# Part 1 Fundamentals of International Finance - Lecture n°3 Exchange rate determination - PowerPoint PPT Presentation Download Presentation Part 1 Fundamentals of International Finance - Lecture n°3 Exchange rate determination

Part 1 Fundamentals of International Finance - Lecture n°3 Exchange rate determination Download Presentation ## Part 1 Fundamentals of International Finance - Lecture n°3 Exchange rate determination

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1. International Finance Part 1 Fundamentals of International Finance - Lecture n°3 Exchange rate determination

2. Exchange rate determination • Models of exchange rate determination • Basis : • Capital in & out-flows lead to appreciation / depreciation of exchange rates, in function of the differential between domestic and foreign interest rates (IS- LM). • Accounting for capital account integration (BOP curve) : Mundell-Fleming model. • Newer models : • Extent from flows models to stock models, since flows accumulate into stocks.

3. Exchange rate determination • Models of exchange rate determination - Stock • (1) Monetary approach (UIP holds) : • (a) Monetarist : PPP holds • (b) Overshooting : sticky prices • (2) Portfolio approach : • UIP does not hold : imperfect asset substitutability • CIP holds. • All assume perfect capital mobility ; CIP holds.

4. Monetary approach • Monetary approach - Monetarist • The exchange rate is the market clearing price between 2 stocks of money, i.e., money demand and money supply. • Perfect asset substitutability : investors are indifferent between holding domestic or foreign assets provided that the expected return on each asset is the same. • M = only asset in the model • S = (m-m*) - (y-y*) + (pe-pe*) • S results from the relative money supply (m) and money demand (m-p ,the real money supply), derived from income, interest rates and expected inflation rate. • Inflation rate modelled as depending on the expected monetary growth (if larger than foreign, S will rise)

5. Monetary approach • Monetarist approach - Theoretical remarks • Based on very strong assumptions : • PPP holding continuously • Demand for money as a stable function of income and interest rates • Perfect price flexibility • Monetarist approach - Empirical Evidence • Types of tests : regressions on the model equation • Poor results : • Wrong signs, low R2, few significant variables. • Exchange rates too volatile to be explained by the model. • Evidence of serial autocorrelation of S, no evidence for efficient market monetary approach.

6. Monetary approach • Monetary approach - Overshooting model • First model : Dornbusch (1976) • Try to explain the observed high volatility of X rates. • States that the difference of speeds of adjustment between asset markets (rapid) and good markets (slow, due to sticky prices) determines exchange rates. • Long-run exchange rates are determined by real factors & monetary factors. • Same equation for the money market (MM) equilibrium (monetarist model) + specification of the goods market.

7. Monetary approach • Overshooting model - Specification • Two key equations of the model : • MM equilibrium condition (1): • m - p =  y -  i (same as previous but in a log linear form) • Goods market equilibrium condition (2): • p =  ( (s+p*-p) - i + y - ^y) • p is a function of the gap between aggregate demand and aggregate supply. • First term : the demand for domestic output is function of real exchange rate • all () less ^y : aggregate demand equation • ^y aggregate supply, at full employment

8. Monetary approach • Overshooting model - Specification • Equations (1) and (2) lead to : • s = s- + (1/) (m - p - y + i*) in logarithm • meaning that the exchange rate and price level are function of three exogenous variables : • the real money supply (m-p) • the domestic real income (y) • the foreign interest rate (i*) • s- is the long-run exchange rate, determined by monetary (inflation differential) and real factors (economic fundamentals). If s above s-, then s is expected to appreciate. • If p falls, the real supply money rises. Then, i falls to maintain MM equilibrium (1). Then se has to fall to maintain the interest parity condition (i=i*+ se ) : the exchange expected to appreciate.

9. Monetary approach • Overshooting model - Hypotheses • Money is neutral in the long-run : changes in the supply of money have no long-run effect on the real economy : an % increase (decrease) in money supply will lead to the same % increase (decrease) in p and s. • Short-run adjustments : m supply decreases, than i rises in the short run since p is sticky (thus (m-p) drops), leading expected exchange rate to appreciate beyond s-, generating next expectations of depreciation = “overshooting”. • Overshooting reaction of money markets are necessary for the goods markets to be in equilibrium in the model to hold. • After the s drop : excess supply of goods then p falls, i falls (by (m-p) rising), then capital outflows, and s expected to depreciate.

10. Monetary approach • Overshooting model - Input • Dornbush’s model can provide an explanation for the large fluctuations in exchange rates. • The model has served as a basis for other models of the overshooting type : no full employment, imperfect currencies and assets substitutability, imperfect capital mobility, rational expectations, dynamic (not analysed here). • Overshooting model - Empirical evidence • Methods : multivariate lagged regressions • Mixed evidence : some support of PPP in the long-run, some evidence of overshooting in the short-run. • Some support from recent tests.

11. Portfolio approach • Portfolio models - Specification • Consider 3 assets that investors hold and diversify (imperfect substitutability - UIP does not hold): • M : Money • B : domestic bonds • F : foreign bonds • Well-defined asset-demand function: • Function of expected rate of return (on both the asset and its various substitutes) • Expected rate of return of foreign assets : defined as i* + expected rate of depreciation of domestic currency. • Function of wealth : implies that changes in price of the assets, and changes in S, will affect assets demand.

12. Portfolio approach • Portfolio models - Specification • Static expectations ( Se = 0) • Macroeconomic model in an open economy : price flexibility, full employment (results may vary the way the real economy is modelled) • The model distinguishes between short-run and long-run exchange rate determination. • Short-run : depends of investors preferences between foreign and domestic assets : S changes to insure that assets markets are in equilibrium. • Long-run : role for the real sector, and in particular, the current account. The short-run S determines the current account, which, in turn, represents net foreign asset accumulation, that, again, causes S to change. • Stability is reached when the current account is in equilibrium.

13. Portfolio approach • Portfolio models - Specification • Differentiates between stocks and flows (1) : • It is the variation of the differential of interest rates that determines capital flows, not the absolute difference (Mundell-Fleming model). • Differentiates between stocks and flows (2) : • Implications of current account imbalances for asset accumulation : • Consider a country with a current account surplus (X>M) : • If S are floating : a current account surplus will be accompanied by a capital account deficit (Xk>Mk, capital outflows), so that the BOP sums up to zero. • This capital account deficit will increase the investors (residents) holdings of foreign assets. • Then, a current account surplus implies an increase in residents holdings of foreign assets.

14. Portfolio approach • Portfolio models - Graphical Equilibrium • MM: equilibrium on the Money Market : • Positive slope, since a rise in S increases wealth (by increase of SF - the value of holdings of foreign bonds) and thus the demand for Money, and i should rise to restore equilibrium. • BB : domestic bond market equilibrium: • Negative slope, because a rise in S generates excess demand on bonds, raise their prices, so i falls. • FF : foreign bond market equilibrium: • Negative slope, for the same reason as BB, but less steeper, since the impact of a rise in demand is less strong on foreign bonds than on domestic bonds (imperfect substitutes, preference for national investments).

15. Portfolio approach • Portfolio models - Graphical Equilibrium S B F M Seq F M B i i0

16. Portfolio approach • Portfolio models - Conclusion • Portfolio models can generate similar results as the sticky prices monetary models : account for exchange rate volatility, misalignment, and the possibility of overshooting. • But they allow a wider range of assumptions than monetary models, like imperfect assets substitutability. • To this extent, they are more satisfying than monetarists models.

17. Portfolio approach • Portfolio models - Empirical evidence • Difficult to test due to important data problems • Good supporting evidence for the tests run • But bad performance at forecasting (in particular, it does not outperform the random walk) • Econometrical problems could explain this failure, like poor data and poorly specified dynamics.

18. “News” approach • Testing models - News approach • Try to distinguish between expected / unexpected components of exchange rates determinants • Models sensitive to the way news are constructed, and to the choice of the type of news • Poor empirical performance • -> research question : what type of news is important to influence expectations on exchange rates?

19. Misalignments • Recent attempts to explain misalignments • Misalignment : departure of exchange rate from its long-run equilibrium • Two types of explanations : • Rational bubble : • Still assuming rational behaviour of markets participants. • Pt = discounted cash-flows + Bt • Bt = E(Bt+1) / (1+r) = bubble component • Bt+1 = (1+r) Bt + Zt • Bubble has a probability of bursting at each period, but grows at an expected rate of r if investors are risk neutral. • Testing for evidence : joint hypothesis of bubble existence and of the model of exchange rate determination.

20. Misalignments • Recent attempts to explain misalignments • Rational bubble : • Mixed empirical evidence for speculative bubbles on the exchange rate markets • Theoretical questions : • Since prices are bounded to zero, a negative bubble could never starts • With rational expectations hypothesis, a bubble should begin at the start of the asset life • An asset with a finite life and a fixed redemption value cannot become the object of a rational bubble • Need for the hypothesis of limited rational expectations and ‘near rational’ bubble : “there is always a greater fool out there”...

21. Misalignments • Recent attempts to explain misalignments • Heterogeneous expectations : • Wide dispersion of opinions observed, in particular for longer maturities • Model of two groups of forecasters (Frankel & Froot, 1987): • Chartists : extrapolate past experience • Fundamentalists : using Dornbush’s overshooting model • Portfolio managers use a weighted average of these two forecasts, and update the weights according to who is doing better. • Broad empirical support : explained the rise and fall of the dollar in early 1980’s. Questionnaires among forecasters supported the approach. • -> still at an infant stage.