, exchange rate determination.
JEL classification: B25, B53, D01, D46, E40, F31, F41, G11.