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Exchange Rate Determination

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  1. 4 Exchange Rate Determination • Chapter Objective: • Reviews PPP and understands • Examines MABP and exchange rate determination. • Understands portfolio balance approach • Knows exchange rate dynamics and overshooting

  2. Exchange Rate Determination PPP Different Exchange rate system Monetary approach Elasticity Sticky Ms , Md IRP Exchange rate and BP portfolio balance approach asset

  3. Chapter Three Outline • 1.Purchasing Power Parity • 2.Monetary Approach to the Balance of payments and Exchange Rate Determination • 3. Exchange Rate Dynamics • 4. Asset Market model and Exchange Rates.Portfolio-Balance Approach • 5.Empirical tests and Exchange Rates Forecasting

  4. 1. Purchasing Power Parity • (1)A law of one price • (2)Absolute and relative PPP • (3) PPP Deviations and Evidence on it • (4) Empirical tests of Purchasing Power Parity

  5. (1) a law of one price • 1)In one country • P=P’+c • P=P’+c(cost)+L(law)+A(arrest) • Non traded goods: Real estate haircuts • 2)In an open economy • P=RP’+c

  6. (2) Absolute and relative PPP • The exchange rate between two currencies should equal the ratio of the countries’ price levels. • Relative PPP states that the rate of change in an exchange rate is equal to the differences in the rates of inflation. • If U.S. inflation is 5% and U.K. inflation is 8%, the pound should depreciate by 3%.

  7. (4)Evidence on PPP • PPP probably doesn’t hold precisely in the real world for a variety of reasons. • Haircuts cost 10 times as much in the developed world as in the developing world. • Film, on the other hand, is a highly standardized commodity that is actively traded across borders. • Shipping costs, as well as tariffs and quotas can lead to deviations from PPP. • PPP-determined exchange rates still provide a valuable benchmark.

  8. Total GDP 2006 (millions of Ranking Economy US dollars) 1 United States 13,201,819 2 Japan 4,340,133 3 Germany 2,906,681 4 China 2,668,071 5 United Kingdom 2,345,015 6 France 2,230,721 a 7 Italy 1,844,749 8 Canada 1,251,463 9 Spain 1,223,988 10 Brazil 1,067,962 11 Russian Federation 986,940 12 India 906,268 13 Korea, Rep. 888,024 • PPP GDP 2006 • (millions of dollars) • 1 United States 13,201,819 • 2 China 10,048,026 a • 3 India 4,247,361 b • 4 Japan 4,131,195 • 5 Germany 2,616,044 • 6 United Kingdom 2,111,581 • 7 France 2,039,171 • 8 Italy 1,795,437 • 9 Brazil 1,708,434 • 10 Russian Federation 1,704,756 • 11 Spain 1,243,440 • 12 Mexico 1,201,838 • 13 Korea, Rep. 1,152,356

  9. (4) Empirical tests of Purchasing Power Parity • See p.508 three points

  10. 2.Monetary Approach to the Balance of Payments and Exchange Rate Determination • (1)Monetary Approach to the balance of payments under Fixed Exchange Rates • (2) Monetary Approach to Exchange RateDetermination (flexible price)

  11. 2.Monetary Approach to the Balance of Payments and Exchange Rate Determination • In the 1970s, the monetary approach to the balance of payments came to popularity, that emphasizes the monetary aspects of the balance of payments. • Money plays the crucial role in the long run both as a disturbance and as an adjustment in the nation’s BP.

  12. 2.Monetary Approach to the Balance of Payments and Exchange Rate Determination • MABP emphasizes the determinants of money demand and supply that will determine the balance of payments. • Those items that directly affect the money supply are below the line which MABP concentrate on.

  13. (1)MABP • Flexible • At a point where the flow of exports just equals the flow of imports, no net international money flows required. • Adjustment through exchange rates. Fixed • Money flowing between countries to adjust the disequilibrium. • Adjustment to changes through international money flows

  14. (1)MABP • 1)basic concepts and assumptions • Central bank controls the money supply by altering base money • Base money changes, the lending ability of commercial banks changes. • Divide base money into domestic and international components.

  15. (1)MABP • 2)framework for the analysis under MABP • Minimum money model • Md=kPY • A stable demand for money • Ms =m(D+F) • Md =Ms

  16. (1)MABP • Md=kPY • P=RP*hereP*the foreign price level R the domestic currency price of foreign currency • k RP*Y=m(D+F) • To discuss the money demand and supply, in terms of percentage changes, since k, m is constant, the changes are zero.

  17. (1)MABP • So • Rearrange

  18. (2) Monetary Approach under Flexible Exchange Rates • Under flexible • Fixed

  19. (1) MABP • Managed float • Given money demand or money supply changes, the central bank can choose to let adjust to the free-market level; or by holding R at some disequilibrium,it will allow to adjust.

  20. (1)MABP

  21. (2)Monetary Approach and Exchange Rate Determined • 1)money plays the crucial role in the long run: • both as a disturbance and as an adjustment in a nation’s BP • 2)The exchange rate is determined by flow of funds, in the process of balancing the total demand and supply of the national currency in each country. • 3)money supply and demand: • The supply of monetary determined by the monetary authorities, the demand for monetary depending on the level of real income, general price level and the interest rate.

  22. (2)Monetary Approach and Exchange Rate Determined(MAER) • The higher are the real income and prices ,the greater is the demand for monetary balances that individuals and businesses demand for their day to day transactions. • The higher of interest, the greater is the opportunity cost of holding money.the higher the rate of interest ,the smaller is the quantity of money demanded. • For a given level of real income and prices, the equilibrium interest rate determined at the intersection of demand and supply curves of money.

  23. (2)Monetary Approach and Exchange Rate Determined • Suppose the FX market being equilibrium or at IRP, suppose that monetary authorities increase the money supply, in the long run, leads to a proportionate increase in the price level in the home country and depreciation of its currency, as PPP discussed. • But it leads to decline of interest and affect financial markets and exchange rates immediately, resulting in increased financial investment flows to the foreign countries.

  24. (2)MAER • Under flexible exchange rate • Backgrounds : elasticity supply ; stable demand; markets are competitive and no tariffs, no obstructions to trade; PPP • Income and interest are not relative to money supply. Supply only leads to the changes of the price.

  25. (2)MAER • Elasticity supply:

  26. (2)MAER • Equilibrium :

  27. (2)MAER • Since • so

  28. (2)MAER • Conclusion • Changes in R are proportional to changes in inversely. • It depends on PPP and the law of one price • Not include interest rate (UIRP) • Exchange rate to adjustment

  29. EA is the expected percentage appreciation per year of the foreign currency to the home currency. • UIA formulation

  30. 3.Asset Market model and Exchange Rates • (1)Asset market model • (2)Extended asset market model • (3) Portfolio Balance Approach

  31. (1)Asset market model • Asset market model(PB) differs from the monetary approach(MA) • Perfect capital flow(MA, PB) • Perfect substitutes(uncovered interest arbitrage and no foreign exchange risk premium(MA)

  32. (1)Asset market model • W=M+D+F • M:domestic currency (transactions) • D:domestic bonds (return it yields) • F:foreign bonds (return and spreading risks) • A change in any of underlying factors will achieves a new portfolio; • An increase in wealth increases the demand for these three assets.

  33. (1)Asset market model • According to asset market approach ,equilibrium in each financial market occurs when the quantity demanded of each financial asset equals its supply. • The exchange rate is determined in the process of reaching equilibrium in each financial market.

  34. (2) Extended asset market model • Book , p.522 models

  35. (2) Extended asset market model • Domestic currency equilibrium R R M D M increase F i i

  36. (2) Extended asset market model • foreign bonds Domestic bonds R R F D increase increase i i

  37. (3) Portfolio Balance Approach • open market purchase M’ R M increases, E’new equilibrium Domestic currency depreciates Interest decreases D M E’ E F’ F i

  38. (3) Portfolio Balance Approach • (BCA surplus) R D D’ M Domestic currency appreciates Save foreign currency to change M More foreign currency supply F depreciates i* increases If i unchanged, wealth unchanged M’ F F’ E E’ i

  39. 4.Exchange Rate Dynamics Exchange Rate Overshooting (sticky price)

  40. 4.Exchange Rate Overshooting • 1)concept • Stock adjustments in financial assets are much larger and quicker to occur than in trade flows.in the short run ,changes in R are likely to reflect the effect of stock adjustments in financial assets and expectations.but in the long run ,adjustments in trade flows occurs. • The immediate flows of financial investment leads to an immediate depreciation of home currency which exceeds or overshoots the expected in the long run according to PPP.

  41. 4.Exchange Rate Overshooting • 2)Sequence : • the money supply increases,the interest rate falls,capital flows out, leads to an immediate depreciation of the home currency. In the long run the home currency’s prices rice and it appreciates to eliminate the overshooting.

  42. 4.Exchange Rate Overshooting • 3)model • Regarding a higher trade deficit for the domestic country, the spot exchange rate will jump immediately above E0 R1 R0 until the new long run equilibrium E1 is reached. After a disturbance, the exchange rate may not move in such an orderly fashion. R t

  43. 4.Exchange Rate Overshooting • PPP doesn’t hold well under flexible exchange rate. Exchange rates exhibit much more volatile behavior than prices do. In the short run, following some disturbance to equilibrium, prices will adjust slowly to the new equilibrium level, but the exchange rates and interest rates will adjust quickly. This different speed of adjustment to equilibrium allows for behavior regarding rates and prices.

  44. 4.Exchange Rate Overshooting • At times,spot exchange rates move too much given some economic disturbance.Also, we have observed instances when country A has a higher inflation rate than country B, yet A’s currency appreciates relative to B’s. such anomalies can be explained in the context of an “overshooting” exchange rate model. We assume that financial markets adjust instantaneously to an exogenous shock, whereas goods markets adjust slowly over time. With this setting, we analyze what happens when country A increases its money supply.

  45. 4.Exchange Rate Overshooting • For equilibrium, money demand must equal supply. If the money supply increases, something must happen to increase demand. Assuming that people hold money for transactions purposes, and holding bonds to pay an interest rate i. A money demand equation: Md=aY+bi • Md,the real stock of money demanded • Y, income • I, interest rate • and i, or b is negative.

  46. 4.Exchange Rate Overshooting • As y increases, tend to demand more things including money. Interest rate is the opportunity cost of holding money, there is an inverse relation between money demand. • In the short run, both income and the price level are relatively constant. • Result :interest rate must drop to equate money demand to supply.

  47. 4.Exchange Rate Overshooting • Bring into analysis a second country: • IRP: i=i*+EA • i falls, i* EA(forward premium on foreign currency ) fall. The money supply in one nation increases ,expect prices in one nation will rise. And spot rate expected depreciation. Imply a higher future exchange rate to achieve PPP, a long run value of exchange rate • RLR=P/P* • P expected to rise over time, given P*, R will rise.

  48. RLR • overshooting R R0 t0 i0 t0 t0 P0

  49. 5.Forecasting Exchange Rates • Forecasting is difficult, especially with regard to the future. Two reasons , p.530 • As a whole, forecasters cannot do a better job of forecasting future exchange rates than the forward rate. • The founder of Forbes Magazine once said: “You can make more money selling advice than following it.”

  50. Rate determined suppose Ms increases sequence