the monetary approach to exchange rates putting everything together

The Monetary The Monetary Approach to Exchange Approach to Exchange

RatesRates

Putting Everything Putting Everything TogetherTogether

Available AssetsAvailable Assets

Home Currency (M) Pays no interest, but needed to buy goods

Domestic Bonds (B) Pays interest rate (i)

Foreign Bonds (B*) Pays interest rate (i*), payable in foreign currency

Foreign Currency (M*) Pays no interest, but needed to buy foreign goods

Five MarketsFive Markets

Foreign Bond Market

Domestic Money Market

Domestic Bond Market

Households choose a combination of the four assets for their portfolios

Foreign Money Market

Currency Market

General EquilibriumGeneral Equilibrium

Foreign Bond Market



We need five prices (P,P*, i , i*,e ) to clear the five markets!!


Currency Market

Lets simplify things!!Lets simplify things!!

Purchasing Power Parity

Currency Markets

Uncovered Interest Parity

P = eP*

(i - i*) =Expected Percentage Change in Exchange Rate

Down to two!!!Down to two!!!

Foreign Bond Market



Now we only need two prices (P,P*) to clear the two remaining markets!!


Currency Market

The Domestic Money The Domestic Money MarketMarket

Cash is used to buy goods (transaction Cash is used to buy goods (transaction motive), but pays no interestmotive), but pays no interest

M = L ( P, i, Y )- - + + d

Real Money Demand

Higher interest rates lower money demand

Higher real income raises transaction motive for holding cash

Higher prices raises money demand

+ +


Cash is Supplied by the Cash is Supplied by the Federal ReserveFederal Reserve

L (i, Y )+ + P MS

M

1

--


An increase in real income An increase in real income raises the demand for raises the demand for money – this lowers the money – this lowers the price level (holding money price level (holding money supply fixed)supply fixed)

L (i, Y )+ + P MS

M

1

--


An increase in interest rates An increase in interest rates lowers money demand – lowers money demand – this raises the price level this raises the price level (holding money supply (holding money supply fixed)fixed)

L (i, Y )+ + P MS

M

1

--


An increase in money An increase in money supply raises the price levelsupply raises the price level

L (i, Y )+ + P MS

M

1

--

The Domestic Money Market The Domestic Money Market EquilibriumEquilibrium

L (i, Y )+ + P MS

1

--

Md= M

S

PY = M(1+i)

Y= M (1+i)PM

The Foreign Money Market The Foreign Money Market EquilibriumEquilibrium

L (i*, Y* )+ + P* M*S

1

--

M*d

= M*S

P*Y* = M*(1+i*)

Y*= M*(1+i*)P*M*

The foreign money market is perfectly symmetric

Exchange Rate Exchange Rate FundamentalsFundamentals

Using PPP and the two Money Market equilibrium Using PPP and the two Money Market equilibrium conditions, we get the “fundamentals” for a currencyconditions, we get the “fundamentals” for a currency

Y*= M*(1+i*)P*

Y= M (1+i)P

Domestic Money Market Foreign Money Market

PPP

P = eP*

YM (1+i) =

Y*eM*(1+i*)

Currency FundamentalsCurrency Fundamentals Taking the previous expression and solving for Taking the previous expression and solving for

the exchange rate, we getthe exchange rate, we get

YYMM (1+i)(1+i)

== Y*Y*M*M* (1+i*)(1+i*)ee

Relative Money Stocks

Relative Output

Relative Interest Rates

Exchange Rates & the Exchange Rates & the Fundamentals (JPY/USD)Fundamentals (JPY/USD)

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Yen/Dollar

Actual Fundamentals

Exchange Rates & the Exchange Rates & the Fundamentals (GBP/USD)Fundamentals (GBP/USD)

00.10.20.30.40.50.60.70.80.91

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GBP/Dollar

Actual Fundamentals

Adding Relative Price Adding Relative Price ChangesChanges

Recall that PPP often fails in the short run. Recall that PPP often fails in the short run. This is possibly due to trading friction or This is possibly due to trading friction or relative price changesrelative price changes

YYMM (1+i)(1+i)

== Y*Y*M*M* (1+i*)(1+i*)ee RERRER

Real Exchange Rate

Exchange Rates & the Exchange Rates & the Fundamentals (JPY/USD)Fundamentals (JPY/USD)

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Yen/Dollar

Actual Fundamentals

Real Depreciation of the Dollar

Adding Speculative Adding Speculative BubblesBubbles

Recall that UIP implies that the differences in Recall that UIP implies that the differences in nominal interest rates reflects expectations of nominal interest rates reflects expectations of currency price changes (countries with high interest currency price changes (countries with high interest rates should expect their currencies to depreciaterates should expect their currencies to depreciate

YYMM (1+i)(1+i)

== Y*Y*M*M* (1+i*)(1+i*)ee RERRER

Expected change in exchange rate (Speculative term)

What about trade deficits?What about trade deficits?

Trade deficits suggest that a country is Trade deficits suggest that a country is spending too much (borrowing from the rest of spending too much (borrowing from the rest of the world). Therefore, the price adjustment the world). Therefore, the price adjustment mechanism necessary to eliminate a trade mechanism necessary to eliminate a trade deficit will be one of the following:deficit will be one of the following:

A country’s currency depreciates – this A country’s currency depreciates – this makes foreign goods more expensive.makes foreign goods more expensive.

A country’s interest rate rises – this A country’s interest rate rises – this makes spending in general more makes spending in general more expensiveexpensive


Recall that PPP always holds in this model. Recall that PPP always holds in this model. Therefore, exchange rates and prices Therefore, exchange rates and prices adjust so that foreign goods always cost adjust so that foreign goods always cost the same as domestic goods.the same as domestic goods.

P = eP*P = eP*


Further, UIP implies that there is no Further, UIP implies that there is no adjustment mechanism in asset markets eitheradjustment mechanism in asset markets either

Inflation – Inflation* =Expected change in nominal exchange rate

= i – i*

UIPPPP

r = i – Inflation = i* - Inflation* = r*r = i – Inflation = i* - Inflation* = r*

Inflation adjusted returns are equalized across countries!!

One last shot….real One last shot….real income. income.

Currency depreciations are associated Currency depreciations are associated with high domestic inflation….shouldn’t with high domestic inflation….shouldn’t rising prices lower the demand for all rising prices lower the demand for all goods/services?goods/services?

Yes, but this particular model assumes that real Yes, but this particular model assumes that real (inflation adjusted) income is fixed….therefore, a (inflation adjusted) income is fixed….therefore, a 10% increase in prices will be matched my an equal 10% increase in prices will be matched my an equal 10% increase in nominal income.10% increase in nominal income.

Bottom LineBottom Line If commodity prices are free to adjust, If commodity prices are free to adjust,

then commodity markets take center then commodity markets take center stage in currency price determination stage in currency price determination (PPP)(PPP)

There is no correlation between trade There is no correlation between trade deficits and currency pricesdeficits and currency prices

Volatility in currency markets is created Volatility in currency markets is created by relative price changes (real exchange by relative price changes (real exchange rate changes) or speculative behaviorrate changes) or speculative behavior

These relative price changes are passed These relative price changes are passed onto nominal exchange ratesonto nominal exchange rates

the monetary approach to exchange rates putting everything together

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