chapter 12 -ECON 335: International Economy - Exchange Rates II: The Asset Approach in the Short Run

Introduction

• Short-run deviations from Purchasing Power Parity (PPP) occur: PPP doesn't always hold in the short term.

• The asset approach explains exchange rates based on currencies as stores of value: Exchange rates are influenced by how currencies are seen as investments.

• The spot exchange rate is the price of foreign exchange: It's the current rate to exchange one currency for another.

Risky Arbitrage

• Uncovered Interest Parity (UIP) equation: $i = i^* + E[e]$: Relates domestic interest rates ($i$), foreign interest rates ($i^*$), and expected exchange rate changes ($E[e]$).

UIP and FX Market Equilibrium

• Nominal interest rate and expected future exchange rate are exogenous: These are determined outside the model.

• The model predicts the current spot exchange rate (endogenous): The model calculates this.

Equilibrium in the FX Market

• The foreign exchange (FX) market is in equilibrium when domestic and foreign returns are equal: No incentive to move funds between currencies.

Changes in Returns and FX Market Equilibrium

• Shocks include changes in domestic/foreign interest rates and expected future exchange rates: Events that shift the equilibrium.

Impact of Interest Rate Changes

• A rise in the domestic interest rate or a fall in the foreign interest rate leads to dollar appreciation: Higher domestic rates make the dollar more attractive.

• A fall in the expected future exchange rate also leads to dollar appreciation: If the dollar is expected to be worth less in the future, it becomes more attractive now.

Money Market Equilibrium in the Short Run

• Short-run assumptions: sticky price level ($\bar{P}$), flexible nominal interest rate: Prices don't adjust quickly, but interest rates do.

Money Market Equilibrium Model

• Equilibrium equation: $M^S = P \cdot L(i, Y)$: Money supply ($M^S$) equals price level ($P$) times liquidity preference $L(i, Y)$, which depends on interest rate ($i$) and income ($Y$).

Short-Run Money Market Equilibrium

• Money supply and real income are exogenous: Determined outside the model.

• Nominal interest rates are endogenous: Determined by the model.

Changes in Money Supply and Interest Rate

• Increase in money supply lowers the interest rate; increase in real income raises it: More money lowers borrowing costs; higher income increases borrowing demand.

Monetary Model: Short Run vs. Long Run

• Expansionary policy affects interest rates differently based on expectation (permanent vs. temporary): Permanent changes have different effects than temporary ones.

Asset Approach: Graphical Solution

• Combines equilibria in money and FX markets: Shows how both markets interact.

• Arbitrage equates domestic and foreign returns: Investors seek the best returns.

Short-Run Policy Analysis

• Increase in money supply depreciates the currency: More money lowers its value.

• Increase in foreign money supply appreciates the domestic currency: More foreign money makes the domestic currency relatively more valuable.

Rise and Fall of the Dollar, 1999–2004

• Dollar appreciated (1999–2001) due to rising U.S. interest rates, then depreciated (2001–2004) with rate cuts: Real-world example of rate effects.

Complete Theory: Unifying Approaches

• Combines asset and monetary approaches to determine exchange rates in both short and long run: A comprehensive view.

Permanent Expansion of Money Supply, Short-Run Impact

• Interest rate falls, currency depreciates: Immediate effects of increasing the money supply.

Long-Run Adjustment

• Prices and exchange rates rise in proportion to the money supply; domestic return shifts back: How the economy adjusts over time.

Responses to Permanent Expansion

• Overshooting: Exchange rate overreacts in the short run but adjusts in the long run: The exchange rate moves more than it ultimately will.

Overshooting in Practice

• Exchange rates fluctuated after the Bretton Woods system ended in 1973: Example of overshooting in the real world.

Fixed Exchange Rates and the Trilemma

• Capital mobility and fixed exchange rates limit monetary policy autonomy: You can't have all three.

The Trilemma

• Only two of the following can be achieved simultaneously: fixed exchange rate, capital mobility, monetary policy autonomy: A fundamental constraint.

Intermediate Regimes

• Rigidity, mobility, and independence can be partial: Countries can choose varying degrees of each.

The Trilemma in Europe

• British float allowed monetary independence; Danish peg did not: Examples of countries' choices.

News and the Foreign Exchange Market in Wartime

• Exchange rates fluctuate based on war news: Uncertainty affects currency values.

Conclusions

• Arbitrage and equilibrium determine exchange rates in