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4. Exchange Rate Determination. Chapter Objective: Reviews PPP and understands Examines MABP and exchange rate determination. Understands portfolio balance approach Knows exchange rate dynamics and overshooting. Exchange Rate Determination. PPP. Different Exchange rate system.

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4

Exchange Rate Determination

  • Chapter Objective:

  • Reviews PPP and understands

  • Examines MABP and exchange rate determination.

  • Understands portfolio balance approach

  • Knows exchange rate dynamics and overshooting


Exchange rate determination
Exchange Rate Determination

PPP

Different

Exchange rate

system

Monetary

approach

Elasticity

Sticky

Ms , Md

IRP

Exchange rate and BP

portfolio balance

approach

asset


Chapter three outline
Chapter Three Outline

  • 1.Purchasing Power Parity

  • 2.Monetary Approach to the Balance of payments and Exchange Rate Determination

  • 3. Exchange Rate Dynamics

  • 4. Asset Market model and Exchange Rates.Portfolio-Balance Approach

  • 5.Empirical tests and Exchange Rates Forecasting


1 purchasing power parity
1. Purchasing Power Parity

  • (1)A law of one price

  • (2)Absolute and relative PPP

  • (3) PPP Deviations and Evidence on it

  • (4) Empirical tests of Purchasing Power Parity


1 a law of one price
(1) a law of one price

  • 1)In one country

  • P=P’+c

  • P=P’+c(cost)+L(law)+A(arrest)

  • Non traded goods: Real estate haircuts

  • 2)In an open economy

  • P=RP’+c


2 absolute and relative ppp
(2) Absolute and relative PPP

  • The exchange rate between two currencies should equal the ratio of the countries’ price levels.

  • Relative PPP states that the rate of change in an exchange rate is equal to the differences in the rates of inflation.

  • If U.S. inflation is 5% and U.K. inflation is 8%, the pound should depreciate by 3%.


4 evidence on ppp
(4)Evidence on PPP

  • PPP probably doesn’t hold precisely in the real world for a variety of reasons.

    • Haircuts cost 10 times as much in the developed world as in the developing world.

    • Film, on the other hand, is a highly standardized commodity that is actively traded across borders.

    • Shipping costs, as well as tariffs and quotas can lead to deviations from PPP.

  • PPP-determined exchange rates still provide a valuable benchmark.


Total GDP 2006

(millions of

Ranking Economy US dollars)

1 United States 13,201,819

2 Japan 4,340,133

3 Germany 2,906,681

4 China 2,668,071

5 United Kingdom 2,345,015

6 France 2,230,721 a

7 Italy 1,844,749

8 Canada 1,251,463

9 Spain 1,223,988

10 Brazil 1,067,962

11 Russian Federation 986,940

12 India 906,268

13 Korea, Rep. 888,024

  • PPP GDP 2006

  • (millions of dollars)

  • 1 United States 13,201,819

  • 2 China 10,048,026 a

  • 3 India 4,247,361 b

  • 4 Japan 4,131,195

  • 5 Germany 2,616,044

  • 6 United Kingdom 2,111,581

  • 7 France 2,039,171

  • 8 Italy 1,795,437

  • 9 Brazil 1,708,434

  • 10 Russian Federation 1,704,756

  • 11 Spain 1,243,440

  • 12 Mexico 1,201,838

  • 13 Korea, Rep. 1,152,356


4 empirical tests of purchasing power parity
(4) Empirical tests of Purchasing Power Parity

  • See p.508 three points


2 monetary approach to the balance of payments and exchange rate determination
2.Monetary Approach to the Balance of Payments and Exchange Rate Determination

  • (1)Monetary Approach to the balance of payments under Fixed Exchange Rates

  • (2) Monetary Approach to Exchange RateDetermination (flexible price)


2 monetary approach to the balance of payments and exchange rate determination1
2.Monetary Approach to the Balance of Payments and Exchange Rate Determination

  • In the 1970s, the monetary approach to the balance of payments came to popularity, that emphasizes the monetary aspects of the balance of payments.

  • Money plays the crucial role in the long run both as a disturbance and as an adjustment in the nation’s BP.


2 monetary approach to the balance of payments and exchange rate determination2
2.Monetary Approach to the Balance of Payments and Exchange Rate Determination

  • MABP emphasizes the determinants of money demand and supply that will determine the balance of payments.

  • Those items that directly affect the money supply are below the line which MABP concentrate on.


1 mabp
(1)MABP

  • Flexible

  • At a point where the flow of exports just equals the flow of imports, no net international money flows required.

  • Adjustment through exchange rates.

Fixed

  • Money flowing between countries to adjust the disequilibrium.

  • Adjustment to changes through international money flows


1 mabp1
(1)MABP

  • 1)basic concepts and assumptions

  • Central bank controls the money supply by altering base money

  • Base money changes, the lending ability of commercial banks changes.

  • Divide base money into domestic and international components.


1 mabp2
(1)MABP

  • 2)framework for the analysis under MABP

  • Minimum money model

  • Md=kPY

  • A stable demand for money

  • Ms =m(D+F)

  • Md =Ms


1 mabp3
(1)MABP

  • Md=kPY

  • P=RP*hereP*the foreign price level

    R the domestic currency price of foreign currency

  • k RP*Y=m(D+F)

  • To discuss the money demand and supply, in terms of percentage changes, since k, m is constant, the changes are zero.


1 mabp4
(1)MABP

  • So

  • Rearrange



1 mabp5
(1) MABP

  • Managed float

  • Given money demand or money supply changes, the central bank can choose to let

    adjust to the free-market level; or by holding R at some disequilibrium,it will allow to adjust.


1 mabp6
(1)MABP


2 monetary approach and exchange rate determined
(2)Monetary Approach and Exchange Rate Determined

  • 1)money plays the crucial role in the long run:

  • both as a disturbance and as an adjustment in a nation’s BP

  • 2)The exchange rate is determined by flow of funds, in the process of balancing the total demand and supply of the national currency in each country.

  • 3)money supply and demand:

  • The supply of monetary determined by the monetary authorities, the demand for monetary depending on the level of real income, general price level and the interest rate.


(2)Monetary Approach and Exchange Rate Determined(MAER)

  • The higher are the real income and prices ,the greater is the demand for monetary balances that individuals and businesses demand for their day to day transactions.

  • The higher of interest, the greater is the opportunity cost of holding money.the higher the rate of interest ,the smaller is the quantity of money demanded.

  • For a given level of real income and prices, the equilibrium interest rate determined at the intersection of demand and supply curves of money.


(2)Monetary Approach and Exchange Rate Determined

  • Suppose the FX market being equilibrium or at IRP, suppose that monetary authorities increase the money supply, in the long run, leads to a proportionate increase in the price level in the home country and depreciation of its currency, as PPP discussed.

  • But it leads to decline of interest and affect financial markets and exchange rates immediately, resulting in increased financial investment flows to the foreign countries.


2 maer
(2)MAER

  • Under flexible exchange rate

  • Backgrounds : elasticity supply ; stable demand; markets are competitive and no tariffs, no obstructions to trade; PPP

  • Income and interest are not relative to money supply. Supply only leads to the changes of the price.


2 maer1
(2)MAER

  • Elasticity supply:


2 maer2
(2)MAER

  • Equilibrium :


2 maer3
(2)MAER

  • Since

  • so


2 maer4
(2)MAER

  • Conclusion

  • Changes in R are proportional to changes in

    inversely.

  • It depends on PPP and the law of one price

  • Not include interest rate (UIRP)

  • Exchange rate to adjustment



3 asset market model and exchange rates
3.Asset Market model and Exchange Rates foreign currency to the home currency.

  • (1)Asset market model

  • (2)Extended asset market model

  • (3) Portfolio Balance Approach


1 asset market model
(1) foreign currency to the home currency.Asset market model

  • Asset market model(PB) differs from the monetary approach(MA)

  • Perfect capital flow(MA, PB)

  • Perfect substitutes(uncovered interest arbitrage and no foreign exchange risk premium(MA)


1 asset market model1
(1) foreign currency to the home currency.Asset market model

  • W=M+D+F

  • M:domestic currency (transactions)

  • D:domestic bonds (return it yields)

  • F:foreign bonds (return and spreading risks)

  • A change in any of underlying factors will achieves a new portfolio;

  • An increase in wealth increases the demand for these three assets.


1 asset market model2
(1) foreign currency to the home currency.Asset market model

  • According to asset market approach ,equilibrium in each financial market occurs when the quantity demanded of each financial asset equals its supply.

  • The exchange rate is determined in the process of reaching equilibrium in each financial market.


2 extended asset market model
(2) foreign currency to the home currency.Extended asset market model

  • Book , p.522 models


2 extended asset market model1
(2) foreign currency to the home currency.Extended asset market model

  • Domestic currency equilibrium

R

R

M

D

M

increase

F

i

i


2 extended asset market model2
(2) foreign currency to the home currency.Extended asset market model

  • foreign bonds

Domestic bonds

R

R

F

D

increase

increase

i

i


3 portfolio balance approach
(3) foreign currency to the home currency.Portfolio Balance Approach

  • open market purchase

M’

R

M increases,

E’new equilibrium

Domestic currency depreciates

Interest decreases

D

M

E’

E

F’

F

i


3 portfolio balance approach1
(3) foreign currency to the home currency.Portfolio Balance Approach

  • (BCA surplus)

R

D

D’

M

Domestic currency appreciates

Save foreign currency to change M

More foreign currency supply

F depreciates i* increases

If i unchanged, wealth unchanged

M’

F

F’

E

E’

i


4 exchange rate dynamics
4.Exchange Rate Dynamics foreign currency to the home currency.

Exchange Rate Overshooting (sticky price)


4 exchange rate overshooting
4.Exchange Rate Overshooting foreign currency to the home currency.

  • 1)concept

  • Stock adjustments in financial assets are much larger and quicker to occur than in trade flows.in the short run ,changes in R are likely to reflect the effect of stock adjustments in financial assets and expectations.but in the long run ,adjustments in trade flows occurs.

  • The immediate flows of financial investment leads to an immediate depreciation of home currency which exceeds or overshoots the expected in the long run according to PPP.


4.Exchange Rate Overshooting foreign currency to the home currency.

  • 2)Sequence :

  • the money supply increases,the interest rate falls,capital flows out, leads to an immediate depreciation of the home currency. In the long run the home currency’s prices rice and it appreciates to eliminate the overshooting.


4.Exchange Rate Overshooting foreign currency to the home currency.

  • 3)model

  • Regarding a higher trade deficit for the domestic country, the spot exchange rate will jump immediately above E0

    R1

    R0

    until the new long run equilibrium E1 is reached. After a disturbance, the exchange rate may not move in such an orderly fashion.

R

t


4.Exchange Rate Overshooting foreign currency to the home currency.

  • PPP doesn’t hold well under flexible exchange rate. Exchange rates exhibit much more volatile behavior than prices do. In the short run, following some disturbance to equilibrium, prices will adjust slowly to the new equilibrium level, but the exchange rates and interest rates will adjust quickly. This different speed of adjustment to equilibrium allows for behavior regarding rates and prices.


4.Exchange Rate Overshooting foreign currency to the home currency.

  • At times,spot exchange rates move too much given some economic disturbance.Also, we have observed instances when country A has a higher inflation rate than country B, yet A’s currency appreciates relative to B’s. such anomalies can be explained in the context of an “overshooting” exchange rate model. We assume that financial markets adjust instantaneously to an exogenous shock, whereas goods markets adjust slowly over time. With this setting, we analyze what happens when country A increases its money supply.


4.Exchange Rate Overshooting foreign currency to the home currency.

  • For equilibrium, money demand must equal supply. If the money supply increases, something must happen to increase demand. Assuming that people hold money for transactions purposes, and holding bonds to pay an interest rate i. A money demand equation: Md=aY+bi

  • Md,the real stock of money demanded

  • Y, income

  • I, interest rate

  • and i, or b is negative.


4.Exchange Rate Overshooting foreign currency to the home currency.

  • As y increases, tend to demand more things including money. Interest rate is the opportunity cost of holding money, there is an inverse relation between money demand.

  • In the short run, both income and the price level are relatively constant.

  • Result :interest rate must drop to equate money demand to supply.


4.Exchange Rate Overshooting foreign currency to the home currency.

  • Bring into analysis a second country:

  • IRP: i=i*+EA

  • i falls, i* EA(forward premium on foreign currency ) fall. The money supply in one nation increases ,expect prices in one nation will rise. And spot rate expected depreciation. Imply a higher future exchange rate to achieve PPP, a long run value of exchange rate

  • RLR=P/P*

  • P expected to rise over time, given P*, R will rise.


R foreign currency to the home currency.LR

  • overshooting R

    R0

    t0

    i0

    t0 t0

P0


5 forecasting exchange rates
5.Forecasting Exchange Rates foreign currency to the home currency.

  • Forecasting is difficult, especially with regard to the future. Two reasons , p.530

  • As a whole, forecasters cannot do a better job of forecasting future exchange rates than the forward rate.

  • The founder of Forbes Magazine once said:

    “You can make more money selling advice than following it.”


Rate determined foreign currency to the home currency.

suppose

Ms increases

sequence


Key words
Key Words foreign currency to the home currency.

  • Arbitrage

  • Covered and uncovered interest arbitrage parity

  • Purchasing power parity

  • Nominal and real income

  • Money supply and demand

  • Base money

  • MABP

  • MA

  • PB

  • Overshooting

  • Stock and flow


Which method would you prefer why
Which method would you prefer? Why? foreign currency to the home currency.

  • 1.While you were visiting London, you purchased a Jaguar for £35,00, payable in three months.you have enough cash at your bank in New York City, which pays 0.35% interest per month, compounding monthly, to pay for the car.Currently, the spot exchange rate is $1.45/£ and the three-month forward exchange rate is $1.45/£. In London the money market interest rate is 2.0% for a three-month investment. Two alternative ways of paying for your Jaguar.

  • 1)Keep the funds at your bank in the U.S and buy £35,000 forward.

  • 2)Buy a certain pound amount spot today and invest the amount in the U.K. for three months so that the maturity value becomes equal to £35,000.


Explain how irp will be restore as a result of covered arbitrage activities
Explain how IRP will be restore as a result of covered arbitrage activities.

  • 2.Currently ,the spot exchange rate is $1.50/£ and the three-month forward exchange rate is $1.50/£. The three-month interest rate is 8.0% per annum in the U.S. and 5.8% in the U.K. Assume that you can borrow as much as $1,500,000 or £1,000,000.

  • 1)Determine whether IRP is holding?

  • 2)If IRP holding ,how would you carry out covered interest arbitrage? Show all the steps and

    determine the arbitrage profit.


  • True, false, uncertain, explain arbitrage activities.

  • 1 PPP holds better in the long run than in the short run.

  • 2 PPP is no theory of exchange rate determination.

  • 3 If nontradable goods prices rise faster in country A than B, and if nontradable goods prices rise faster than prices in general, the currency of A will appreciate by more than is called for by PPP, as measured by price indexes.


  • 1 For what type of goods does the law of one price hold quite well?

  • 2 Why IRP hold better than PPP over time?

  • 3 true or false,explain: “lenders benefit from unexpected inflation, but borrowers are hurt by it”.

  • 4 Should we believe that interest differentials cause exchange rate changes, or that exchange rate changes cause interest differentials?


  • 5. quite well?What is the difference between the MA and PB.and what are the similarities between them?

  • 6.Using MABP or MA model explain how the following events will affect the foreign-exchange value of domestic currency (assume flexible rates)

  • 1)The foreign inflation rate decreases.

  • 2)A natural disaster destroys a significant fraction of domestic industry and therefore destroys productive capacity.

  • 3)The domestic central bank decreases the growth rate of the domestic credit component of base money to try to reduce the domestic inflation rate.

  • 7.Discuss the value of domestic currency under flexible rates: A foreign oil cartel succeeds in doubling the market price of oil, and the domestic economy(such as China) is heavily dependent on imported oil.


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