Speculation, Hedging and Arbitrage

Abstract

Perhaps the most difficult problem that economists and policy makers face is understanding how the existence of uncertainty affects people’s behaviour and in particular their reaction to various economic policies. In the simple model developed in earlier chapters, we emphasised that the informational requirements for the achievement of equilibrium are quite large. When we realise that people base their decisions not only on current prices and incomes but also on expectations about the future values of these variables, the magnitude of the problem becomes apparent. As a result buyers and sellers gather whatever information is readily available and form expectations about prices, etc. on the basis of this. This means that although they may often be correct, their actions may sometimes lead markets away from their equilibrium positions. The purpose of this chapter is to explain some of the transactions that arise in the foreign exchange market because of uncertainty and to show how the demand and supply of foreign exchange may be affected by changes in expectations, particularly about exchange rates. In Chapters 10 and 11 this theme will be returned to when we examine the implications of alternative exchange rate mechanisms. One conclusion will become quite clear: it is extremely difficult to reach any decision about the most desirable international monetary system without more information about the activities discussed in this chapter.