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International Finance
Part 1
Fundamentals of
International Finance
Lecture n°3
Exchange rate determination
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Exchange rate determination
Models of exchange rate determination
Basis :
Capital in & out-flows lead to appreciation / depreciation
of exchange rates, in function of the differential between
domestic and foreign interest rates (IS- LM).
Accounting for capital account integration (BOP curve) :
Mundell-Fleming model.
Newer models :
Extent from flows models to stock models, since flows
accumulate into stocks.
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Exchange rate determination
Models of exchange rate determination - Stock
(1) Monetary approach (UIP holds) :
(a) Monetarist : PPP holds
(b) Overshooting : sticky prices
(2) Portfolio approach :
UIP does not hold : imperfect asset substitutability
CIP holds.
All assume perfect capital mobility ; CIP holds.
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Monetary approach
Monetary approach - Monetarist
The exchange rate is the market clearing price between 2
stocks of money, i.e., money demand and money supply.
Perfect asset substitutability : investors are indifferent
between holding domestic or foreign assets provided that the
expected return on each asset is the same.
M = only asset in the model
S = (m-m*) - (y-y*) + (pe-pe*)
S results from the relative money supply (m) and money
demand (m-p ,the real money supply), derived from income,
interest rates and expected inflation rate.
Inflation rate modelled as depending on the expected
monetary growth (if larger than foreign, S will rise)
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Monetary approach
Monetarist approach - Theoretical remarks
Based on very strong assumptions :
PPP holding continuously
Demand for money as a stable function of income and
interest rates
Perfect price flexibility
Monetarist approach - Empirical Evidence
Types of tests : regressions on the model equation
Poor results :
Wrong signs, low R2, few significant variables.
Exchange rates too volatile to be explained by the model.
Evidence of serial autocorrelation of S, no evidence for
efficient market monetary approach.
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Monetary approach
Monetary approach - Overshooting model
First model : Dornbusch (1976)
Try to explain the observed high volatility of X rates.
States that the difference of speeds of adjustment
between asset markets (rapid) and good markets (slow,
due to sticky prices) determines exchange rates.
Long-run exchange rates are determined by real factors
& monetary factors.
Same equation for the money market (MM) equilibrium
(monetarist model) + specification of the goods market.
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Monetary approach
Overshooting model - Specification
Two key equations of the model :
MM equilibrium condition (1):
m - p =  y -  i (same as previous but in a log linear
form)
Goods market equilibrium condition (2):
p =  ( (s+p*-p) - i + y - ^y)
p is a function of the gap between aggregate demand and
aggregate supply.
First term : the demand for domestic output is function of
real exchange rate
all () less ^y : aggregate demand equation
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^y aggregate supply, at full employment
Monetary approach
Overshooting model - Specification
Equations (1) and (2) lead to :
s = s- + (1/) (m - p - y + i*)
in logarithm
meaning that the exchange rate and price level are function
of three exogenous variables :
• the real money supply (m-p)
• the domestic real income (y)
• the foreign interest rate (i*)
s- is the long-run exchange rate, determined by monetary
(inflation differential) and real factors (economic fundamentals). If
s above s-, then s is expected to appreciate.
If p falls, the real supply money rises. Then, i falls to maintain MM
equilibrium (1). Then se has to fall to maintain the interest parity
condition (i=i*+ se ) : the exchange expected to appreciate. 8
Monetary approach
Overshooting model - Hypotheses
Money is neutral in the long-run : changes in the supply of
money have no long-run effect on the real economy : an %
increase (decrease) in money supply will lead to the same %
increase (decrease) in p and s.
Short-run adjustments : m supply decreases, than i rises in
the short run since p is sticky (thus (m-p) drops), leading
expected exchange rate to appreciate beyond s-, generating
next expectations of depreciation = “overshooting”.
Overshooting reaction of money markets are necessary for the
goods markets to be in equilibrium in the model to hold.
After the s drop : excess supply of goods then p falls, i falls
(by (m-p) rising), then capital outflows, and s expected to
depreciate.
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Monetary approach
Overshooting model - Input
Dornbush’s model can provide an explanation for the large
fluctuations in exchange rates.
The model has served as a basis for other models of the
overshooting type : no full employment, imperfect currencies
and assets substitutability, imperfect capital mobility, rational
expectations, dynamic (not analysed here).
Overshooting model - Empirical evidence
Methods : multivariate lagged regressions
Mixed evidence : some support of PPP in the long-run, some
evidence of overshooting in the short-run.
Some support from recent tests.
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Portfolio approach
Portfolio models - Specification
Consider 3 assets that investors hold and diversify
(imperfect substitutability - UIP does not hold):
M : Money
B : domestic bonds
F : foreign bonds
Well-defined asset-demand function:
Function of expected rate of return (on both the asset and
its various substitutes)
Expected rate of return of foreign assets : defined as i* +
expected rate of depreciation of domestic currency.
Function of wealth : implies that changes in price of the
assets, and changes in S, will affect assets demand.
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Portfolio approach
Portfolio models - Specification
Static expectations ( Se = 0)
Macroeconomic model in an open economy : price flexibility,
full employment (results may vary the way the real
economy is modelled)
The model distinguishes between short-run and long-run
exchange rate determination.
Short-run : depends of investors preferences between foreign
and domestic assets : S changes to insure that assets markets
are in equilibrium.
Long-run : role for the real sector, and in particular, the
current account. The short-run S determines the current
account, which, in turn, represents net foreign asset
accumulation, that, again, causes S to change.
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Stability is reached when the current account is in
equilibrium.
Portfolio approach
Portfolio models - Specification
Differentiates between stocks and flows (1) :
It is the variation of the differential of interest rates that
determines capital flows, not the absolute difference (MundellFleming model).
Differentiates between stocks and flows (2) :
Implications of current account imbalances for asset
accumulation :
• Consider a country with a current account surplus (X>M) :
• If S are floating : a current account surplus will be accompanied
by a capital account deficit (Xk>Mk, capital outflows), so that
the BOP sums up to zero.
• This capital account deficit will increase the investors (residents)
holdings of foreign assets.
• Then, a current account surplus implies an increase in residents
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holdings of foreign assets.
Portfolio approach
Portfolio models - Graphical Equilibrium
MM: equilibrium on the Money Market :
Positive slope, since a rise in S increases wealth (by increase
of SF - the value of holdings of foreign bonds) and thus the
demand for Money, and i should rise to restore equilibrium.
BB : domestic bond market equilibrium:
Negative slope, because a rise in S generates excess
demand on bonds, raise their prices, so i falls.
FF : foreign bond market equilibrium:
Negative slope, for the same reason as BB, but less steeper,
since the impact of a rise in demand is less strong on foreign
bonds than on domestic bonds (imperfect substitutes,
preference for national investments).
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Portfolio approach
Portfolio models - Graphical Equilibrium
S
B
F
M
Seq
F
M
B
i0
i
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Portfolio approach
Portfolio models - Conclusion
Portfolio models can generate similar results as the
sticky prices monetary models : account for exchange
rate volatility, misalignment, and the possibility of
overshooting.
But they allow a wider range of assumptions than
monetary models, like imperfect assets substitutability.
To this extent, they are more satisfying than monetarists
models.
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Portfolio approach
Portfolio models - Empirical evidence
Difficult to test due to important data problems
Good supporting evidence for the tests run
But bad performance at forecasting (in particular, it does
not outperform the random walk)
Econometrical problems could explain this failure, like
poor data and poorly specified dynamics.
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“News” approach
Testing models - News approach
Try to distinguish between expected / unexpected
components of exchange rates determinants
Models sensitive to the way news are constructed, and
to the choice of the type of news
Poor empirical performance
-> research question : what type of news is important
to influence expectations on exchange rates?
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Misalignments
Recent attempts to explain misalignments
Misalignment : departure of exchange rate from its longrun equilibrium
Two types of explanations :
Rational bubble :
Still assuming rational behaviour of markets participants.
•
•
•
•
Pt = discounted cash-flows + Bt
Bt = E(Bt+1) / (1+r) = bubble component
Bt+1 = (1+r) Bt + Zt
Bubble has a probability of bursting at each period, but grows
at an expected rate of r if investors are risk neutral.
• Testing for evidence : joint hypothesis of bubble existence and
of the model of exchange rate determination.
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Misalignments
Recent attempts to explain misalignments
Rational bubble :
Mixed empirical evidence for speculative bubbles on the
exchange rate markets
Theoretical questions :
• Since prices are bounded to zero, a negative bubble could
never starts
• With rational expectations hypothesis, a bubble should begin
at the start of the asset life
• An asset with a finite life and a fixed redemption value
cannot become the object of a rational bubble
Need for the hypothesis of limited rational expectations
and ‘near rational’ bubble : “there is always a greater fool
out there”...
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Misalignments
Recent attempts to explain misalignments
Heterogeneous expectations :
Wide dispersion of opinions observed, in particular for longer
maturities
Model of two groups of forecasters (Frankel & Froot, 1987):
• Chartists : extrapolate past experience
• Fundamentalists : using Dornbush’s overshooting model
Portfolio managers use a weighted average of these two
forecasts, and update the weights according to who is doing
better.
Broad empirical support : explained the rise and fall of the
dollar in early 1980’s. Questionnaires among forecasters
supported the approach.
-> still at an infant stage.
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