International Financial Integration: The Limits of by David T. Llewellyn

By David T. Llewellyn

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Speculative activity in the forward market affects spot capital flows indirectly through its effect upon the covered interest-rate differential. A speculative forward sale of sterling will tend, other things being equal, to cause the forward rate to depreciate and the covered interest-rate differential to move against sterling. Arbitrageurs react by reducing the proportion of their portfolios held in sterling and increasing the proportion in foreign currency assets. In this way speculation conducted entirely in the forward market affects both the magnitude and direction of international capital flows.

THE FORWARD EXCHANGE RATE 39 However, if speculation or official intervention prevents the forward rate from adjusting to interest-rate differentials, a greater volume of capital flows is needed to restore the equilibrium parity condition as the adjustment has to be made entirely by interest rates. This is because a given volume of capital flows tends normally to have a greater impact on the forward exchange rate than on interest rates, as it is likely to represent a higher proportion of total forward exchange transactions than money market transactions.

N. (1976) 'Monetary Theory and Policy in an Open Economy', Scandinavian Journal of Economics, May 1976. Fleming, J. M. (1962) 'Domestic Financial Policies under Fixed and Floating Exchange Rates', IMF Staff Papers, Nov 1962. Galbis, V. (1975) 'Monetary and Exchange Rate Policies in a Small Open Economy', IMF Staff Papers, July 1975. Helliwell, J. F. (1969) 'Monetary and Fiscal Policies for an Open Economy', Oxford Economic Papers, 1969. , and Marston, R. (1977) National Monetary Policies and International Financial Markets (Amsterdam: North-Holland) chap.

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