Exchange Rate Determination

Chapter 15

Introduction
Based on monetary approach and asset market or portfolio balance approach Exchange rate is a financial phenomena- modern theories

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

Weaknesses of Absolute PPP

Assumes trade in goods and services only but not capital A/c Non traded goods and services cant be arbitragedconsidered but part of general price level Assumes there are no transport cost and barriers to trade- wrong.

Relative PPP Theory

States that change in the exchange rate over a period of time should 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, trade obstructions leads to rejection of Absolute PPP. Only change in these will lead to rejection of relative PPP.

Challenges with Relative PPP

Balassa- Samuelson effect- ratio of the price of the price of non-traded to the price of traded goods and services is systematically higher in developed countries than developing countries. Results from labor productivity in traded goods being higher in developed than developing countries, but about the same in many non traded goods and services sectors. Services and non traded goods should receive almost same salary as traded in developed countries for pple to remain in the sector. This makes prices to be high in developed countries of non traded goods, hair cut may cost $10 in US and averages $1 in developing countries.

Challenges Cont
R PPP therefore tend to predict overvalued exchange rates for developed countries and undervalued for developing countries.

Relative PPP Empirical Test

Will work with highly traded individual commodities PPP works over very long periods Works during periods f monetary aggression and high inflation but not so well in stable conditions.

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 to nominal 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 out of nation.

Monetary Approach Flexible Exchange rates Under flexible exchange rates BoP are corrected automatically moving exchange rates- without inflow/outflow Occurs via change in prices Excess Ms, leads to depreciation of the currency then P 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 of money growth and Income.

Monetary Approach to Exchange Rate Determination

Assumes no barriers to trade, no transport cost, and PPP then according 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

Exchange Determination
Theory depends on PPP and law of one price Derived from money demand which does not include interest rates

Expectations , Interest Differentials,& Exchange rates Exchange rates depends on inflation expectations and expected changes in exchange rates. % changes in expected inflation will lead to equal % changes in exchange rates Using Uncovered interest argument- an expected change in exchange rate will lead to real change in exchange rate. Foreign and domestic bonds are perfect substitutes. i= i* = EA(expected %change in forex)appreciation of foreign currecy to domestic currency)

Expectations Cont
If Appreciation of foreign currency is more than interest differential, then Capital outflow. If I<I*, the foreign currency will depreciate.

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.

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 through depreciation of currency leading to capital loss. It also allows for spread of risk between domestic and foreign money

Portfolio Balance Cont

Therefore a financial portfolio will hold domestic money, domestic bond and foreign bond. Given a holders taste, preferences, wealth, level of domestic and foreign interest rates, expectations as to the future value of currency, rates of inflation at home and abroad- then individuals choose a portfolio that maximizes their satisfaction. An increase in foreign interest will prompt immediate purchase 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, domestic and foreign bonds- purchase of foreign currency increases in value.

Portfolio
Accordingly exchange rate is determined by equilibrium in each financial market.

Extended Portfolio Balance Model

Includes factors that determine demand for money(M), demand for domestic bond(D) and demand for the foreign bond(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*=EA But there is some risk involved which arise from unexpected changes in the exchange rate/limitations that foreign nations might impose on transferring earnings.

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 ) - + + - - +

Portfolio Balance
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.

Portfolio Adjustments and Exchange rates

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*)

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

Exchange Rate Dynamics

Analyzing change in the exchange rate over time as it moves towards a new equilibrium level after an exogenous change. Oveshooting Model By Rudiger Dornbursch.

Exchange rate Overshooting

Changes in interest rates, expectations, wealth disturbs equilibrium and leads to investors reallocating financial assets to achieve new equilibrium or balanced portfolio. Any change in the financial market results in an immediate/instantaneous change in the stock of financial assets 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 foreign bonds Adjustment is huge and happens immediately.

Overshooting
Activities in the goods market are slow e.g flow of merchandise 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.

Exchange Rate Overshooting

Overshooting Exchange Time Path to New Equilibrium and Exchange rate

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.

Why Overshoots
Recall UIP I=I*+EA By assumption that domestic and foreign bonds are perfect substitutes no 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 and increase in the long run as goods market slowly adjust to bring back equilibrium.

Overshooting
Exchange rate overshooting is not limted to money supply only but to any financial disturbance that may result in disturbances of the financial market. Also variables which influence expectations