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TRANSCRIPT
Course web page: http://Stanford2009.pageout.net
ID: mse247s; PASSWORD: Stanford88
Handout #8
Foreign Exchange MarketsSpot Exchange Rate Determination
TTh 3:15-4:30 Gates B01on Tuesday July 7, 2009
Slides to highlight: 1-56, 60-77, 94-165, 200-210.
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Levich
Luenberger
Solnik
Eun
Wooldridge
Reading Assignments for this Week
Chap 6
Chap
Chap 3
Chap 7
Scan Read
Pages
Pages
Pages
Pages
Chap 21 Pages
Foreign Exchange Determination and Forecasting
Spot Exchange Rate Determination
Multiple Regression Analysis with Qualitative Information: Binary (or Dummy) Variables
http://highered.mcgraw-hill.com/sites/dl/free/0072521279/91312/eun21279_ch21_dr.pdf
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Reading assignments for this week last year
Monetary Policy Report to the CongressSubmitted pursuant to section 2B of the Federal Reserve Act, July 15, 2008http://www.federalreserve.gov/boarddocs/hh/2008/july/FullReport.pdfhttp://www.federalreserve.gov/printable.htm
WSJ 1024 2005: The Greenspan Era
WSJ 0516 2008: Bernanke's Bubble Laboratory
Federal Reserve System 0710 2008:Bernanke on Regulatory Restructuring
IHT 0528 2008: With bold steps, Bernanke revamps Fed rule book
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Mankiw on Macroeconomics
(great optional reading)Chapter 4 Money and Inflation
http://www.bfwpub.com/pdfs/mankiw/0716752379_04.pdf
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Stephen G. Cecchetti on Central Banks, Monetary Policy, and
Financial Stability
(must read)Chapter 15 Central Banks in the World Today
http://highered.mcgraw-hill.com/sites/dl/free/0072452692/238721/cec5269
2_ch15.pdf
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http://highered.mcgraw-hill.com/sites/dl/free/0072452692/238721/cec52692_ch15.pdf
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Stephen G. Cecchetti on Central Banks, Monetary Policy, and
Financial Stability
(great optional reading)Chapter 16 The Structure of Central Banks:
The Federal Reserve and the European Central Bankhttp://highered.mcgraw-
hill.com/sites/dl/free/0072452692/238721/cec52692_ch16.pdf
6-8http://highered.mcgraw-hill.com/sites/dl/free/0072452692/238721/cec52692_ch16.pdf
Foreign Exchange MarketsSpot Exchange Rate Determination
MS&E 247S International InvestmentsYee-Tien Fu
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The famous random walk hypothesis holds that the best guess about tomorrow’s stock price is today’s stock price (plus a bit of upward drift to reward patience and risk taking).
According to the random-walk theory, stock prices should move in response to news about the value of the underlying companies.
Introduction
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To many economists, exchange rate models built around a set of structural macroeconomic variables seems to have little power to explain the patterns of short-term exchange rate behavior.
For most countries, the exchange rate is the single most important price in the economy. The daily trading is over US$1 trillion. (1 trillion = 1000 billion = 1,000,000 million = 1012)
Introduction
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The depth to which market economists follow macroeconomic developments suggests that an understanding of the macroeconomic news is critical for understanding (and perhaps predicting) exchange rate behavior.
Financial economists at banks, securities firms, and elsewhere also have been hard at work analyzing the variables that might impact foreign exchange rates.
Introduction
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The view that exchange rates follow a simple random walk and evolve without regard to macroeconomic fundamentals is an extreme characterization, and we believe a false one.
We will see that the presence of nonrandom-walk behavior offers market economists an opportunity to add value. While the link between exchange rates and macroeconomic variables may be difficult to uncover, there is evidence that such a link exists in the short run and to a greater extent in the long run.
Introduction
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Financial market economists are trained to be skeptical.The principal result from models of exchange rate determination is that the exchange rate is a forward-looking variable that should be priced in the same way as other financial assets.The current price of foreign exchange can be shown to equal (in theory) the net present value of all the fundamental variables that affect the exchange rate. This suggests why the exchange rate would be difficult to model and even more so to forecast.
Introduction
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The current exchange rate already reflects the expected values of future macroeconomic variables.
We will use several news items about macroeconomic events to show the forward-looking nature of the foreign exchange market and the difficulties we face in modeling exchange rates.
Introduction
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We will survey some of the stylized models of exchange rate determination developed over the past 20 years.
We outline the broad predictions of these models and then we analyze the empirical evidence to determine whether these models offer a satisfactory explanation for exchange rate behavior.
Introduction
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Measure Amount (billions) What’s IncludedM1 1995: $1,148 Currency, Traveler’s checks
1998: $1,081 Demand depositsOther checkable deposits
M2 1995: $3,630 M1 plus Saving deposits1998: $4,165 Retail money market mutual funds
Small time depositsM3 1995: $4,357 M2 plus Large time deposits
1998: $5,574 Repurchase agreementsEurodollars, Institution-onlymoney market mutual funds
L 1995: $5,426 M3 plus Other liquid assets1998: $6,826 such as savings bonds and
short-term Treasury securities
Four Measures of the Money Stock for the US Economy
6-19Source: http://www.newyorkfed.org/aboutthefed/fedpoint/fed49.html
U.S. Money Aggregates
Money Supply MeasuresSeptember 2001
Savings Deposits
Small Time Deposits
Retail Money Funds$5.3 trillion
M2
Large Time DepositsInstitutional MMFs
Euros & Repos$7.8 trillion
M2 M3
Bill
ions
of D
olla
rs
9,0008,0007,0006,0005,0004,0003,0002,0001,000
0
$1.2 trillion
M1
M1CurrencyCheckable Deposits
6-20http://www.bfwpub.com/pdfs/mankiw/0716752379_04.pdf
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▪ For decades, the Federal Reserve has published data on the money supply, and for many years the Fed set targets for money supply growth.
▪ In the past two decades, a number of developments have broken down the relationship between money supply growth and the performance of the U.S. economy.
▪ In July 2000, the Federal Reserve announced that it was no longer setting target ranges for money supply growth.
Source: http://www.newyorkfed.org/aboutthefed/fedpoint/fed49.html
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News and Foreign Exchange Rates:An Introduction
• Financial markets are preoccupied with news.• However, we usually cannot find a simple
unambiguous link between a news announcement and an exchange rate reaction.¤ The market is forward-looking, and permanent
changes versus transitory phenomena are viewed differently.
¤ While two news announcements may seem similar, their underlying aspects may be in fact different.
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News and Foreign Exchange Rates - Hindsight Smart?
Example 1:In a period of floating exchange rates we might have read that following an increase in the US money supply, the US$ fell because the news generated inflationary expectations.
But on another occasion, we might have read that following a similar increase in the US money supply, the US$ rose because the news generated expectations that the Federal Reserve would tighten money growth and raise interest rates.
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• The Fed has three tools in its monetary toolbox:
Open-market operationsChanging the reserve requirementChanging the discount rate
The Fed’s Tools of Monetary Control
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The Fed’s Tools of Monetary Control
Open-Market Operations: the purchase and sale of U.S. government bonds by the Fed
Reserve Requirements: regulations on the minimum amount of reserves that banks must hold against deposits
The Discount Rate: the interest rate on the loans that the Fed makes to banks
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Open-Market Operations
• The Fed conducts open-market operations when it buys government bonds from or sells government bonds to the public:
When the Fed buys government bonds, the money supply increases (helicopter).The money supply decreases when the Fed sells government bonds (vacuum cleaner).
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Changing the Discount Rate
• The reserve requirement is the amount (%) of a bank’s total reserves that may not be loaned out.
Increasing the reserve requirement decreases the money supply. Decreasing the reserve requirement increases the money supply.
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Changing the Discount Rate
• The discount rate is the interest rate the Fed charges banks for loans.
Increasing the discount rate decreases the money supply. Decreasing the discount rate increases the money supply.
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Problems in Controlling the Money Supply
• The Fed’s control of the money supply is not precise.
• The Fed must wrestle with two problems that arise due to fractional-reserve banking.
The Fed does not control the amount of money that households choose to hold as deposits in banks.The Fed does not control the amount of money that bankers choose to lend.
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http://money.cnn.com/markets/IRC/economic.htmlhttp://money.cnn.com/news/specials/eyes_on_fed/http://money.cnn.com/news/economy/
Markets: Investor Research Center - Economic Calendar
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http://money.cnn.com/markets/IRC/economic.htmlhttp://money.cnn.com/news/specials/eyes_on_fed/http://money.cnn.com/news/economy/
Markets: Investor Research Center - Economic Calendar
6-32http://money.cnn.com/markets/IRC/
6-33http://money.cnn.com/markets/IRC/
6-34http://money.cnn.com/markets/IRC/
6-35http://money.cnn.com/markets/IRC/
6-36http://woodrow.mpls.frb.fed.us/research/data/us/charts/int1.cfm
6-37http://woodrow.mpls.frb.fed.us/research/data/us/charts/int1.cfm
6-38http://woodrow.mpls.frb.fed.us/research/data/us/charts/int1.cfm
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http://www.federalreserve.gov/econresdata/default.htm
Research Data
http://www.federalreserve.gov/econresdata/researchdata.htm
6-42http://woodrow.mpls.frb.fed.us/research/data/us/charts/int2.cfm
6-43http://woodrow.mpls.frb.fed.us/research/data/us/charts/int2.cfm
6-44http://woodrow.mpls.frb.fed.us/research/data/us/charts/int2.cfm
6-45http://woodrow.mpls.frb.fed.us/research/data/us/charts/int2.cfm
6-46http://woodrow.mpls.frb.fed.us/research/data/us/charts/int2.cfm
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http://www.federalreserve.gov/econresdata/default.htm
Research Data
http://www.federalreserve.gov/econresdata/researchdata.htm
6-48http://woodrow.mpls.frb.fed.us/research/data/us/charts/exc1.cfm
Index of weighted average exchange value of U.S. dollar against currencies of other G-10 countries.Source: Board of Governors, Federal Reserve System
6-49http://woodrow.mpls.frb.fed.us/research/data/us/charts/exc1.cfm
Index of weighted average exchange value of U.S. dollar against currencies of other G-10 countries.Source: Board of Governors, Federal Reserve System
6-50http://woodrow.mpls.frb.fed.us/research/data/us/charts/exc1.cfm
Index of weighted average exchange value of U.S. dollar against currencies of other G-10 countries.Source: Board of Governors, Federal Reserve System
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Index of weighted average exchange value of U.S. dollar against (in terms of) currencies of other G-10 countries. (note: US$ is in the denominator here)Source: Board of Governors, Federal Reserve System
http://woodrow.mpls.frb.fed.us/research/data/us/charts/exc1.cfm
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Index of weighted average exchange value of U.S. dollar against (in terms of) currencies of other G-10 countries. (note: US$ is in the denominator here)Source: Board of Governors, Federal Reserve System
http://woodrow.mpls.frb.fed.us/research/data/us/charts/exc1.cfm
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http://www.federalreserve.gov/econresdata/default.htm
Research Data
http://www.federalreserve.gov/econresdata/researchdata.htm
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Figure 1, Box 7-5 in Dornbusch: Macroeconomics 8EUnemployment Rates For Selected European Countries and the United States, 1960-2000
Source: European Economy, 1998
Germanunemploymentrate is up!
http://www.mhhe.com/economics/dornbusch8e/
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WHAT'S NEW as of July 13, 2007
Retail sales drop worst in 2 years: Sales drop 0.9 percent, much weaker than forecasts - a signal consumers are tired after years of heavy spending. (July 13 2007: 10:40 AM EDT)Retail sales posted the biggest drop in nearly two years in June, the government reported Friday, fanning worries that consumers were starting to feel the pinch of higher gas prices and the slumpinghousing market.
http://money.cnn.com/news/economy/
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WHAT'S NEW as of July 12, 2007
The greatest economic boom ever: A lot could go wrong. And it may not feel like a day at the beach to most Americans. But for your average globetrotting Fortune 500 CEO, right now is about as good as it gets, says Fortune's Rik Kirkland. (July 12 2007: 9:46 AM EDT)(Fortune Magazine) -- Just how red-hot is the current worldwide expansion? "This is far and away the strongest global economy I've seen in my business lifetime," U.S. Treasury Secretary HankPaulson declared on a recent visit to Fortune's offices.
http://money.cnn.com/news/economy/
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WHAT'S NEW as of July 11, 2007
Hank Paulson takes on the world: In a wide-ranging interview with Fortune, the U.S. Secretary of the Treasury explains why, despite the “strongest global economy” he has ever seen, it still “pays to be vigilant.” (July 11 2007: 4:59 PM EDT)
http://money.cnn.com/news/economy/
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Paulson On risks: We haven't had a global financial shock since 1998. I believe that these large and dramatic increases in private pools of capital [hedge funds and private equity] and in the credit derivatives markets since then have helped manage and disperse risk and make the economy more efficient. When we do have one - and it's when, not if; that's not me being negative, it's just that we're not going to defy economic gravity -we'll be seeing for the first time how some of these instruments perform under stress.
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Paulson On U.S. competitiveness: I believe economic integration is inevitable, and it's good for our country, because I believe no other country is better positioned than the U.S. to compete long term and win. I just dismiss the notion that somehow or other China - with all the issues it has - or anyone else is going to take its growth rate, and extrapolate it, and pass the U.S. in ten or 20 years.
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WHAT'S NEW as of July 13, 2008
U.S. plan to save Fannie and Freddie
Paulson and Bernanke proposal would give mortgage finance giants bigger line of credit with Treasury
and open NY Federal Reserve lending window.
By Tami Luhby, CNNMoney.com senior writerLast Updated: July 13, 2008: 8:54 PM EDT
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Chairman Ben S. Bernanke
Regulatory restructuring“Work is also ongoing to strengthen
the framework for prudential oversight of financial institutions.”
Before the Committee on Financial Services, U.S. House of Representatives
July 10, 2008
WHAT'S NEW as of July 10, 2008
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WHAT'S NEW as of July 16, 2008Chairman Ben S. Bernanke
delivered theSemiannual Monetary Policy Report to the Congress
Before the Committee on Financial Services, U.S. House of Representatives
on Tuesday July 15, 2008
Chairman Bernanke presented testimony before the Committee on Banking, Housing, and Urban Affairs,
U.S. Senateon Tuesday July 15, 2008
http://www.federalreserve.gov/boarddocs/hh/2008/july/fullreport.htmhttp://www.federalreserve.gov/newsevents/testimony/bernanke20080715a.htm
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Fed Officials See Stronger Growth and Higher Inflation
Fed officials suggested that, in near term, they were growing more concerned about inflation than economic growth, while still seeing "significant downside risks" to growth. The expectation is that overall inflation will moderate in 2009 and 2010,
What are two ways to alleviate inflation woes? Higher interest rate or Stronger $?
WHAT'S NEW as of July 16, 2008
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Despite the expectation that overall inflation will moderate in 2009 and 2010, Mr. Bernanke told lawmakers on July 16, 2008, officials “viewed the inflation outlook as unusually uncertain and cited the possibility that commodity prices will continue to rise as an important risk to the inflation forecast.”
Why? Higher wages will be paid to alleviate workers’ suffering; higher wages in turn add to production costs and higher product prices.
WHAT'S NEW as of July 16, 2008
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In these circumstances, the Federal Reserve will employ all available tools to promote economic recovery and to preserve price stability. The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.
http://www.federalreserve.gov/newsevents/press/monetary/20090624a.htm
WHAT'S NEW as of June 24, 2009
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As previously announced, to provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Federal Reserve will purchase a total of up to $1.25 trillion of agency mortgage-backed securities and up to $200 billion of agency debt by the end of the year. In addition, the Federal Reserve will buy up to $300 billion of Treasury securities by autumn. The Committee will continue to evaluate the timing and overall amounts of its purchases of securities in light of the evolving economic outlook and conditions in financial markets. The Federal Reserve is monitoring the size and composition of its balance sheet and will make adjustments to its credit and liquidity programs as warranted.
http://www.federalreserve.gov/newsevents/press/monetary/20090624a.htm
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News and Foreign Exchange Rates - Hindsight Smart?
Example 2:
We might have read that following an upsurge in the US fiscal budget deficit, the US$ fellbecause the news generated expectations that the Fed would monetize the deficit; but on another occasion, we might have read that the US$ rose because the news generated expectations that further government borrowing and higher interest rates would result.
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There are two reasons explaining why we do not find a simple unambiguous link between a news announcement and an exchange rate reaction.
News and Foreign Exchange Rates - Hindsight Smart?
First, the foreign exchange market, like other financial markets, is a forward-looking market.
Once a news item has occurred, traders are concerned whether the news represents a permanent change or only a transitory phenomenon.
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An increase in the current account deficit between the United States and Japan may have resulted from an increase in US imports from Japan or a decrease in Japanese imports from the US.
Second, while two news announcements may seem similar, on closer examination we may conclude that they are not.
News and Foreign Exchange Rates - Hindsight Smart?
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- is a Balance Of Payment account- records transactions in goods and services- a simple way of understanding how transactions
are recorded is to think of debits as arising when money flows out of US or in foreign currencies, and credits when money flows intothe US or in dollars.
- credits result from purchases by foreigners; they give rise to inflows or sources of foreignexchange. Debits result from purchases bydomestic residents; they give rise to outflows or uses of foreign exchange.
The Current Account
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CURRENT ACCOUNT(a) ‘TRADE BALANCE’
(goods, services, transfers)
(b) ‘DEBT SERVICE’
import of a Japanese car; foreign aid to Israel
exports of PC’s; money transfers from abroad to local students
Payments of dividends & interest to foreigners
Receipts from dividends, interest payments on overseas investments by US citizens
DEBIT (-)
Imports
CREDIT (+)
Exports
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Exchange Rates and News Stories: Illustrations
The news service puts us in a ceteris paribus (all other things being equal) setting common to macroeconomic analysis.
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Story: An Increase in the US Money Supply
News announced at t1 :
US money supply grew by $3 billion in the most recent week.
Assuming that the consensus market forecast on money supply growth was $2 billion,
=> realized money growth is a “positive surprise”
Exchange Rates and News Stories: Illustrations
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Story: An Increase in the US Money Supply
- the market feels that the higher moneysupply will be maintained
- with national output constant, a largermoney supply leads to a higher price level
- if both prices and exchange rates are perfectly flexible, then the US$ will weaken immediately
Why might the US$ weaken in response to this news?
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U.S.money supply
Figure 6.2
The Reaction of the US$ to a Money Supply Announcement:Scenario (a)
Timet1 t2
$ interest rate
U.S. price level
Nominal exchangerate ($ /FC)
4. the interest rate does not change since the price level isconstant after the monetary shock
1. realized money growth is a “positive surprise”; the market feels that the higher money supply will be maintained
2. if both prices and exchange rates are perfectly flexible, then the US$ will weaken immediately
3. at the same time, with national output constant, a larger money supply leads to a higher price level
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- yes, if market participants believe that theFederal Reserve will drain reserves from thebanking sector in the coming weeks to makeup for its past excessive money supply creation
Story: An Increase in the US Money Supply
Could the US$ strengthen in response to the same news item?
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U.S.money supply
Figure 6.2
The Reaction of the US$ to a Money Supply Announcement:Scenario (b)
Timet1 t2
$ interest rate
U.S. price level
Nominal exchangerate ($ /FC)
1. assume that market participants believe thatthe Federal Reserve will drain reserves from thebanking sector in the coming weeks
2. market projects an low growth in the money supplyand interest rates are projected to rise; interest ratesrise immediately in anticipation
3. higher US$ interest rates attract capital, and the US$ rises
4. since market believes excessive money creationwill be corrected soon, U.S. price level does not change
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What if a permanent change in the rate of growth of the money supply is expected?- in this scenario, inflation turns positive after t1, the interest rate jumps, and the US$ steadily depreciates.
Story: An Increase in the US Money Supply
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U.S.money supply
Figure 6.2
The Reaction of the US$ to a Money Supply Announcement:Scenario (c)
Timet1 t2
$ interest rate
U.S. price level
Nominal exchangerate ($ /FC)
1. assume a permanent change in the rate of growthof the money supply is expected
2. then, inflation turns positive after t1 (prices rise when the government prints too much money)
3. and the interest rate jumps (Fisher Closed)
4. at the same time, the US$ steadily depreciates(relative PPP)
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Which is the correct response of the exchange rate to the news?
- all the responses are correct, but with respectto different scenarios derived from the same news announcement.
Story: An Increase in the US Money Supply
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U.S.money supply
Figure 6.2
The Reaction of the US$ to a Money Supply Announcement:Alternative Scenarios
Timet1 t2
$ interest rate
U.S. price level
Nominal exchangerate ($ /FC)
a
a
aa
b
b
b
b
c
c
c
c
The Modern Art of Exchange Rates!
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Story: An Increase in U.S. Interest Rates
News: U.S. interest rates at all maturities along the term structure of interest rates have risen by 0.10 percent or 10 basis points (bp).
Assume that the market consensus was for no change in interest rates, so the entire 10 bpincrease comes as an unexpected surprise.
Could the US$ be weaker as a result of this news? Could the US$ be stronger as a result of this news? Which is the correct response of the exchange rate to an increase in the level of interest rates - a weaker currency or a stronger currency?
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It could be that US$ interest rates could have risen because of concern about rising U.S. inflation (the Fisher Effect). Following purchasing power parity, a weaker US$ would be expected - call this path d.
Could the US$ be weaker as a result of this news?
The weaker US$ (path d) assumes that the rise in U.S. interest rates is stemming from inflationary concerns, and therefore a rise in the nominalinterest rate, but not necessarily the real interest rate.
FOREIGNUSSpot PP Δ−Δ=Δ %%%
( )USE Pri~
$$ Δ+=
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Might the US$ strengthen in response to the same news item?
If market participants were attracted by the higher yields now available to US$ securities, capital flows to the United States would contribute to a stronger US$ - call this path e.
The stronger US$ (path e) assumes that inflation is under control, so the higher interest rate corresponds to an increase in the real interest rate. And a higher real interest rate draws in foreign capital and raises the foreign exchange value of domestic currency.
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Which is the correct response of the exchange rate to an increase in the level of interest rates -a weaker currency or a stronger currency?
Because nominal U.S. interest rates respond to both real and inflationary factors, the exchange rate response must be ambiguous.
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From 1976 to 1978, the differential between U.S. and foreign interest rates rose from -3 percentage points to +4 percentage points.
Despite this sharp increase in interest rates, the trade-weighted value of the dollar depreciated by almost 20 percent, from 105.0 in mid-1976 to 85.0 by November 1978.
This is certainly an example of negative correlation between interest rates and exchange rates as in path d.
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In the following 2 years (1979-80), the correlation between exchange and interest rates turned significantly positive. Certainly, higher U.S. interest rates were stimulating US$ currency purchases.
The policy events behind this change include: (1) Nov 1, 1978’s intervention, which was intended to convince the market that U.S. policymakers were serious about controlling inflation and arresting the downward slide in the US$; (2) Oct. 6, 1979’s announcement by the U.S. Federal Reserve about a change in its operating procedure -the new policy emphasized containing the growth rate of monetary aggregates within announced limits, allowing interest rates to take on greater volatility.
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= exports – imports + unilateral transferscurrentaccount = government (tax collections – expenditures)
+ private (savings – investments)
¤ Case I: The shortfall in exports or increase in imports is viewed as permanent and the US$ weakens.
¤ Case II: The change is due to greater private sector investments, and the US$ strengthens as foreign capital flows in to finance the investments.
Story: It is announced that the U.S. current account deficit will reach an annual rate of $250 billion. ( The
consensus was $200 billion.)
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FIGURE 1, BOX 19-5 in Dornbusch/MacroeconomicsTHE U.S. CURRENT ACCOUNT AS A PERCENTAGE OF GDP, 1970-2000
Source: DRI/McGraw-Hill Macroeconomic Databasehttp://www.mhhe.com/economics/dornbusch8e/
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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 demand for a nation’s money as a currency or as an investment choice depends on a small group of factors including...
Foreign Exchange Rate Behavior: Major Concepts
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...national income, real interest rates, inflation rate, changes in national wealth (through the current account), preferred currency mix for holding financial wealth, financial risk factors, political risk factors etc.
Foreign Exchange Rate Behavior: Major Concepts
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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By “character,” we mean whether the news item was representing:- an unanticipated or anticipated disturbance- a permanent or transitory disturbance- a shock affecting the level of a variable or its
rate of change- a real or nominal (monetary) disturbance- a shock affecting a single industry sector or
an economy-wide shock- a shock to beliefs that were weakly held
or strongly held.
Foreign Exchange Rate Behavior: Major Concepts
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Foreign Exchange Rate Behavior: Major Concepts
By “context,” we mean a variety of factors including:- whether the monetary authorities are perceived
to have discipline relative to their targets- whether foreign demand for home country
currency & securities is satiated or growing- whether prices in the economy are free to adjust
quickly instead of being sticky- whether the shock resulted from a change in
exports instead of imports, a change in public savings instead of private savings, etc.
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By “nature” of the exchange rate response, we mean:
Foreign Exchange Rate Behavior: Major Concepts
- whether the exchange rate jumps at once to its next long-term equilibriumand stays there at rest
- or whether the exchange rate overshoots its next long-run equilibriumand continues to adjust following its initial jump
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Economic fundamentals form the backdrop for asset markets and, indeed, ultimately determine financial asset returns.
Key U.S. Economic Indicators & Their Interpretation
Financial market participants are increasingly called on to monitor economic indicators and interpret the data to determine the likely impact that new information will have on financial markets.
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Growth determines profits and real returns while inflation features prominently in setting the discount that is embedded, explicitly or implicitly, in every investment decision.
Key U.S. Economic Indicators & Their Interpretation
The focus is on the implications for growth and inflation.
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Barometric Indicators
Fig 6.5
Coincidentindicator(peak & trough)
Indi
cato
r lev
el (v
alue
)
Businesscycle
peak date
Businesscycle
trough date
Leadingindicator(peak & trough)
Laggingindicator(peak & trough)
Time
Note that an indicator may be peak-leading & trough-lagging.
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The composite index of leading indicators is composed of 10 equally weighted indicators that lead the economy:
1. Average weekly hours of production workers inmanufacturing.
2. Initial unemployment claims.3. Manufacturers’ new orders for consumer goods4. Vendor performance.5. Plant and equipment orders.6. Building permits. 7. S&P 500 Index of stock prices.8. M2 money supply.9. Interest rate spread, 10-year Treasury bonds less the
federal funds rate.10. Index of consumer expectations.
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Average weekly hours in manufacturing
This certainly is a key indicator since the more people working regularly, the more likely they will be consumers of goods and services. The question I would raise is if the U.S. is a service economy with six times more service hours than manufacturing hours (www.BLS.GOV/CES, see table six), then why not include the service hours worked as well as manufacturing hours?
6-104
Manufacturer’s new orders, non-defense capital goods
This is an excellent indicator for future capital investment. It could be asked whether this is really a leading indicator anymore. Most manufacturers I speak with tell me they will not be expanding their capital budgets for equipment until the general economy shows solid signs of improvement. If that’s the case, then this may be a lagging indicator during this particular business cycle.Just-in-time manufacturing would dictate no new plant and equipment until market demand says to invest. As long as deliveries stay short on capital equipment, manufacturers can get away with this strategy.
6-105
Stock prices, 500 common stocks
S&P 500 Index of stock prices is a leading indicator.
Another strictly manufacturing-focused stock index you might want to follow is the Heavy Metal 40 index maintained on website www.winningstrategy.com. Forty large manufacturing companies comprise the Heavy Metal Index, the HM40 index. Since stock prices reflect investor’s opinions about the earnings outlook for companies over the mid- to long-term, movements in stock prices generally precede the actual changes in the performance of the companies and are a very good leading indicator.
6-106
Money supply, M2This is an indicator that the Federal Reserve can manage to reinforce monetary policy. M2 is the sum of all cash, checking accounts, and money market funds in the economy available for purchases or investments. The Fed can juice up the money supply by purchasing treasury notes and bills and so releasing more cash into the economy. With Federal budget deficits forecast as far as the calculator can calculate, the Treasury will have ample opportunity to issue debt, and the Fed will have ample opportunity to purchase it along with individuals, both here and abroad.This cost is not bad when interest rates are low, but gets pretty scary when rates start to climb. The money supply should stay generous in a deficit-driven economy such as the future portends unless excessive inflation returns and then the money supply will tighten.
6-107
Interest rate spread, 10-year treasury bonds less federal funds
This indicator is a measure of the risk perceived by investors as they follow the prospects of the economy for the near and longer term. When the rate spread between the 10-year note (a longer term debt instrument) and the federal funds rate (a very safe short term debt instrument) is large, then the market is betting that the economy is in for future difficulties and investment and growth will be hard to sustain.When the spread narrows, the market is betting that economic results are destined to become stronger and so risk in investing has diminished.
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Heading Off DangerSince the mid-1990s, the Fed has moved in an aggressive, pre-emptive fashion to maintain growth and price stability.
Source: WSJ: The Greenspan Era
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8324.87As of 0706 2009
1787.40As of 0706 2009
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The composite index of coincident (at the same time) indicators is comprised of only four indicators:
1. Employees on nonagricultural payrolls.2. Personal income. 3. Index of industrial production.4. Manufacturing and trade sales.
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The composite index of lagging (following) indicators has seven items:
1. Average unemployment duration.2. Manufacturing inventories/sales ratio.3. Changes in per-unit labor cost.4. Prime rate changes.5. Commercial and industrial loan outstanding6. Ratio of consumer installment credit
outstanding to personal income.7. Changes in the consumer price index
for services.
6-112
Measuring Exchange Rate Movements
• An exchange rate measures the value of one currency in units of another currency.
• A decline in a currency’s value is referred to as depreciation, while an increase is referred to as appreciation.
• % Δ in foreign currency value = (S - St-1) / St-1
• A positive % Δ represents appreciation of the foreign currency, while a negative % Δrepresents depreciation.
Exchange Rate Determination
6-113
Exchange Rate Equilibrium
• An exchange rate represents the price of a currency, which is determined by the demand for that currency relative to supply.
Value of £
Quantity of £
equilibrium exchange
rate
S
D
Exchange Rate Determination
6-114
Factors that Influence Exchange Rates
• Relative Inflation Rates¤ A relative increase in U.S. inflation will increase
the U.S. demand for British goods, and hence the U.S. demand for British pounds.
¤ In addition, the British desire for U.S. goods, and hence the supply of pounds, will drop.
Value of £
Quantity of £
S
DD2
S2
r2r
Exchange Rate Determination
6-115
Factors that Influence Exchange Rates
• Relative Interest Rates¤ A relative rise in U.S. interest rates will
decrease the U.S. demand for British pounds. ¤ In addition, the supply of pounds by British
corporations will increase.
Value of £
Quantity of £
S
DD2
S2rr2
Exchange Rate Determination
6-116
Real Interest Rates¤ A relatively high interest rate may reflect
expectations of relatively high inflation, which may discourage foreign investment.
¤ Real interest rates adjusts nominal interest rates for inflation:
real nominalinterest = interest - inflation
rate rate rateThis relationship is sometimes called the Fisher effect.
Factors that Influence Exchange Rates
Exchange Rate Determination
6-117
Factors that Influence Exchange Rates
Value of £
Quantity of £
S
DD2
rr2
• Relative Income Levels¤ A relative increase in the U.S. income level will
increase the U.S. demand for British goods, and hence the demand for British pound.
¤ The supply of pounds does not change.
Exchange Rate Determination
6-118
• Government Controls¤ Governments can influence the equilibrium
exchange rate in many ways, including :– the imposition of foreign exchange barriers,– the imposition of foreign trade barriers,– intervening in the foreign exchange market, and– affecting macro variables such as inflation, interest
rates, and income levels.
Factors that Influence Exchange Rates
Exchange Rate Determination
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• Expectations¤ Foreign exchange markets react to any
news that may have a future effect.¤ Institutional investors often take currency
positions based on anticipated interest rate movements in various countries too.
¤ Because of speculative transactions, foreign exchange rates can be very volatile.
Factors that Influence Exchange Rates
Exchange Rate Determination
6-120
Factors that Influence Exchange RatesTrade-Related
Factors1. Inflation
Differential2. Income
Differential3. Gov’t Trade
Restrictions
FinancialFactors
1. Interest Rate Differential
2. Capital FlowRestrictions
U.S. demand for foreign goods, i.e. demand for
foreign currency
Foreign demand for U.S. goods, i.e. supply of
foreign currency
U.S. demand for foreign securities, i.e. demand
for foreign currency
Foreign demand for U.S. securities, i.e. supply of
foreign currency
Exchange rate
between foreign
currency and the dollar
Exchange Rate Determination
6-121
• Interaction of Factors¤ Trade-related factors and financial factors
sometimes interact. For example, an increase in income levels sometimes causes expectations of higher interest rates.
¤ Over a particular period, different factors may place opposing pressures on the value of a foreign currency. The sensitivity of the exchange rate to these factors is dependent on the volume of international transactions between the two countries.
Factors that Influence Exchange Rates
Exchange Rate Determination
6-122
Factors that Influence Exchange Rates
Rx
• Economic Factors¤ relative interest rates¤ purchasing power parity (PPP)¤ economic conditions (balance of payments,
economic growth, rate of inflation, money supply, unemployment figures, rates of taxation)
¤ supply and demand for capital (capital flows to a country where investors see opportunities)
6-123
Factors that Influence Exchange Rates
Rx
• Political Factors¤ the type of economic policies pursued by the
government¤ the amount of uncertainty in the political
situation¤ the regulatory policies followed by central banks
and/or other regulatory bodies¤ central bank intervention in the foreign
exchange market to strengthen or weaken its currency
6-124
Factors that Influence Exchange Rates
Rx
• “People” Factors¤ market sentiment (the perception traders have
of the short-term prospects for the movement in a currency)
¤ technical analysis (many market participants trade on the basis of past price movements)
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How Factors Have Influenced Exchange Rates
¤ Because the dollar’s value changes by different magnitudes relative to each foreign currency, analysts measure the dollar’s strength with an index.
60
100
140
180
1972 1977 1982 1987 1992 1997
Dol
lar’s
Inde
x
Year
high U.S.inflation
high U.S. interest rates, a somewhat depressed U.S. economy, and low inflation
large balance of trade deficit
high U.S. interest rates
Persian Gulf War
Exchange Rate Determination
6-126
Speculating on Anticipated Exchange Rates
Chicago Bank expects the exchange rate of the New Zealand dollar to appreciate from its present level of $0.50 to $0.52 in 30 days.
Exchange Rate Determination
1. Borrows $20 million
2. Holds NZ$40 million
Exchange at $0.50/NZ$
Lends at 6.48% for 30 days 3. Receives
NZ$40,216,000
Exchange at $0.52/NZ$
4. Holds $20,912,320
Borrows at 7.20% for 30 days
Returns $20,120,000Profit of $792,320
Start here
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Speculating on Anticipated Exchange Rates
Chicago Bank expects the exchange rate of the New Zealand dollar to depreciate from its present level of $0.50 to $0.48 in 30 days.
Exchange Rate Determination
1. Borrows NZ$40 million
2. Holds $20 million
Exchange at $0.50/NZ$
Lends at 6.72% for 30 days 3. Receives
$20,112,000
Exchange at $0.48/NZ$
4. Holds NZ$41,900,000
Borrows at 6.96% for 30 days
Returns NZ$40,232,000Profit of NZ$1,668,000
or $800,640
Start here
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Flow versus Stock Models of the Exchange Rate
A model of exchange rate determination requires the specification of demand and supply curves, the intersection of which determines a price.
Flows approach concentrates on the flows of currency passing through the foreign exchange market. Foreign exchange was thought to be in demand or supply largely as a medium of exchange for executing international trade transactions.
6-129
The flow demand for UK£ represents American demand for British goods and services. The supply of UK£ represents the demand for American goods by British residents. The intersection of the two determines the exchange rate.
Flow versus Stock Models of the Exchange Rate
Priceof £
Quantityof £/Time
Demand
Supply
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Flow versus Stock Models of the Exchange Rate
Stock approach focuses on the total quantity of currency outstanding at a moment in time.
Currency is treated as an asset - durable and transferable.
At a moment in time, the stock of currency is in fixed supply.
At the equilibrium currency price, the stock of currency is willingly held.
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Figure 6.4 provides an example of the stock approach for the static case where the supply of currency is fixed.
Holding demand constant, an increase in the supply of £ to S’ (through money creation or retiring £ bonds) leads to a fall in the price of £to point b.
Holding supply constant, an increase in the demand for £ leads to a rise in the price of £ to point c.
Flow versus Stock Models of the Exchange Rate
6-132
Determination of Exchange Rates: A Stock Approach
Price ofsterling
Quantity of sterlingat a moment in time
$2.82
$2.78
S S ’D D ’
D
D ’
a
c
b
Figure 6.4
6-133
Flow versus Stock Models of the Exchange Rate
The stock approach is also known as the asset approach - where the current exchange rate is set to equilibrate the (risk-adjusted) expected rate of return on assets denominated in different currencies.
In the asset approach the current spot exchange rate is set equal to the present discounted value of the expected future spot exchange rate.
6-134
From current spot rate, the expected US$-denominated return on a UK £ investment can be obtained.
);~()1()1(
1$
£+×
++
= tt SEiiS
£$50.1
)1(%)101(
£$4474.1
$
×++
=i
Recall that from the International Fisher Effect:
Flow versus Stock Models of the Exchange Rate
%6.3£$4474.1)
£$4474.1
£$50.1( =−
An US investor would earn about 3.6% on the expected exchange rate change:
6-135
%1411.1£$4474.1
£$50.1$ =−×=i
To produce a US$ return of 14 percent on UK assets:
Flow versus Stock Models of the Exchange Rate
However, if St= $1.5421/£ (point B), the corresponding numbers are:
£$50.1
)1(%)101(
£$5421.1
$
×+
+=
i
%73.2£$5421.1)
£$5421.1
£$50.1( −=−
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%711.1£$5421.1
£$50.1$ =−×=i
To produce a US$ return of 7 percent on UK assets:
Flow versus Stock Models of the Exchange Rate
However, if St= $1.5421/£ (point B), the corresponding numbers are:
-2.73% on the expected exchange rate change, and a US$ return of only 7% on UK assets
=> current US$/£ exchange rate and expected US$ return on UK assets are negatively related.
6-137
The Current US$/£ Exchange Rate and the Expected US$ Return on UK Assets
Figure 6.5
1.35
1.40
1.45
1.50
1.55
1.60C
urre
nt U
S$/£
Exc
hang
e R
ate
Expected US$ Return on UK Assets
B
0.06 0.08 0.10 0.12 0.14
A
Assumptions1. The expected future
spot rate is $1.50/£.2. The nominal interest
rate on £ is 10.0%.
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Foreign exchange is used as both a medium of exchange and a store of value, so an overall equilibrium in the foreign exchange market requires balance in both flow and stock aspects of the market.- stock concept (as in the asset approach) are important for the determination of exchange rate in the short run.
- flow imbalance can be maintained over the short run as long as surplus (deficit) countries are willing to accumulate (run down) assets.
Combining Flow and Stock Concepts of the Exchange Rate
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No deficit country wants to accumulate liabilities to foreigners forever either since the marginal cost of debt is rising, and will finally cut into present consumption.
Combining Flow and Stock Concepts of the Exchange Rate
In the long run, no surplus country wants to accumulate foreign assets forever since the risks of counterparty default are high and the cost of forgone consumption is high.
6-140
A country that runs a current account surplus accumulates wealth, and may use this wealth to bid for international assets; a deficit country relinquishes its wealth.
Combining Flow and Stock Concepts of the Exchange Rate
Thus transfers of wealth through the current account may tilt the demand for currencies in the foreign exchange market.
6-141
Asset Modelsof the Spot Exchange Rate
Small Country Model
Preferred LocalHabitat Model
Uniform PreferenceModel
Portfolio-Balance Approach Monetary Approach
imperfect capital substitutability perfect capital substitutability
Monetarist Model
Overshooting Model
completely flexiblecommodity prices
sticky commodity prices
Asset Model Approach
perfect capital mobility
6-142
Models based on the asset approach begin by specifying a menu of assets. The interrelationship between the demand and the supply of those assets determines the price of foreign exchange.
In the monetary approach, the menu is short and simple - just the domestic and foreign money, M and M*.In the portfolio-balance approach, the menu of assets include M, M*, and domestic and foreign bonds (B and F).
Asset Models of the Spot Exchange Rate
6-143
The Monetary Approach to Exchange Rate Determination is derived directly from…
1. purchasing power parity, and 2. the quantity theory of money
(the quantity of money available determinesthe price level and the growth rate in thequantity of money available determines theinflation rate)
The Monetary Approach
6-144
PPP concludes that the exchange rate is the relative price of goods in two countries; monetary theory suggests that spot exchange rates are the relative price of two monies.
It follows that exchange rate behavior reflects the evolution of the relative supplies and demands for two monies.
The Monetary Approach
Within the monetary approach are two models, the flexible-price model and the sticky-price model.
6-145
Assuming that domestic good prices are fully flexible (i.e., if domestic money supply↑ => domestic currency value ↓ proportionately), then the implication is that PPP holds continuously and the real exchange rate never changes.
demandmoney supplymoney
),(level price ===
iYLMP
For the home country,
where Y is domestic real income (real GDP)
Flexible-Price Models
6-146
countryforeign for the),( **
**
iYLMP =
)assumption(by 0 0; where <∂∂
>∂∂
iL
YL
Y represents transactions demand for money; i is opportunity cost of holding money balances.
By PPP condition,
),(),(****gnhome/forei iYLM
iYLMPPS ==
Flexible-Price Models
i decreases => demand of local currency increases or L(Y, i) increases => S decreases => foreign currency depreciates
6-147
countryforeign for the),( **
**
iYLMP =
)assumption(by 0 0; where <∂∂
>∂∂
iL
YL
Y represents transactions demand for money; i is opportunity cost of holding money balances.
By PPP condition,
),(),(****gnhome/forei iYLM
iYLMPPS ==
Flexible-Price Models
i* decreases => demand of foreign currency increases or L(Y*, i*) increases => S increases => foreign currency appreciates
6-148
A common specification of the money demandfunction is ieKYiYL ),( εη −=
hands changesmoney rate1
money ofvelocity 1
==K
income%demandedmoney ofquantity %
ΔΔ
=η
DY
YD
YYDD
•∂∂
=ΔΔ
=η = income elasticity of DMoney
MoneyDi ofcity semielasti =ε
Flexible-Price Models
6-149
(6.3) * *
**
* i
i
eKYMeYMK
PPS
εη
εη
==
ttttt iikkyymmS )()()()(ln **** −+−+−+−= εη
YyKkMm ln,ln,ln ===
(6.3) and (6.4) =>predictions of theflexible-price monetary model => if M ↑ 2M -> (1/S), domestic
currency value ↓ 1/2 (1/S)
Flexible-Price Models
(6.4)
6-150
Flexible-Price Monetary Model
• A common specification of L(Y,i) is K Yηe– ε i
K - constant (the inverse of the velocity of money)
η - income elasticity of the demand for moneyε - interest rate semielasticity of the demand for
money
• By PPP, * *
**
*gnhome/forei i
i
eKYMeYMK
PPS εη
εη
==
( ) ( ) ( ) ( )ttttt iikkyymmS **** ln −+−+−+−=⇒ εη
subscript timea is ln ,ln ,ln where
tYyKkMm ===
6-151
(6.3) predicts that the domestic currency will appreciate in response to a rise in domestic real income (Y) or a fall in domestic interest rate (i), because both changes will increase the demand for domestic money.
While a rise in US real income will lead to greater demand for imports and an increased demand for foreign currency, it is only a partial equilibrium result that neglects capital flows that also respond to an increase in US income.
Flexible-Price Models
6-152
Monetary theory argues that in general equilibrium, the net effect of higher US income should be a US$ appreciation because the increase in the demand for money and the corresponding improvement in the financial account (formerly called the capital account) exceeds the decline in the trade balance.
The Monetary Approach
6-153
- another Balance of Payment (BOP) account- asset (real & financial) transactions- payment flows from current account transactions
- the way they are recorded on the US BOP account is US assets abroad (net), Foreign assets in the US (net)
- don’t interpret these terms as ‘physically’ beingabroad, e.g., a US bank in New York acquiringDM increases the item ‘US assets abroad’
- anything that is capital inflow is a credit, anything that is a capital outflow (“capital export”) is a debit
Financial Account
6-154
DEBIT (-) CREDIT (+)CAPITAL EXPORT(-) CAPITAL IMPORT(+)
↑US assets abroad ↑foreign assets in thee.g. US citizens buy U.S. e.g. Japanese firmJapanese stocks/bonds buys Sears tower
↓foreign assets in the ↓US assets abroad US e.g. Japanese e.g. US firm sells stake citizens sell US stocks in British firm
Financial Account
6-155
- introduced by Rudiger Dornbusch (1976)- highlight the impact of assuming that the speedof adjustment of goods prices is slow relative tothe speed of adjustment of asset prices
- when a central bank announces its money supply figures, the traders in financial marketsrespond quickly, adjusting the prices of varioussecurities and their portfolio positions until a new equilibrium is reached; while Wal-Mart,McDonalds’ prices remain virtually the same and change only gradually in response to general inflationary pressures
Sticky-Price (Overshooting) Monetary Models
6-156
Sticky-Price (Overshooting) Monetary Models
When good prices are sticky, Dornbusch showed that it is necessary for asset prices to move by more than in the flexible price case, in order for markets to reach a temporary equilibrium.
He also showed that the gradual adjustment of goods prices following a monetary shock reveals a dynamic adjustment path to the exchange rate,
so that while the real exchange rate changes in the short run, it reverts to its original level in the long run.
6-157
i.e. the only time sequence of exchange rates that accurately reflects the nature of the shock and removes all unusual profit opportunities in financial markets.
Sticky-Price (Overshooting) Monetary Models
The Dornbusch model assumes perfect certainty.
The exchange rate path derived is the only equilibrium path...
6-158
Sticky-Price (Overshooting) Monetary Models
Prior to this monetary shock, assume i = i* and exchange rate is at PPP rate S0. The shock occurs at t1, raising the domestic money supply M0 to M1 (liquidity effect occurs).
In response to a one-time, permanent, unanticipated jump in the domestic money supply, iUS↓, US$ value↓ and capital flows out of US to foreign countries with higher i*.
6-159
Traders dilemma: How can they willingly hold domestic currency that will depreciate over the long term and also pay a low interest rate?
In the short run S0>> S1 [(1/S0) << (1/S1) US$ depreciates too much]. Over the long term (1/S1) < (1/SN) (US$ appreciates) => IRP will hold:
*1 ][ iiSSF ttt −=−+
Sticky-Price (Overshooting) Monetary Models
Over time, the excess money supply leads to US price inflation, and iUS↑ gradually as the liquidity effect goes away and the US$ gradually appreciates.
6-160
In the long run, the economy is once again in equilibrium at a higher price level (PN) and higher (depreciated) exchange rate (SN), but at the same real exchange rate as before the shock.
In the long run, iUS returns to its original level and the US$ has depreciated in nominal terms, but the real exchange rate is unaffected.
Sticky-Price (Overshooting) Monetary Models
6-161
US price level
$ Interest rate
US money supply
Timet 1 t N
Time-Series Pattern of Variables in the Sticky-Price (Overshooting) Monetary Model
Figure 6.7
Nominal exchange rate ($/FC)
M 0
P 0
S 0
M 1
P N
S 1
S N
6-162
This relationship, where the immediate, short-run change in the nominal exchange rate exceeds the long-run change in the nominal exchange rate, is defined as overshooting. Because goods prices are sticky in the short run, the real exchange rate also follows an overshooting path.Thus, a monetary disturbance which in the long run has only nominal effect (changing the price level and the nominal exchange rate) has real effect in the short run by changing the real exchange rate and the competitiveness of firms in international trade.
Sticky-Price (Overshooting) Monetary Models
6-163
Sticky-Price (Overshooting) Monetary Model
• Both the nominal and real exchange rates follow an overshooting path. (The immediate, short-run change exceeds the long-run change.)
• The path of the exchange rate is given by:( ) ( ) ( ) tttt iiyymms
*
*
* 1 −+−+−=θ
η
where θ is the rate at which the exchange rate adjuststoward its long-run equilibrium.
6-164
“Overshooting” defined - prices move by “too much” in the short-run relative to some benchmark» Relative to the movement if markets had full
information» Relative to the movement needed to establish PPP» Our def’n: Relative to the movement required in the
long-runYou have encountered overshooting before in the market for goods that are in limited supply when there is a sudden demand shock» “Overshooting” of this sort is not bad, an equilibrium
result caused by rigidities of some sortTypical microeconomics example: Rigidities in supplyInternational finance example: Stickiness in goods prices
Price Dynamics and “Overshooting”
6-165
Initial equilibrium at “A”, then sudden shift in demand from D to D’In the short-run prices “overshoot” to $12,000 and gradually adjust to their long-term equilibrium at $11,000
Price Dynamics in the Marketfor Honda (fuel efficient) Automobiles
Price/Unit
$12,000
$11,000
$10,000
S (Very short-run)
S (Long-run)
8,000 10,000 Quantity/Time
BC
DD’
A
6-166
As an empirical regularity, we find that prices of goods are less variable in the short-run than exchange rates. Domestic prices of goods are described as “sticky” or “rigid” but in the long-run, goods prices become more flexible.
Inflation and Exchange Rate Dynamics
6-167
Exchange Rate Overshooting (1 of 2)
US pricelevel
$ Interestrate
US moneysupply
TimeT(1) T(N)
Nominalexchangerate ($/FC)
Consider the following “experiment”.Assume i($)=i(£) and exchange rate is flat and not expected to change.
NOW, let the US money supply rise unexpectedly by 1% at time T(1), while conditions in the rest of the world stay unchanged.The surplus of money leads $ interest rates to fall, but goods prices are sticky.As a result, capital flows out of US, and toward foreign investments, and $ depreciates.
6-168
US pricelevel
$ Interestrate
US moneysupply
TimeT(1) T(N)
Nominalexchangerate ($/FC) Long-Run value
Exchange Rate Overshooting (2 of 2)$ has two strikes against it(1) Low interest rates(2) Excess money supply
likely to cause inflation in the long run
Puzzle: How to get investors to willingly hold US$ assets?
Answer: Let the US$ depreciate immediately by “too much”, to “overshoot.Then in the medium run, the US$ can appreciate, and compensate investors for the low $ interest rate.
6-169
Why does exchange rate “overshooting” occur?» Goods prices are sticky in the short run. If goods
prices were completely flexible, then M(US)↑ by x%, P(US)↑ by x%, and S($/£)↑ by x% in an instant. (Monetary approach + PPP)
» Capital is very mobile, and asset prices adjust quickly.» The world is noisy. Unexpected macroeconomic shocks.Is overshooting a bad thing? In our context, “No”» It is an natural process to equilibrate returns in US
assets and foreign assets, and remove arbitrage profits» It reflects full information, and not confusion» Would be better to have fewer macroeconomic surprises
(less exchange rate volatility), but surprises happen.Even with overshooting, PPP holds in long run
Lessons of Exchange Rate Overshooting
6-170
Should be very difficult to predict changes» Asset markets tend to be efficient, prices reflect
information» Short-run price changes caused by “news” -
unpredictableShort-run prediction» Many analysts use technical, trend-following models
to predict the direction (but not magnitude) of changes» No traditional economic foundation for these models,
but studies find that they are often useful & profitable.Medium to Long-run prediction» Some evidence that exchange rates gravitate toward
the values indicated by structural, monetary models» Short-run deviations are temporary, in the medium to
longer run, fundamentals matter for exchange rates
Predicting Exchange Rate Changes
6-171
Asset Modelsof the Spot Exchange Rate
Small Country Model
Preferred LocalHabitat Model
Uniform PreferenceModel
Portfolio-Balance Approach Monetary Approach
imperfect capital substitutability perfect capital substitutability
Monetarist Model
Overshooting Model
completely flexiblecommodity prices
sticky commodity prices
Asset Model Approach
perfect capital mobility
6-172
- focuses on the excess demand for financialassets
- money & bonds assets; home & foreigncountries
- assume that home country agent are free toallocate their wealth (W) among three holdings: domestic money (M), domestic bonds (B), foreign bonds(F / valued at SF)
- home country wealth W ≡ M + B + SF- the greater the country’s fiscal deficit, the
larger the supply of government bonds
The Portfolio Balance Approach
6-173
- ↑domestic interest rate i => ↑domestic demandfor domestic bonds B (1)
- ↑[foreign interest rate i* + expected exchangerate change E(s)] => ↑domestic demand for foreign bonds F (2)
- ↑[ Ø = i - i* - E(s)] => ↑[domestic demand for B-domestic demand for F] (1) - (2)
- Ø represents the expected excess return ondomestic currency bonds over foreign currency bonds
The Portfolio Balance Approach
6-174
The Portfolio Balance Approach
The second element in the demand for bonds is wealth itself.
As W↑, (M, B, F)↑.
How individuals spread their wealth across M, B, F has an important impact on the exchange rate.
6-175
Under this model, if wealth grows faster in the home or foreign country, there is no exchange rate impact because investors from both countries bid for assets in the same proportions.
The Portfolio Balance Approach
The Uniform Preference Model makes sense if both domestic and foreign investors consumed the same basket of goods and therefore found it sensible to hold identical investment portfolios.
6-176
The Preferred Local Habitat Model assumes that BH/WH > FH/WH and FF/WF > BF/WF where the subscripts H and F indicate home and foreign residents. That is, both the home and foreign countries prefer to hold a larger fraction of their wealth in local bonds. Assume as follows:
bond portfolios compositionsin US$ in Yen
US investor 90% 10%Japan investor 30% 70%
The Portfolio Balance Approach
A yen-denominated bond issued in Tokyo by a non-Japanese company and subject to Japanese regulations, Samurai Bond, has hence prospered.
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If US runs $1 billion current account deficit, then(0.9 billion US$ + 0.1 billion Yen) moves from US hands to Japanese hands to become (0.3 billion US$ + 0.7 billion Yen). The transfer of wealth would tend to shift demand toward the Japanese Yen (and Yen assets) and away from US$ assets.
The portfolio balance model, with demand given by preferred local habitat, predicts a correlation between current account surpluses (deficits) and strong (weak) currencies.
The Portfolio Balance Approach
6-178Assumption: all other aspects of the economy are unchanged.
The Portfolio Balance Approach
Effects of Macroeconomic Shocks on the Exchange Rate
BFii*E(s)
WCA
supply of home country bondssupply of foreign country bondsdomestic interest ratesforeign interest rateexpected rate of home currencydepreciation
home country wealthhome country current account surplus
S+ hc depreciatesS- hc appreciatesS- hc appreciatesS+ hc depreciatesS+ hc depreciates
S- hc appreciatesS- hc appreciates
Increase inImpact on
home currency
all
preferredlocal
habitat
Model
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↑W(US wealth) => ↓S => ↑ (1/S) => US$ appreciates
and
↑CA(US current account surplus) => ↓S => ↑ (1/S)
The Portfolio Balance Approach: Effects of Macroeconomic Shocks on the Exchange Rate
Preferred local habitat version, US is home country
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The portfolio balance approach highlights the role of wealth and views assets as imperfect substitutes.
The exchange rate and interest rates have to adjust to ensure portfolio equilibrium at which the assets are willingly held by investors.
The Portfolio Balance Approach: Effects of Macroeconomic Shocks on the Exchange Rate
All versions, US is home country
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The Portfolio Balance Approach: Effects of Macroeconomic Shocks on the Exchange Rate
All versions, US is home country
Let’s consider a very simple version of the portfolio balance model:B/SF = Exp {α + β [ i - i* - E(ΔS)]}
ln [B/SF] = ln { Exp {α + β [ i - i* - E(ΔS)] } }
lnB - lnS - lnF = α + β [ i - i* - E(ΔS)]
S equation: s = -α - β [ i - i* - E(ΔS)] + b - fwhere b = lnB, f = lnF, s= lnS
What if bond-financed gov’t deficits ↑?
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(Note that ↑S => ↓(1/S) => US$ depreciates and↓S => ↑(1/S) => US$ appreciates)
↑B(Supply of US bonds) => ↑S↑F(Supply of Foreign bonds) => ↓S↑i (US interest rate) => ↓S↑i* (Foreign interest rate) => ↑S↑ E(s) Expected rate of US$ depreciation => ↑S
Note: ↑B(Supply of US bonds) => ↑S by assuming i fixed and all the adjustment takesplace in S
The Portfolio Balance Approach: Effects of Macroeconomic Shocks on the Exchange Rate
All versions, US is home country
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Monetary approach assumes perfect substitutability between domestic and foreign currency bonds. That is to say, an investor will be indifferent between holding B and F if Ø = 0, or i - i* = E(s) = expected %ΔS
Ø = i - i* - E(s) defines the exchange risk premium
ttt SSSE ])~([ 1 −= +
(International Fisher Effect)
Monetary Approach v.s. Portfolio Balance Approach
6-184
Portfolio balance approach allows imperfect substitutability between domestic and foreign currency bonds, with Ø = i - i* - E(s) ≠ 0.
It makes sense with the differences : liquidity, tax treatment, default risk, political risk, and exchange risk.
Monetary Approach v.s. Portfolio Balance Approach
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An overall equilibrium in the foreign exchange market would balance both flow and stock dimensions of the market.Figure 6A.1 has positive numbers emanating from the origin. Take the initial condition as an equilibrium in both the stock market (at point A) and in the flow market (at point a), where each show an exchange rate of $0.50/DM. The supply curve in Figure 6A.1 represents the supply of German government bonds offered to non-German investors.
The Implications of Flow and Stock Equilibrium onthe Foreign Exchange Rate
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Determination of Exchange Rates:A Simultaneous Stock and Flow Approach
Quantity of DMper unit of time
Quantity of DM at a moment in time
$/DMFlow Stock
$0.50a A
s
dS
D
Figure 6A.1
++0
s
d S
D
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Figure 6A.2 represents a shock to the stock demand schedule - investors seek to increase permanently their holdings of DM-denominated assets.The stock demand schedule shifts outward to D’D’ and intersects the stock supply schedule at $0.52/DM. DM appreciates immediately to clear the stock market.
The Implications of Flow and Stock Equilibrium onthe Foreign Exchange Rate
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With the weaker dollar, the US runs a current account surplus equal to the amount bc per period. The current account surplus implies that the US is accumulating foreign assets, so over time the stock supply schedule shifts outward, eventually reaching S’S’.
On the flow side, the stronger DM has resulted in an excess flow supply of DM in the amount bc. The flow demand for German goods has fallen with the appreciating DM, while the flow supply for US goods has risen along with the depreciating dollar.
6-190
Stock and Flow Reactions to Permanent Increase in the Stock Demand for German Assets
Quantity of DMper unit of time
Quantity of DM at a moment in time
$/DMFlow Stock
$0.50aA
s
dS
D
Figure 6A.2
$0.52b c
BC
S’
D’
0 ++
s
d S
D D’
S’
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A stylized version of the time path of the exchange rate following this permanent stock demand shock is shown in Figure 6A.3. The jump in the exchange rate occurs immediately to clear the stock market.Since the US cannot run a current account surplus indefinitely - nor Germany a current account deficit indefinitely - the exchange rate changes gradually to bring about a long-run equilibrium in both the stock and flow dimensions.
The Implications of Flow and Stock Equilibrium onthe Foreign Exchange Rate
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Exchange Rate Response to Permanent Increase in the Stock Demand for German Assets
Figure 6A.3
$/DM
$0.52
$0.50
TimeT0 T1
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Next consider a shock to the flow demand schedule.
Suppose that consumers seek to increase permanently their purchase of German goods and services.This is shown in Figure 6A.4 by an outward shift in the flow demand schedule to d’d’, such that the intersection with the flow supply schedule occurs at $0.52/DM.
The Implications of Flow and Stock Equilibrium onthe Foreign Exchange Rate
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With the increase in demand for German goods, the US runs a current account deficit equal to the amount ba per period.The current account deficit implies that the US is reducing its stock of foreign assets, so over time the stock supply schedule shifts inward, eventually reaching S’S’.
The appreciation of the DM does not occur immediately because in this stylized model the exchange rate is determined in the stock market, which is unaffected. With the exchange rate at $0.50/DM, there is excess flow demand for DM in the amount ba.
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Stock and Flow Reactions to Permanent Increase in the Flow Demand for German Goods
Quantity of DMper unit of time
Quantity of DM at a moment in time
$/DMFlow Stock
$0.50a A
s
dS’
D
Figure 6A.4
$0.52
bc B
S
d’
0 ++
s
dd’ S’
S
D
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Figure 6A.5 contains a stylized version of the time path of the exchange rate following this permanent flow demand shock.The exchange rate changes gradually to clear the flow market, while the stock market is cleared at all times.Again the logic is that the current account imbalance cannot persist indefinitely, so that the exchange rate must eventually bring about a long-run equilibrium in both stock and flow dimensions.
The Implications of Flow and Stock Equilibrium onthe Foreign Exchange Rate
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Exchange Rate Response to Permanent Increase in the Flow Demand for German Goods
Figure 6A.5
$/DM
$0.52
$0.50
TimeT0 T1
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Because asset portfolios can be rebalanced quickly and at a low cost, these actions will influence exchange rate behavior (and vice versa) over the short run.
The Implications of Flow and Stock Equilibrium onthe Foreign Exchange Rate
Figure 6A.4 and 6A.5 illustrate one important stylized finding in models of exchange rate determination. The stock side is of primary importance for the determination of exchange rates in the short run.
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Flow imbalances can be maintained over the short run as long as surplus countries are willing to accumulate assets and deficit countries are willing to run down assets.
The Implications of Flow and Stock Equilibrium onthe Foreign Exchange Rate
Eventually, flow imbalances cannot be left unchecked. The flow side becomes an anchor for the exchange rate in the long run.
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A speculative bubble is measured by the difference between the present spot rate and the fundamental equilibrium rate.
A speculative bubble could develop if traders buy a currency not based on a determination that it undervalued on the basis on fundamentals, but solely on the basis that the currency is expected to appreciate in tomorrow’s market.
Speculative Bubbles
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Fundamentals: The basic economic, financial, and operating factors that influence the success of a business and the price of its securities. Fundamentals of a security include the price-earnings ratio, dividend payout, and earnings-per-share growth.
If other traders also buy based on the expectation of further appreciation, rather than on the basis of fundamentals, a bubble may develop between the actual spot rate and its fundamental value.
Speculative Bubbles
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note that there is no bubble on oil, the strong support of "demand" pushes up the price; the demand comprises real and speculators' demand
Source: WSJ 0516 2008 Bernanke's Bubble Laboratory; Princeton Proteges of Fed Chief Study the Economics of Manias
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The Market for Loanable Funds
Saving = Domesticinvestment
Net foreigninvestment+
S = I + NFI
Net foreign investment is the purchase of foreign assets by domestic residents minus the purchase of domestic assets by foreigners.
6-204
Equilibriumquantity
Quantity ofLoanable Funds
RealInterest
Rate
Equilibriumreal interest
rate
Supply of loanable funds(from national saving)
Demand for loanable funds (for domestic investment
and net foreign investment)
A MACROECONOMIC THEORY OF THE OPEN ECONOMY
The Market for Loanable Funds
6-205
The Market for Loanable FundsThe interest rate in an open economy, as in a closed economy, is determined by the supply and demand for loanable funds.National saving is the source of the supply of loanable funds. Domestic investment and net foreign investment are the sources of the demand for loanable funds.At the equilibrium interest rate, the amount that people want to save exactly balances the amount that people want to borrow for the purpose of buying domestic capital and foreign assets.
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The Market for Foreign Currency Exchange
Net foreign investment = Net exports
NFI = NX
Suppose that Boeing sells some planes to a Japanese airline for yens. This sale increases U.S. net exports and U.S. net foreign investment by the same amount. Boeing then exchanges its yen for dollars with a U.S. mutual fund that wants the yen to buy stock in Sony (Japan). NX and NFI rise by an equal amount again!
6-207
Equilibriumquantity
Quantity of Dollars Exchangedinto Foreign Currency
RealExchange
Rate
Equilibrium real
exchange rate
Supply of dollars(from net foreign investment)
Demand for dollars(for net export toforeign countries)
A MACROECONOMIC THEORY OF THE OPEN ECONOMY
The Market for Foreign Currency Exchange
Quantity of US Cadilacsexchanged to German Mercedes Benz
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The Market for Foreign Currency ExchangeThe real exchange rate is determined by the supply and demand for foreign-currency exchange.The supply of dollars comes from net foreign investment (NFI). Because NFI does not depend on the real exchange rate, the supply curve is vertical. The demand for dollars comes from net exports. Because a lower real exchange rate stimulates net exports (and thus increases the quantity of dollars demanded to pay for these net exports), the demand curve is downward sloping.At the equilibrium real exchange rate, the number of dollars people supply to buy foreign assets exactly balances the number of dollars people demand to buy net exports.
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Net Foreign Investment :The Link Between the Two Markets
S = I + NFI
NFI = NX
6-210
0 Net ForeignInvestment
Net foreign investmentis negative.
Net foreign investmentis positive.
RealInterest
Rate
A MACROECONOMIC THEORY OF THE OPEN ECONOMY
How Net Foreign Investment Depends on the Interest Rate
6-211
How Net Foreign InvestmentDepends on the Interest Rate
Because a higher domestic real interest rate makes domestic assets more attractive, it reduces net foreign investment.Note the position of zero on the horizontal axis: Net foreign investment can be either positive or negative.
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Equilibrium in the Open Economy
Prices in the loanable funds market and the foreign-currency exchange market adjust simultaneously to balance supply and demand in these two markets.As they do, they determine the macroeconomic variables of national saving, domestic investment, net foreign investment, and net exports.
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(a) The Market for Loanable Funds (b) Net Foreign Investment
(c) The Market for Foreign-Currency Exchange
Quantity ofLoanable Funds
Demand
Supply
Quantity of Dollars
Demand
Supply
Net ForeignInvestment
Net foreign investment, NFI
Real Exchange
Rate
Real Interest
Rate
Real Interest
Rate
r1
E1
r1
The Real Equilibrium in an Open Economy
US$ is in the denominator,As in Econ Literature
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How Changes in Policies and Events Affect an Open Economy
The magnitude and variation in important macroeconomic variables depend on the following:
Government budget deficitsTrade policiesPolitical and economic stability
6-215
Government Budget Deficits
In an open economy, government budget deficits . . . …reduces the supply of loanable funds,…drives up the interest rate,…crowds out domestic investment,…cause net foreign investment to fall.
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r2 r2
E2
1. A budget deficit reduces the supply of loanable funds...
S2
B
(a) The Market for Loanable Funds (b) Net Foreign Investment
(c) The Market for Foreign-Currency Exchange
Quantity ofLoanable Funds
Demand
S1
Quantity of Dollars
Demand
S1S2
Net ForeignInvestment
NFI
5. …which causes the real exchange rate to appreciate.
Real Exchange
Rate
Real Interest
Rate
Real Interest
Rate
3. ...which in turn reduces net foreign investment.
4. The decrease in net foreign investment reduces the supply of dollars to be exchanged into foreign currency…
r1
A
E1
r1
The Effects of Government Budget Deficit
2. ...which increases the real interest...
US$ is in the denominator,As in Econ Literature
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Effect of Budget Deficits on the Loanable Funds Market
A government budget deficit reduces national saving, which . . .. . . shifts the supply curve for loanable funds to the left, which. . . raises interest rates.
6-218
Effect of Budget Deficits on Net Foreign Investment
Higher interest rates reduce net foreign investment.
6-219
Effect on the Foreign-Currency Exchange Market
A decrease in net foreign investment reduces the supply of dollars to be exchanged into foreign currency.This causes the real exchange rate to appreciate.
6-220
Trade Policy
A trade policy is a government policy that directly influences the quantity of goods and services that a country imports or exports. Tariff: A tax on an imported good.Import quota: A limit on the quantity of a good produced abroad and sold domestically.
6-221
Trade Policy
Because they do not change national saving or domestic investment, trade policies do not affect the trade balance.
For a given level of national saving and domestic investment, the real exchange rate adjusts to keep the trade balance the same.
Trade policies have a greater effect on microeconomic than on macroeconomic markets.
6-222
Effect of an Import Quota
Because foreigners need dollars to buy U.S. net exports, there is an increased demand for dollars in the market for foreign-currency.
This leads to an appreciation of the real exchange rate.
6-223
Effect of an Import Quota
There is no change in the interest rate because nothing happens in the loanable funds market.There will be no change in net exports. There is no change in net foreign investment even though an import quota reduces imports.
6-224
Effect of an Import Quota
An appreciation of the dollar in the foreign exchange market encourages imports and discourages exports.This offsets the initial increase in net exports due to import quota.
6-225
1. An import quota increases the demand for dollars…
(a) The Market for Loanable Funds (b) Net Foreign Investment
(c) The Market for Foreign-Currency Exchange
Quantity ofLoanable Funds
Demand
S1
Quantity of Dollars
Demand
Supply
Net ForeignInvestment
NFI
Real Exchange
Rate
Real Interest
Rate
Real Interest
Rate
r1
E1
r1
The Effects of an Import Quota
E2 2. …and causes the real exchange rate to appreciate.
3. Net exports, however, remain the same.
US$ is in the denominator,As in Econ Literature
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Effect of an Import Quota
Trade policies do not affect the trade balance.
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Political Instability and Capital Flight
Capital flight is a large and sudden movement of funds out of a country, usually due to political instability.
6-228
Political Instability and Capital Flight
Capital flight has its largest impact on the country from which the capital is fleeing, but it also affects other countries.If investors become concerned about the safety of their investments, capital can quickly leave an economy.Interest rates increase and the domestic currency depreciates.
6-229
Political Instability in Mexico & Capital FlightWhen investors around the world observed political problems in Mexico in 1994, they sold some of their Mexican assets and used the proceeds to buy assets of other countries.This increased Mexican net foreign investment.
The demand for loanable funds in the loanable funds market increased, which increased the interest rate.
This increased the supply of pesos in the foreign-currency exchange market.
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NFI1 1. An increase in net foreign investment...
2. …increases the demand for loanable funds...
D2
(a) The Market for Loanable Funds (b) Mexican Net Foreign Investment
(c) The Market for Foreign-Currency Exchange
Quantity ofLoanable Funds
D1
S1
Quantity of Pesos
Demand
S1
Net ForeignInvestment
NFI1
Real Exchange
Rate
Real Interest
Rate
Real Interest
Rate
E1
r1 r1
S2
r2 r2
E2
The Effects of Capital Flight
5. …which causes the real exchange rate to appreciate.
4. At the same time, the increase in net foreign investment increases the supply of pesos...
3. …which increases the interest rate.
Peso is in the denominator,As in Econ Literature
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An Example of Interest Rate Parity
Suppose an investor with $1,000,000 to invest for 90 days is trying to decide between investing in U.S. dollars at 8% per annum (2% for 90 days) or in DM at 6% per annum (1.5% for 90 days).The current spot rate is DM 1.5311/$ and the 90-day forward rate is DM 1.5236/$.As shown in the next slide, regardless of the investor’s currency choice, his hedged return will be identical.
Multinational Financial Management
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An Example of Interest Rate Parity
Multinational Financial Management Ex 5.7
Alternative investment:Invest $1,000,000 in
New York for 90 days at 2%and receive $1,020,000 in 90 days
New York
Start$1,000,000
Finish$1,020,000
Convert $1,000,000to DM at DM 1.5311/$ for DM 1,531,100
1.
DM 1,531,100Frankfurt: today
DM 1,554,066.50Frankfurt: 90 days
Invest DM 1,531,100 at 1.5%for 90 days, yielding DM 1,554,066.50 in 90 days
2.
Simultaneously with the DMinvestment, sell the DM1,554,066.50 forward at arate of DM 1.5236/$ for delivery in 90 days, &receive $1,020,000in 90 days
3.
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An Example of Covered Interest ArbitrageSuppose the interest rate on pounds sterling is 12% in London, and the interest rate on a comparable dollar investment in New York is 7%. The pound spot rate is $1.75 and the one-year forward rate is $1.68. These rates imply a forward discount on sterling of 4% [(1.68 - 1.75) / 1.75] and a covered yield on sterling approximately equal to 8% (12% - 4%). Because there is a covered interest differential in favor of London, funds will flow from New York to London.To illustrate the profits associated with covered interest arbitrage, we will assume that the borrowing and lending rates are identical and the bid-ask spread in the spot and forward markets is zero.
Multinational Financial Management
6-234
An Example of Covered Interest Arbitrage
Multinational Financial Management Ex 5.8
New Yorktodayone year
Borrow $1 million at an interestrate of 7%, owing $1,070,000at year end
1.
London : todayLondon: one year
Start:
Convert the $1 million to pounds at $1.75/£ for£571,428.57
2.
Invest the £571,428.57in London at 12%,generating £640,000by year end
3.
Simultaneously, sell the £640,000 in principal plus interest forward at a rate of $1.68/£ for delivery in year, yielding $1,075,200 at year end
4.
Net profit equals$5,200
7.Finish:
Repay the loan plus interest of $1,070,000 out of the $1,075,200
6.
Collect the £640,000 and deliver it to the bank’s foreign exchange department in return for $1,075,200
5.
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A Formula for the Government Purchases Multiplier
• The formula for the multiplier is:Multiplier = 1/(1 - MPC)
• An important number in this formula is the marginal propensity to consume (MPC).¤ This is the fraction of extra income that a household
consumes rather than saves.¤ With an MPC of 3/4, when the workers and owners of
McDonnell Douglas earn $20 billion from a government contract, they increase their consumer spending by 3/4 x $20 billion, or $15 billion, which in turn raises the income for the workers and owners of the firms that produce the consumption goods.
6-236
A Formula for the Government Purchases Multiplier
Change in government purchasesFirst change in consumptionSecond change in consumptionThird change in consumption
= $20 billion= MPC x $20 billion= MPC2 x $20 billion= MPC3 x $20 billion
Total change in demand =(1 + MPC + MPC2 + MPC3 + …) x $20 billion
The government-purchases multiplier, 1 + MPC + MPC2 + MPC3 + …, tells us the demand for goods and services that each dollar of government purchases generates.
6-237
A Formula for the Government Purchases Multiplier
For , 11 +≤≤− xThe infinite geometric series ( )xxxx −=++++ 111 32 K
Thus,
Multiplier = 1 / (1 - MPC)
For example, if MPC is 3/4, then the government-purchases multiplier is 1/(1 - 3/4) = 4.In this case, the $20 billion of government spending generates $80 billion of demand for goods and services.
6-238
The Structure of the IS-LM ModelThe term IS is a shorthand representation of the relationship investment (Investment, I ) equals saving (Saving, S ) - the goods market equilibrium.
The term LM is a shorthand representation of the relationship money demand (Liquidity, L) equals money supply (Money, M ) - the money market equilibrium.
The IS-LM model emphasizes the interaction between the goods and assets markets. Spending, interest rates, and income are determined jointly by equilibrium in the goods and assets markets.
Dornbusch: Figure 10.3
6-239
The Structure of the IS-LM Model
DemandSupply
Money market Bond market
DemandSupply
Assets market Goods market
Aggregate demandOutput
Income
Interest ratesMonetary policy Fiscal policy
http://www.mhhe.com/economics/dornbusch8e/
6-240
FIGURE 10-11 in Dornbusch
GOODS AND MONEY MARKET EQUILIBRIUM
http://www.mhhe.com/economics/dornbusch8e/
6-241
Money Supply, Money Demand, and Monetary Equilibrium
In the long run, the overall level of prices adjusts to the level at which the demand for money equals the supply.
6-242
Quantity fixedby the Fed
Quantity ofMoney
Value ofMoney (1/P) Price
Level (P)
A
Money supply
0
1
(Low)
(High)
(High)
(Low)
1/2
1/4
3/4
1
1.33
2
4Moneydemand
Money Supply, Money Demand, and the Equilibrium Price Level
Equi
libriu
m
valu
e of
mon
ey Equilibrium
price level
6-243
Quantity ofMoney
Value ofMoney (1/P) Price
Level (P)
A
MS1
0
1
(Low)
(High)
(High)
(Low)
1/2
1/4
3/4
1
1.33
2
4Moneydemand
The Effects of Monetary Injection
M1
MS2
1. An increase in the money supply...
2. ..
.dec
reas
es th
e va
lue
of m
oney
... 3. …an d in crea ses
the p ri ce l ev el
M2
B
6-244
PPP does not mean that commodity price changes are the underlying fundamental cause of exchange rate changes.PPP is an “equilibrium” condition, not a model of cause and effect.Examples:» Under pegged rates, a country experiences inflation,
loss of international competitiveness, then devalues home currency
Inflation comes before devaluation» Or country devalues, imports more expensive,
workers feel poorer, wage demands, home country inflation accelerates
Devaluation comes before inflation
From PPP to the Monetary Approach (1 of 3)
6-245
What determines the price level in an economy?» Relationship between Money Supply (MS ) and Money
Demand (MD )» MD = f (velocity(-), price level(+), real income(+))
= k x P x Y» In equilibrium, MS = MD = k P Y» ⇒ P = MS / k YAssume the above relationship exist in the US & UK» P($) = M($)S / k($) Y($)» P(£) = M(£)S / k(£) Y(£)Returning to PPP, we had Spot ($/£) = P($) / P(£)By substitution» Spot ($/£) = (M($)S / M(£)S) (k(£) / k($)) (Y(£) / Y($))
From PPP to the Monetary Approach (2 of 3)
6-246
Repeating:
Spot($/£) =
Interpretation:» Spot rate (in $/£) positively related to:
Increases in M($) and Y(£)» Spot rate (in $/£) negatively related to:
Increases in M(£) and Y($)MS, Y, k and their determinants are more fundamental causes (drivers) of spot exchange rate.Changes in MS, Y, and k [at home or other country] will impact the exchange rate in the long run (& perhaps short-run).
From PPP to the Monetary Approach (3 of 3)
M($) x k(£) x Y(£)M(£) x k($) x Y($)
6-247
Spot rates display large changes over last 25 years» Some currencies appreciated vs. US$, others
depreciated» Changes in nominal rates, real rates, real effective ratesWhat factors lie behind exchange rate changes?» Inflation differences are a “proximate” factor (not a
cause)» PPP works well in the long run for many exchange rates» Money, income, and velocity are more fundamental
factorsCritical to understand difference between nominal and real exchange rate changes» Possible to have nominal exchange rate change without
real exchange rate change (or vice versa)» Only real exchange rate Δ ⇒ change in competitiveness
Summary: Exchange Rates in the Long Run
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Most tantalising of all, there is the huge mountain ofJapanese personal savings, estimated at ¥1300 trillion ($12 trillion), much of it stacked up in the postal savings system, and ¥106 trillion of which is expected to mature over the next two years. As these deposits made at relatively high interest rates a decade ago mature, the post office will be able to offer only nugatory yields on reinvested or new deposits. Some of this money is expected to find its way into the stockmarket, so the financial industry is scrambling for a chunk of the assets.
The Economist: Survey Online Finance May 20, 2000
6-249
Assignment for Chapter 6 Exercises 3, 7, 10, 14.
http://www.mhhe.com/business/finance/levich2e/-or-
http://pages.stern.nyu.edu/~rlevich/links.htmlhttp://pages.stern.nyu.edu/~rlevich/datafile.html
6-250
Chapter 6. Stock Models of Foreign ExchangePricing
Hint:
You keep an asset in your portfolio as long as the return is commensurate with the return on other financial assets.
6-251
Chapter 6. Monetary Approach v.s. the PortfolioBalance Approach
Hint:
Both models assume forward looking, rational behavior in which the exchange rate reflects the present value of all future exogenous variables.
6-252
Chapter 6. Speculative Bubble in the ForeignExchange Market
Hint:A speculative bubble is measured by the difference between the present spot rate and the fundamental equilibrium rate.A speculative bubble could develop if traders buy a currency not based on a determination that it is undervalued on the basis on fundamentals, but solely on the basis that the currency is expected to appreciate in tomorrow’s market.If other traders also think and behave so...