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EXCHANGE RATES II:
THE ASSET APPROACH
IN THE SHORT RUN and compare it with
the foreign return.
The last step is to
look at comparative nominal ei. Take The Key variable is
the nominal rate of equilibrium. Price
does not adjust as exchange rate is
given by the price are price regididies.
This is important which means that We will be focusing 1
Exchange Rates and
in the Short Run
Interest Rates in the
The Asset Approach
A Complete Theory
Fixed Exchange Rates
and the Trilemma
Conclusions PPP is not useful as a short-run theory
Why? PPP does not work in theory the exchange
rate between EA/B=
prices are adjusting to
yield the equilibrium In the SR: prices do
not adjust freely. For
example(labor market how do we determine
the equilibrium spot
are going to use the the foreign exchange
Market. We will use 2 Risky Arbitrage • Fundamental equation of the asset approach.
UIP= Icad= iusd+ in dollar in canada
USD Expected icad is
ned by money
s of the
s do 3 Equilibrium in the FX Market: An Example Endo
n(ica • Asset approach to exchange rates.
• The fundamental equation of the asset approach
is the equilibrium condition in the foreign
• We can illustrate the foreign exchange market,
using an FX market diagram showing the
relationship between domestic returns and foreign
returns. icad usd- Ecad/usd/Ecad/Usd 4
ot Equilibrium in the FX Market: An Example
• First the data, from which we construct the diagram… so as
es. The represe
e E was
to the here DR
and the depreci
um in bank
ot 5 LEARNING OBJECTIVES
Interest Rates in the Short Run: Money Market Equilibrium •
• Review the general model of money demand.
Understand why money market is in equilibrium
when money supply (MS) equals money demand
Derive the money market diagram and identify
the money market equilibrium.
Understand adjustment toward equilibrium and
why the equilibrium is stable.
Use the money market diagram to conduct
analysis of interest rates in the short run.
6 Money Market Equilibrium in the Short Run:
How Nominal Interest Rates are Determined
• In the short run, the nominal interest rate adjusts to bring
the money market into equilibrium, given fixed price levels.
In the LR: Prices adjust to left hand side is exogenous,
the right side the Y is given
as goods and services. The
interest rates will adjust to and this holds true for any 7 Money Market Equilibrium in the Short Run:
• Long-run assumptions from monetary approach (last
chapter) The price level is fully flexible and adjusts to bring the
money market to equilibrium. The nominal interest rate is equal to the sum of the
world real interest rate and domestic inflation. Based on theory of purchasing power parity and the
Fisher effect. Recall, this implied real interest parity. 8 Money Market Equilibrium in the Short Run:
• Short-run assumptions in the asset approach (this
chapter) The price level is fixed. Nominal rigidities because of long-term labour
contracts and/or menu costs, for example. The nominal interest rate is fully flexible and adjusts to
bring the money market to equilibrium. PPP holds only in the long run. Nominal interest rates can adjust independently of
Fisher effect in the short run. 9 Money Market Equilibrium in the Short Run:
al. • Supply of real money balances. M is set by the central bank. P is assumed to be fixed in the short run. In the long run, the price adjusts to bring the money market into
equilibrium. Notice, both of these variables are independent of the
nominal interest rate. Therefore, the money supply
(MS) curve is vertical. 10 Money Market Equilibrium in the Short Run:
• Demand for real money balances. Money demand is a decreasing function of the nominal
interest rate. As the nominal interest rate increases, the opportunity cost of
holding money increases, so the demand for money balances
decreases. Since the quantity of real money balances demanded
decreases with an increase in the nominal interest rate, the
money demand curve is downward sloping.
SR Icad 11
s in Cad Money Market Equilibrium:
The Short Run versus the Long Run
• Note: short-run analysis gives results that differ
significantly from those we found using the monetary
approach in the long run. This chapter versus last chapter. • Thus, in applications, it is important to distinguish
between temporary shocks and permanent shocks. Temporary shocks dissipate before prices adjust. Therefore, they
affect the economy only in the short run. Expectations for the future will remain unaffected. Permanent shocks affect the economy in the long run, so that
price adjustment will occur. And expectations will be affected. 12 Money Market Equilibrium:
The Short Run versus the Long Run • Example: A central bank that had previously kept the
money supply constant, now lets M grow at x% per year. tax
ease. change in
change in positive, increase.
In the SR.
decreases, goes up to
maintain 13 Money Market Equilibrium:
The Short Run versus the Long Run ke
co In the short run, if the central bank temporarily changes
its money supply without causing prices to become
unstuck (triggering inflation), then looser money means
lower interest rates, which might be temporarily
desirable for some purposes. But, if the same monetary policies were permanent and
persisted in the long run, prices will not remain fixed
and eventually looser money will mean higher inflation
rates and higher interest rates, which might be rather
s 14 The Monetary Model:
The Short Run versus the Long Run
• To sum up, expanding M leads to a weaker currency.
But: In the short run, low interest rates are associated with a
weaker currency (depreciation). In the long run, high interest rates are associated with a
weaker currency. • What is the intuition for this?
increases, i depreciation
for the home Fisher effect change in Ea/ ia-ib= pia-pib inﬂation will
value of the 15 LEARNING OBJECTIVES Asset Approach: Applications and Evidence
• Understand the model’s equilibrium requires
equilibrium in both the money market and the
foreign exchange market.
Derive the combined FX-money market diagram.
Identify equilibrium in the combined FX-money
Use the asset approach to exchange rates to
conduct analysis, including policy predictions.
Evaluate the empirical evidence for the asset
approach to exchange rates. 16 The Asset Approach to Exchange Rates:
ei • Equilibrium spot exchange rate determined in two
markets. Money market (home and foreign)—determination of interest
rates Use the money market diagram E
A/ Foreign exchange market—determination of spot exchange
rate, based on nominal interest rates and expected
exchange rate. Use the FX market diagram 17 The Asset Approach to Exchange Rates:
The Home Money Market
• Home Money Market Determination of domestic interest rate. ia= ib+E^e
a/b- EA/B/ as the spot
increases, Note a rise in (m/p)a=attributed to a
La(ia)*Y Foreign (M/ 18 The Asset Approach to Exchange Rates:
The FX Market
• The Market for Foreign Exchange Determination of the spot exchange rate. 19 The Asset Approach to Exchange Rates:
th Note, the two diagrams share a common axis (which measures
the home nominal interest rate). Convenient…
B: 20 The Asset Approach to Exchange Rates:
Capital Mobility is Crucial
• This model of exchange rate determination hinges on
arbitrage. The UIP condition, and therefore the intersection of DR and
FR being an equilibrium, relies on arbitrage.
UIP fails to a) there is a
which causes between and Restrictions
on the ﬂow of c) Information 21 The Asset Approach to Exchange Rates:
Putting the Model to Work
• How do we use the model?
o spot exchange rate.
In order to determine
we need to determine DR= ia is efected by
supply and output A.
ib is effected by the
variables and EA/B is Price
th appreci currenc domesti outward
. and foreign
curve to causes 22 LEARNING OBJECTIVES
A Complete Theory
• Combine the asset and monetary approaches to
develop a comprehensive model of exchange
rate determination in the short run and the long
Apply the theory to generate long and short run
Analyze the short run and long run effects of
Define and identify exchange rate overshooting.
Examine empirical evidence of overshooting. 23 A Complete Theory:
Unifying the Monetary and Asset Approaches
• Asset Approach (3 equations, 3 unknowns) Money Market
L(I)* Uncovered Interest Parity (UIP)
B/ In the asset approach, the spot exchange rate and nominal interest
rates adjust to ensure the money market is in equilibrium and UIP
condition is satisfied. The expected future exchange rate can be found from the
24 A Complete Theory:
Unifying the Monetary and Asset Approaches
• Monetary Approach (3 equations, 3 unknowns) Money Market Purchasing Power Parity
a/ The expected exchange rate is based on expected prices, which in
turn, depend on the expectations of money supplies, nominal
interest rates, and real income at home and abroad. If the L are not constant, then interest rates need to be known, and
can be calculated based on the Fisher effect.
ter 25 Confessions of a Forex Trader
SIDE BAR • Three basic strategies for forecasting exchange
Y^ 1. Economic fundamentals. Investor assumes that exchange rates behave according to
economic fundamentals, such as the money supply, price level,
and real income. 2. Politics.
Factors such as war influence investors’ perception of risk,
influencing their forecasts of the exchange rate. 3. Technical methods.
This approach relies on statistical methods to predict exchange
rate movements, often independent of economic fundamentals.
26 Long-Run Policy Analysis
• Our model can be used for analysis of short run policy
experiments. Key assumption: Temporary policy. This presumes expected exchange rate is unchanged. Ignores the long-run building blocks. • The model can be used for long-run analysis as well.
ec Study permanent monetary policy shocks. This implies expected exchange rate changes according to
the monetary model. The expected exchange rate changes in the short run,
based on long-run forecasts from the monetary model. Uses all of the building blocks, long run and short run.
ad 27 Long-Run Policy Analysis
• Permanent increase in the home money supply
• Assumptions Identical economies, output Y fixed.
Start in long run equilibrium.
Home money supply increases x% at time T.
Price level is sticky in the short run.
te • Solution Must work backwards to determine what happens to expected
exchange rate. The expected change is based on long-run forecasts. These expectations will also affect the market in the short run. 28 Long-Run Policy Analysis: Overshooting
• For example, suppose you are told that: Home M rises today permanently by x%. Home nominal interest rate falls today by y% points. Prices sticky now, but flexible in “long run” = one year.
• What happens?
subscrip price to
ne if we
are in term or
in the term. A
ent E^e increas
, if not
ent the would increas
e and 29 Long-Run Policy Analysis: Overshooting
• The exchange rate E overshoots its long run equilibrium
after a permanent change in the money supply. Why? The next is
to focus on
the LR on
back to its
value and continues
to shift, to
back to the
same i but
Exchange less than the LR,
policies. 30 Overshooting in Practice
SIDE BAR Why were floating exchange rates more volatile, given the very
small changes in monetary fundamentals? The Dornbusch model provided an explanation.
31 LEARNING OBJECTIVES
Fixed Exchange Rates and the Trilemma
• Understand how to apply the complete theory to
the case of a fixed exchange rate regime.
Compare fixed and floating regimes. Identify why the model is the same, but the causality is
different. Floating: the money supply is exogenous and
exchange rate is endogenous. Fixed: the exchange rate is exogenous and money
supply is endogenous. • Understand the trilemma of policy objectives. 32 What is a Fixed Exchange Rate Regime?
• Consider the case of a fixed exchange rate with a
hard peg or narrow bands, without capital
controls. In this case, the government must engage in
foreign exchange market intervention to control the
value of the currency. The central bank is responsible for these
interventions, through buying and selling foreign
currency, in order to keep the exchange rate fixed. The central bank will manipulate the home money
supply, in order to maintain the fixed exchange
33 Pegging Sacrifices Monetary Policy Autonomy
in the Short Run: Example
• The short run theory still applies, but with a
different chain of causality. Floating exchange rate regime. Central bank chooses the money supply (exogenous), this
determines the nominal interest rate in the money market. According to UIP, and the FX market diagram, this determines
the spot exchange rate (endogenous). Fixed exchange rate regime. Central bank chooses the exchange rate (exogenous), this
determines the nominal interest rate in the foreign exchange
market through UIP. This determines the money supply (endogenous). 34 Pegging Sacrifices Monetary Policy Autonomy
in the Long Run: Example
• The long run theory still applies, but with a
different chain of causality. Floating exchange rate regime. Central bank chooses the growth in the money supply
(exogenous), this determines the inflation rate and nominal
interest rate via the Fisher effect and the price level.
According to relative PPP, this determines the spot exchange
rate (endogenous). Fixed exchange rate regime. Central bank chooses the exchange rate (exogenous), this
determines the nominal price level (through PPP) and the
interest rate through UIP. This determines the money supply (endogenous). 35 The Trilemma
• Consider three policy goals:
1. Fixed exchange rate Promote stability in trade and
investment. 2. International capital mobility Promote integration, risk sharing
and efficiency. 3. Monetary policy autonomy
Tool for managing home
country’s business cycle. 36 ...
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This document was uploaded on 03/13/2012.
- Spring '12