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The Monetary Approach to Exchange Rates

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Therefore, exchange rates and prices adjust so that foreign goods always cost ... These relative price changes are passed onto nominal exchange rates ... – PowerPoint PPT presentation

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Title: The Monetary Approach to Exchange Rates


1
The Monetary Approach to Exchange Rates
  • Putting Everything Together

2
Available Assets
Foreign Currency (M) Pays no
interest, but needed to buy foreign goods
Home Currency (M) Pays
no interest, but needed to buy goods
Foreign Bonds (B) Pays interest rate (i),
payable in foreign currency
Domestic Bonds (B) Pays interest rate (i)
3
Five Markets
Foreign Bond Market
Domestic Bond Market
Households choose a combination of the four
assets for their portfolios
Domestic Money Market
Currency Market
Foreign Money Market
4
General Equilibrium
Foreign Bond Market
We need five prices (P,P, i , i,e ) to clear
the five markets!!
Domestic Bond Market
Domestic Money Market
Foreign Money Market
Currency Market
5
Lets simplify things!!
Purchasing Power Parity
Currency Markets
P eP
Uncovered Interest Parity
Expected Percentage Change in Exchange Rate
(i - i)
6
Down to two!!!
Foreign Bond Market
Domestic Bond Market
Now we only need two prices (P,P) to clear the
two remaining markets!!
Domestic Money Market
Foreign Money Market
Currency Market
7
The Domestic Money Market
Cash is used to buy goods (transaction motive),
but pays no interest
-


d
M
L ( P, i, Y )

Higher real income raises transaction motive for
holding cash
Higher prices raises money demand
Real Money Demand
Higher interest rates lower money demand
8
The Domestic Money Market
Cash is Supplied by the Federal Reserve
S

P
M
-
L (i, Y )
1
M
9
The Domestic Money Market
S

P
M
-
L (i, Y )
An increase in real income raises the demand for
money this lowers the price level (holding
money supply fixed)
1
M
10
The Domestic Money Market
S

P
M
-
L (i, Y )
An increase in interest rates lowers money demand
this raises the price level (holding money
supply fixed)
1
M
11
The Domestic Money Market
An increase in money supply raises the price level
S

P
M
-
L (i, Y )
1
M
12
The Domestic Money Market Equilibrium
d
S
M

M
S

P
M
-
L (i, Y )
PY

M
(1i)
1
M
(1i)

P
M
Y
13
The Foreign Money Market Equilibrium
The foreign money market is perfectly symmetric
d
S
M

M
S

P
M
-
L (i, Y )
PY

M
(1i)
1
M
(1i)
M

P
Y
14
Exchange Rate Fundamentals
  • Using PPP and the two Money Market equilibrium
    conditions, we get the fundamentals for a
    currency

Domestic Money Market
Foreign Money Market
M
(1i)
M
(1i)

P

P
Y
Y
PPP
P eP
M
(1i)
eM
(1i)

Y
Y
15
Currency Fundamentals
  • Taking the previous expression and solving for
    the exchange rate, we get

(1i)
M
Y

e
Y
M
(1i)
Relative Money Stocks
Relative Interest Rates
Relative Output
16
Exchange Rates the Fundamentals (JPY/USD)
17
Exchange Rates the Fundamentals (GBP/USD)
18
Adding Relative Price Changes
  • Recall that PPP often fails in the short run.
    This is possibly due to trading friction or
    relative price changes

(1i)
M
Y

e
RER
Y
M
(1i)
Real Exchange Rate
19
Exchange Rates the Fundamentals (JPY/USD)
Real Depreciation of the Dollar
20
Adding Speculative Bubbles
  • Recall that UIP implies that the differences in
    nominal interest rates reflects expectations of
    currency price changes (countries with high
    interest rates should expect their currencies to
    depreciate

(1i)
M
Y

e
RER
Y
M
(1i)
Expected change in exchange rate (Speculative
term)
21
What about trade deficits?
  • Trade deficits suggest that a country is spending
    too much (borrowing from the rest of the world).
    Therefore, the price adjustment mechanism
    necessary to eliminate a trade deficit will be
    one of the following
  • A countrys currency depreciates this makes
    foreign goods more expensive.
  • A countrys interest rate rises this makes
    spending in general more expensive

22
What about trade deficits?
  • Recall that PPP always holds in this model.
    Therefore, exchange rates and prices adjust so
    that foreign goods always cost the same as
    domestic goods.

P eP
23
What about trade deficits?
  • Further, UIP implies that there is no adjustment
    mechanism in asset markets either

Expected change in nominal exchange rate
Inflation Inflation


i i
PPP
UIP
r i Inflation i - Inflation r
Inflation adjusted returns are equalized across
countries!!
24
One last shot.real income.
  • Currency depreciations are associated with high
    domestic inflation.shouldnt rising prices lower
    the demand for all goods/services?

Yes, but this particular model assumes that real
(inflation adjusted) income is fixed.therefore,
a 10 increase in prices will be matched my an
equal 10 increase in nominal income.
25
Bottom Line
  • If commodity prices are free to adjust, then
    commodity markets take center stage in currency
    price determination (PPP)
  • There is no correlation between trade deficits
    and currency prices
  • Volatility in currency markets is created by
    relative price changes (real exchange rate
    changes) or speculative behavior
  • These relative price changes are passed onto
    nominal exchange rates
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