CHAPTER 4 FALL 2010 - 4 EXCHANGE RATES II: THE ASSET...

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Unformatted text preview: 4 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 Interest Rates in the Short Run 2 Interest Rates in the Short Run 3 The Asset Approach 4 A Complete Theory 5 Fixed Exchange Rates and the Trilemma 6 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 canadian return USD Expected icad is determi ned by money market and the would expecte exchan ge rate would also be given using forecast s of the money market equilibri SR: Ecad /usd base d on the icad, iusd and the expe cted rate depr ecati on. We assu me the last two are exog enou s and focus on the first varia ble. Fishe effect ineffe ctive, beca use price s do 3 Equilibrium in the FX Market: An Example Endo geno us Spot exch ange rate and dom estic curre ncy retur n(ica • Asset approach to exchange rates. • The fundamental equation of the asset approach is the equilibrium condition in the foreign exchange market. • 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 Sp ot Equilibrium in the FX Market: An Example • First the data, from which we construct the diagram… so as increas ECad/ decreas es. The represe nts the expecte d return on the measur canadia dollars or the return in the US. Suppos e E was to the here DR is less FR, E go up and the depreci ate. E* stable unique equilibri um in bank cana da expa nds mon etary policy inter est rate decr ease Sp 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 (MD). 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: Key Assumptions • 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: Key Assumptions • 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: Graphical Solution M/P, both const ants, whic mea ns that the mon ey suppl y is vertic 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: Graphical Solution • 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. Y = Yb ar , as no mi na l int er es t in cr ea se s an d L(i Mon ey Mark et in SR Icad 11 money Balance 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 cut, expa nsion ary fiscal policy ,Y incre ases, more inco me and subs eque nt, more dem and, shifti ng the real mon ey dem and upwa rd. This upwa cost capit mea ns inves tmen t will decr ease. change in Change in P/P= pi= change in positive, increase. In the SR. increases. requires the right increase, if decreases, goes up to maintain 13 Money Market Equilibrium: The Short Run versus the Long Run ke ep in g pri ce co ns ta nt, an d E^ e 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 undesirable. for bo rro w er 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 decrease the 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 market diagram. 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: Graphical Solution A is ho m e, B is for 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 exchange 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: Graphical Solution Yo u wil l ha ve to re pli ca te th es e gr ap hs on th Note, the two diagrams share a common axis (which measures the home nominal interest rate). Convenient… A: U S B: Eu ro pe C urr en cy A: $ C urr en cy 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 risk premium: uncertainty 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? fir st st ep : D et er mi ne i(d o spot exchange rate. In order to determine comparitive statistics we need to determine DR= ia is efected by supply and output A. ib is effected by the variables and EA/B is Price s are fixed and beca use temp orary this mea ns that e is held const and causi ng an appr eciati on of the dom estic curre ncy. S R, te m po rar y co ntr ac tio na ry m on et ar increasi ng Ea, co ntr ac tio n in m on et ar y po lic y in B. N ot hi ng ha pp en s in 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 run. Apply the theory to generate long and short run policy predictions. Analyze the short run and long run effects of permanent shocks. 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 AND M/P= L(I(* Y) P= MI/ L(I)* Uncovered Interest Parity (UIP) IA = IB + E^ E A/ BE A/ 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 monetary approach. 24 A Complete Theory: Unifying the Monetary and Asset Approaches • Monetary Approach (3 equations, 3 unknowns) Money Market Purchasing Power Parity E^ e A/ B = Pe 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. sa m e as ch ap ter 25 Confessions of a Forex Trader SIDE BAR • Three basic strategies for forecasting exchange rates. (F ut ur e pe rfo rm an ce or 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. W he re ex pe ca tio ns is aff 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. Ev en tu all y w e wil l all o w for pri ce 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. Unexpected. Price level is sticky in the short run. E^ e is eff ec 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? M on et ar y Ex pa ns Pe rm an en t look at subscrip price to determi ne if we are in term or in the term. A perman ent E^e increas e and subseq uently foreign return curve will shift outward , if not perman 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 expansion, increases but price increases bringing it back to its value and continues to shift, to bring us back to the same i but increased Exchange less than the LR, change in M/M Change in P/P= Change in E/E Monetar neutralit y, which basicall means that all nominal variable s adjust same way in the LR. In the LR M/P is held constan adjusts, less in the long run as compar the SR. We are compari ng the perman 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 rate. 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.

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