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The Monetary Approach to Exchange Rates Putting Everything Together Available Assets Foreign Currency (M*) Pays no interest, but needed to buy foreign goods Home Currency (M) Pays no interest, but needed to buy goods

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the monetary approach to exchange rates

The Monetary Approach to Exchange Rates

Putting Everything Together

available assets
Available Assets

Foreign Currency (M*) Pays no interest, but needed to buy foreign goods

Home Currency (M) Pays no interest, but needed to buy goods

Foreign Bonds (B*) Pays interest rate (i*), payable in foreign currency

Domestic Bonds (B) Pays interest rate (i)

five markets
Five Markets

Foreign Bond Market

Domestic Bond Market

Households choose a combination of the four assets for their portfolios

Domestic Money Market

Currency Market

Foreign Money Market

general equilibrium
General Equilibrium

Foreign Bond Market

We need five prices (P,P*, i , i*,e ) to clear the five markets!!

Domestic Bond Market

Domestic Money Market

Foreign Money Market

Currency Market

lets simplify things
Lets simplify things!!

Purchasing Power Parity

Currency Markets

P = eP*

Uncovered Interest Parity

Expected Percentage Change in Exchange Rate

(i - i*) =

down to two
Down to two!!!

Foreign Bond Market

Domestic Bond Market

Now we only need two prices (P,P*) to clear the two remaining markets!!

Domestic Money Market

Foreign Money Market

Currency Market

the domestic money market
The Domestic Money Market

Cash is used to buy goods (transaction motive), but pays no interest

+

-

+

d

M

L ( P, i, Y )

=

Higher prices raises money demand

Higher real income raises transaction motive for holding cash

Real Money Demand

Higher interest rates lower money demand

the domestic money market8
The Domestic Money Market

Cash is Supplied by the Federal Reserve

S

P

M

-

+

L (i, Y )

1

M

the domestic money market9
The Domestic Money Market

S

P

M

-

+

L (i, Y )

An increase in real income raises the demand for money – this lowers the price level (holding money supply fixed)

1

M

the domestic money market10
The Domestic Money Market

S

P

M

-

+

L (i, Y )

1

An increase in interest rates lowers money demand – this raises the price level (holding money supply fixed)

M

the domestic money market11
The Domestic Money Market

An increase in money supply raises the price level

S

P

M

-

+

L (i, Y )

1

M

the domestic money market equilibrium
The Domestic Money Market Equilibrium

d

S

M

=

M

S

P

M

-

+

L (i, Y )

PY

=

M

(1+i)

1

M

(1+i)

M

P

=

Y

the foreign money market equilibrium
The Foreign Money Market Equilibrium

The foreign money market is perfectly symmetric

d

S

M*

=

M*

*S

P*

M

-

+

L (i*, Y* )

P*Y*

=

M*

(1+i*)

1

M*

(1+i*)

M*

P*

=

Y*

exchange rate fundamentals
Exchange Rate Fundamentals
  • Using PPP and the two Money Market equilibrium conditions, we get the “fundamentals” for a currency

Domestic Money Market

Foreign Money Market

M

(1+i)

M*

(1+i*)

P

=

P*

=

Y

Y*

PPP

P = eP*

M

(1+i)

eM*

(1+i*)

=

Y

Y*

currency fundamentals
Currency Fundamentals
  • Taking the previous expression and solving for the exchange rate, we get

(1+i)

M

Y*

e

=

M*

Y

(1+i*)

Relative Money Stocks

Relative Interest Rates

Relative Output

adding relative price changes
Adding Relative Price Changes
  • Recall that PPP often fails in the short run. This is possibly due to trading friction or relative price changes

(1+i)

M

Y*

e

=

RER

M*

Y

(1+i*)

Real Exchange Rate

exchange rates the fundamentals jpy usd19
Exchange Rates & the Fundamentals (JPY/USD)

Real Depreciation of the Dollar

adding speculative bubbles
Adding Speculative Bubbles
  • Recall that UIP implies that the differences in nominal interest rates reflects expectations of currency price changes (countries with high interest rates should expect their currencies to depreciate

(1+i)

M

Y*

e

=

RER

M*

Y

(1+i*)

Expected change in exchange rate (Speculative term)

what about trade deficits
What about trade deficits?
  • Trade deficits suggest that a country is spending too much (borrowing from the rest of the world). Therefore, the price adjustment mechanism necessary to eliminate a trade deficit will be one of the following:
      • A country’s currency depreciates – this makes foreign goods more expensive.
      • A country’s interest rate rises – this makes spending in general more expensive
what about trade deficits22
What about trade deficits?
  • Recall that PPP always holds in this model. Therefore, exchange rates and prices adjust so that foreign goods always cost the same as domestic goods.

P = eP*

what about trade deficits23
What about trade deficits?
  • Further, UIP implies that there is no adjustment mechanism in asset markets either

Expected change in nominal exchange rate

Inflation – Inflation*

=

=

i – i*

PPP

UIP

r = i – Inflation = i* - Inflation* = r*

Inflation adjusted returns are equalized across countries!!

one last shot real income
One last shot….real income.
  • Currency depreciations are associated with high domestic inflation….shouldn’t rising prices lower the demand for all goods/services?

Yes, but this particular model assumes that real (inflation adjusted) income is fixed….therefore, a 10% increase in prices will be matched my an equal 10% increase in nominal income.

bottom line
Bottom Line
  • If commodity prices are free to adjust, then commodity markets take center stage in currency price determination (PPP)
  • There is no correlation between trade deficits and currency prices
  • Volatility in currency markets is created by relative price changes (real exchange rate changes) or speculative behavior
  • These relative price changes are passed onto nominal exchange rates