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The Monetary Models of Exchange Rate Determination

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Title: The Monetary Models of Exchange Rate Determination


1
The Monetary Models of Exchange Rate Determination
  • The Flexible-Price Model
  • The Sticky-Price Model
  • The Portfolio Balance Model


2
Monetary Models
3
Asset Modelsof the Spot Exchange Rate
4
The Flexible-Price Model
  • We start with the following assumptions
  • PPP holds continuously
  • Bonds denominated in different currencies are
    perfect substitutes ? UIP
  • Perfect capital mobility
  • 1, 2 and 3 together imply that real interest
    rates are equal internationally ? r r

5
The Flexible-Price Model
Ex-Ante PPP is implied by Absolute PPP
UIP implies that
Combined with the Fisher equation,
Gives Real Interest Parity
6
The Flexible-Price Model
Further assume that money demand in each country
is given by the liquidity preference theory.
  • where
  • mt is the domestic money supply in logs
  • pt is the log of domestic price level
  • yt is the log of domestic real income
  • it is the domestic nominal interest rate

7
The Flexible-Price Model
A similar money demand exists for the foreign
country
Note The use of logarithms allows us to make an
otherwise non-linear relationship linear. Linear
models are much easier to work with.
8
The Flexible-Price Model
The assumption of PPP implies
Combine the PPP relationship with the two money
demands
9
The Flexible-Price Model
Re-write the money demands as
10
The Flexible-Price Model
Using PPP to combine the two money demands yields
or
11
The Flexible-Price Model
We can simplify this equation further by assuming
that the money demand elasticities are the same
in both the foreign and domestic economies
12
The Flexible-Price Model
This last equation represents the basic
Flex-Price Model
Using the UIP relationship the Flex-Price model
can be equivalently written as
or
13
Implications of the Flex-Price Model for Exchange
Rate Behavior
14
Sticky-Price Model
  • One of the most important facts about the
    floating exchange rate system is the huge
    increase in exchange rate volatility observed
    since the demise of the Bretton Woods regime.
    What can explain this large increase in
    volatility?
  • Remember that PPP does not have strong empirical
    support in the short run.
  • PPP holds better in the long run.
  • If we assume that price levels are sticky, i.e.
    they do not adjust quickly in response to a
    changing economic environment, then PPP will not
    hold every period.

15
Sticky-Price Model
  • Assume that PPP only holds in the long run, such
    that
  • where a bar over a variable indicates a long-run
    equilibrium value.
  • In the long run PPP holds and thus the
    Flex-Price model is valid, but only in the long
    run.
  • In the short run, prices are sticky and PPP will
    not hold and neither will the Flex-Price model.

16
Sticky-Price Model
  • Maintain the assumption of UIP
  • Assume PPP only holds in the long run
  • Deviations of the exchange rate from its long-run
    equilibrium value, i.e. its PPP value, will
    adjust in the following way

17
Sticky-Price Model
Noting that ?se i-i implies,
or
Then substitute from the earlier equation to get
18
Sticky-Price Model
This last equation is the basic Sticky-Price
model. It has the following equivalent
representation
19
Implications of the Sticky-Price Model for
Exchange Rate Behavior
20
Overshooting Exchange Rates
21
The Portfolio Balance Model
Now relax assumption of risk neutrality, i.e.
assets denominated in different currencies are no
longer perfect substitutes. The UIP relation
must now be augmented with a risk premium that is
a function of the relative supplies of domestic
to foreign assets expressed in a common currency.
22
The Portfolio Balance Model
This yields the following adjustment equation for
the exchange rate
and by substitution we obtain the Portfolio
Balance model
23
Implications of the Portfolio Balance Model for
Exchange Rate Behavior
24
Forecasting Exchange Rates
  • Efficient Markets Approach
  • Fundamental Approach
  • Technical Approach
  • Performance of the Forecasters

25
Efficient Markets Approach
  • Financial Markets are efficient if prices reflect
    all available and relevant information.
  • If this is so, exchange rates will only change
    when new information arrives, thus
  • St ESt1
  • and
  • Ft ESt1 It
  • Predicting exchange rates using the efficient
    markets approach is affordable and is hard to
    beat.

26
Fundamental Approach
  • MVPY ? PMV/Y
  • PPP ? S P/P
  • Combine so that s a0a1(m-m)a2(i-i)a3(y-y)
  • Involves econometrics to develop models that use
    a variety of explanatory variables. This involves
    three steps
  • step 1 Estimate the structural model.
  • step 2 Estimate future parameter values.
  • step 3 Use the model to develop forecasts.
  • The downside is that fundamental models do not
    work any better than the forward rate model or
    the random walk model.

27
Technical Approach
  • Technical analysis looks for patterns in the past
    behavior of exchange rates.
  • Clearly it is based upon the premise that history
    repeats itself.
  • Thus it is at odds with the EMH

28
Technical Analysis
29
Technical Analysis
30
Performance of the Forecasters
  • Forecasting is difficult, especially with regard
    to the future.
  • As a whole, forecasters cannot do a better job of
    forecasting future exchange rates than the
    forward rate.
  • The founder of Forbes Magazine once said
  • You can make more money selling financial
    advice than following it.

31
Forecasting Performance
32
Banks Forecasts
33
News and Foreign Exchange RatesAn Introduction
  • Financial markets are preoccupied with news.
  • However, we usually cannot find a simple
    unambiguous link between a news announcement and
    an exchange rate reaction.
  • The market is forward-looking, and permanent
    changes versus transitory phenomena are viewed
    differently.
  • While two news announcements may seem similar,
    their underlying aspects may be in fact different.

34
Exchange Rates and News StoriesThree
Illustrations
  • Story 1 At time t1, it is announced that the
    U.S. money supply grew by 3 billion in the most
    recent week. (The consensus market forecast was
    2 billion.)
  • Case a The US weakens as the market feels that
    the higher money supply will be maintained.
  • Case b The US strengthens as the market
    believes that the Federal Reserve will take
    corrective actions.
  • Case c The US weakens and then steadily
    depreciates as the market feels that the change
    in the growth rate is permanent.

35
Story 1 An Increase in the U.S. Money Supply
36
Exchange Rates and News StoriesThree
Illustrations
  • Story 2 U.S. interest rates at all maturities
    have risen by 0.10 or 10 basis points. (The
    market consensus was for no change in rates.)
  • Case d The US weakens as the market feels that
    the rise stems from inflationary concerns, and is
    therefore a rise in the nominal interest rate.
  • Case e The US strengthens as the market
    believes that inflation is under control, such
    that the higher rate corresponds to an increase
    in the real interest rate.

37
Exchange Rates and News StoriesThree
Illustrations
  • Story 3 It is announced that the U.S. current
    account deficit will reach an annual rate of 250
    billion. ( The consensus was 200 billion.)
  • Case g The change is due to greater private
    sector investments, and the US strengthens as
    foreign capital flows in to finance the
    investments.
  • Case f The shortfall in exports or increase in
    imports is viewed as permanent and the US
    weakens.

38
News and Foreign Exchange RatesA Summary
  • Only unanticipated events cause exchange rates to
    deviate from their expected path of movement.
  • Factors that increase the demand for a currency
    tend to raise the price of that currency.
  • The character and the context of the economic
    news item will greatly influence the nature of
    the exchange rate response that follows.
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