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International Economics Chapter 7 Theories of Exchange Rate Determination Chapter 7 Theories of Exchange Rate Determination 7.1 Theory of Purchasing Power Parity 7.2 Theory of Interest Rate Parity 7.3 Balance of Payments Approach 7.4 Asset Market Approach 7.1 Theory of Purchasing Power Parity Absolute Purchasing Power Parity the law of one price Identical goods should cost the same in all countries. P e P* Absolute purchasing power parity The equilibrium exchange rate between two currencies is equal to the ratio of the price levels in the two countries. P e P* 7.1 Theory of Purchasing Power Parity Defects: Not all products made by a country can be traded internationally. – Tradable goods v.s. Nontradable goods The actually-existing transportation costs and trade barriers make the law of one price unrealistic. It ignores the influence of international capital flow on exchange rates. 7.1 Theory of Purchasing Power Parity Relative Purchasing Power Parity The changes of exchange rates are proportional to the relative changes of two countries’ prices in a certain period. P1 P0 e1 * * e0 P1 P0 e * It can provide a quick judgment on the change of exchange rates once a country’s inflation rate has been known. 7.1 Theory of Purchasing Power Parity Defects: It tends to overvalue the exchange rates of developed countries and to undervalue the exchange rates of developing countries. – Because the prices of nontradable goods in developed countries are usually higher than that in developing countries. It is hard to choose the base period in which the existing exchange rates should be in equilibrium. Chapter 7 Theories of Exchange Rate Determination 7.1 Theory of Purchasing Power Parity 7.2 Theory of Interest Rate Parity 7.3 Balance of Payments Approach 7.4 Asset Market Approach 7.2 Theory of Interest Rate Parity Covered Interest Rate Parity Home Country (r) Now 1 Year Later 1 1+r ef /e∙(1+r*) 1+r = f/e∙(1+r*) Foreign Country (r*) e ef 1/e 1/e∙(1+r*) 7.2 Theory of Interest Rate Parity f 1 r f e ( ) e 1 r * e r r* The premium or discount ratio of the forward exchange rate equals the difference between two countries’ interest rates. If home interest rate is higher than foreign interest rate, there will be a premium in the forward exchange rate. If home interest rate is lower than foreign interest rate, there will be a discount in the forward exchange rate. 7.2 Theory of Interest Rate Parity Uncovered Interest Rate Parity Ee f e 1 r (E ) E r r * e e 1 r * Ee f The expected changing ratio of future exchange rates equals to the difference between two countries’ interest rates. If home interest rate is higher than foreign interest rate, the market will expect domestic currency to depreciate in the future. 7.2 Theory of Interest Rate Parity To sum up, the theory of interest rate parity applies in the short run. It explains the relations between the exchange rate and the interest rate from the perspective of capital flows. Chapter 7 Theories of Exchange Rate Determination 7.1 Theory of Purchasing Power Parity 7.2 Theory of Interest Rate Parity 7.3 Balance of Payments Approach 7.4 Asset Market Approach 7.3 Balance of Payments Approach The balance of payments consists of a current account and a financial and capital account whose sum is 0. BP CA KA 0 The current account is mainly determined by exports and imports. CA CA(Y , Y *, P, P*, e) The capital and financial account is mainly determined by home interest rate r, foreign interest rate r* and the expectation of future exchange rate. KA KA(r , r*, Ee ) f 7.3 Balance of Payments Approach Factors affecting the balance of payments are shown in the below equation: BP BP(Y , Y *, P, P*, r , r*, e, Ee ) f The equilibrium exchange rate can be depicted as: e f (Y , Y *, P, P*, r , r*, Ee f ) 7.3 Balance of Payments Approach e S E1 e1 e0 E0 D’ D O (a) A Rise in Y f An increase in Y will cause more imports, increase the demand for foreign exchange and worsen the balance of payments, leading to a depreciation of domestic currency. 7.3 Balance of Payments Approach e e1 e0 S’ E1 S E0 D’ D O (b) A Rise in P f A rise in P will cause an appreciation of real exchange rate, reduce the competitiveness of home products, decrease exports and the supply of foreign exchange, increase imports and the demand for foreign exchange, and worsen the balance of payments, resulting in a depreciation of domestic currency. 7.3 Balance of Payments Approach e e0 e1 S E0 E1 D’ (c) A Rise in r S’ D f A rise in r will attract capital to flow in, increase the supply of foreign exchange, reduce the desire to invest in foreign financial assets and the demand for foreign exchange, and cause a surplus in the balance of payments, leading to an appreciation of domestic currency. 7.3 Balance of Payments Approach S’ e e1 e0 S E1 E0 D D’ O (d) Expectation of ef↑ f If domestic currency is expected to depreciate in the future, people will buy foreign exchange and sell domestic currency in markets, causing more demand for and less supply of foreign exchange and leading to an immediate depreciation of domestic currency. 7.3 Balance of Payments Approach In conclusion, the balance of payments approach takes all important factors affecting exchange rates into consideration. It is helpful for analyzing the determination and changes of exchange rates in the short run. Chapter 7 Theories of Exchange Rate Determination 7.1 Theory of Purchasing Power Parity 7.2 Theory of Interest Rate Parity 7.3 Balance of Payments Approach 7.4 Asset Market Approach 7.4 Asset Market Approach The asset market approach to the exchange rate can be divided into: Monetary Approach Flexible-Price Monetary Approach Sticky-Price Monetary Approach Portfolio Approach 7.4 Asset Market Approach Flexible-Price Monetary Approach Home money demand function ln P ln Y r Foreign money demand function ln M d ln M d * ln P * ln Y * r * Money demand is equal to money supply: Ms Md Then Ms* Md * ln P ln M s ln Y r ln P* ln M s * ln Y * r * 7.4 Asset Market Approach Purchasing power parity: e P P* ln e ln P ln P * And we finally get ln e (ln M s ln M s *) (ln Y * ln Y ) (r r*) The money supply, the national income and the interest rate of either home country or the foreign country affect the exchange rate via the price level of each country. 7.4 Asset Market Approach An increase in home money supply causes an excess money supply and results in a price increase in home country and a depreciation of domestic currency. Since the economy is at the full employment level, its output keeps constant. And an increase in money demand resulting from the higher price offsets the excess money supply and keeps the interest rate constant. 7.4 Asset Market Approach Ms P Ms1 P1 Ms0 P0 O t0 (a) t O t0 (b) r e r0 e1 t e0 t0 t (c) O t t0 (d) 7.4 Asset Market Approach An increase in home national income brings about more money demand. With a fixed money supply which is controlled by the central bank, the price level falls. When absolute purchasing power parity is tenable, the exchange rate falls or in other words, domestic currency appreciates. A rise in home interest rate reduces money demand and causes the price level to increase. The exchange rate then rises according to absolute purchasing power parity. A rise in the expectation of future exchange rates will result in an immediate depreciation of domestic currency. 7.4 Asset Market Approach To summarize, the flexible-price monetary approach is based on purchasing power parity and flexible price and is helpful for analyzing the long-run trend of the exchange rate. It is the simplest one among the asset market approaches. 7.4 Asset Market Approach Sticky-Price Monetary Approach Absolute purchasing power parity holds in the long run rather than in the short run. In the short run, the price level is sticky and money supply can influence the national output and the interest rate. 7.4 Asset Market Approach The effect of a once-for-all money supply increase Ms P Ms1 P1 Ms0 P0 O t0 (a) t O (b) r e e1 r0 e r1 e0 t0 t (c) t0 O t t t0 (d) 7.4 Asset Market Approach In the long run, since the purchasing power parity is tenable, the result should be the same to that of the flexible-price monetary approach. In the short run: – First, since the price is sticky, it is not able to change at the time when the money supply is increased. – Second, excess money supply causes the interest rate to fall because the money market can adjust rapidly. – Third, the spot exchange rate rises even higher than the long-run exchange rate. » ln e ln e ( r r*) » exchange rate overshooting: The exchange rate responds to a change in the money supply or other factor shocks greater in the short run than in the long run. 7.4 Asset Market Approach As time goes by, the price becomes no longer sticky and is rising due to the excess money supply. Higher price results in more money demand and the interest rate is caused to be increasing. According to the theory of interest rate parity, the exchange rate is falling with an increasing interest rate. The processes continue until the long-run equilibrium is reached. 7.4 Asset Market Approach The sticky-price monetary approach explains the determination and changes of exchange rates in a more realistic way. It also provides governments with the ground for intervening the economy since otherwise the over-fluctuation of exchange rates will do greater damage to the economy. 7.4 Asset Market Approach Portfolio Approach to Exchange Rate The portfolio approach maintains exchange rates are affected by different portfolios of financial assets. The wealth of home residents is made up of three financial assets: home money, home bonds and foreign bonds. W M B e F Ms is controlled by the central bank; Md is inversely affected by r and r* and is positively affected by W. Bs is controlled by the government; Bd is inversely affected by r* and is positively affected by r and W. Fs is acquired by the surplus of the current account. Fd is inversely affected by r and is positively affected by r* and W. 7.4 Asset Market Approach e Ms↑ O MM r (a) A rise in e increases the value of B in terms of home currency and W. Increased W brings about more money demand, causing higher r. Thus, e changes in the same direction to r in a balanced home money market. If money supply is increased, MM curve shifts leftward because a fall in r is then required so as to increase money demand to match the expanded money supply and keep the home money market in equilibrium. 7.4 Asset Market Approach e Bs↑ BB O r (b) A rise in e increases the value of F in terms of home currency and W. Increased W brings about more demand for home bonds, causing the price of B to rise and r to fall. So, e changes in the opposite direction to r in a balanced home bonds market. If the supply of B is increased, BB curve shifts rightward because a rise in r is then required so as to reduce the price of home bonds and increase their demand. Thus the added supply of B is matched and the equilibrium of home bonds market is restored. 7.4 Asset Market Approach e Fs↑ FF O r (c) A rise in e increases the value of F in terms of home currency and the demand for F increases. More demand for F in turn raises their price and causes r to fall. Thus, e changes in the opposite direction to r. If the supply of F is increased, FF curve shifts leftward because a fall in r is then required so as to increase the demand for F. FF curve is flatter than BB curve because the home bonds market is more sensible to the change of r. 7.4 Asset Market Approach MM’ e MM e1 E1 E0 e0 FF’ FF BB’ BB O r1 r0 r Increased Ms pulls MM leftward to MM’ and augments W. Augmented W causes excess demands for B and F. Excess Bd causes higher price of B and lower r, pulling BB leftward to BB’. Excess Fd causes an appreciation of foreign currency and a depreciation of domestic currency, pushing FF rightward to FF’. New overall equilibrium reaches at E1, where e rises and r falls. 7.4 Asset Market Approach e MM MM’ e0 e1 E0 E1 FF FF’ BB’ BB O r0 r Increased Fs pulls FF leftward to FF’ and augments W. Augmented W causes excess demands for M and B. Excess Md causes higher r, pushing MM rightward to MM’. Excess Bd causes higher price of B and lower r, pulling BB leftward to BB’. New overall equilibrium reaches at E1, where e falls. 7.4 Asset Market Approach In summary, the portfolio balance approach points out the imperfect substitution between home assets and foreign assets and takes the current account into consideration. These make the approach more realistic and helpful for decision making.