Exchange Rate Dynamics in a Peripheral Monetary Economy:
A Keynesian Perspective
Rogerio P. Andrade
Daniela Magalhães Prates
(Institute of Economics, University of Campinas, Brazil)
The purpose of this paper is to discuss, from a Keynesian perspective, the determinants of
exchange rate behaviour in a peripheral monetary economy. The paper starts by
approaching the essential properties of both monetary and open monetary economies. It
then proceeds to present the Post-Keynesian view of exchange rate determination, chiefly
developed by John Harvey, who does not discuss, however, the specific causes of exchange
rate behaviour in “emergent” peripheral economies. Next, after re-examining the notion of
“peripheral condition”, the paper discusses the historical and institutional characteristics
associated with the integration of a peripheral economy in the modern international
monetary and financial system.
Keywords: Exchange Rates; Monetary Economy; Keynesian Economics; Centre-
JEL Classification: B50; F02; F30; F50.
The purpose of this paper is to discuss the determinants of exchange rate behaviour
in a peripheral monetary economy that, having engaged in the process of financial
globalization, became an “emerging” economy. It does so by resorting to a Keynesian
The paper is structured in the following manner: after this Introduction, in section 2
we discuss what the essential properties of a monetary economy are according to the
Keynesian approach. In section 3 we discuss the main aspects of an open monetary
economy. Part 4 presents the Post-Keynesian view of exchange rate determination. Part 5
takes up the idea of “peripheral condition” and examines the characteristics of exchange
rate behaviour in emerging peripheral economies. The last part of the paper presents a few
2) The Analytical Structure: Characteristics of a Monetary Economy
Our starting point is the acknowledgement of the importance of Keynes’s
suggestion (1933) that modern economies are monetary economies in the sense that the
existence of money crucially affects the motives and the decisions of economic agents, as
much in the short as in the long term.
In a monetary economy, money’s function as a store of value is fundamental. It
allows one to understand money as a “refuge from uncertainty”, the “abode of purchasing
power” or a “liquidity time machine” (Davidson, 1994). Money becomes the least uncertain
link between the present (or the “irrevocable past”) and the unknown future, the safest way
to preserve wealth and purchasing power across time. One of the consequences of this is
that, by becoming a means of storing wealth, money also becomes an asset; it thus becomes
an alternative to other means of accumulating wealth, especially in contexts of pronounced
uncertainty regarding the future.
Based on Keynes (1933, pp. 408 ff.), it is therefore possible to make a conceptual
distinction between an “exchange economy” (or a “real exchange economy”) and a
“monetary economy”. In the latter, which is the one we are interested in, money is not
neutral, acting as a simple means of rendering exchange easier. It crucially affects the
motivations and choices of agents. Thus, “monetary economy” is the expression that ought
to be employed to define a (capitalist) economic system
in which money plays a part of its own and affects motives and decisions and is, in
short, one of the operative factors in the situation, so that the course of events
cannot be predicted, either in the long period or in the short, without a knowledge of
the behaviour of money between the first state and the last (Keynes, 1933, pp. 408-
In a monetary economy, the different assets, including money, have specific
attributes. These attributes, which every asset has to a larger or lesser degree, are (Keynes,
1936, chapter 17; Carvalho, 1992, chapter 5): a) the expected quasi-rent, q; b) the carrying
cost, c; c) the liquidity premium, l; and d) the expected appreciation, a.
The combination of these attributes yields an asset’s specific interest rate (ra) (or its
total expected return):
ra = a + q – c + l
In this analytical treatment, liquidity preference is expressed by means of a trade-off
between monetary returns (a + q – c) and the liquidity premium (l). This dilemma is
reflected in the way in which agents structure their assets portfolio, i.e., in how they
manage their stock of wealth over time. More specifically, in a monetary economy with
such characteristics, liquidity is strongly valued in times in which uncertainty regarding the
future is deemed to be higher, justifying an increased demand for money as an asset or for
its close substitutes, so as to structure a portfolio which is as liquid as possible, while one
waits for better circumstances in which one can take on less liquid assets which may,
however, yield higher monetary returns. In this sense, the search for liquidity has a crucial
role to play in the determination of expenditure decisions. Hence, the idea that money has
short and long-term implications on the “real side” of economy.
Given the logic of capitalist accumulation and the ubiquitous existence of
uncertainty, in certain situations there will be a clear preference for money and its closer
substitutes, since they are the liquid assets par excellence. Thus, (the perception of) greater
uncertainty causes q to decrease and l to increase. What matters here is the monetary return
(and not an imaginary “physical” return, expressed by the marginal productivity of the
asset). More specifically, in the case of investments in fixed-capital goods, what is relevant
is the expected monetary profit.
The liquidity preference therefore corresponds to a kind of rational (or defensive)
behaviour under genuine or fundamental Keynesian uncertainty (non-quantifiable, non-
probabilistic).1 The liquidity preference and the resort to conventions (discussed below) are,
from a Keynesian point of view, the typically rational answers of agents that must make
prospective calculations and strategic decisions in an environment of uncertainty.
Conventions and Speculation
In a monetary economy, one of the means for agents to deal with uncertainty
regarding the future is the adoption of conventional behaviour. Keynes’s analysis of
conventions is developed in chapter 12 of the General Theory (GT) and in his seminal 1937
article (Keynes, 1936, 1937a).
In Keynes’s terms, a convention can be characterized in the following way:
1) The current market conditions provide a reasonable guide for decision-making
(under “normal” conditions, agents tend to give little importance to future changes).
2) Agents presume that the current state of opinion, as expressed in prices and
production, is based on a correct summary of the future perspectives of the
economy, which they accept until something new and relevant comes up (Keynes,
1936, p. 152; Keynes, 1937a, p. 114). In other words, people act based on inductive
reasoning, believing that “the future will resemble the past” (Keynes, 1937b, p.
3) Besides, Keynes emphasises the intersubjectivity of the agents’ actions. Since they
believe that their knowledge is “limited, vague and uncertain” and that other agents
might be better informed than they are, the individual agent that has to make a
decision will tend “to conform with the behaviour of the majority or the average
opinion” (Keynes, 1937, p. 114).2
Thus, conventions appear because agents have limited and uncertain knowledge
concerning the different relevant factors affecting their decisions as well as the results of
these decisions. As an anchor, conventions guide decision-making processes under
fundamental uncertainty. Conventions act as a kind of “substitute for the knowledge which
1 The concept of uncertainty here alluded to is obviously the one consistently developed, since Keynes, by
Shackle (e.g., 1972, 1979), Davidson (e.g., 1994), Lawson (1988), Runde (1990), Dow (1995), Vercelli
(2002) and Dequech (2000), among others.
2 On the issue of intersubjectivity, see the many contributions in Fullbrook (2002).
is unattainable” (Keynes, 1937b, p. 124). They are a kind of tacit social knowledge,
generated from past experiences and from agents’ interactions in time and space.
Conventions are the embodiment of a kind of knowledge that was generated through
intersubjective action in historical time.
In the GT, there is also a discussion concerning the relation between conventions
and speculation. The “activity of speculation” is likened to a sort of “beauty contest”. The
logic of the behaviour of agents engaged in that activity (in the assets market) is defined as
to anticipating what average opinion expects average opinion to be. … to guess
better than the crowd how the crowd will behave (Keynes, 1936, p. 157).
According to Keynes, the majority of these “game-players” (p. 156) is actually
not with making superior long-term forecasts of the probable yield of an investment
over its whole life, but with foreseeing changes in the conventional basis of
evaluation a short time ahead of the general public (Keynes, 1936, p. 154).
It is the precariousness of the convention itself, partly owing to speculative
behaviour (which can be interpreted as a kind of unconventional behaviour) that, according
to Keynes, lies at the root of economic cycles and of the waves of instability and volatility
which characterize prices in assets markets, with negative consequences for the “real side”
of the economy, especially for the decisions concerning investment in fixed capital.
Such rationality (which some theories interpret as irrationality) is pervasive in the
assets markets. In other words, the way for successful gambling in financial markets is not
what the individual investor considers to be the virtues or advantages of a particular
financial asset, nor even in what the hoard of investors actually believes to be the
attractions of that particular financial asset. The “professional” investor is more concerned
with finding out or anticipating what each agent in the market believes to be the other
Thus, the pricing of assets depends on current conventional assessments in each
context. According to this view, there are no a priori fundamentals to tell the direction in
which the prices of assets will inexorably evolve (in a mythical long term). As far as the
future is concerned, uncertainty prevails.
In order to reduce or minimise the uncertainty that is always (to a greater or lesser
degree) present, if “fundamentals” exist, they are created through social interactions so as
to provide a view of the (imaginary) future that influences current decisions (Wray &
Tymoigne, 2008, p. 15).
The price of assets, expressed by q, c, l and a, is compared to a “normal”, or
conventional, price which provides a kind of anchor for agents. This normal price is
socially determined through a process of imitation, consisting in copying what the majority,
or the general opinion in the market, considers to be “correct” in that context. Those agents
that attempt to anticipate the general opinion concerning the best market prices are engaged
in speculative activity (as in the beauty contest described by Keynes). Thus, the convention
of a normal price provides a concrete alternative to the supposed existence of “inherent
fundamentals” in the determination of expectations concerning price changes. If the agents
of a given market assess that “structural changes” created an environment in which the
“normal price” ought to be much different from what it actually is, strong speculation might
ensue (Wray & Tymoigne, 2008, p. 16). This is what usually happens, for example, in
exchange rate markets in which there is a perception that a certain currency is
Mutually Exclusive Starting Points in the Analysis of Financial Markets
In order to arrive at a more detailed description of a monetary economy,
emphasising the dynamics of financial markets, it is necessary to discuss other equally
important aspects. Here, we intend to contrast the idea of efficient financial markets (and
the associated concepts of rational expectations and “fundamentals”), the hypothesis of
financial instability (Minsky) and the theory of liquidity preference (Keynes, Davidson).
According to the traditional view, if the levels of production and employment are
generated by the efficient operation of markets, money and financial relations have no
relevant role to play. In the case of exchange rate markets, this worldview is expressed by
the idea that it is the trade flows, much more than the capital flows, that determine the
prices. Capital flows (money and credit) would have the sole purpose of providing funds
for the main activity (foreign trade). Besides, there would be an inexorable tendency
towards a balance between imports and exports, a natural conclusion if the main demand
for foreign currency derives from the purpose of pursuing foreign trade. In the long run, the
prices of foreign currencies would be the result of the global demand for goods and
services, in such a way that there can be a trade balance. This macroeconomic result
derives, in the microeconomic sphere, from individual rational (“substantive” rationality,
i.e., dynamic optimisation) and efficient decisions; in this process of decision-making, there
is no place for biased forecasts of the future prices of assets. In other words, irrational
actions cannot be sustained in the long run.
Minsky (1982, 1986) proposes a different perspective based on the hypothesis of
financial instability. The idea is that periods of prosperity carry within themselves the seeds
of their own destruction. There are endogenous forces in modern capitalist economies, of
which one should single out the role of banks and other financial institutions which
generate, in cycles of expansion, debt structures that will eventually become financially
fragile and incapable of being sustained or rolled. There is an inevitable interpenetration
between the real and the monetary sides of economy. It would therefore make no sense to
resort here to the methodological framework known as the “classical dichotomy” (the
separation between a monetary and a real side for the purposes of analysis) or to the idea of
the neutrality of money in the long run. The growing weakness of financial structures built
during periods of prosperity will inevitably bring about negative consequences for the real
side of economy. There is therefore an “evolutionary” path of the economy towards the
financing structure (the weakest of all) that Minsky named Ponzi (unless a strategy of
economic policy and, more specifically, of monetary policy, acts so as to stop these
Davidson (1998, 2000) argues that financial markets cannot be efficient. In a “non-
ergodic” world, one cannot believe that the data available at every moment provides a
reliable and safe guide for decisions that will have concrete results in the future. Under
these conditions, the main function of financial markets is to provide liquidity. This
“liquidity function” (Davidson, 1998, p. 282) requires the ability to buy and sell assets in an
orderly and well-organized market, so that it is always possible to get hold of the asset
(money) that makes it possible to pay off debts. Rules and institutions should be created to
ensure that liquid markets work in a well-organized way.
If the main role of financial markets is to offer liquidity in an organized way, then
the issue of efficiency is not relevant. In the real world of modern capitalist economies, as
stated by Davidson, “efficient markets are not liquid and liquid markets are not efficient”
(Davidson, 2000, p. 6; emphasis in the original).
As one can see, the hypothesis of efficient markets, as typical to approaches inspired
in the old “classical” tradition, limits the role of money and finance to the short term at
Markets and Liquidity
Liquid assets are financial assets traded in spot markets which are orderly and well-
organized (see Davidson, 1994, pp. 49-50). A well-organized market is one in which the
interaction between buyers and sellers does not involve high costs. A well-organized
market requires a standardized good with low carrying costs. In an orderly market, given
the routine nature of the activities performed, the expected changes in market prices will be
low and within a “reasonable” range.
An orderly market requires a regulating institution known as the market maker: the
agent or institution that publicly announces the disposition to act promptly as a residual
buyer and/or seller so as to ensure stability and orderliness in case of a sudden destabilizing
change affecting either the demand or the supply. The market maker, based on previously
announced and known rules of that market, must make sure that, after a disturbance or
shock, the market price will not chaotically differ from the recently observed price.
In order to be able to operate adequately, the market maker needs the following
resources: a) a regulatory stock of the asset that is traded in that market; b) a significant
stock of money (and/or, when necessary, immediate access to an additional amount of
money). In situations in which abrupt changes in demand or supply can generate ample
variation in market prices, the market maker must intervene. The market maker must buy in
a falling market and must sell in a rising market, so as to limit market price fluctuations to
an acceptable range.
The market maker must be an institution that has credibility. The organization of the
market follows from the public’s trust in the market maker. The existence of a market
maker allows the asset holders to “sleep peacefully”. These agents know (actually, they
believe) that, on the following day, the spot price of the market will not be significantly
different from the closing price of the previous day.3
3) Open Monetary Economy: Relevant Theoretical Aspects
After having discussed the more general aspects of a monetary economy, the next
step is to “open” it. The heterodox literature deals with the notion of monetary economy in
general, without making a clear distinction regarding the (trade and financial) interactions
of a given economy with the rest of the world. Our purpose here is to extend the discussion
and apply concepts and ideas associated with monetary economy to a specific dimension of
financial markets, namely the markets where exchange rate assets are traded. In these
markets, one faces two phenomena which begs further analysis: 1) the existence of a
specific class of assets, the “exchange rate assets” (for the lack of a better name) which
have some distinctive traits (such as the strong volatility of a and a hierarchy of liquidity
premium l); 2) the process of determination of the prices of these exchange rate assets.
Therefore, based on the above theoretical foundations, we shall attempt to broaden
the discussion so as to account for the openness of markets, that is to say, for the fact that
modern economies are characterised for trading goods and financial assets with the rest of
In these markets, a crucial determinant of the agents’ decisions is obviously the
exchange rate (both current and expected). In the current stage of development of the world
economy, in the post-Bretton Woods era, the exchange rate itself is an object of speculation
(Davidson, 2000). Variations in the exchange rate reflect changes in the speculative
positions of agents that act on strongly interconnected exchange rate markets, much more
than changes in the patterns of trade among the different nations (Harvey, 1999).
In exchange rate markets, it is the central banks of each country, whether they
operate in isolation or as a group, informed by their larger goals in the conduct of domestic
3 In a well-organized spot market, when the market maker notices that it cannot perform its role of keeping
order and stability, negotiations are usually suspended. This allows the market maker to reorganize its
resources and intervention strategies, so that order can be reestablished when the market is reopened.
policy, that act as market makers in their national spheres, with the purposes of containing
exchange rate volatility, and, especially in the case of emerging peripheral economies, of
keeping exchange rates at a competitive level and accumulating foreign currency (more on
this in section 5).
It is therefore necessary to discuss, based on the previous concepts, the determinants
of the exchange rate in a monetary economy from a Keynesian point of view. More
specifically, our discussion seeks to demarcate further the analytical field and to focus on a
particular issue, namely the behaviour of the exchange rate in a peripheral monetary
4) Exchange Rate Determination: The Post Keynesian View
The Post Keynesian approach to the determination of the exchange rate provides an
explanation for the volatility of exchange rates in the globalised monetary and financial
system which came about after the collapse of the Bretton Woods regime. Its starting point
is a specific historical context distinguished by the following characteristics: 1) higher
volatility, with exchange rates, interest rates and the prices of assets being subject to both
ample fluctuation in the short run and to important changes in the long run; 2) a high degree
of contagion, with financial turbulence spreading from the epicentre of the system to
countries and markets that apparently have no relation with the original problem (even to
those considered to have “sound” macroeconomic policies).
Agents’ greater liquidity preference, the volatility of capital flows and, for this
reason, the volatility of the exchange rate markets, are a result both of the key currency5
(the dollar) and of the combination of the floating exchange rate regime with an
environment of free mobility of capitals – which stimulated speculation in the exchange
rate markets as well as the short-term capital flows, causing these markets to become even
more volatile – and of the dynamics of the international financial system, determined by
financial globalisation and by the pre-eminence of the so-called “market finance”.
4 Later on we will define what we understand by “peripheral condition”, identifying the mechanisms, relations
and forces which operate in such economies, but are absent in the so-called central economies.
5 We resort here to the concepts of money and currency proposed by Aglietta (1986). According to this
author, money is sovereign in the national sphere and it becomes a currency when it starts circulating in the