Exchange Rates Theories

1. Exchange Rates Theories Asset Approach

2. Goods flows and Capital flows • When there is not much international capital flows, • TB>0 Currency appreciation • TB<0  Currency depreciation • These exchange rate movements eliminate trade imbalances. • The ex rate adjusts to equilibrate transaction of goods and services

3. Goods flows and Capital flows • International capital transaction has recently become much larger than international transaction of goods services.

4. Asset approach • 1. Financial assets prices adjust more quickly than goods prices. • 2. Exchange rates are much more variable than goods prices.  Ex rates are responding to conditions in financial-asset markets.

5. Perfect Capital Mobility • No transaction costs and no capital controls so that capital flows freely between nations. • Under this assumption, Covered Interest Parity (CIP) holds, or i - i* = (F - E)/E. • Changes in interest rates  Changes in ex rates.

6. Asset approach • 1. Monetary approach (MAER) • 2. Portfolio Balance approach (PB) • 1. assumes that domestic and foreign bonds are perfect substitutes. • 2. assumes imperfect substitutability.

7. MAER and PB which implies, respectively • 1. No risk premium Uncovered Interest Parity (UIP) holds. • 2. Risk premium  UIP does not hold.

8. PB approach • According to PB approach, relative supplies of domestic and foreign bonds, in addition to domestic and foreign money, determine the ex rate. • Remember, MAER equation is -E^ = P*^ + L^ - w•DC^

9. PB approach (cont’d) • Let B = supply of domestic bonds B* = supply of foreign bonds • B*^ - B^ < 0  risk premium on B   E^ > 0 or E (depreciation) • E today & Ee unchanged  expected rate of depreciation  (expected rate of appreciation )

10. PB approach (cont’d) • B*^  E^ appreciate at a faster rate • B^  E^ depreciate at a faster rate • The PB approach is summarized by -E^ = P*^ + L^ - w•DC^ + B*^ - B^

11. Sterilization • According to MABP, Excess money supply  IR  BOP < 0 Excess money demand  IR  BOP > 0 • Is there any way to neutralize IR flows induced by monetary policy?  Sterilization

12. Sterilization (cont’d) • With sterilization, the monetary authorities can determine the money supply in the SR without having reserve flows offset their goal. • If there are barriers to int’l capital mobility, int’l asset return differential would persist.  The central bank can change the money supply growth in the SR without inflicting reserve flows.

13. Sterilization (cont’d) • Is it possible without barriers? By, for example, decreasing DC by an amount equal to an increase in IR. • The MABP equation with E^ = 0 is given by IR^ = [1/(1-w)]•(P*^ + L^) - [w/(1-w)]•DC^ (+) (-)

14. Sterilization in a floating exchange rate system • Let E = E¥/$. Suppose E or the yen is appreciating against the dollar. • The BoJ intervenes in the FX market to stop the yen appreciation. buy the dollar-denominated bonds  DC  MS  demand for $  E sell the yen-denominated bonds  DC  MS

15. Sterilized intervention • A FX market intervention that leaves the domestic money supply unchanged. • In essence, sterilized intervention is an exchange of domestic bonds for foreign bonds.

16. How does it have an effect on the spot exchange rate? • Under the PB approach, Sterilized intervention  (supply of dollar assets relative to yen assets)   the yen depreciates.

17. Sterilized intervention • -E^ = P*^ + L^ - w•DC^ + B*^ - B^    (1)   (2) (1): FX market intervention (2): open market sale (1) + (2): sterilized intervention

18. Exchange Rates and the Trade Balance • When KA is not either increasing or decreasing, Trade deficits Holdings of foreign money relative to domestic money  E (depreciation) Trade surplus  Holdings of foreign money relative to domestic money  E (appreciation)

19. Ex rate and the Trade Balance • Expected future trade deficits  expected future holdings of foreign currency  Ee • Future oil price increase  people anticipate a decrease in holdings of foreign currency  Ee  F  expected rate of depreciation  people try to shift from domestic to foreign money immediately  E (an immediate depreciation of domestic currency)

20. Ex rate and TB • Changes in expectations about future trade flows a change in the current spot rate.

21. Currency Substitution • An advantage of flexible exchange rates = independence of monetary policy • Fixed exchange rates  country A must follow a monetary policy similar to country B and vice versa. • What if currencies are substitutable?

22. Currency Substitution • Perfectly substitutable currencies: people are indifferent between the use of one currency or another  all currencies would have to have the same inflation rates (why?) • People believe that the relative value of currency A to currency B will not change  They are indifferent between holding A or B  no change in exchange rate

23. Currency Substitution (cont’d) • However, suppose inflation rate is higher for country A. Then, the cost of holding currency A rises relative to the cost of holding B  demand shifts from A to B  currency A depreciates against B even more than justified by the inflation differential.

24. Currency Substitution (cont’d) • This creates volatile exchange rates. • A high degree of currency substitution  more volatile ex rates  a need for int’l coordination of monetary policy  currency unions

25. Currency Substitution (cont’d) Examples of a high degree of currency substitution: • Among European currencies before the euro. • Between the US dollar and the local currencies in many Latin American countries.

26. The Role of News • News = unpredictable shocks or surprises faced by int’l economy • Difficulty in predicting future spot rates  ex rates are affected by news. • News have an immediate impact on ex rates, while prices of goods and services are slow to be affected  Large deviations from PPP during periods dominated by news.