exchange rate determination chap 15

8/2/2019 Exchange Rate Determination Chap 15

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Exchange Rate Determination

Chapter 15


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Introduction

Based on monetary approach and asset market or

portfolio balance approach

Exchange rate is a financial phenomena- modern

theories


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Purchasing Power Parity Theory-

Absolute PPP Theory

States that equilibrium btwn 2 currencies is equal

to the ratio of general price levels in 2 nations

R= P/P*

Law of one price-

Commodity arbitrage brings equilibrium


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Weaknesses of Absolute PPP

Assumes trade in goods and services only but not

capital A/c

Non traded goods and services cant be arbitraged-

considered but part of general price level

Assumes there are no transport cost and barriers to

trade- wrong.


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Relative PPP Theory

States that change in the exchange rate over a period of timeshould be proportional to the relative change in the price

levels in the two nations over the same time

R1= P1/P0 = R0

P*1/P*0

Absolute PPP, will not necessarily hold if Relative holds, as

for example capital flows ,transport cost, tradeobstructions leads to rejection of Absolute PPP. Only

change in these will lead to rejection of relative PPP.


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Challenges with Relative PPP

Balassa- Samuelson effect- ratio of the price of the priceof non-traded to the price of traded goods and services issystematically higher in developed countries thandeveloping countries.

Results from labor productivity in traded goods beinghigher in developed than developing countries, but aboutthe same in many non traded goods and services sectors.

Services and non traded goods should receive almost samesalary as traded in developed countries for pple to remainin the sector.

This makes prices to be high in developed countries of nontraded goods, hair cut may cost $10 in US and averages $1

in developing countries.


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Challenges Cont

R PPP therefore tend to predict overvaluedexchange rates for developed countries and

undervalued for developing countries.


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Relative PPP Empirical Test

Will work with highly traded individualcommodities

PPP works over very long periods

Works during periods f monetary aggression andhigh inflation but not so well in stable conditions.


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Monetary Approach to BOP under Fixed Exchange

Rates

Views the BoP as purely a monetary Phenomena

Md= k PY ( k-desired ratio of nominal money balances tonominal National Income)

Ms = m( D+F) m(money multiplier). D- domestic

component and F foreign component. D+F is monetary base or high powered money.

In equilibrium Ms =Md

An increase in Md ( probably from increase in Y) can be

satisfied by an increase in D or F. If central bank does not increase D then inflow of forex

If D increases and without change in Md, money flows outof nation.


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Monetary ApproachFlexible Exchange rates

Under flexible exchange rates BoP are corrected

automatically moving exchange rates- withoutinflow/outflow

Occurs via change in prices

Excess Ms, leads to depreciation of the currency thenP rises, to absorb excess money supply.

Excess supply of forex leads to appreciation, and

decline in price level

Exchange value is purely determined by rate ofmoney growth and Income.


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Monetary Approach to Exchange Rate

Determination

Assumes no barriers to trade, no transport cost, and PPP thenaccording to law of one price commodity must be same in price in all

nations.

P = rP*

And R = P/P* If Md= kPY and M*d = k*P*Y*

In Equilibrium Md= Ms

Therefore

M*s/Ms= Kp*Y*/kpy

Dividing both sides: by P*/P and M*/Ms

Then P/P*= Msk*Y*/M*skY

R= Msk*Y*/Ms*kY


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Exchange Determination

Theory depends on PPP and law of one price

Derived from money demand which does not

include interest rates

E i I Diff i l &


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Expectations , Interest Differentials,&

Exchange rates

Exchange rates depends on inflation expectationsand expected changes in exchange rates.

% changes in expected inflation will lead to equal %changes in exchange rates

Using Uncovered interest argument- an expectedchange in exchange rate will lead to real change inexchange rate.

Foreign and domestic bonds are perfect substitutes. i= i* = EA(expected %change in forex)-

appreciation of foreign currecy to domesticcurrency)


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Expectations Cont

If Appreciation of foreign currency is more thaninterest differential, then Capital outflow.

If I


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Portfolio Balance Model and

Exchange Rates

A.k.a- Asset Market Approach Differs from Monetary approach as it assumes that domestic

and foreign bonds are imperfect substitutes.

Also differs by asserting that exchange rate is determined in

the process of equilibrating or balancing the stock or total

demand and supply of financial assets(of which money is

the only one) in each country.

Individuals and firms hold wealth in domestic bonds,domestic money,and foreign bonds denominated in foreign

currency.

Incentive to hold bonds results from interest rate and risk.


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Portfolio Balance Cont

Opportunity cost of holding domestic money is the

foregone interest

Individuals therefore hold either bonds or money

depending on interest and risk aversion.

Higher the interest the smaller the money holdings Choice has to be made between holding domestic money,

domestic bond and foreign bond

Foreign bond imposes an exchange rate risk throughdepreciation of currency leading to capital loss.

It also allows for spread of risk between domestic and

foreign money


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Portfolio Balance Cont

Therefore a financial portfolio will hold domestic money,domestic bond and foreign bond.

Given a holders taste, preferences, wealth, level ofdomestic and foreign interest rates, expectations as to thefuture value of currency, rates of inflation at home andabroad- then individuals choose a portfolio that maximizestheir satisfaction.

An increase in foreign interest will prompt immediatepurchase of foreign bonds, this exchange rate increases

If domestic interest rates fall results in fall in exchange rate.

Increase in wealth increases demand for money, domesticand foreign bonds- purchase of foreign currency increases

in value.


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Portfolio

Accordingly exchange rate is determined by

equilibrium in each financial market.


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Extended Portfolio Balance Model

Includes factors that determine demand for money(M),

demand for domestic bond(D) and demand for the foreignbond(F).

Key factors I &I* and expected change in the spot rate(EA)-expected Appreciation, Risk premium(RP)-required to

compensate for additional risk of holding foreign bond,level of real income of output(Y), domestic price level(P)and wealth (W)

Recall Uncovered interest parity I=I*=EABut there is some risk involved which arise from unexpected

changes in the exchange rate/limitations that foreign nationsmight impose on transferring earnings.


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Extended Portfolio

The UIAP will include risk premium

I-I* =EA-RP

I= I*+EA-RP

M = f (I, I*, EA, RP, Y, P, W)

- + - + + + +

D = f( I, I*, EA, RP , Y, P, W )

+ - - + - - + F =f( I, I*, EA, RP , Y, P, W )

- + + - - - +


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or o o a ance

Therefore if M, D, F demand equal their supplies we

get equilibrium money balances, domestic bonds,foreign bonds as well as equilibrium rates of interest

and exchange rate.

Any change will ultimately affect these balance.

P tf li Adj t t d E h


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Portfolio Adjustments and Exchangerates

Shows mvts in exchange rates Say home nation engages in OMO (sale of gvt

bonds/securities)

Ms is reduced Bond price is reduced

Increases interest rates- leads to reduction in

M&F, while D increases.

Reduced demand for foreign bond lowers its price

and increases the foreign interest rate(I*)

Adj


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Adjustments

Sale of foreign bond and purchase of the domestic

bond by domestic and foreign residents involve sale

of foreign currency and purchase of domestic

currency.

Leads to appreciation of domestic currency and

depreciation of foreign currency.

We can do the same analysis with:

Expected appreciation

Increases in real income


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Exchange Rate Dynamics

Analyzing change in the exchange rate over time asit moves towards a new equilibrium level after an

exogenous change.

Oveshooting Model By Rudiger Dornbursch.


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Exchange rate Overshooting

Changes in interest rates, expectations, wealth disturbs

equilibrium and leads to investors reallocating financialassets to achieve new equilibrium or balanced portfolio.

Any change in the financial market results in an

immediate/instantaneous change in the stock of financialassets as investors attempt to quickly reestablish equilibrium

in their portfolios

An unanticipated increase in Ms results in decreases in

interest rates= investors shift money in favour of foreignbonds

Adjustment is huge and happens immediately.


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Overshooting

Activities in the goods market are slow e.g flow ofmerchandise trade.

Therefore changes in Ms increases depreciation of

currency immediately caused by interest rates fall in the

Short -run. In the long run trade flows will prevail.

The immediate rise of the exchange rate is called

Exchange rate Overshooting.


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Exchange Rate Overshooting


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Overshooting Exchange

Time Path to New Equilibrium and

Exchange rate

Ti P h


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Time Path

a. Increase in Ms by 10%

b. Increase in Ms leads to fall in interest rates

C. Increase in Ms have no immediate effect on

prices-Prices are assumed to be STICKY,

D. Shows purchase of currency as purchase of

domestic bonds increase.

Wh O h t


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Why Overshoots Recall UIP

I=I*+EA By assumption that domestic and foreign bonds are perfect

substitutesno risk premium.

Assuming also that EA=0

Therefore with any disturbance I=I*

Unanticipated changes in Ms leads to fall in interest rates

and therefore UIP will be balanced by expected

Appreciation.

Therefore currency depreciates in the short-run andincreasein the long run as goods market slowly adjust to bring back

equilibrium.

O h i


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Overshooting

Exchange rate overshooting is not limted to money

supply only but to any financial disturbance thatmay result in disturbances of the financial market.

Also variables which influence expectations

exchange rate determination chap 15

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