1 Models of Exchange Rate Determination Lecture 1 IME LIUC Nov-Dec. 2003.

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<ul><li> Slide 1 </li> <li> 1 Models of Exchange Rate Determination Lecture 1 IME LIUC Nov-Dec. 2003 </li> <li> Slide 2 </li> <li> 2 Exchange Rates Movements Show Some Regularities Correlation between monthly changes in the exchange rate and the current account position is low Exchange rates of countries with high inflation depreciate in the long run by about the inflation rate differential Daily and monthly exchange rates are highly unpredictable The high variability of exchange rate in the short run is not systematically related to change in money supply </li> <li> Slide 3 </li> <li> 3 Do We Have a Theory to Explain Exchange Rate Behaviors ? No, we have several theories that try to explain empirical regularities: The PPP model, Mundell Fleming model, Monetary Model, .. They all have limitations and indeed. </li> <li> Slide 4 </li> <li> 4 Exchange-Rate Forecasting is Difficult! "There may be more forecasting of exchange rates, with less success, than almost any other economic variable. Although measures such as real interest- rate differentials, differential rates of productivity gains, and chronic external deficits are often employed to explain exchange rate behavior, none has been found to be consistently useful in forecasting exchange rates even over substantial periods of one or two years." Alan Greenspan (July 2002) </li> <li> Slide 5 </li> <li> 5 The Dornbushs model: the overshooting model What is the evidence for and against the model? Why is the model so famous? What is the model about? </li> <li> Slide 6 </li> <li> 6 Why is the model so famous? Quoting from Rogoff The model is elegant: it is the beauty and clarity of Dornbushs analysis that has made it so flexible and useful. The model is path breaking: it changed our way of thinking about the exchange rate. </li> <li> Slide 7 </li> <li> 7 Quoting from Krugman Rudi was, first of all, the economist who brought international monetary economics into the modern world. The workhorse of pre- Dornbusch open-economy macro, the Mundell- Fleming model, was a fine thing.. But it didnt capture the volatility of a floating-exchange- rate world, the way currencies can soar or plunge not because big things have already happened, but because things are expected to happen.. Rudis famous overshooting paper changed it all (NYT, July 26 2002) </li> <li> Slide 8 </li> <li> 8 What is the model about? Two relationships lie at the hart of the model: The UIP: The money demand: The model also assumes that: P fix in the short-run and flexible in the long- run output y is exogenous money is neutral in the long run, so that a permanent rise in m leads a proportionate rise in e and p, in the long run. </li> <li> Slide 9 </li> <li> 9 How does the overshooting work? Hp: Unanticipated permanent increase in the money supply m. Long run: The increase in m will imply a proportional increase in P and given that the PPP holds also in e </li> <li> Slide 10 </li> <li> 10 in the short run: If m rises but the price level is temporarily fixed, then the supply of real balances must rise as well. To equilibrate the system, the demand for real balances must rise. Since output is assumed fixed in the short run, i on domestic currency bonds falls. According to the UIP, it is possible for i to fall if and only if, over the future life of the bond contract, the home currency is expected to appreciate. But how is this possible if we know that the long run impact of the money supply shock must be a proportionate depreciation in the exchange rate? Dornbusch's brilliant answer is that the initial depreciation of the exchange rate must, on impact, be larger than the long- run depreciation. The exchange rate must overshoot. The volatility of m implies the volatility of e </li> <li> Slide 11 </li> <li> 11 Graphically </li> <li> Slide 12 </li> <li> 12 What are prices doing? </li> <li> Slide 13 </li> <li> 13 Hp: Announcement in t of a permanent increase in the money supply m a t+3 The potential for arbitrage profits rules out the possibility of any discrete jump of e; no jumps in the instant in which the policy is implemented e will jump at the announcement The depreciation generate an excess demand for goods, therefore p increases An increase in p implies a reduction in m/p and an increase in i i higher than i* implies further expected depreciation,,,e and p will continue to increase until t+3 when m increases At this point i is below i* therefore expected appreciation, the e must be above its long run level </li> <li> Slide 14 </li> <li> 14 Graphically </li> <li> Slide 15 </li> <li> 15 Evidence for and against the model To test the model many have used Frankel's (1979) observation that, under a reasonably general set of assumptions, Dornbusch model predicts that high real interest rates will cause the real exchange rate to appreciate. Looking at data: the model captures major turning points in monetary policy quite well, however, it does not seem to capture all the other big exchange rate swings that regularly take place. </li> <li> Slide 16 </li> <li> Slide 17 </li> <li> Slide 18 </li> <li> 18 </li> <li> Slide 19 </li> <li> 19 Dollar/ Exchange Rate: Where Next? Substantial $ depreciation since spring 2002 (20%) </li> <li> Slide 20 </li> <li> 20 Recent movements: expectations vs fundamentals Following the call for more flexibility for more flexibility in the exchange rate of major countries (IMF/WB annual meetings sept 03, G7 communiqu), the $ experienced a rather broad weakening while the yen rose to its highest level in 3 years. Following the remarks by Duisenberg that the flexibility was not so much for the $/ exchange rate but for the Asian regimes, the $ recovered </li> <li> Slide 21 </li> <li> 21 </li> <li> Slide 22 </li> <li> 22 Recent data on US labour market and growth resulted in a further appreciation of the $ However there is a general consensus that the $ should weaken further, Why? Because of the unsustainable current account deficit, which has reached 5% of GDP Bergsten (IIE Washington 2003) to finance both the current account deficit and our sizable capital exports, the US must import about $1 trillion of foreign capital every year, more than $4 billion every working day. The situation is clearly unsustainable. the trade-weighted average exchange rate of the $ needs to fall by another 10-15 %..the decline should occur against a broader group of currencies </li> <li> Slide 23 </li> <li> 23 A similar view, but a stronger position on the $/ exchange rate. Lynn (Bloomberg 12 Nov 2003): The appreciation of the will not last.. some figures: from July to Sept the US economy expanded at a rate of 7.2% and Europe? In the second quarter, the euro-countries contracted by 0,1%. Unemployment in Europe is still at about 9%, Germany, Europes largest economy </li> </ul>

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