The Changing Regime of the Pound/Guilder Exchange Rate

Transcription

1 The Changing Regime of he Pound/Guilder Exchange Rae Peer Kugler WWZ/Universiä Basel Absrac Before he shor 0 h cenury he exchange rae regime was deermined by he inernal moneary sandard: privae arbirage led o fixed equilibrium exchange rae for currencies wih he same meallic sandard, whereas differen sandard led o flexible raes. However, he srong decrease in ransacion coss during he 19 h cenury led o more fixiy of exchange raes as i is illusrae by applicaion of a TAR model o hisorical daa for pound-guilder rae: under he 17 h and 18 h cenury silver sandard, we have deviaions of.8% from pariy unil privae arbirage operaions wih only 8% annual adjusmen are riggered. In he gold sandard period his bandwidh is ighened o only 0.5% wih full adjusmen wihin one year. The inermediae period from 1817 o 1874 wih a gold pound and silver guilder he no-arbirage band around a changing pariy according o he gold/silver raio is 0.84% and 60% adjusmen wihin one year. During he inconveribiliy regime for he pound ( ) we have highly volaile flexible exchange rae as no pariy rae exiss and arbirage operaions were no possible. Key Words: Foreign exchange marke arbirage, pariy, ransacion coss, hreshold auoregressive model, guilder, pound JEL: N3 Firs Draf July 013

2 1. Inroducion Before he wide spread creaion of cenral banks a he end of he 19 h and beginning of he 0 h cenury he exchange rae regime beween wo currencies was deermined sponaneously by he inernal moneary regime seleced by he wo counries: firsly, for currencies wih he same meallic sandard (say silver or gold) wih full converibiliy and free inernaional movemen of money and he moneary meal privae arbirage operaion resuled in an equilibrium exchange rae corresponding o he relaive meallic conen of he currencies being exchanged. Secondly, for currencies wih differen meallic moneary sandard he arbirage-equilibrium exchange rae evolved according o he relaive price of he wo meals. Thirdly, when a leas one of he currencies was on a paper sandard no arbirage was possible and he exchange rae was fully flexible and was deermined by he volume of fia money issued. However, even wih he same meallic sandard and a fixed equilibrium exchange rae acual raes may have been raher volaile in pre-modern imes as hese arbirage operaions were subjec o raher high ransacion coss. In paricular, in preindusrial imes hazardous and cosly ranspor roues for goods and informaion may ofen have prevened he arbirage operaions beween he foreign exchange and meal marke. Thus, we conjecure a raher broad band of exchange rae movemens around he meallic pariy and a corresponding flexibiliy unil he informaion and ranspor revoluion riggered by he inroducion of elegraphy, seamships and railways in he 19 h cenury. In his paper he relaionship beween inernal moneary sandard and exchange rae regime is analysed for he pound/guilder exchange rae and he period 1600 o 191. These wo currencies are of major ineres in our conex. Firsly, boh counries showed srong financial developmens wih a Duch lead during he 17 h and 18 h cenury. Indeed, Amserdam was considered o be he mos imporan financial and rade cenre worldwide unil he lae 18 h cenury when London ook over his posiion. Secondly, Amserdam and London are relaively close ciies and hey were well conneced by see ranspor, which was much less cosly han land ranspor in pre-indusrial imes. Thirdly, boh

3 currencies were based for mos of he ime period under consideraion on he same sable meallic sandard, bu here were periods which differen moneary sandards which provide illusraions for all he possible exchanger rae oucomes skeched above. The paper is organized as follows: Secion presens he annual daa for he Amserdam and London foreign exchange markes aken from Denzel (010) and gives a brief accoun of he hisory of he pound/guilder exchange rae. The Threshold Auoregressive model which is used o esimae he non-linear adjusmen paer o he meallic pariy wih ransacion coss is described in Secion 3. The resuls are repored in Secion 4 and secion 5 concludes.. The Pound/Guilder Exchange Rae In order o analyze he relaionship beween inernal moneary sandard and exchange rae we will consider he hisorical developmen of he pound/guilder exchange rae from 1600 o 191. The hisorical developmen of his exchange rae over more han hree cenuries is ineresing for wo reasons: Firsly, during he 17h cenury he Neherlands (Duch Republic) became he economically mos advanced counry and dominan rade naion wih Amserdam as he leading financial cener. The counry had a high saving rae and an advanced financial sysem was developed. Moreover, sound governmen finance provided a sable currency (Flemish pound = 6 guilder) and low ineres raes. During he 18h cenury Briain followed he developmen in he Duch Republic and became he economically mos advanced counry wih London as he leading financial cener and he pound as leading currency in he 19 h cenury. Therefore, he exchange rae beween he pound and he guilder assumed a funcion of major hisorical imporance. Secondly, he wo currencies experienced differen moneary sandards. The guilder was based on a silver sandard from 1600 o 1839, followed by a brief bimeallisic period (wih a de faco silver sandard) and finally swiched over o a gold sandard in The pound was based on a bimeallic sandard from 1600 o 1797, on an inconverible paper 3

4 sandard from 1797 o 1816, and subsequenly on he gold sandard which was kep unil 1914 (Denzel, 010, pp. 3 4, 57 59) 1. Figure 1 presens wo series, namely he London and Amserdam marke price of he guilder expressed in pounds, respecively. The daa is based on bills of exchange beween Amserdam and London drawn in boh direcions provided by Denzel (010, xxii-xlix, 3-101). The daa are averages of monhly observaions which were, however, no always available for all 1 monhs in paricular before he 19 h cenury. Thus, he annual daa are based on a varying number of exchange bills. The wo prices are highly correlaed, i.e. he simple correlaion coefficien is Neverheless he series are no equal as in a fricionless world and he difference we observe is mainly brough abou by ransacion coss prevening arbirage operaions beween he wo markes. In addiion, we noe ha we have some missing daa unil he end of he Napoleonic wars. In paricular his is rue for he London marke wih 39 missing observaions. For he Amserdam marke we noe only 15 missing values indicaing he leading role of Amserdam as financial cener in he 17 h and 18 h cenury. This posiion of Amserdam is suppored by he median number of exchange bills annually available of 1 compared o only 6 for London. An economeric analysis provided by Kugler (013) shows ha hese wo exchange raes could deviae by approximaely.5% unil his gap was closed by arbirage operaions in he 17 h and 18 h cenury. This bandwidh of oscillaion was srongly reduced in he 19 h cenury when i became considerably smaller; namely, reaching approximaely 0.4%. Before he 19 h cenury, larger deviaions led o an adjusmen of he London marke, whereas hereafer he gap of he wo exchange raes was closed by changes in he Amserdam marke. This paern of adjusmen is consisen wih he leading role of he Amserdam (London) marke in he 17 h and 18 h (19 h ) cenury. 1 Silver remained he relevan moneary meal for bills of exchange and he converibiliy of bank noes of he Bank of England, even when gold coins crowded ou silver coins in domesic circulaion and Briain moved de faco o a domesic gold sandard during he 18 h cenury. 4

5 Figure 1: Pound/Duch Guilder Exchange Rae in Amserdam and London Guilder: silver ( ), bimeallic ( ), gold ( ) Pound serling: bimeallic ( ), paper ( ), gold ( ), Daa: Denzel (010) /Guilder London /Guilder Amserdam Figure 1 suggess a long run sabiliy of he exchange rae from 1600 o In he 19 h cenury afer he Napoleonic wars we noe again long run exchange rae sabiliy, bu now a a lower level. Indeed, he uni roo hypohesis is clearly rejeced by he Phillips-Perron es for he boh sub-periods and For he inernaional gold sandard in he period we noe very low exchange rae volailiy afer he informaion and ranspor revoluion in he second half of he 19 h cenury. This was brough abou by privae arbirage operaions a low ransacion coss. The gold conen of he guilder and he pound was and 7.3 gr., respecively, and he 3 The PP-saisic is -3.3 and for London as well as and in he wo periods, respecively. 5

6 corresponding equilibrium exchange rae was herefore /G. Now assume he exchange rae would be.08 /G. Wih 1 pound we can buy 1.5 guilder conver hem ino 7.56 gr. gold in he Neherlands and conver his in England ino 7.56/7.3= 1.035, i.e., we would make an arbirage profi of 3.5%. During he period immediaely before ( ) when he guilder was based on a silver or bimeallic (de faco silver) sandard and he pound on a gold sandard, we see more flexibiliy in he exchange rae, and, in paricular, we observe very high volailiy in he period of he pound s inconveribiliy during he Napoleonic wars ( ) where no arbirage was possible. Arbirage possibiliies exiss bu are more complicaed for he silver-gold case han he same meallic sandard: if he exchange rae of he Duch (silver- ) guilder agains he (gold-) pound was higher han he silver-gold raio, we could buy guilder for pounds, conver hem ino silver, sell he silver o buy gold, which we subsequenly conver ino pounds, and hereby make an arbirage gain. Thus in he long run, he exchange rae was flexible bu followed he relaive price developmens of silver and gold. In Figure, he London pound serling/guilder exchange rae and he corresponding silver/gold pariy rae is displayed for he period The pariy rae is calculaed by dividing he silver conen of he guilder (9.61 g, , 9.45 g, ) by he silver-marke value of he 7.3 g of gold conained in he pound serling. In order o gain he silver value of he pound, we muliplied 7.3 by he London marke price raio of gold o silver, which is displayed for he period in Figure 3. Figure suggess a raher high correlaion beween he marke and pariy exchange rae. Indeed, he simple correlaion coefficien beween he wo series is

7 Figure : Log Pound Serling/Duch Guilder Exchange Rae in London and he Varying Silver/Gold Pariy, /Guilder London Marke /Guilder Varying Silver/Gold Pariy Figure 3: Gold/Silver Marke Price Raio, Gold/Silver Price Raio London Marke Daa source: Officer and Williamson (013). 7

8 The remarkable long-run sabiliy of he exchange rae during mos of he 17 h and 18h cenury (before he French revoluion) is explained by a sable link o silver of boh currencies. Indeed, he silver conen of he guilder was 10.4 g and ha of he pound, 111 g (Denzel, 010, pp. 3 4, 57 59), which implies a silver pariy exchange rae of pounds/guilder, which is close o he mean of he exchange rae unil he end of he 18 h cenury. In he 17 h cenury, we noe some srong deviaions from pariy caused by difficul poliical condiions (civil war in England and hree Duch-English wars, he Nine Years War) wih emporary resricions on he free movemen of silver. Table 1 collecs a couple of descripive saisics of he deviaion from pariy for he silver sandard ( ) and gold sandard ( ), as well as he silver/gold inerlude ( ). We use he exchange rae daa from he leading marke, namely Amserdam ( ) and London ( ), respecively. All hese saisics indicae a srong endency owards narrower bounds around he pariy exchange rae: he sandard deviaion is reduced from 3.57% ( ) o 0.19% ( ). Equally impressive are he observed ranges: in he 17 h and 18 h cenury, we have values ranging from -1% o 18%, whereas in he gold sandard period hese figures range from -0.9% o 0.08%. Noe ha in he firs and second period, we have a sligh average premium on he guilder (mean = 0.3/0.38%), whereas in he gold sandard, we have a sligh average discoun on he guilder (mean = -0.17%). Table 1: Deviaions from Pariy Pound/Guilder Exchange Rae, , in Percen Period Pound/Guilder Mean Sandard Min Max Sandard deviaion Silver/silver Gold/silver Gold/gold

9 3. Economeric Model Now le us urn o he economeric model used in his sudy. Le y be he log pound/guilder exchange rae in London or Amserdam and yp he meallic pariy rae, respecively. We apply he following hreshold auoregressive model for hese series 4 : y y = a = a Var( ε ) = σ + λ ( y + λ ( y λ = 0, λ 0; / n 1 yp ) + ε, yp ) + ε, if abs( y 1 if abs( y 1 xp ) < τ xp ) τ (1) The model above is slighly differen from he sandard TAR as we ake ino accoun he heeroskedasiciy of he error erm. As we noed in secion we have differen numbers of observaions used o calculae he mean annual exchange rae in he wo markes, in paricular in he 17 h and 18 h cenury. This ime varying precision of he exchange raes calculaed is aken ino accoun by dividing a ime invarian error variance by he number of observaions used, n, respecively. This reflecs he formula for he sandard deviaion of he arihmeic mean. This ime varying variance is incorporaed by a GLS-approach involving simply he division of he observaions enering equaion (1) by n 0.5. If ransacion coss are relevan, we expec λ1 = 0and he oher error correcion coefficien o have a negaive sign. An inercep erm, which may differ across he wo regimes, is included in he model. As he wo series have no drif, he consan erm can only arise from an inercep erm in he equilibrium relaionship ( y 1 yp c) indicaing a non-zero long-run equilibrium value for he pariy deviaion. Correspondingly, a = 0 1 should hold, oo. 4 This model can be direcly applied o saionary series (as indicaed o be he case) when he equilibrium coefficiens are known o be one, as in our case. 9

10 Defining z 1 yp and a dummy variable d, which is one when abs = < τ = y 1 holds and oherwise 0, we can rewrie our model in one equaion: ( z 1 ) y = ( a1 + λ 1z 1) d 1 + ( a + λz 1)(1 d 1) + ε () These equaion can be esimaed by GLS when τ is known. In order o deermine his parameer, we use a grid search over he possible inerval 5 o ge he value which minimizes he residual sum of squares of equaion (). The parameer τ is only idenified if his non-lineariy is presen. This condiion appears o be fulfilled as he non-lineariy ess repored for he exchange rae on he Amserdam and London marke clearly rejec he lineariy hypohesis (Kugler, 013). 4. Empirical Resuls Table 1 repors he resuls for he TAR-model for hree subsamples, namely and , and For he firs Period we have a consan silver pariy for boh currencies. From he pound was on a paper sandard and here is no defined pariy rae 6. For he period he meallic pariy is deermined by he silver/gold price raio as displayed in Figure and he las sub sample is he gold sandard period wih a fixed gold pariy. From he wo exchange rae series available we seleced always ha of he leading marke, namely Amserdam ( ) and London ( ), respecively. Table displays he esimaion for a resriced varian of he TAR model, namely he error correcion coefficien and he inercep in he inner band is se o zero in boh equaions ( λ = 1 0, a = 0 3 ). Of course, his resricion is moivaed by ransacion coss. Allowing hese coefficiens o be differen from zero does, however, no have an essenial influence on our findings as he corresponding esimaes are saisically insignifican. 5 The range of τ is resriced o values beween 10% and 90% quaniles of he absolue values of z. 6 The years of, and immediaely before he French Revoluion are excluded as hey are a period of ransiion wih a relaively high number of missing observaions. 10

11 Table shows a hreshold esimae of.8% for he firs sub-period. This hreshold corresponds nicely wih he value esimaed for he adjusmen beween he Amserdam and London marke which is obained as.4% (Kugler, 013). The esimaed adjusmen coefficien (-0.4) is highly saisically significan bu has relaively low absolue value: only one fourh of he deviaion from pariy is correced wihin one year. The a-esimae is saisically highly significan and indicaes ha we have a premium on he inernaionally leading currency of approximaely 4% 7. The esimaes for he period shows hree major breaks. Firsly, he hreshold esimae is now 0.87%, which is only one hird of he earlier value. This reflecs he increased arbirage possibiliies and increased inernaional financial inegraion riggered by he informaion and ransporaion revoluion of he 19 h cenury. Secondly, he adjusmen paern is much faser: he EC-Coefficien esimae is now and saisically highly significan. Thirdly, he esimae of he consan erm is saisically significan wi a reversed sign indicaing ha we have now a premium on he pound of approximaely 1.3%. Finally his premium disappears in he gold sandard period and we have now nearly complee adjusmen (0.93) wih a band of only 0.5%. These resuls confirm wih he findings for he inegraion of he Amserdam and London marke for he enire period obained by Kugler (013): he esimaed band was 0.44% and he EC coefficien in he Amserdam marke was 0.7 in absolue value. Moreover, he gold sandard resuls are consisen wih he findings of Caniels e al. (004) for he pound-dollar exchange rae. The srong move o lower band and faser adjusmen from he gold/silver regime o he gold/gold regime in he 19 h cenury is explained by echnological progress and by fac he former regime has ceeris paribus higher ransacion coss as he arbirage operaion involving boh meals is more complicaed. 7 Remember ha consan erm in he EC equaion sems from an inercep erm in he equilibrium deviaion. Correspondingly, he a-coefficien is equal o -λc and for non-zero λ values we ge c=-a/ λ which is equal o wih our esimaes. 11

12 Table : Esimaion Resuls Threshold Auoregressive Model Log Pound/Guilder Exchange Rae, y y = a = a Var( ε ) = σ + λ ( y + λ ( y λ = 0, λ 0; / n 1 yp yp ) + ε, if abs( y 1 ) + ε, if abs( y 1 xp ) < τ xp ) τ a λ τ R-squared DW (0.0033) (0.008) (0.0004) (0.0443) (0.110) (0.069) Sandard errors in parenheses 1

13 5. Conclusion Before he wide spread creaion of cenral banks a he end of he 19 h and beginning of he 0 h cenury he exchange rae regime beween wo currencies was deermined sponaneously by he inernal moneary regime seleced by he wo counries. For currencies wih he same meallic sandard wih full converibiliy and free inernaional movemen of money and he moneary meal privae arbirage operaion resuled in an equilibrium exchange rae corresponding o he relaive meallic conen of he currencies being exchanged. When currencies had differen meallic moneary sandard, he arbirage-equilibrium exchange rae evolved according o he relaive price of he wo meals. Finally, he exchange rae was fully flexible and was deermined by he volume of fia money issued when a leas one of he currencies was on a paper sandard. However, even wih he same meallic sandard and a fixed equilibrium exchange rae acual raes may have been raher volaile in pre-modern imes as hese arbirage operaions were subjec o raher high ransacion coss. In paricular, in preindusrial imes hazardous and cosly ranspor roues for goods and informaion may ofen have prevened he arbirage operaions beween he foreign exchange and meal marke. Thus, we conjecure a raher broad band of exchange rae movemens around he meallic pariy and a corresponding flexibiliy unil he informaion and ranspor revoluion riggered by he inroducion of elegraphy, seamships and railways in he 19 h cenury. The relaionship beween inernal moneary sandard and exchange rae regime is analysed for he pound/guilder exchange rae and he period 1600 o 191. These wo currencies are of major ineres in our conex as hey played an imporan inernaional role and were based for mos of he ime period under consideraion on he same and raher sable meallic sandard bu here were periods which differen moneary sandards (paper sandard of he pound , silver guilder and gold pound ). The esimaion of a TAR model for he pound-guilder exchange rae show indicae a srong endency owards narrower bounds around he pariy exchange rae: In he 17 h and 18 h cenury wih silver sandard, we have deviaions of.8% from pariy unil arbirage operaions are riggered, which lead o a raher slow adjusmen of 8% wihin one year. 13

14 In he gold sandard period, his bandwidh is ighened o only 0.5%, where a near full adjusmen is achieved wihin one year. The inermediae period from 1817 o 1874 wih a silver guilder and a gold pound is wihin hese wo exremes wih a pariy deviaion bandwidh of 0.84% and 60% of he adjusmens achieved wihin one year. The pariy rae is deermined by he gold silver marke price raio. During he inconveribiliy regime for he pound ( ) we have high volailiy of he exchange rae as no pariy rae exiss and arbirage operaions were no possible. 6. References Bernholz and Kugler, P.: Financial Marke Inegraion in Early Modern Spain: Resuls from a Threshold Error Correcion Model, Economics Leers 110, 011, Canjels, E., Prakash-Canjels G. and Taylor, A. M.: Measuring Marke Inegraion: Foreign Exchange Arbirage and he Gold Sandard, , The Review of Economics and Saisics 86 (4), 004, Denzel, M. A.: Handbook of World Exchange Raes, , Ashgae, Burlingon, 010 Kugler, P.: Financial Marke Inegraion in Lae Medieval Europe: Resuls from a Threshold Error Correcion Model for he Rhinegulden and Basle Pound, , February 011, Swiss Journal of Economics and Saisics 147, 3, Kugler, P: The Changing Paern beween he Foreign Exchange Markes in Amserdam and London , mimeo, Universiy of Basel, February, 013. Prakash G. and Taylor, A. M.: Measuring Marke Inegraion: A Model of Arbirage wih an Economeric Applicaion o he Gold Sandard, , NBER Working Paper 6073, June