is the “ proper ” exchange rate? this is based not just on their views about some “ fundamentals ”, but also their guesses about other market participants ’ views, so there is certainly plenty of opportunity for exchange rates to move very significantly, and stay away from the underlying fundamentals for significant periods of time. we noted, earlier, that this has happened in the case of countries such as the united states, japan and australia, where there are well - developed views about how the economy works and detailed analytical and econometric studies of what proper pricing relativities should be. the “ models ” or “ mind - sets ” for the countries in question are much less fully developed and universally held, so there is far more opportunity for prices to shift sharply, and stay at rates which, earlier, would have seemed abnormal. on top of this, there are substantial information asymmetries, asymmetries which made market participants very nervous about going against the run of the market or taking significant contrarian positions. this combination - very large, footloose capital flows and an exchange rate not firmly anchored by “ fundamentals ” - goes a long way to explain the big exchange rate moves. when sentiment and confidence changed and the original investors began to pull out their capital, the exchange rate fall did nothing to induce new inflows. where were the stabilising speculators of textbook theory, who were supposed ( in the textbook view ) to respond to the fall in the exchange rate by recognising that, once the exchange rate was below its fundamental level, there was a profit opportunity for those who bought the currency? in the absence of a firmly - defined “ fundamental ” equilibrium exchange rate, as the exchange rate fell, the market changed its view on what was the “ correct ” equilibrium rate. even when most market participants agreed that exchange rates had gone too far, they recognised the possibility that they could go further still. to stand against the run of the market in a contrarian position might be ultimately vindicated, but in the short run required a degree of courage and confidence that no fund manager ( whose performance is evaluated more - or - less constantly ) could afford to take. in short, there were no equilibrating flows to anchor the exchange rates. how should exchange rates behave? let ’ s try to develop this a bit further to see whether there is any clear, fairly universally - accepted idea of how exchange rates should move in the circumstances

is an identifiable principal problem, it is more deep - seated and lies in the fragility of the financial sector. it has many of the characteristics of an old - fashioned bank liquidity crisis, with failing confidence at the heart of the problem. i am not going to go through this argument again today, because this session is about exchange rates. and, in any case, the exchange rate clearly did play an important part in the story. what i shall argue, however, is that it was not the central, over - riding, element of the story. the facts first, the facts. table 1 shows the exchange rate movements in a number of east - asian countries during 1997 and of course there have been some further large falls in the early days of 1998. these have been very large movements and unusually rapid, but the magnitudes, at least during 1997, are not unprecedented. not long after the exchange rate was floated in australia in 1983, there was a change of close to 40 per cent in the trade - weighted exchange rate ( which would be of the same order of magnitude that we saw in asia in 1997 ). for japan, in the two years beginning in * i am grateful for the help of john hawkins and amanda thornton in preparing this paper. april 1995, the exchange rate depreciated by 34 per cent : over a longer period of time ( e. g. ten years ), we can find much larger changes in the yen, from around 250 to the dollar at one extreme, to 80 to the dollar at the other extreme. even the exchange rate between the two “ safe havens ” - the us dollar and the german mark - experienced changes ( both up and down ) of around 50 per cent in the mid 1980s. table 1 : east asian exchange rates per cent change during 1997 vs us dollar trade - weighted * indonesia malaysia philippines south korea thailand - 56 - 35 - 33 - 47 - 45 - 44 - 24 - 26 - 43 - 38 * rba calculation why do these big changes in exchange rates occur? this is a central question, to which there is no clear answer yet. but i want to put forward two issues which may be a large part of the story : the first has to do with large capital flows ; and the second has to do with what the technicians would call “ model uncertainty ” : there is no close, well - established relationship between the fundamentals of the economy and the exchange rate. when these uncertainties are great,