Study Notes on Exchange Rate Determination

Chapter 15: Exchange Rate Determination

Long-Run Exchange Rate Determination

• Under a flexible exchange rate system, balance-of-payments equilibrium is adjusted automatically by changes in exchange rates.
• This adjustment occurs without international flows of money or reserves, allowing nations to control their money supply and domestic monetary policy.

Factors Influencing Exchange Value

• The actual exchange value of a currency is influenced by:
    - Rate of money supply growth in the nation vs. other nations.
    - Growth of real income in the nation vs. other nations.

Scenario Analysis

• Example 1:
    - If real income and demand for money are constant in the rest of the world, an increase in the money supply beyond the growth of real income and demand leads to:
      - Price increase
      - Currency depreciation (higher exchange rate)
• Example 2:
    - If money supply growth falls below real income increase, this leads to:
      - Price reduction
      - Currency appreciation (lower exchange rate)
• Conclusion:
    - Currency depreciation signals excessive money growth relative to real income.
    - Conversely, currency appreciation signals inadequate money growth relative to real income.

Monetary Approach Explained

• A nation with higher inflation compared to others will see its currency depreciate due to increased money growth relative to income growth.
• The U.S. dollar's depreciation and the German mark's appreciation in the 1970s were attributed to:
    - Higher money growth in the U.S.
    - Lower money growth in Germany.

International Effects

• Flexible exchange rates provide some shielding for other nations against monetary excesses.
• Nations with depreciating currencies will transmit inflation mainly via increased imports.
• The timing of this effect depends on global economic conditions and structural foreign conditions.

Managed Floating Exchange Rate Systems

• In current managed floating exchange systems, nations may intervene in foreign exchange markets to mitigate excessive currency fluctuations.
• Balance-of-payments deficits are partly corrected through currency depreciation and partly through reserve loss, impacting the domestic money supply and monetary policy effectiveness.

Monetary Approach to Exchange Rate Determination

• The exchange rate (R) is defined as the domestic currency price of a foreign currency, e.g., USD/GBP.
• Law of One Price (Purchasing Power Parity - PPP):
    - The price of a commodity must be the same in both countries under perfect competition without tariffs/obstructions:
      - $P_x (USD) = R imes P_x (GBP)$
• Exchange rate equation:
    - R = rac{P}{P^}     - Where R = exchange rate; P = domestic price index; P = foreign price index.

Expectations, Interest Differentials, and Exchange Rates

• Exchange rates are sensitive to:
    - Inflation expectations
    - Anticipated changes in exchange rates
• Increased expected U.S. inflation by 10% affects exchange rates:
    - Immediate depreciation of the dollar by 10% against the euro to maintain price levels according to PPP.

Uncovered Interest Arbitrage

• Determined by the relationship:
    - $i - i^* = EA$
      - Where i is the home country interest rate, i* is the foreign interest rate, and EA is the expected currency appreciation.
• Example:
    - If i = 6 ext{%} and i^* = 5 ext{%}, the expectation is EA = 1 ext{%} appreciation of the pound.

Capital Flows Impact

• A change in interest rates impacts capital flows directly influencing exchange rates and adhering to equilibrium.
• Increased interest in foreign bonds leads to increased foreign currency demand, affecting exchange rates.

Asset Market Model and Exchange Rates

• Presents alternative views on exchange rate determination, focusing on financial asset balance rather than just monetary factors.

Portfolio Balance Approach

• Financial assets comprise domestic money, domestic bonds, and foreign bonds.
• Investors hold diversified portfolios balancing risks and returns.

Effects of Financial Variables

• Changes in interest rates, expected currency values, and individual portfolio preferences lead to currency demand shifts affecting exchange rates.

Extended Asset Market Model

• Takes into account factors such as risk premium and relative interest rates affecting portfolio choices of domestic and foreign investors.
• Equations define demand functions for money, domestic bonds, and foreign bonds.
    - $M = f(i, i^<em>, EA, RP, Y, P, W)$   - $D = f(i, i^</em>, EA, RP, Y, P, W)$
    - $F = f(i, i^*, EA, RP, Y, P, W)$

Dynamics of Exchange Rates

• Examines the adjustment towards new equilibrium exchange rates post exogenous changes.

Exchange Rate Overshooting

• Immediate adjustment of exchange rates in relation to changes in monetary supply/interest rates often leads to overshooting beyond new long-run equilibriums.

Rudi Dornbusch’s Model

• Illustrated scenarios of exchange rate adjustments post money supply changes visualized in sequential panels.
    - Example: A 10% increase in the U.S. money supply leads to:
      - Immediate decline in interest rates.
      - Long-run prices adjust gradually while initial impacts on exchange rates are rapid.
      - Overshooting: The exchange rate might alter immediately by more than the expected long-run change (e.g., 16% instead of 10%).

Empirical Tests of Models

• Studies show varying support for monetary and asset market models across different historical contexts.
    - Critiques: Models often underperform in short-term forecasting, emphasizing nuances in market behavior not captured by rigid theories.
• Conclusion:
    - While theoretical frameworks provide insights, they need deeper examination and refinement for practical applications in the increasingly volatile exchange rate landscape.
    - Ongoing research needed to understand underlying expectations and market dynamics better.