Download overshooting exchange rates

Chapter 18
Exchange
Rate Theories
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Topics to be Covered
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The Asset Approach
The Monetary Approach to the Exchange Rate
The Portfolio Balance Approach
Sterilization
Exchange Rates and the Trade Balance
Overshooting Exchange Rates
Currency Substitution
Role of News
Foreign Exchange Market Microstructure
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The Asset Approach
• The exchange rate is viewed as adjusting to
equilibrate global trade in financial assets.
• An implication of this approach is that
exchange rates are more variable than
goods prices. See Table 18.1.
• The asset approach assumes perfect capital
mobility, that is, there are no barriers to
international capital flows.
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TABLE 18.1 Standard Deviations of
Prices and Exchange Rates1
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Types of Asset Approach
Models
• Monetary Approach to the Exchange
Rate—the exchange rate is determined by
relative money demand and money supply
between two countries (see Chapter 17).
• Portfolio Balance Approach—a theory of
exchange rate determination which argues
that the exchange rate is a function of the
relative supplies of domestic and foreign
bonds.
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Monetary Approach vs. Portfolio
Balance Approach
• The main difference between the two groups
of asset approach models is that the
monetary approach model assumes
domestic and foreign bonds to be perfect
substitutes, while the portfolio balance
model assumes they are not.
• See Table 18.2
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TABLE 18.2 The Asset Approach to
the Exchange Rate
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Monetary Approach to the
Exchange Rate (MAER)
• Following the discussion from Chapter 17,
the monetary approach equation is (in
percentage terms):
where R is international reserves, E is
exchange rate (domestic currency units
per unit of the foreign currency), PF the
foreign price level, Y domestic income, and
D domestic credit.
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MAER (cont.)
• With flexible exchange rates, reserves are zero,
and the MAER equation becomes:
–E = PF + Y – D
or, after multiplying both sides by (-1), we get:
• An increase in domestic credit, other things
constant, will result in E increasing (i.e.,
depreciating at a faster rate), while changes in
inflation and income growth will cause changes in E
in the opposite direction.
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Portfolio Balance Approach
• The PB approach assumes that financial assets are
imperfect substitutes because investors perceive
foreign exchange risk to be linked to foreign
currency-denominated bonds.
• It modifies the MAER equation by adding the
percentage changes in the supplies of foreign
bonds BF and domestic bonds B:
• An increase in supply of foreign bonds causes E to
fall (domestic currency appreciates faster) while an
increase in domestic bond supply raises E, other
things constant.
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Sterilization
• Sterilization refers to central banks
offsetting international reserve flows in order
to follow an independent monetary policy.
• Suppose the central bank is following some
money supply growth path and then money
demand increases, leading to reserve
inflows. The central bank will sterilize these
reserve inflows by decreasing domestic
credit, thus keeping base money and the
money supply constant or at desired levels.
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Sterilization (cont.)
• If sterilization occurs, then the causality
implied in the basic monetary approach
equation no longer holds. This is because
sterilization implies that there is also a
causality running from reserve changes to
domestic credit, as in:
where β is the sterilization coefficient,
ranging from 0 (no sterilization) to 1
(complete sterilization).
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Sterilized Intervention
• Sterilized Intervention—refers to a
foreign exchange market intervention that
leaves the domestic money supply
unchanged.
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Exchange Rates and the Trade
Balance
• It is useful to incorporate trade flows into
the asset approach models because trade
flows have implications for financial asset
flows.
• If the exchange rate adjusts so that the
stocks of domestic and foreign money are
willingly held, then the country with a trade
surplus will be accumulating foreign
currency. As holdings of foreign money
increase relative to domestic money, then
the foreign currency will depreciate.
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Exchange Rates and the Trade
Balance (cont.)
• Refer to Figure 18.1
• An unexpected event causes a trade deficit.
The resulting outflow of money leads to
depreciation of the domestic currency and to
a new exchange rate equilibrium.
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FIGURE 18.1 The Path of the Exchange
Rate after a New Event Causing Balance-ofTrade Deficits
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Overshooting Exchange
Rates
• Since exchange rates are more volatile and
adjust more quickly than goods prices, this
differential speed of adjustment can lead to
a situation where it appears that spot
exchange rates move too much for a given
disturbance. This is called overshooting
exchange rates.
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Overshooting Exchange Rate
Model
• Money demand (L) is positively related to
income Y and negatively to interest rate i:
• In the short run, as money supply increases,
income and price level are constant.
Consequently, interest rates must fall to
equate money demand and money supply.
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Overshooting XR Model
(cont.)
• The drop in interest rate will have a direct effect on
the exchange rate via the interest rate parity
relation:
• With the increase in money supply in country A,
prices will be expected to rise. This higher future
price will imply a higher long run exchange rate to
achieve PPP:
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Overshooting XR (cont.)
• The spot exchange rate will increase above
the long run equilibrium exchange rate due
to a need to maintain interest parity. Over
time, as prices increase, the interest rate
rises, and the exchange rate converges to its
new equilibrium level.
• Refer to Figure 18.2
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FIGURE 18.2 The Time Path of the Forward and Spot
Exchange Rate, Interest Rate, and Price Level after an
Increase in the Domestic Money Supply at Time t0
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Currency Substitution
• An advantage of flexible exchange rates is that
countries can pursue independent monetary policy.
This advantage is reduced if there is an
international demand for currencies.
• Currency substitution deals with the
substitutability of currencies on the demand side of
the market.
• So long as people believe that the exchange value
between two currencies will never change, then
money demanders will be indifferent between
holding the two currencies.
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Currency Substitution (cont.)
• If money demanders are no longer
indifferent between two currencies, then
currency substitution becomes another
source of exchange rate variability.
• Regions with a high degree of currency
substitution may benefit from currency
unions where countries coordinate
monetary policies and fix exchange rates.
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The Role of News
• The real world is characterized by
unpredictable shocks or surprises. As such,
predicting future spot rates is difficult
because the exchange rate is partly
determined by unforeseen events.
• Exchange rates are more sensitive, and
respond more quickly, to expectations and
new information (e.g., unemployment
rates).
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Foreign Exchange Market
Microstructure
• At the micro level, exchange rates can be
determined by interactions among traders.
• A foreign exchange trader may be influenced
to change his exchange rate quotes even in
the absence of news regarding exchange
rate fundamentals.
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FEM Microstructure Effects
• Inventory control effect—traders will
want to have no inventory at the end of the
day, so that their quotes reflect this desire.
• Asymmetric information effect—
traders fear that they are trading with
agents who have better information than
they do.
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