Exchange Rate Determination Chap 15
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Transcript of 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