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Part 1Fundamentals of

International Finance -

Lecture n°3Exchange rate determination

International Finance

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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.

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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.

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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)

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Monetary approach

Monetarist approach - Theoretical remarks Based on very strong assumptions :

PPP holding continuouslyDemand for money as a stable function of income and

interest ratesPerfect 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.

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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.

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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 rateall () less ^y : aggregate demand equation^y aggregate supply, at full employment

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Monetary approachOvershooting model - Specification

Equations (1) and (2) lead to :s = s- + (1/) (m - p - y + i*) in logarithmmeaning 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.

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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.

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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.

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Portfolio approach

Portfolio models - Specification Consider 3 assets that investors hold and diversify

(imperfect substitutability - UIP does not hold):M : MoneyB : domestic bondsF : 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.

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Portfolio approachPortfolio 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.

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Portfolio approachPortfolio 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.

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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).

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Portfolio approach

Portfolio models - Graphical Equilibrium

Seq

i

S

i0

B

B

M

M

F

F

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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.

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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.

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“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?

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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.

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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 bubbleNeed for the hypothesis of limited rational

expectations and ‘near rational’ bubble : “there is always a greater fool out there”...

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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.