Journal Article The Forward Rate and the Interest Parity Get access Jerome L. Stein Jerome L. Stein Brown University Search for other works by this author on: Oxford Academic Google Scholar The Review of Economic Studies, Volume 32, Issue 2, April 1965, Pages 113–126, https://doi.org/10.2307/2296056 Published: 01 April 1965

The Rationality of Official Intervention in the Forward Exchange Market: Reply Get access Jerome L. Stein Jerome L. Stein Brown University Search for other works by this author on: Oxford Academic Google Scholar The Quarterly Journal of Economics, Volume 79, Issue 1, February 1965, Pages 150–152, https://doi.org/10.2307/1880520 Published: 01 February 1965

I. Fighting speculative flurries, 312. — II. Living with a deficit on the basic balance, 314. — III. Conclusion, 316.

The “Pessimists” and the “Optimists” disagree whether the US external deficits and the associated buildup of US net foreign liabilities are problems that require urgent attention. A warning signal should be that the debt ratio deviates significantly from the optimal ratio. The optimal debt ratio or debt burden should take into account the vulnerability of consumption to shocks from the productivity of capital, the interest rate and exchange rate. The optimal debt ratio is derived from inter-temporal optimization using Dynamic Programming, because the shocks are unpredictable, and it is essential to have a feedback control mechanism. The optimal ratio depends upon the risk adjusted net return and risk aversion both at home and abroad. On the basis of alternative estimates, we conclude that the Pessimists’ fears are justified on the basis of trends. The trend of the actual debt ratio is higher than that of the optimal ratio. The Optimists are correct that the current debt ratio is not a menace, because the current level of the debt ratio is not above the corresponding level of the optimum ratio.

In the absence of futures markets, cobweb cycles and other behavior inconsistent with Muth rational expectations persist for long periods of time. When futures markets are introduced in commodities, these markets behave in a manner much more consistent with Muth rational expectations. By contrast, despite the existence of active forward and futures markets, the Muth rational expectations hypothesis is rejected in the financial and foreign exchange markets. The aim of this paper is to suggest an explanation of how futures markets change the structure of the supply response.

P AUL COOTNER stimulated significant research on the subject of speculative markets in both commodities and equities. His papers (1960, 1964, 1967) were original and provocative. One paper began with the statement: subject matter of this paper is bound to be considered heresy. I can say that without equivocation, because whatever views anyone expresses on this subject are sure to conflict with someone else's deeply held beliefs (1964, p. 231). Most of the papers concerned with the operation of futures markets in commodities test the 'efficiency of the market by examining the stochastic nature of futures prices (which Samuelson refers to as the Idiot of Chance).' In particular, it is asked whether the price of a futures contract is a martingale. Cootner's contention, which runs counter to the tide of academic writings, is that speculative prices are not random walks but are constrained by economically determined barriers (1964, ch. 11). The present paper is in the spirit of Cootner's thinking about the economic and welfare implications of speculative markets. My main conclusions are as follows. (1) The optimality of resource allocation (defined as the sum of consumer and producer surplus) depends upon the accuracy of the forward price, at the time production decisions are made, as a forecast of the subsequent spot price when consumption occurs. The existence or nonexistence of the martingale property of futures prices between these two dates is irrelevant for welfare purposes. (2) Social loss is a multiple of the square of the forecast error between the forward price and the subsequent spot price. Expected social loss is irreducible when the forward price is equal to the mathematical expectation of the subsequent spot price. (3) The longer the period between the production decisions and the subsequent consumption decisions, the greater the bias between the forward price and subsequent spot price. (4) It has been claimed that in an efficient market, the spot price at time t should just depend upon the price at t 1 and not upon earlier prices. It is proved that this situation is neither a necessary nor a sufficient condition for rational expectations. (5) Therefore, there is a tenuous connection between the stochastic nature of speculative price and measures of economic welfare; but there is a direct connection between the forecast errors and economic welfare.