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National Interest Rates, the Forward Interest Rate, and International Capital Flows

Published online by Cambridge University Press:  17 August 2016

Robert Z. Aliber
Robert Z. Aliber*
Affiliation:
University of Chicago
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Extract

John Maynard Keynes introduced economists to the forward exchange market in 1923 in a celebrated section in A Tract on Monetary Reform The currencies of the European countries were floating in the exchange market, and market rates were substantially below their prewar gold and dollar parities. Most European governments were committed to peg their currencies to gold at their prewar parities, which would have required a substantial appreciation.

Type
Research Article
Information
Recherches Économiques de Louvain/ Louvain Economic Review , Volume 38 , Issue 2 , July 1972 , pp. 149 - 156
Copyright
Copyright © Université catholique de Louvain, Institut de recherches économiques et sociales 1972 

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References

(1) John Maynard KEYNES, A Tract on Monetary Reform, (London, Macmillan and Co., Limited, 1923). Keynes’ comments remain amazingly fresh after fifty years. He noted that the difference between the interest rates in various centers, after covering the exchange risk through forward contracts, reflected the preferences for holding funds in one center rather than another because of the uncertainties of financial and political risk, the possibility of a moratorium, the sudden introduction of exchange controls, and the contingency of a drastic demonetization.

(2) A good theoretical exposition of this theorem, together with an empirical test is to be found in H. STOLL, “An empirical study of the foreign exchange market under fixed and flexible exchange rate systems”, Canadian Journal of Economics, vol. 1 (February 1968), pp. 55-66.

(3) The interest agio is the difference between the money-market interest rates. The exchange agio is the interest equivalent of the difference between the forward rate and the spot rate.

(4) The analysis in this section is more fully explained in Robert Z. ALIBER, “The Interest Rate Parity Theorem : A Reinterpretation”, forthcoming, Journal of Political Economy.

(5) The traditional analysis of the exchange market also includes commercial hedgers. Commercial hedgers have no need for a forward market; they may satisfy their need for risk avoidance by spot transactions.

(6) The impact on the forward rate is smaller under the pegged system than under the floating system, largely because of greater substitutability between the spot exchange rate and the forward rate.

(7) Commercial banks differ from other investors jn that the cash position narrowly constrains the amount of arbitrage they engage in.