International Monetary Policy. Exchange Rates and Money. International Monetary Theory. Given the large amount of economic activity that takes place across borders, we need to consider the effects of monetary policy on this activity
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Exchange Rates and Money
Home Currency Return on Foreign Assets =The Local Currency Return on Foreign Assets
Spot Exchange Rate (Eh/f)
Home assets have a higher return on foreign assets – the foreign currency will depreciate today, leading to a higher expected appreciation of the foreign currency
Foreign assets have a higher return than home assets. Investors will bid up the price of foreign currency, thereby increasing the expected appreciation of the home currency
Rh,h = Rh,f
Rates of Return in home currency
Rh,h = Rh,f
Home Currency Returns
Changes in price
levels are less
that price levels
Exchange rates are influenced by interest rates and
expectations, which may change rapidly, making exchange rates volatile.
Investors expect the dollar to be devalued, so the expected future rate rises from E0 to E1. This shifts the expected dollar return on an EU bond up.
The relatively higher return on EU bonds creates an excess demand for euros. To maintain the fixed exchange rate, the Fed must offer to buy dollars and sell EU assets. This lowers the U.S. money supply and raises U.S. interest rates
E = E0
REU + (E1-E)/E
REU + (E0-E)/E
The adjustment by the Fed is contingent on them having enough reserves of EU assets to satisfy the excess demand for euros. What if they don’t? Then they must devalue the dollar!