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International Economics. Portfolio Balance Models. “Asset Market” Approaches. Asset Market approaches focus on role of capital flows due to increasing capital mobility in causing fluctuations in Balance of payments and/or EXR in response to "news".
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International Economics Portfolio Balance Models
“Asset Market” Approaches • Asset Market approaches focus on role of capital flows due to increasing capital mobility in causing fluctuations in Balance of payments and/or EXR in response to "news". • assumes that the EXR adjusts instantly to keep international demand for stocks of national assets equal to their supply. • Monetary approach to the balance of payments is a simple version that focuses on the money market only. • EXR moves to equilibrate domestic & foreign markets for money. • Assumes domestic and foreign bonds are perfect substitutes. • Portfolio Balance approach allows foreign & domestic bonds to be imperfect substitutes. • More complicated, events that change stock of one or the other types of bonds disturb overall equilibrium, requiring EXR changes to offset.
Monetary Approach • Based on idea that exchange rate is the relative price of the domestic currency (domestic money) in terms of a foreign currency (foreign money). • Relative demand/supply of the currencies determine exchange rate. Domestic Money Market • Money Demand L = Pf(Y, i, W, E(p)) • Y = Domestic Real Output, fY > 0 • P = Domestic Price Level, fP > 0 • i = Domestic Interest Rate, fi < 0 • W = Domestic Wealth, fW > 0 • E(p) = Expected Domestic Inflation, fp < 0
Money Supply • Money Supply Ms = a(BR + C) = a(DR + IR) • a = Money Multiplier • BR = Commercial Bank Reserves • C = Currency held by Non-bank Public • DR = Domestic Reserves • IR = International Reserves • Money multiplier, a, is determined by operation of the fractional reserve banking system and its parameters. • Monetary Base (MB = BR + C) are liabilities of the domestic central bank. Equal to central bank assets DR + IR. • Be sure to understand how central bank liabilities and assets are related. • Money Market Equilibrium Ms= a(DR + IR)= Pf(Y, i, W, E(p))= L
Supply of FX (from Foreign Citizens) D IR > 0 Fixed EXR1 Flexible EXR Fixed EXR2 Demand for FX D IR < 0 (from Domestic Citizens) FX* Market for Foreign Exchange Exchange Rate $/Foreign Currency Quantity of Foreign Currency Exchanged
Demand for Goods up Domestic prices up Possible Wealth increase Exports down + + + Imports up + - ( -ve) Increased Domestic savings Domestic interest rate falls Possible Expected Inflation ( -ve) ( -ve) DIR = BofP = DCurrent Account + DCapital Account Capital Outflows DCAB < 0 Fixed EXR & Monetary Approach Money Market Pf(Y, i, W, E(p)) ( +ve) = mm(IR + DR)
Demand for Goods up Domestic prices up Possible Wealth increase Exports down + + + Imports up + - Increased Domestic savings Domestic interest rate falls Possible Expected Inflation Domestic Currency Depreciates, (e rises) Capital Outflows FX Demand up FX Supply down FX Demand up FX Supply down Flexible EXR & Monetary Approach Money Market Pf(Y, i, W, E(p)) ( +ve) = mm(IR + DR) Market for Foreign Currency FX Demand Increases FX Supply Decreases
Simple Monetary Model • Assume • Domestic and foreign price level fixed in short run. • Expected value of future exchange rate fixed. • Domestic & foreign bonds perfect substitutes. • So return on domestic & foreign bonds must be equal. • Return on Foreign Bonds, RF = i* + xa • xa = expected %De = [E(e1) – e0]/e0 • For given E(e1), increase in e lowers xa, and RF. • Return on Domestic Bonds, RD = i • Determined by domestic monetary policy and demand for domestic money by residents.
Domestic Money Market M0 Foreign Bond Yield, i* + xa Domestic Bond Yield, i i0 L( i, Y0, P0) e0 Domestic MS Simple Monetary Approach Perfect Capital Mobility Interest rates Spot Rate, e
M1 RD1 i1 e1 Expansionary Monetary Policy Perfect Capital Mobility Domestic Money Market Interest rates M0 Foreign Bond Yield, i* + xa RD0 i0 L( i, Y0, P0) e0 Spot Rate, e Domestic MS
Linking Domestic & Foreign Money • To link countries, monetary approach needs relationship linking changes in nominal exchange rate to changes in the domestic and foreign money markets. • Absolute Purchasing Power Parity • “Law of One Price” links nominal exchange rate to levels of prices in the foreign and domestic countries. • Price level plays a crucial role in determining real money in the money market equilibrium of each country as the government determines only the nominal supply of the currency. e = P/P* • e = nominal exchange rate, e, expressed in domestic currency per unit of foreign currency. • P = Domestic Price level, P* = Foreign Price level.
Domestic Money Foreign Money Market Equilibrium Market Equilibrium MS= Pf(i,Y,W,E(p)) MS*=P*f*(i*,Y*,W*,E(p*)) Absolute Purchasing Power Parity e = P/P* Monetary Approach to Exchange Rate Monetary Approach to EXR I
Special Case of Monetary Approach • Domestic Money Market Equilibrium Msd = kd(id)PdYd orPd =Msd/ kd(id)Yd • Foreign Money Market Equilibrium Msf = kf(if)PfYf orPf = Msf /kf(if) Yf • Absolute Purchasing Power Parity e = Pd/Pf • Combining 1-3 yields monetary approach to EXR e =kf(if)Yf/ Msf kd(id)Yd / Msd
Domestic Money Foreign Money Market Equilibrium Market Equilibrium MS= Pf(i, Y) MS*= P*f*(i*, Y*) Relative Purchasing Power Parity %De = p - p* Monetary Approach to EXR Changes OR Monetary Approach to EXR II
Summary of Monetary Approach • Absolute PPP and Monetary Approach e =kf(if)Yf/ Msf kd(id)Yd / Msd • A currency depreciates if its relative demand falls vis a vis the relative demand for the foreign currency. • Relative PPP and Monetary Approach %De = (ms– ms*) + j (y* – y) + l (i* – i) • A currency depreciates if: • Its supply grows faster than the foreign supply. • Its demand grows less quickly than the foreign demand. • A currency depreciates if its relative demand falls vis a vis the relative demand for the foreign currency.
Monetary Approach Empirical Results • Fixed Exchange Rates • Under fixed exchange rates, adjustment to equilibrium by changes in Balance of Payments, BOP. Expect empirical relation between BOP and certain economic variables. BOP = a + bDD + cDi* + fDY D = Domestic Credit, i* = foreign interest rate, Y = domestic real income. • Use estimated equation to test implications of Monetary Approach for Balance of Payments under fixed EXR. • Expect b > 0, c > 0, f > 0. (Why?) Results for Japan 1959-1972 indicate that b > 0, domestic monetary policy matters in way predicted, but c, f not signif. different from zero. • Partial empirical support for Monetary Approach to Balance of Payments under Fixed Exchange Rate Regime.
Monetary Approach Empirical Results • Flexible Exchange Rates • Under flexible exchange rates, adjustment to equilibrium by changes in exchange rate, e. log e = a + b log Ms + c log E(p) • Expect b =1 > 0, c > 0. (Why?) • Results for German hyperinflation Feb. 1921 – Aug. 1923 indicate that b 1 and c > 0. In hyperinflation, prices dominate EXR, and money dominates prices. log e = a + b (ms– ms*) + c (y – y*) + d (i – i*)S + f (i – i* )L • Expect b > 0, c < 0, d > 0, f > 0. (Why?) • Results for five countries relative to Germany 1973–1979 indicate that b and c not signif. different from zero. Only interest rate signs were correct & significant. • Problem stems from lack of support for PPP in data.
