2010 OEM Chapter 6

2010 OEM Chapter 6 - Chapter 6: Exchange Rates 6.1...

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Chapter 6: Exchange Rates 6.1 Introduction The focus of this chapter is on exchange rate behavior. The chapter distinguishes between two types of behavior, short run and long run. Short run behavior refers to day to day, week to week, or month to month movements in exchange rates. As we show below, market determined exchange rates tend to be very volatile in the short run, similar to the behavior of share prices we see in stock markets. The model that we present to explain this volatility is similar to models found in finance that try to explain the behavior of equity prices. A major component of the model is the notion that expectations about the future value of a currency play a role in setting today’s exchange rate. Long run exchange rate behavior refers to long term trends in the values of currencies. The model that we use to explain these trends is based on an idea known as purchasing power parity. This theory states that in the long run, exchange rates will tend to find levels that equalize prices across countries when measured in the same currency. 6.2 Exchange Rates in the Short Run Figure 6.1 provides graphs of month to month changes in the value of the Canadian dollar (C$), and Canadian stock prices between 1990 and 2003. Notice that for much of this period there was considerable volatility in both of these series; the exchange rate fluctuated randomly as did the stock market. It was not uncommon for the C$ to gain or lose as much as 4% of its value during any given month. This type of volatility was not limited to the C$. The currencies of virtually all major 1 countries fluctuated with similar random gyrations over this period. See Figures 6.2 and 6.3 for graphs of similar data series over the same time period. As the graphs show, volatility is common Nor was this period more volatile than any other recent experience. Indeed, asset price volatility, including 1 exchange rate changes has been especially high since the onset of the current recession.
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for stock prices as well. It is also true of many other financial assets such as corporate or government bonds. Because of this similarity, most economists rely on asset market models to explain short run exchange rate behavior. 2 The chief characteristic of an asset market model is its emphasis on forward looking behavior. Again, remember that an asset is a form of wealth--something that retains or (hopefully) increases in value over time. Examples of assets abound in the real world: money, shares of stock, bonds, paintings, houses, etc. What determines the price of these things? Consider a house. The amount you are willing to pay for a house depends upon a number of things including its size, state of repair, and location. In turn, the value of all of these things depends upon your predictions about the future. For instance, if you think that the neighborhood may become very popular in the future, even if it isn't today, you might be willing to pay more today because you think that the house will
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This note was uploaded on 04/17/2011 for the course ECON 1510 taught by Professor Stevenhusted during the Spring '11 term at Pittsburgh.

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2010 OEM Chapter 6 - Chapter 6: Exchange Rates 6.1...

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