econ 141 fall 2013 slide set 5 asset approach to the exchange rate
TRANSCRIPT
Econ 141 Fall 2013
Slide Set 5Asset approach to the exchange rate
The Asset Approach to Exchange Rates
• Substantial deviations from purchasing power parity (PPP) occur in the short run: the same basket of goods generally does not cost the same everywhere at all times.
• These short-run failures of the monetary approach prompted economists to develop an alternative theory to explain exchange rates in the short run: the asset approach to exchange rates, the subject of this chapter.
• The asset approach is based on the idea that currencies are assets. • The price of the asset in this case is the spot exchange rate, the price of
one unit of foreign exchange.
Exchange Rates and Interest Rates in the Short Run
The beginning point is to return to the uncovered interest parity (UIP) equation. This is the fundamental equation of the asset approach to exchange rates.
Interest Rates, Exchange Rates, Expected Returns, and FX Market Equilibrium
This table is a numerical example from the text. It shows how the current exchange rate depends on the expected future exchange rate.
Equilibrium in the FX market
The foreign return given the expected future exchange rate is downward sloping in the current exchange rate. In this graph, the home and foreign nominal interest rates are given.
Changes in Home and Foreign Bond Returns
• To illustrate how the exchange rate responds to changes in interest rates and expectations, we can use the numerical example.
• We consider three different shocks:
a. A higher domestic interest rate (i$ = 7%)b. A lower foreign interest rate (i€ = 1%)c. A lower expected future exchange rate (Ee
$/€ = 1.20)
Changes in Domestic and Foreign Returns and FX Market Equilibrium
a. A rise in the U.S. interest rate from 5% to 7% shifts up the horizontal line which indicates U.S. returns to U.S. bonds.
The exchange rate today is lower.
b. A fall in the euro interest rate from 3% to 1% lowers returns to holding euros and reduces the expected return in dollars from holding euro bonds unless the exchange falls. It must fall in equilibrium.
Changes in Domestic and Foreign Returns and FX Market Equilibrium
c. A fall in the expected future exchange rate from 1.224 to 1.20 lowers expected dollar returns to holding euro bonds. The equilibrium exchange rate must again fall.
Changes in Domestic and Foreign Returns and FX Market Equilibrium
Money Market Equilibrium in the Short Run: Nominal Interest Rates
The short run vs. the long run:1. In the short run, the price level is sticky; it is a known
predetermined variable, 2. In the short run, the nominal interest rate i is fully flexible and
adjusts to bring the money market to equilibrium.The assumption of sticky prices is also called nominal rigidity.
PP
MUS
P US
U.S. supply ofreal money balances
L(i$ )YUS
U.S. demand forreal money balances
balancesmoney realfor demandEuropean
balancesmoney realofsupply European
)( EUREUR
EUR YiLP
M
The expressions for money market equilibrium in the two countries are as follows:
Money Market Equilibrium in the Short Run: Nominal Interest Rates
Money Market Equilibrium in the Short Run
Money Market Equilibrium in the Short Run
Can Central Banks Always Control the Interest Rate? A Lesson from the Crisis of 2008–2009
• In the United States, the Federal Reserve sets as its policy rate the interest rate that it charges banks for overnight loans.
• In normal times, changes in this cost of short-term funds for the banks are usually passed through into the market rates the banks charge to borrowers as well as on interbank loans between the banks themselves.
• This process is one of the most basic elements in the so-called transmission mechanism through which the effects of monetary policy are eventually felt in the real economy.
• In the recent crisis, although the Fed lowered the Fed Funds Rate from 5.25% to 0% during 2007 and 2008, there was no similar decrease in market rates.
• A second problem arises once policy rates hit the zero lower bound (ZLB). At that point, central banks exhaust their capacity to lower policy rates further. However, many central banks wanted to keep reducing market interest rates to ease financial markets. The Fed’s response was a policy of quantitative easing.
Can Central Banks Always Control the Interest Rate? A Lesson from the Crisis of 2008–2009
The Fed undertook several extraordinary policy actions to increase the money supply rapidly:1. It expanded the range of credit securities it would accept as
collateral to include lower-grade, private-sector bonds.2. It expanded the range of securities that it would buy outright to
include private-sector credit instruments such as commercial papers and mortgage-backed securities.
3. It expanded the range of counterparties from which it would buy securities to include some nonbank institutions such as primary dealers and money market funds.
Can Central Banks Always Control the Interest Rate? A Lesson from the Crisis of 2008–2009
Broken monetary transmission: the Fed’s extraordinary interventions did little to change private credit market interest rates in 2008–2009.
Interest rates during the crisis of 2008–2009
The Monetary Model: The Short Run versus the Long Run
To understand how the short run and long run exchange rates are related, we consider how monetary policy in one country affects the exchange rate.
To begin, we look at how a change in monetary policy affects the interest rate in the long run and short run.
For a single economy:Increasing the money supply growth rate raises the long-run nominal
interest rate through the Fisher effect.Raising the current money supply lowers the interest rate when prices
are sticky.A higher growth money supply growth rate also increases real balances
in the short run and lowers the interest rate.
Monetary expansions and interest rates
Suppose the growth rate of the home money supply has been zero. The central bank now increases its money supply growth rate to 5%.
1. If the expansionary monetary policy is expected to be a permanent (that is, for the long run), the long-run monetary approach tells us that the home nominal interest rate will rise by 5% in the long run.
2. If the monetary expansion is expected to be temporary, then (all else equal) the real money balances rise in the short run. The home interest rate will fall in the short run.
Monetary policy and the exchange rate
The importance of capital mobility
The domestic return (DR) equals the foreign return (FR) in equilibrium because financial capital is perfectly mobile. Foreigners can buy U.S. assets and U.S. residents can buy foreign assets. If capital controls are imposed, financial market arbitrage is not possible and there is no reason why DR has to equal FR.
Monetary policy and the exchange rate
Monetary policy in the short run
An increase in the U.S. money supply MUS raises real money balances, MUS /PUS in the short run. This leads to a drop in the U.S. interest rate, iUS .
To maintain equality between domestic returns (DR) and foreign returns (FR), the current exchange rate, , must fall given the future expected exchange rate, . eE €/$
€/$E
Monetary policy in the short run
Monetary policy in the short run
In graph (a), the U.S. (home) money supply does not change. Graph (b) shows an increase in the European (foreign) money supply leading to a fall in the euro interest rate from i1
€ to i2€.
If the exchange rate does not change, the foreign return in dollars, i€ + (Ee$/ €
− E$/€)/E$/€, falls as i€ falls. For domestic and foreign returns in the FX market to be equal, the exchange rate falls (the dollar appreciates) from E1
$/€ to E2$/€. The
new equilibrium is at point 2 .′
Monetary policy in the short run
The euro and the dollar, 1999-2004
The dollar appreciated against the euro from 1999 to 2001. The Fed Funds Rate was reduced starting in early 2001 and the dollar depreciated against the euro from 2001 to 2004.
Putting the Monetary and Asset Approaches Together:a) The asset approach:The monetary approach tells us how exchange rates are determined in
the long run. The asset approach tells us how they are determined in the short run.
To link the long and short runs, begin in the short run with short-run money market equilibrium and uncovered interest parity:
€/$
€/$€/$€$
€
$
])(/[
])(/[
E
EEii
YiLMP
YiLMP
e
EUREUREUREUR
USUSUSUS
b) The monetary approach: To forecast the future expected exchange rate, we use the long-run
monetary model and purchasing power parity:
Using both parts as building blocks, we will be able to understand how the two key mechanisms of expectations and arbitrage work to determine exchange rates in the short run and in the long run.
/
])(/[
])(/[
€/$
€
$
eEUR
eUS
e
eEUR
eEUR
eEUR
eEUR
eUS
eUS
eUS
eUS
PPE
YiLMP
YiLMP
Putting the Monetary and Asset Approaches Together:
The monetary and asset approaches together
Permanent expansion in the home money supply in the short run – first effects.
Permanent expansion in home money supply – the exchange rate depreciates in the short run and the expected future exchange rate depreciates. The change in expectations shifts the FR line upward.
The monetary and asset approaches together
The long-run adjustment: In the long-run all prices are flexible so the home price level and the long-run exchange rate rise in proportion to the permanent increase in the home money supply. Real money balances eventually return to their original level.
The monetary and asset approaches together
Long-run adjustment: As home real money balances and interest rates return to their original levels. The FR curve remains shifted outward, and the long-run exchange rate has depreciated.
The monetary and asset approaches together
Overshooting
What happened when the home money supply rose permanently?1. Home real money balances rose, reducing the home interest rate, in the short run.2. In the long-run, real money balances and the interest rate return to their initial levels.3. The exchange rate rises in the short run and in the long run.4. But in the short run it is higher than in the long run:
falls first and then rises toward the long run.
€/$
€/$€/$€$ E
EEii
e
$i
Overshooting
Permanent increase in MUS
In graph (a), there is a one-time permanent increase in U.S. nominal money supply at time T.In graph (b), the real money supply rises in the short run and the U.S. interest rate falls because prices are sticky in the short run.
Overshooting
In graph (c), prices rise in the same proportion as the money supply in the long run.In graph (d), the exchange rate overshoots its long-run value (the dollar depreciates a lot) in the short run, but in the long run, the exchange rate rises only in proportion to changes in money and prices.
Is there overshooting in the data?
Exchange rates for major currencies under Bretton Woods and after. Exchange rates were stable under adjustable pegs from 1950 to 1973. In 1973, these currencies officially floated against the dollar.
Fixed Exchange Rates and the ‘Trilemma’
Fixed exchange rate regimes
• We next learn how fixed rate regimes without capital controls operate. • Capital is mobile and the foreign exchange market is open to arbitrage. • Exchange rate intervention takes the form of the central bank buying
and selling foreign currency at a fixed price so as to keep the market exchange rate equal to the fixed level, E.
• For example, the Foreign country is the Eurozone, and the Home country is Denmark. What happens when Denmark decides to peg the krone to the euro at a fixed rate: EDKr/€
Interest rates and the DKr-euro exchange rate
1999
M01
1999
M06
1999
M11
2000
M04
2000
M09
2001
M02
2001
M07
2001
M12
2002
M05
2002
M10
2003
M03
2003
M08
2004
M01
2004
M06
2004
M11
2005
M04
2005
M09
2006
M02
2006
M07
2006
M12
2007
M05
2007
M10
2008
M03
2008
M08
2009
M01
2009
M06
2009
M11
2010
M04
2010
M09
2011
M02
2011
M07
0
1
2
3
4
5
6
7
8
euro interest rate krone interest rate exchange rate (DKr per euro)
Interest differentials and the DKr-euro exchange rate
1999M02 1999M11 2000M08 2001M05 2002M02 2002M11 2003M08 2004M05 2005M02 2005M11 2006M08 2007M05 2008M02 2008M11 2009M08 2010M05 2011M02
-2
-1.5
-1
-0.5
0
0.5
interest differential rate of depreciation
• The Danish price level is determined by PPP in the long run. With the exchange rate is pegged, the long-run price level for Denmark is
and the long-run inflation rate is• The long-run nominal interest for Denmark equals the Eurozone rate
• Because the long-run price level and interest rate are outside Danish control,
the Danish central bank cannot choose the money supply, MDEN .
That is, Denmark gives up monetary policy autonomy by adopting the peg.
EURDKrDEN PEP €/
,)()( €/ DENEURDENEURDKrDENDKrDENDENDEN YiLPEYiLPM
Fixed rates and monetary policy autonomy in the long run
.EURDEN
EUREURDENDEN irri **
The long-run theory still works, but with the chain of causality changes:
• With a floating exchange rate, the Danish central bank can choose the Danish money supply MDEN.
• In the long run, the money supply growth rate determines the interest rate i (via the Fisher effect) and the price level PDEN.
• Through PPP, the level of PDEN determines the exchange rate EDKr/€. • The money supply is a policy instrument (an exogenous variable), and
the exchange rate is an outcome from a policy choice (an endogenous variable).
Fixed rates and monetary policy autonomy in the long run
The long-run theory still works, but with the chain of causality changes:
• With a fixed exchange rate, this logic is reversed. • The Danish central bank chooses the exchange rate EDKr/€. • In the long run, the choice of E determines the price level PDEN through PPP,
and the interest rate iDKr through UIP.• The necessary level of the money supply MDEN is determined by the price level
and interest rate as
• The exchange rate is now the policy instrument, and the money supply is an outcome of that choice (an endogenous variable).
Fixed rates and monetary policy autonomy in the long run
.)( €/ DENEURDENEURDKrDEN YiLPEM
• The central bank can consider the three desirable policy goals:
• A fixed exchange rate may be desired to promote stability in trade and investment.
• International capital mobility may be desired as a means to promote economic integration, efficiency and risk sharing.
• Monetary policy autonomy may be desired as a means for managing the domestic business cycle and maintain low unemployment.
The Trilemma
• Each of these policy goals is represented by an relationship:
• A fixed exchange rate
• International capital mobility
• Monetary policy autonomy
The Trilemma
0 €/
€/€/
DKr
DKreDKr
E
EE
€ €/
€/€/ iiE
EEDKr
DKr
DKreDKr
€€/ iiDKr
These three relationships cannot all be satisfied at the same time.• We can have capital mobility and a fixed exchange rate,
by always letting • Or, we can have capital mobility and monetary autonomy by letting
The Trilemma
€ €/
€/€/ iiE
EEDKr
DKr
DKreDKr
0
€/
€/€/
DKr
DKreDKr
E
EE
€€/ iiDKr
0€ €/
€/€/
iiE
EEDKr
DKr
DKreDKr
These three relationships cannot all be satisfied at the same time.• We cannot choose a fixed exchange rate and monetary autonomy,
without possibly violating UIP. Thus, arbitrage in foreign exchange cannot be allowed – capital mobility must be restricted.
• This idea of having to choose two of three in open economy monetary policy is called the trilemma.
The Trilemma
0 €/
€/€/
DKr
DKreDKr
E
EE€€/ iiDKr
The trilemma in a cute diagram
Managed float – Bretton Woods
How Bretton Woods ended
How Bretton Woods ended
From Bretton Woods to the euro
Who started it
Harry Dexter White and J.M. Keynes were the U.S. and U.K. negotiators.
Who ended it
Richard Nixon