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Domestic Credit Expansion, Confidence and the Foreign Exchange Market: Sterling in 1976
Credit and Capital Markets – Kredit und Kapital, Vol. 15 (1982), Iss. 3 : pp. 434–456
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Abstract
Domestic Credit Expansion, Confidence and the Foreign Exchange Market: Sterling in 1976
This paper examines in detail the reasons for the wide fluctuations in the sterling exchange rate during 1976, fluctuations which can be argued to have had lasting and significant effects on the course of the UK economy. Three possible explanations, emphasising movements in the current account, prior monetary growth rates and prior movements in relative price levels, are rejected as inaccurate and oversimple. The ‘established’ interpretation of the episode is then set out within the framework of the monetary approach to the balance of payments; this interpretation emphasises the importance and relative autonomy of fluctuations in confidence, in both the foreign exchange and the government securities markets, and implies ‘reverse causation’ from the balance of payments/exchange rate via confidence to domestic credit expansion (DCE). Some criticisms of this interpretation in the literature are discussed, and the thinking underlying the behaviour of the monetary authorities is examined in some detail: in particular the authorities are shown to have taken an essentially passive view of their own monetary policy, to have focussed on money supply growth rather than DCE and to have attached great importance to announcement effects and other factors affecting confidence. An alternative interpretation is then developed which regards confidence as determined, except in the very short run, by monetary policy (DCE) and which views causation as going primarily from DCE to the balance of payments/exchange rate. The difficulties involved in tests to discriminate between these two interpretations are discussed and it is argued that no definite conclusion can be drawn. However it is concluded that future sterling fluctuations can be prevented by the appropriate control of DCE, and that monetary policy should therefore focus on this aggregate rather than on the growth of the money supply. Finally the role of some political factors in the episode is considered in an Appendix