ch4 international econ

8/12/2019 Ch4 International Econ

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41

Exchange Rates and

Interest Ratesin the Short Run

2

Interest Rates in the

Short Run

3The Asset Approach

4

A Complete Theory

5

Fixed Exchange Ratesand the Trilemma

6

Conclusions

EXCHANGE RATES II:

THE ASSET APPROACH

IN THE SHORT RUN


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2 of 97 2008 Worth Publishers International Economics Feenstra/Taylor

Chapter Outline

1. Exchange Rates and Interest Rates in the ShortRun: revisit UIP and FX Market Equilibrium

2. Interest Rates in the Short Run: Money MarketEquilibrium

3. The Asset Approach: Applications and Evidence

4. A Complete Theory: Unifying the Monetary andAsset Approaches

5. Fixed Exchange Rates and the Trilemma

Today: topics 4 and 5


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4. A Complete Theory

Putting everything together: short run, long run,

and expectations

comprehensive model of exchange rate

determination

First, take a detour, through oil!


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Detour: The Oil Market

Purpose: illustrate how economists think about short run

and long run equilibrium in markets for durable goods

(assets)--in a simple context.

Static model, demand equals supply

2 equations and 2 unknowns: q=S(p), q=D(p)


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Present and future

4 equations and 4 unknowns


6/366 of 97 2008 Worth Publishers International Economics Feenstra/Taylor


Intertemporal arbitrage interest parity

(1+r) p = pe

Expectations determine current supply and price

Harold Hotelling (1895-1973)

Still 4 equations and 4 unknowns




Assume the supplier is cartel that sets the

quantity q

Then we need to specify the behavior: peg the

price, stabilize income, maximize income

Unmovable constraint: demand

But still 4 equations and 4 unknowns



Coming back to the FX market: the short run

Short run: Asset Approach (3 equations, 3 unknowns)

Money Market

Uncovered Interest Parity (UIP)

All we need to know is the expected future exchange rate.

The expected future exchange rate can be found from themonetary approach.


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A Complete Theory:

Unifying the Monetary and Asset Approaches



Policy Analysis: Overshooting

Impact of permanent shock to money supply

Suppose you are told that: Home M rises today permanently by 5%

Prices sticky now, but flexible in long run = one year.

What happens?



Overshooting



Overshooting

Short run effects Home interest rate decreases (DR shifts down).

Expected exchange rate increases (FR shifts up). Why?

Exchange rate increases.



Overshooting

Long run effects Home price level increase to bring money market to equilibrium.

Home interest rate returns to initial value (DR shifts back up).

Exchange rate increases, but less than the short run increase.



Overshooting


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SIDE BAR


Overshooting in Practice

The exchange rate is more volatile than either asset

approach or monetary approach model would predict Result discovered in 1970s by Rudiger Dornbusch (1942-2002)

This explains why exchange rates became so volatile

after fall of Bretton Woods system


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SIDE BAR


Overshooting in Practice



Expectations matter

We look at 4 illustrations of the impact of

expectations about the long run for exchange

rates

Bernankes bold move (September 18, 2007)

US civil war

Irak war

The pound last week


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APPLICATION


Bernankes Bold Move

Example:

September 18, 2007

The Federal Reserve cut

the overnight rate by 50

basis points.

Market was not sure

beforehand if it would be

50 or 25.

The result was a large

reaction in financial

markets, including the

forex market.

John Gress/Reuters/CORBIS


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APPLICATION


Bernankes Bold Move

The figure above shows the euro-dollar spot exchange rate on

September 18, 2007.

The Fed announcement occurred at 2pm EST (14:00).

Source: XE.com 2007 FXtrek.com


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Bernankes bold move


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APPLICATION


News and the Foreign Exchange Market

During wartime, there is greater likelihood of

observing dramatic changes in the exchange

rate. Why?

Governments often finance war through printing

money, generating inflation.

The uncertainty associated with war allow for

dramatic changes in money demand, as there is a

risk that the currency may be converted into another

currency unit, or eliminated altogether.


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APPLICATION



U.S. Civil War, 186165 The Confederacy (South) issued its own currency, the

Confederate dollar, in order to finance the war effort against theUnion (North).

Courtesy of the Federal Reserve Bank of Richmond


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APPLICATION




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The Iraq War: 2002-03


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APPLICATION




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APPLICATION




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APPLICATION


The Pound Last Week

The pound lost ground this week as the Bank ofEngland delivered a gloomy assessment of theUK economy. (FT, 2/14/09)

there was an interest rate cut

But it was the statement that the Bank wouldembark on a policy of quantitative monetaryeasing once interest rates fell to zero thatundermined sterling.


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5. Fixed Exchange Rates and the Trilemma

Use the model to understand the constraintsimposed by capital mobility and fixed exchangerate regimes

There must be as many unknowns (endogenousvariables) as equations limits margin ofmanoeuver

trilemma of policy objectives.

The Asset Approach to Exchange Rates:


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The Asset Approach to Exchange Rates:

Capital Mobility is Crucial

The model assumes capital mobility: this is

necessary for UIP

If a country imposes capital controls, then

investors ability to move funds may be diminished

or eliminated.

Example: Tobins tax

James Tobin, 1918-2002

Nobel 1981


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The Trilemma

Consider three policy goals:

1. Fixed exchange rate

Promote stability in trade andinvestment.

2. International capital mobilityPromote integration, risk sharingand efficiency.

3. Monetary policy autonomyTool for managing homecountrys business cycle.


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The Trilemma

It is not possible to achieve all three of these goals.

These choices represent a trilemma. One of the threegoals must be sacrificed to achieve the other two.

Again, count the equations and the unknowns!


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The Trilemma

Also called Mundells impossible trinity

(based on Mundell-Fleming model)

Robert Mundell, 1932-

Nobel 1999

Th T il


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The Trilemma


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APPLICATION


The Trilemma in Europe

U.K. interest rates do not move in sync with Eurozone rates;

Denmarks interest rates do.

Do Fixed Exchange Rates Diminish


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APPLICATION

Do Fixed Exchange Rates Diminish

Monetary Autonomy and Stability?

The Trilemma and Interest Rate Correlations

Data support the predictions.

Panel (a) slope close to 1, panel (c) close to 0.

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