economics of international finance econ. 315

Economics of International Finance Economics of International Finance Prof. M. El-SaqqaProf. M. El-Saqqa CBA. Kuwait University CBA. Kuwait University

Economics of International FinanceEconomics of International FinanceEcon. 315Econ. 315

Chapter 3Chapter 3Exchange Rate DeterminationExchange Rate Determination


Purchasing Power Parity Theory (PPP)Purchasing Power Parity Theory (PPP)

The Law of One Price (LOOP)The Law of One Price (LOOP)

the the same same good (x) in different competitive markets must good (x) in different competitive markets must sell for sell for the same pricethe same price in the absence of transportation costs and trade in the absence of transportation costs and trade barriers between these markets i.e.,barriers between these markets i.e.,

PPxx= (R) . (P= (R) . (P**xx))

Absolute PPP:Absolute PPP:

Is the application of the law of one price across countries for Is the application of the law of one price across countries for all all goodsgoods and services, or for representative groups (baskets) of goods and services, or for representative groups (baskets) of goods and services: and services:

P = (R) . (PP = (R) . (P**) ) R= P/P*R= P/P*


PPP Postulates that equilibrium exchange rate between two PPP Postulates that equilibrium exchange rate between two currencies equals the ratio of the price levels in the two nations.currencies equals the ratio of the price levels in the two nations.

If the price of a bushel of wheat in USA is $1 and in EMU area is If the price of a bushel of wheat in USA is $1 and in EMU area is €1 then the exchange rate between the two currencies is $1/€1 = 1. €1 then the exchange rate between the two currencies is $1/€1 = 1. This is the loop.This is the loop.

according to LOOPaccording to LOOP (a given commodity should have the same (a given commodity should have the same price, so that the purchasing power of the two currencies is at price, so that the purchasing power of the two currencies is at parity)parity). .

If the price of the good in the two countries is different (e.g., $ 0.5 If the price of the good in the two countries is different (e.g., $ 0.5 in USA and $ 1.5 in EMU area), firms would purchase the good in in USA and $ 1.5 in EMU area), firms would purchase the good in USA and resell it in EMU area. This USA and resell it in EMU area. This commodity arbitragecommodity arbitrage causes causes the price of wheat to be the same in the two markets (assuming no the price of wheat to be the same in the two markets (assuming no transportation costs or subsidies ..etc). transportation costs or subsidies ..etc).


Relative PPP theoryRelative PPP theory

The changeThe change in the exchange rate should be proportional to the in the exchange rate should be proportional to the relative change in the price levels (relative change in the price levels (inflationinflation) in the two nations over ) in the two nations over the same period. the same period.

R1 = ((pR1 = ((p11/p/p00)/(p)/(p**11/p/p**

00)).R)).R00

R1 and R0 are exchange rates in period (1) and base period (0), the R1 and R0 are exchange rates in period (1) and base period (0), the same for the price level P.same for the price level P.

Example, if R0 = $1/€1, and there is no change in the price level of Example, if R0 = $1/€1, and there is no change in the price level of the EMU area, while in the US the price increases by 50% the EMU area, while in the US the price increases by 50% the US the US $ should depreciate by 50% compared to the base period. $ should depreciate by 50% compared to the base period. [(1.5/1)/(1/1) . 1= $1.5/ € 1 [(1.5/1)/(1/1) . 1= $1.5/ € 1

(i.e. (1.5-1)/1 = 50% depreciation of the US $)](i.e. (1.5-1)/1 = 50% depreciation of the US $)]


Big Mac indexBig Mac index: : From Wikipedia, the free encyclopedia ( (Redirected from Tall Latte index)) From Wikipedia, the free encyclopedia ( (Redirected from Tall Latte index)) McDonald’s Big Mac purchased in Australia. The Big Mac index is an informal way of measuring the McDonald’s Big Mac purchased in Australia. The Big Mac index is an informal way of measuring the

(PPP) between two countries and provides a test of the extent to which market exchange rates result in (PPP) between two countries and provides a test of the extent to which market exchange rates result in goods costing the same in different countries.goods costing the same in different countries.

The Big Mac index was introduced by the Economist newspaper in September 1986 as a humourous The Big Mac index was introduced by the Economist newspaper in September 1986 as a humourous illustration and has been published by that paper more or less annually since then. The index also illustration and has been published by that paper more or less annually since then. The index also gave rise to the word Burgernomics. gave rise to the word Burgernomics.

One suggested method of predicting exchange rate movements is that the rate between two currencies One suggested method of predicting exchange rate movements is that the rate between two currencies should naturally adjust so that a sample basket of goods and services should cost the same in both should naturally adjust so that a sample basket of goods and services should cost the same in both currencies. In the Big Mac index, the "basket" in question is considered to be a single Big Mac as sold currencies. In the Big Mac index, the "basket" in question is considered to be a single Big Mac as sold by the Macdonald’s fast food restaurant chain. The Big Mac was chosen because it is available to a by the Macdonald’s fast food restaurant chain. The Big Mac was chosen because it is available to a common specification in many countries around the world, with local McDonald's franchisees having common specification in many countries around the world, with local McDonald's franchisees having significant responsibility for negotiating input prices. For these reasons, the index enables a significant responsibility for negotiating input prices. For these reasons, the index enables a comparison between many countries' currencies.comparison between many countries' currencies.

The Big Mac PPP exchange rate between two countries is obtained by dividing the cost of a Big Mac in The Big Mac PPP exchange rate between two countries is obtained by dividing the cost of a Big Mac in one country (in its currency) by the cost of a Big Mac in another country (in its currency). This value is one country (in its currency) by the cost of a Big Mac in another country (in its currency). This value is then compared with the actual exchange rate; if it is lower, then the first currency is under-valued then compared with the actual exchange rate; if it is lower, then the first currency is under-valued (according to PPP theory) compared with the second, and conversely, if it is higher, then the first (according to PPP theory) compared with the second, and conversely, if it is higher, then the first currency is over-valued.currency is over-valued.

For example, suppose a Big Mac costs $2.50 in the United States and £2.00 in the United Kingdom; For example, suppose a Big Mac costs $2.50 in the United States and £2.00 in the United Kingdom; thus, the PPP rate is 2.50/2.00 = 1.25. If, in fact, the dollar buys £0.55 (or £1 = $1.81), then the pound is thus, the PPP rate is 2.50/2.00 = 1.25. If, in fact, the dollar buys £0.55 (or £1 = $1.81), then the pound is over-valued (1.81 > 1.25) with the respect to the dollar by 44.8% in comparison with the costs of the Big over-valued (1.81 > 1.25) with the respect to the dollar by 44.8% in comparison with the costs of the Big Mac in both countries (information as of 2005).Mac in both countries (information as of 2005).

In January 2004, The Economist introduced a sister Tall Latte index. The idea is the same, except that In January 2004, The Economist introduced a sister Tall Latte index. The idea is the same, except that the Big Mac is replaced by a cup of Starbucks coffee, acknowledging the global spread of that chain in the Big Mac is replaced by a cup of Starbucks coffee, acknowledging the global spread of that chain in recent years. In a similar vein, in 1997, the newspaper drew up a “ Coca Cola map" that showed a recent years. In a similar vein, in 1997, the newspaper drew up a “ Coca Cola map" that showed a strong positive correlation between the amount of Coke consumed per capita in a country and that strong positive correlation between the amount of Coke consumed per capita in a country and that country's wealth.country's wealth.

The burger methodology has limitations in its estimates of the PPP. In many countries, eating at The burger methodology has limitations in its estimates of the PPP. In many countries, eating at international fast-food chain restaurants such as McDonald’s is relatively expensive in comparison to international fast-food chain restaurants such as McDonald’s is relatively expensive in comparison to eating at a local restaurant, and the demand for Big Macs is not as large in countries like India as in the eating at a local restaurant, and the demand for Big Macs is not as large in countries like India as in the United States. Whereas low income Americans may eat at McDonalds a few times a week, low income United States. Whereas low income Americans may eat at McDonalds a few times a week, low income Malysians probably never eat Big Macs. Social status of eating at fast food restaurants like Malysians probably never eat Big Macs. Social status of eating at fast food restaurants like McDonald's, local taxes, levels of competition, and import duties for burgers may not be representative McDonald's, local taxes, levels of competition, and import duties for burgers may not be representative of the country's economy as a whole. In addition, there is no theoretical reason why non-tradable of the country's economy as a whole. In addition, there is no theoretical reason why non-tradable goods and services such as property costs should be equal in different countries. Nevertheless, the goods and services such as property costs should be equal in different countries. Nevertheless, the Big Mac index has become widely cited by economists.Big Mac index has become widely cited by economists.


BIG MAC INDEXBIG MAC INDEX The EconomistThe Economist's Big Mac index is based on the theory of purchasing-power parity 's Big Mac index is based on the theory of purchasing-power parity (PPP), according to which exchange rates should adjust to equalize the price of a (PPP), according to which exchange rates should adjust to equalize the price of a basket of goods and services around the world. Our basket is a burger: a McDonald’s basket of goods and services around the world. Our basket is a burger: a McDonald’s Big Mac.Big Mac.

The table below shows by how much, in Big Mac PPP terms, selected currencies The table below shows by how much, in Big Mac PPP terms, selected currencies were over- or undervalued at the end of January. Broadly, the pattern is such as it were over- or undervalued at the end of January. Broadly, the pattern is such as it was last spring, the previous time this table was compiled. The most overvalued was last spring, the previous time this table was compiled. The most overvalued currency is the Icelandic kronur: the exchange rate that would equalize the price of an currency is the Icelandic kronur: the exchange rate that would equalize the price of an Icelandic Big Mac with an American one is 158 kronur to the dollar; the actual rate is Icelandic Big Mac with an American one is 158 kronur to the dollar; the actual rate is 68.4, making the kronur 131% too dear. The most undervalued currency is the 68.4, making the kronur 131% too dear. The most undervalued currency is the Chinese yuan, at 56% below its PPP rate; several other Asian currencies also appear Chinese yuan, at 56% below its PPP rate; several other Asian currencies also appear to be 40-50% undervalued.to be 40-50% undervalued.

The index is supposed to give a guide to the direction in which currencies should, in The index is supposed to give a guide to the direction in which currencies should, in theory, head in the long run. It is only a rough guide, because its price reflects non-theory, head in the long run. It is only a rough guide, because its price reflects non-tradable elements—such as rent and labor. For that reason, it is probably least rough tradable elements—such as rent and labor. For that reason, it is probably least rough when comparing countries at roughly the same stage of development. Perhaps the when comparing countries at roughly the same stage of development. Perhaps the most telling numbers in this table are therefore those for the Japanese yen, which is most telling numbers in this table are therefore those for the Japanese yen, which is 28% undervalued against the dollar, and the euro, which is 19% overvalued. Hence 28% undervalued against the dollar, and the euro, which is 19% overvalued. Hence European finance ministers’ beef with the low level of the yenEuropean finance ministers’ beef with the low level of the yen Source: The EconomistSource: The Economist..


Implied PPP=Implied PPP=(domestic price of big (domestic price of big Mac in US Mac in US dollars/USA price of dollars/USA price of the big Mac) x (actual the big Mac) x (actual exchange rate of the exchange rate of the US dollar.US dollar.e.g., e.g., In ArgentinaIn ArgentinaPPP* = PPP* = (4.64/4.20)*4.31 (4.64/4.20)*4.31 = 4.77= 4.77

This is what the This is what the exchanger rate should exchanger rate should be. be.

But the actual rate is But the actual rate is 4.31. This means that 4.31. This means that the Argentina peso is the Argentina peso is undervalued by undervalued by =(4.31-4.77)/4.77=(4.31-4.77)/4.77= -10.47%= -10.47%according to the big according to the big Mac index.Mac index.


This is the new

big Mac index in

Feb 2009.

Compare

to last slide

Source: http://www.economist.com/markets/indicators/displaystory.cfm?story_id=13055650


Under and over

valuation in 2009.

Compare with last

slide.


•The Economist magazine launched its "Tall Latte Index." Like its counterpart the Big Mac Index, which the Economist launched in 1986, the new ranking is meant to show how currency-exchange rates translate to actual purchasing power.

•Quite simply, the index shows how many lattes (as opposed to Big Macs) U.S. dollars buy in a given country when exchanged for the local currency.

•One theory has it that, if all is working right in currency markets, the price of baskets of goods should be the same all over the world. Deviations can suggest that a currency is over- or under-valued. The cost of doing business from place to place may be a factor, too.

•The idea works best with goods that are more or less the same from country to country. Anywhere a Big Mac is sold, of course, it consists of two all beef patties, special sauce, lettuce, cheese, pickles, onions, and a sesame seed bun.

•Now comes the latte. Starbucks uses the same formula to appeal to caffeine freaks in 34 countries, and innumerable languages. (Let's see, what's the French term for "yuppie

•To come up with the index, the magazine determined the average price of a latte in 16 countries outside of the United States. Then it used the most recent exchange rates to see what the frothy drink costs in dollars.

•Here in the United States, according the index, the average price of a latte is $2.80. In Thailand, caffeine fiends will pay only $1.93 to get their fix, while in Switzerland they'll have to shell out $4.54.

•The average price of a tall latte in countries that are part of the European Union, meanwhile, is 2.93 euros or about $3.70.

•Oddly enough, both the Starbucks latte and the Big Mac cost $2.80 in the United States. Yet, in a number of countries there's a significant price gap between the coffee and the burger.

•In Hong Kong, a tall latte is $3.22, but a Big Mac is only $1.54. In Britain and Switzerland, however, you'll actually pay more for a Big Mac than you will for a latte.

•Source: http://www.finfacts.com/Private/bestprice/latteindex.htmhttp://www.finfacts.com/Private/bestprice/latteindex.htm

Tall latte index

http://www.starbucks.com/retail/nutrition_beverages.asp


The two indices may produce different results. The following is a comparison for the year 2004.

SourceL Economist Newspaper Group, Incorporated, January 17, 2004, 370(8258), 75.


Empirical tests of PPP Empirical tests of PPP

1.1. PPP works well for PPP works well for highly tradedhighly traded goods, e.g., wheat and steel, but less goods, e.g., wheat and steel, but less well for well for all traded goodsall traded goods together, and not so well for together, and not so well for all goodsall goods (which (which includes includes non-tradednon-traded commodities). commodities).

2.2. PPP works reasonably well over PPP works reasonably well over very long periodsvery long periods of time, and not well of time, and not well in the short run.in the short run.

3.3. PPP works well in cases of purely PPP works well in cases of purely monetary disturbancesmonetary disturbances and in and in inflationary periodsinflationary periods, but not so well in periods of , but not so well in periods of monetary stabilitymonetary stability and not well at all in situations of and not well at all in situations of major structural changemajor structural change..

Reasons why PPP may fail empirically:Reasons why PPP may fail empirically:

1. Trade barriers, transportation costs, and non-tradable goods and services2. Imperfect competition in product markets (price discrimination across

markets)3. Differences in price level measures (different “consumption baskets”)


The monetary approach to BOP and exchange ratesThe monetary approach to BOP and exchange ratesConcentrates on monetary factors to predict long-run adjustment of nominal Concentrates on monetary factors to predict long-run adjustment of nominal

exchange rates:exchange rates:1.1. Based on the PPP condition.Based on the PPP condition.2.2. Uses the long-run assumption of fully flexible prices.Uses the long-run assumption of fully flexible prices.3.3. Price levels adjust to equate real aggregate Price levels adjust to equate real aggregate money supplymoney supply with real aggregate with real aggregate

money demandmoney demand::

Monetary approach to BOP under Monetary approach to BOP under fixed exchange ratesfixed exchange rates

The demand for money:The demand for money:

1.1. Positively related to the level of nominal income.Positively related to the level of nominal income.2.2. Stable in the long run.Stable in the long run.

Md = kPYMd = kPY

k k = = the desired ratio of nominal money balances to nominal income (1/v).the desired ratio of nominal money balances to nominal income (1/v).P = price levelP = price level Y = real incomeY = real income

The demand for money is also inversely related to the interest rate.The demand for money is also inversely related to the interest rate.


The supply of moneyThe supply of money

Ms = m (D+F)Ms = m (D+F)

m = money multiplier (1/rrr) [we assume that it is constant]m = money multiplier (1/rrr) [we assume that it is constant]D = domestic component of the nation’s D = domestic component of the nation’s monetary basemonetary base. It is the domestic credit . It is the domestic credit

created by the nation’s monetary authorities, or the domestic assets backing created by the nation’s monetary authorities, or the domestic assets backing the nation’s money supply (mainly government bonds). the nation’s money supply (mainly government bonds).

F = international component of the F = international component of the monetary basemonetary base (international reserves of the (international reserves of the nation, e.g., in US $ and SDRs), D+F = the monetary base. nation, e.g., in US $ and SDRs), D+F = the monetary base.

Starting from the equilibrium where Starting from the equilibrium where Md = Ms (m (D+F))Md = Ms (m (D+F)), , an increase in an increase in MdMd can be satisfied either by: can be satisfied either by:

an increase in D or,an increase in D or, inflow of F (BOP surplus).inflow of F (BOP surplus).

If D does not increase, the extra demand will be satisfied by an increase in F.If D does not increase, the extra demand will be satisfied by an increase in F.

Hence, a Hence, a surplus in BOP resultssurplus in BOP results from an excess in the stock of money from an excess in the stock of money demanded that is not satisfied by an increase in D. demanded that is not satisfied by an increase in D.


An increase in D, and Ms in the face of unchanged Md, F flows out the nation An increase in D, and Ms in the face of unchanged Md, F flows out the nation and leads to a and leads to a fall in F (BOP deficit).fall in F (BOP deficit).

Hence, a deficit in BOP results from an excess in Ms that is not eliminated by Hence, a deficit in BOP results from an excess in Ms that is not eliminated by the nation’s monetary authority, but is corrected by an outflow of F.the nation’s monetary authority, but is corrected by an outflow of F.

Note That:Note That:

1.1. Under fixed exchange rate the nation has Under fixed exchange rate the nation has no control over its money supplyno control over its money supply system. The size of Ms will be the one that is consistent with BOP system. The size of Ms will be the one that is consistent with BOP equilibrium.equilibrium.

2.2. The nation’s BOP surplus or deficit isThe nation’s BOP surplus or deficit is temporary temporary and and self correctingself correcting in the in the long run. long run.

3.3. After any excess demand or supply of money is eliminated through an After any excess demand or supply of money is eliminated through an inflow inflow or outflow of fundsor outflow of funds, the BOP surplus or deficit is corrected and the , the BOP surplus or deficit is corrected and the international flow of money dries up and comes to an end. international flow of money dries up and comes to an end.

e.g., if GDP increases from 1 bn, to 1.1 bn, if v = 5, Md will increase from 200 e.g., if GDP increases from 1 bn, to 1.1 bn, if v = 5, Md will increase from 200 mn. to 220 mn. mn. to 220 mn.

If RRR = .2 and D is kept constant, F will have to increase by 4 million, such If RRR = .2 and D is kept constant, F will have to increase by 4 million, such that MS increases by 20 mn.that MS increases by 20 mn.


Monetary approach to BOP under flexible exchange rates.Monetary approach to BOP under flexible exchange rates.

Under flexible exchange rates, BOP is immediately corrected by Under flexible exchange rates, BOP is immediately corrected by automatic automatic changes in exchange rateschanges in exchange rates which causes prices to change which causes prices to change without any flow of without any flow of money or reservesmoney or reserves. Here the nation retains control over its Ms and monetary . Here the nation retains control over its Ms and monetary policy: policy:

A BOP deficit (resulting from excess Ms) leads to an A BOP deficit (resulting from excess Ms) leads to an automaticautomatic depreciationdepreciation causing the prices and Md to rise sufficiently to absorb the causing the prices and Md to rise sufficiently to absorb the excess Ms and eliminate the BOP deficit without a change in F. excess Ms and eliminate the BOP deficit without a change in F.

A BOP surplus (resulting from excess Md) leads to an A BOP surplus (resulting from excess Md) leads to an appreciationappreciation causing the prices to fall and eliminate excess Md and BOP surplus causing the prices to fall and eliminate excess Md and BOP surplus without a change in F. without a change in F.

Under a flexible exchange rate system, a Under a flexible exchange rate system, a BOP disequilibrium is immediately BOP disequilibrium is immediately corrected by an automatic change in exchange ratescorrected by an automatic change in exchange rates and without any and without any international flow of money or reserves. international flow of money or reserves.


The actual exchange value of the currency is determined by The actual exchange value of the currency is determined by the the rate of growth of money supply and real income in the rate of growth of money supply and real income in the nationnation relative to other nations. relative to other nations.

Note:Note:1.1. A currency depreciation results from excessive money growth A currency depreciation results from excessive money growth

in the nation over time. A currency appreciation results from in the nation over time. A currency appreciation results from inadequate money growth in the nation. inadequate money growth in the nation.

2.2. A nation facing greater inflationary pressures than other A nation facing greater inflationary pressures than other nations (resulting from more rapid growth in money in nations (resulting from more rapid growth in money in relation to real income and demand for money) will find its relation to real income and demand for money) will find its exchange rate rising (exchange rate rising (aa depreciationdepreciation). ).

3.3. A country facing lower inflationary pressures than the rest of A country facing lower inflationary pressures than the rest of the world, will find its exchange rate falling (the world, will find its exchange rate falling (an appreciationan appreciation). ).


Managed floating of exchange rateManaged floating of exchange rate

Under a managed floating, the authorities will intervene in Under a managed floating, the authorities will intervene in foreign exchange markets and either lose or accumulate foreign exchange markets and either lose or accumulate international reserves to prevent an excessive depreciation or international reserves to prevent an excessive depreciation or appreciation of its currency, i.e., Under the system part of appreciation of its currency, i.e., Under the system part of the BOP deficit is corrected by:the BOP deficit is corrected by:

a.a. One Part by a depreciation of the domestic currency,One Part by a depreciation of the domestic currency,b.b. The other part is corrected by a loss of international reserves The other part is corrected by a loss of international reserves

(F). (F).

The country’s money supply is also affected by Excessive or The country’s money supply is also affected by Excessive or inadequate money supply in other nations but to a smaller inadequate money supply in other nations but to a smaller extent than under flexible exchange rate system.extent than under flexible exchange rate system.


The monetary approach to exchange rate determinationThe monetary approach to exchange rate determination If markets are competitive and there are no tariffs, transportation costs or If markets are competitive and there are no tariffs, transportation costs or

other obstructions to trade, then according to LOOP the price of a commodity other obstructions to trade, then according to LOOP the price of a commodity must be the same in two countries.must be the same in two countries.

P = R P*P = R P*andand

R = P/P*R = P/P*

We can show that the exchange rate between two currencies is determined We can show that the exchange rate between two currencies is determined according to the monetary approach by using the according to the monetary approach by using the money demand in the two money demand in the two nations. nations.

Md = k PY and Md*=k *P*Y*Md = k PY and Md*=k *P*Y*

In equilibrium Md = Ms and Md* = Ms*In equilibrium Md = Ms and Md* = Ms*

Ms*/Ms = k* P*Y*/k PYMs*/Ms = k* P*Y*/k PY

Divide both sides by P*/P and Ms*/Ms we getDivide both sides by P*/P and Ms*/Ms we get


P/P* = Msk*Y*/Ms*kYP/P* = Msk*Y*/Ms*kY

But since R=P/P* we have;But since R=P/P* we have;

R = Ms k*Y* / Ms* kYR = Ms k*Y* / Ms* kY

Since k*and Y* as well as k and Y are assumed constant Since k*and Y* as well as k and Y are assumed constant R is constant as R is constant as long as Ms and Ms*long as Ms and Ms* remain unchanged. remain unchanged.

If k*y*(UK)/ky(USA) =1/2; and Ms(USA)/Ms*(UK)=4 then;If k*y*(UK)/ky(USA) =1/2; and Ms(USA)/Ms*(UK)=4 then;

R = 4/(1/2) = 2, i.e., $ 2 = £ 1R = 4/(1/2) = 2, i.e., $ 2 = £ 1

Changes in R are Changes in R are proportionalproportional to changes in Ms and to changes in Ms and inversely inversely proportionalproportional to changes in Ms* to changes in Ms*

If Ms increases by 10% in relation to Ms* If Ms increases by 10% in relation to Ms* R increases by 10% R increases by 10% (depreciation)(depreciation)


FIGURE 1 Relative Money Supplies and Exchange Rates.FIGURE 1 Relative Money Supplies and Exchange Rates.

The relationship between Ms in US relative to UK

S=MS(US)/MS(UK)

As S increases R rises (a depreciation of the $

depreciation


Note the following:Note the following:

1.1. R is derived from the demand for nominal money balances R is derived from the demand for nominal money balances that does not include that does not include interest ratesinterest rates

2.2. Exchange rates adjusts to clear money markets in each Exchange rates adjusts to clear money markets in each country without any flow of reserves. Hence For a small open country without any flow of reserves. Hence For a small open economy R depends on PPP and LOOPeconomy R depends on PPP and LOOP

3.3. In a small open economy, the PPP determines the price level In a small open economy, the PPP determines the price level under fixed exchange rates system and the exchange rates under fixed exchange rates system and the exchange rates under flexible exchange rates system.under flexible exchange rates system.


Expectations, Interest Differentials and Exchange RatesExpectations, Interest Differentials and Exchange Rates

Exchange rates depend not only on relative growth of Ms and y, Exchange rates depend not only on relative growth of Ms and y, but also on inflation expectations and expected changes in but also on inflation expectations and expected changes in exchange rates.exchange rates.

An increase in the expected rate of inflation in a nation leads to An increase in the expected rate of inflation in a nation leads to an immediate equal depreciation of the nation’s currency.an immediate equal depreciation of the nation’s currency.

An expected change in the exchange rate will also lead to an An expected change in the exchange rate will also lead to an immediate change in the exchange rate.immediate change in the exchange rate.

Using the theory of uncovered interest arbitrageUsing the theory of uncovered interest arbitrage

i – i* = EAi – i* = EA

EA = expected appreciation of foreign currencyEA = expected appreciation of foreign currency


If i = 6% and i* = 5%, the If i = 6% and i* = 5%, the expectationexpectation is that the foreign is that the foreign currency appreciates by 1% in order to make returns on investing currency appreciates by 1% in order to make returns on investing at home and abroad equal as required by uncovered interest at home and abroad equal as required by uncovered interest parity.parity.

If the If the expected appreciationexpected appreciation of the foreign currency of the foreign currency increasesincreases this would lead to an immediate this would lead to an immediate capital outflowcapital outflow and expected and expected depreciation depreciation falls to go back to uncovered interest parity.falls to go back to uncovered interest parity.

If interest differentials changes, the new If interest differentials changes, the new expected appreciationexpected appreciation will be different, but it will always have to will be different, but it will always have to equalequal the interest the interest differentials so as to satisfy the uncovered interest parity.differentials so as to satisfy the uncovered interest parity.


Asset Market Model and Exchange Rates:Asset Market Model and Exchange Rates:

The asset market or portfolio balance approach differs from the monetary The asset market or portfolio balance approach differs from the monetary approach in that:approach in that:

domestic and foreign bonds are assumed to be imperfect substitutesdomestic and foreign bonds are assumed to be imperfect substitutes, , and postulates. and postulates.

the exchange rate is determined in the process of the exchange rate is determined in the process of equilibrating or equilibrating or balancing the stock or total demand and supply of financial assetsbalancing the stock or total demand and supply of financial assets (of (of which money is one) in each country.which money is one) in each country.

Individuals and firms hold their financial assets in some combination of Individuals and firms hold their financial assets in some combination of domestic and foreign assets. The incentive to hold bonds results from the domestic and foreign assets. The incentive to hold bonds results from the yield or interest they provide. But they carry the risk of default, the risk yield or interest they provide. But they carry the risk of default, the risk arising from the variability of their market value over time. Domestic and arising from the variability of their market value over time. Domestic and foreign bonds are imperfect substitutes. Foreign bonds pose some foreign bonds are imperfect substitutes. Foreign bonds pose some additional risk with respect to domestic bonds. additional risk with respect to domestic bonds.

Holding domestic money, though riskless, but provides no interest. The Holding domestic money, though riskless, but provides no interest. The opportunity cost of holding domestic money is the yield forgone on opportunity cost of holding domestic money is the yield forgone on holding bonds. The higher the interest on bonds, the smaller is the quantity holding bonds. The higher the interest on bonds, the smaller is the quantity of money they will want to hold.of money they will want to hold.


The choice however is not only between holding domestic The choice however is not only between holding domestic money and bond, but also foreign bond. Foreign bond carries money and bond, but also foreign bond. Foreign bond carries additional risk; the foreign currency may depreciate. However, additional risk; the foreign currency may depreciate. However, holding a foreign bond allows individuals to spread their risk. holding a foreign bond allows individuals to spread their risk.

Factors that affect the portfolio choice are; tastes and Factors that affect the portfolio choice are; tastes and preferences, wealth, the level of domestic and foreign interest preferences, wealth, the level of domestic and foreign interest rates, expectations about future levels of inflation rates at home rates, expectations about future levels of inflation rates at home and abroad ..etc. A change in the underlying factors will prompt and abroad ..etc. A change in the underlying factors will prompt holders to reshuffle their portfolio until they achieved the desired holders to reshuffle their portfolio until they achieved the desired (equilibrium) portfolio.(equilibrium) portfolio.

An increase in interest rates raises the demand for the domestic An increase in interest rates raises the demand for the domestic bond, but reduces the demand for domestic money and the bond, but reduces the demand for domestic money and the foreign bond. As investors will sell the foreign bond, exchange foreign bond. As investors will sell the foreign bond, exchange foreign currency into domestic currency to acquire more of the foreign currency into domestic currency to acquire more of the domestic bond the exchange rate falls (appreciation).domestic bond the exchange rate falls (appreciation).


An increase in foreign interest rate raises the demand for the foreign bond but An increase in foreign interest rate raises the demand for the foreign bond but reduces the demand for the domestic bond and demand for money. The reduces the demand for the domestic bond and demand for money. The exchange rate rises (depreciation).exchange rate rises (depreciation).

An increase in wealth increases the demand for money for domestic and An increase in wealth increases the demand for money for domestic and foreign bonds. As investors buy foreign currency to acquire more of the foreign bonds. As investors buy foreign currency to acquire more of the foreign bond, the exchange rate also rises (depreciation). foreign bond, the exchange rate also rises (depreciation).

The asset market model is also called the The asset market model is also called the portfolio balance approachportfolio balance approach. If . If investors demand more of the foreign bond either because foreign interest investors demand more of the foreign bond either because foreign interest rose or their wealth increase, the demand for the foreign currency increases rose or their wealth increase, the demand for the foreign currency increases and this causes an increase in R (depreciation). and this causes an increase in R (depreciation).

If investors sell the foreign bond either because reduction of foreign interest, If investors sell the foreign bond either because reduction of foreign interest, or a reduction of their wealth, the supply of foreign currency increases or a reduction of their wealth, the supply of foreign currency increases causing a decrease in R (appreciation) causing a decrease in R (appreciation)

Hence Exchange rate is determined in the process of reaching Hence Exchange rate is determined in the process of reaching equilibrium in each financial market. equilibrium in each financial market.


Extended Asset Market ModelExtended Asset Market Model

Extended asset market model adds more complex set of Extended asset market model adds more complex set of variables that determines the demand for money M, the variables that determines the demand for money M, the demand for the domestic bond B and the foreign bond F, demand for the domestic bond B and the foreign bond F, which in the previous model depend on interest differentials which in the previous model depend on interest differentials (i-i*). (i-i*).

The variables added are the expected change in the spot rate The variables added are the expected change in the spot rate (EA), the risk premium RP, the level of real income Y, the (EA), the risk premium RP, the level of real income Y, the domestic price level (P), the wealth of the nation (W).domestic price level (P), the wealth of the nation (W).

We know that the uncovered interest parity condition is i-i* We know that the uncovered interest parity condition is i-i* = EA, EA is included as an additional explanatory variable = EA, EA is included as an additional explanatory variable in the demand function for M, D, and F in the assets market in the demand function for M, D, and F in the assets market model. model.


Since the domestic and foreign bond are imperfect substitutes, there is Since the domestic and foreign bond are imperfect substitutes, there is an extra risk in holding the foreign bond arising from unexpected an extra risk in holding the foreign bond arising from unexpected changes in the exchange rate (currency risk), and/or limitations foreign changes in the exchange rate (currency risk), and/or limitations foreign countries can put on transferring earnings back home. The uncovered countries can put on transferring earnings back home. The uncovered interest parity condition must be extended to be:interest parity condition must be extended to be:

i – i* = EA – RP i – i* = EA – RP So that So that

i = i* + EA – RPi = i* + EA – RP

This means that interest rate in the home country (i) must be equal to This means that interest rate in the home country (i) must be equal to the interest rate in the foreign country (i*) plus the expected the interest rate in the foreign country (i*) plus the expected appreciation (EA) minus the risk premium (RP) on holding foreign appreciation (EA) minus the risk premium (RP) on holding foreign assets.assets.

Example, if i = 4%, i* = 5% and EA = 1%, then RP on the foreign bond Example, if i = 4%, i* = 5% and EA = 1%, then RP on the foreign bond must be 2% in order to be at uncovered interest parity. If RP is only must be 2% in order to be at uncovered interest parity. If RP is only 1%, residents will buy more foreign bonds until the interest parity 1%, residents will buy more foreign bonds until the interest parity condition is satisfied. condition is satisfied.


The extended demand functions for M, D, and F are given by the The extended demand functions for M, D, and F are given by the following equations: following equations:

- - - + + + +- - - + + + + M=f( i, i*, EA, RP, Y, P, W) M=f( i, i*, EA, RP, Y, P, W)

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

Expected signs (direction of the relationship) are above each variable. Expected signs (direction of the relationship) are above each variable.

At equilibrium between the demand for M, D and F and the supply of At equilibrium between the demand for M, D and F and the supply of these assets, interest rates and exchange rates are simultaneously these assets, interest rates and exchange rates are simultaneously obtained. But since M, D and F are substitutes, any change in the value obtained. But since M, D and F are substitutes, any change in the value of any of the variables of the model will affect every other variable of of any of the variables of the model will affect every other variable of the model. For example any switch to or from money balances and/or the model. For example any switch to or from money balances and/or domestic bonds into foreign bonds affects the exchange rate because domestic bonds into foreign bonds affects the exchange rate because they involve the exchange of currencies. they involve the exchange of currencies.


Portfolio Adjustments and Exchange RatesPortfolio Adjustments and Exchange Rates

Example: suppose that the central bank engages in open Example: suppose that the central bank engages in open market sale of government securities (D) market sale of government securities (D) MS ↓ MS ↓ i ↑ i ↑ M M and F ↓, but D ↑. Foreign residents are also expected to and F ↓, but D ↑. Foreign residents are also expected to demand more D demand more D inflow of funds (moderates the increases inflow of funds (moderates the increases i*). The sale of F and purchase of D involves the sale of i*). The sale of F and purchase of D involves the sale of foreign currency and purchase of domestic currency foreign currency and purchase of domestic currency appreciation of the domestic currency (depreciation of the appreciation of the domestic currency (depreciation of the foreign).foreign).

The increase in i and i* and the appreciation of the domestic The increase in i and i* and the appreciation of the domestic currency (depreciation of the foreign) currency (depreciation of the foreign) larger expected larger expected future appreciation of the foreign currency (EA) and a future appreciation of the foreign currency (EA) and a reduction of RP (less F are now held), at the end when reduction of RP (less F are now held), at the end when equilibrium is reestablished in all markets simultaneously, equilibrium is reestablished in all markets simultaneously, the uncovered interest parity conditionthe uncovered interest parity condition holdsholds. .


Another example: suppose that EA is more than is Another example: suppose that EA is more than is previously believed, previously believed, M and D ↓ but F ↑ M and D ↓ but F ↑ i ↓, but the i ↓, but the outflow of funds moderate i fall and reduced i* rise. But the outflow of funds moderate i fall and reduced i* rise. But the higher demand for foreign currency leads to appreciation of higher demand for foreign currency leads to appreciation of the foreign currency (depreciation of the domestic), which the foreign currency (depreciation of the domestic), which moderates expected appreciation of the foreign currency, moderates expected appreciation of the foreign currency, again equilibrium will be established and uncovered interest again equilibrium will be established and uncovered interest parity holds.parity holds.

A third example, if Y and Y* ↑ A third example, if Y and Y* ↑ ↑ M, but D and F ↓ (due to ↑ M, but D and F ↓ (due to more demand for M), more demand for M), appreciation of the domestic appreciation of the domestic currency (depreciation of the foreign), these will affect other currency (depreciation of the foreign), these will affect other variables in the model until equilibrium is achieved, variables in the model until equilibrium is achieved, exchange rate stops changing.exchange rate stops changing.


Exchange Rate DynamicsExchange Rate Dynamics

Exchange rate dynamics: Exchange rate dynamics: the change in the exchange rate over the change in the exchange rate over time as it moves toward a new equilibrium level after an time as it moves toward a new equilibrium level after an exogenous change. exogenous change.

A- Exchange rate overshooting (R. Dornbusch 1976) A- Exchange rate overshooting (R. Dornbusch 1976)

We know that changes in the set of variables mentioned above We know that changes in the set of variables mentioned above lead investors to reallocate financial assets to balance their lead investors to reallocate financial assets to balance their portfolio. Financial assets are accumulated over a long period of portfolio. Financial assets are accumulated over a long period of time, i.e., they are time, i.e., they are very largevery large in relation to the annual flows in relation to the annual flows (changes in their stock) through savings and investments. (changes in their stock) through savings and investments.

Changes in one of the variables (e.g., interest rates) affect returns Changes in one of the variables (e.g., interest rates) affect returns and costs of portfolios, and is likely to lead to a and costs of portfolios, and is likely to lead to a very rapid very rapid changechange in their stocks to reestablish portfolio balance. in their stocks to reestablish portfolio balance.


If all markets are in equilibrium, an increase in MS If all markets are in equilibrium, an increase in MS ↓ ↓ interest, interest, an immediate ( an immediate (very largevery large) shift from domestic ) shift from domestic bonds to money and foreign bonds over a very short period bonds to money and foreign bonds over a very short period of time. Now compare this with the of time. Now compare this with the gradualgradual change in trade change in trade flows due to e.g., a depreciation, which takes place over a flows due to e.g., a depreciation, which takes place over a longer period of time. Hence stock adjustments in financial longer period of time. Hence stock adjustments in financial assets are much larger and quicker than adjustments in assets are much larger and quicker than adjustments in trade flows.trade flows.

The differences in the size and quickness of stock The differences in the size and quickness of stock adjustments in financial assets as opposed to trade flow have adjustments in financial assets as opposed to trade flow have very important implications for the process by which very important implications for the process by which exchange rates are determined and change (exchange rates are determined and change (dynamicsdynamics) over ) over time.time.


For example if there is an unexpected increase in MS For example if there is an unexpected increase in MS ↓ ↓ interest, interest, large and quick increase in the demand for large and quick increase in the demand for foreign currency foreign currency an immediate and large depreciation of an immediate and large depreciation of domestic currency which is likely to swamp the smaller and domestic currency which is likely to swamp the smaller and gradual changes in exchange rate resulting from changes in gradual changes in exchange rate resulting from changes in real markets (e.g., trade flows). This explains why in the real markets (e.g., trade flows). This explains why in the short run, exchange rates tend to short run, exchange rates tend to overshootovershoot (bypass) their (bypass) their long run equilibrium levels as they move towards long run equilibrium levels as they move towards equilibrium. But over time as the cumulative contribution to equilibrium. But over time as the cumulative contribution to adjustment coming from the real sector (e.g., trade) reverses adjustment coming from the real sector (e.g., trade) reverses exchange rate movement and exchange rate movement and overshooting is eliminatedovershooting is eliminated..

Note that if the real sector responds immediately as financial Note that if the real sector responds immediately as financial sectors do, there would be no exchange rate overshooting.sectors do, there would be no exchange rate overshooting.


B – Time Path to a New equilibrium Exchange RateB – Time Path to a New equilibrium Exchange Rate

Explanation: look at figure 2, and note that i – i* = EA, i.e, Explanation: look at figure 2, and note that i – i* = EA, i.e, i = i* + EA, if EA = 0, then uncovered interest parity condition is i i = i* + EA, if EA = 0, then uncovered interest parity condition is i = i*, before the increase in MS. The rise in MS leads to a reduction = i*, before the increase in MS. The rise in MS leads to a reduction in i. Since i < i*, we expect the foreign currency to appreciate and in i. Since i < i*, we expect the foreign currency to appreciate and the domestic currency to depreciate, for uncovered interest parity the domestic currency to depreciate, for uncovered interest parity to be satisfied again. to be satisfied again.

The only way we can expect the domestic currency to appreciate in The only way we can expect the domestic currency to appreciate in the future and still end up with a net depreciation of 10% (in the the future and still end up with a net depreciation of 10% (in the long run), is for the domestic currency to depreciate by more than long run), is for the domestic currency to depreciate by more than 10%, and then gradually 10%, and then gradually appreciate in the long run, in order to appreciate in the long run, in order to eliminate the overshooting.eliminate the overshooting.


FIGURE 2 Exchange Rate Overshooting: Permanent increase in US money supply.FIGURE 2 Exchange Rate Overshooting: Permanent increase in US money supply.

An increase in MS by 10% An immediate decline in interest

No immediate impact on prices

The dollar immediately depreciatesBy more than 10% (excessive Depreciation by 16%, overshooting)

Gradual appreciationto eliminate overshooting


FIGURE 3 Overshooting of Dollar Exchange Rates.FIGURE 3 Overshooting of Dollar Exchange Rates.

Fixed exchange rates period

Wild fluctuations of the dollar rates are an indication of overshooting


Key Terms:Key Terms:

Purchasing-power parity (PPP) theoryPurchasing-power parity (PPP) theory Monetary baseMonetary base Absolute purchasing-power parity theoryAbsolute purchasing-power parity theory Real exchange rateReal exchange rate Law of one priceLaw of one price Asset market or portfolio balance approach Asset market or portfolio balance approach Relative purchasing-power parity theory Relative purchasing-power parity theory Monetary approach to the balance of paymentsMonetary approach to the balance of payments Expected change in spot rateExpected change in spot rate Demand for moneyDemand for money Risk premium Risk premium Supply of moneySupply of money Exchange rate overshootingExchange rate overshooting

Economics of International Finance Economics of International Finance Prof. M. El-SaqqaProf. M. El-Saqqa CBA. Kuwait University CBA. Kuwait UniversityIn jul 2007

economics of international finance econ. 315

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