Transcript Slide 1

International Monetary Economics
Mar 23 2004
Lesson 14
By
John Kennes
How and why might asset prices deviate
from their fundamental values?
Mar 23 2004
1. The coexistence of professional traders and inexperiened
amateurs
•
•
•
•
•
Only a subset of traders are informed and have access to information
about the underlying value of assets
The remainder are noise traders who act on limited noisy information
Noise traders can be either simply irrational or simply misinformed.
The result is they systematically lose money.
New noise traders continue to enter, stock prices diverge from
fundamental values, despite actions of professionals.
Andrei Shleifler (2000) Inefficient Markets, Oxford University Press
2. The phenomenon of rational speculative bubbles
Speculative Bubbles (1)
Mar 23 2004
–
–
–
–
–
–
To see how bubbles arise, consider the valuation of a stock and
assume that the real interest rate r is constant and the real
dividend d is fixed forever.
The fundamental value is
q = S(1/1+r)id = d/r summed over i = 0 until infinity
It is constant and satisfies the no-profit condition since Dq=0
The puzzling observation is that an infinite number of paths
also satisfy the no-profit condition
Consider the case where the stock price is higher than q. This
is only possible if the share price is expected to rise tomorrow
An overvalued share calls for a continuing increase in price
Speculative Bubbles (2)
Mar 23 2004
Asset Price
(3)
(2)
(1)
0
Time
Speculative Bubbles (3)
Mar 23 2004
–
–
–
–
–
–
Only one of the paths does not explode, and it corresponds to
its fundamental value
The explosive paths are self-fullfilling: price rises because they
are expected to.
The apparent inexrable growth of the share price is called a
speculative bubble
There is a catch: Bubbles eventually burst. Why?
If the asset price grows indefinitely, it would eventual exceed
the world’s wealth, becoming too expensive for anyone.
If there is a know date for this situation, the situation will
unravel
Speculative Bubbles (4)
Mar 23 2004
–
–
–
Bubbles may appear bizare because they have all the features
of economic rationality and market efficiency, save the end
Economists debate whether they exist or whether they can
have subtle rational aspects
Examples of claimed bubbles
•
•
•
•
Stock market crash of 1929, 87, and 89
Explosion of property prices in UK and Scandanavia in the late 1980s,
Ireland early 90s.
IT and the new economy in the late 90s and early 00s. See behaviour of
NASDAQ. Pattern very similar to the following:
Famous historical example: Tulipmania in Holland 1637
Tulipmania 1637
Mar 23 2004
Guilders
.18
0
1 Jan
10 Jan
20 Jan
30 Jan
10 Feb
Exchange Rate Determination in the
Short Run
Mar 23 2004
–
–
–
–
–
–
Only one of the paths does not explode, and it corresponds to
its fundamental value
The explosive paths are self-fullfilling: price rises because they
are expected to.
The apparent inexrable growth of the share price is called a
speculative bubble
There is a catch: Bubbles eventually burst. Why?
If the asset price grows indefinitely, it would eventual exceed
the world’s wealth, becoming too expensive for anyone.
If there is a know date for this situation, the situation will
unravel
Mussa’s Stylized Facts and the Asset
Behaviour of Exchange Rates (1)
Mar 23 2004
– In 1979, Micheal Mussa made the following observations
1. On a dailybasis, changes in floating foreign exchange rates are
largely unpredictable
2. On a month-to-month basis, over 90% of exchange rate
movements are unexpected, and less than 10% are predictable
3. Countries with high inflation rates have depreciating
currencies, and over the long run the rate of depreciation of
the exchange rate between two countries is approximately
equal to the difference in national inflation rates
Mussa’s Stylized Facts and the Asset
Behaviour of Exchange Rates (2)
Mar 23 2004
4. Countries with rapidly expanding money supplies tend to have
depreciating exchange rates vis-a-vis countries with slowly
expanding money supplies. Countries with rapidly expanding
money demands tend to have appreciating exchange rates visa-vis countries with slowly expanding money demands
5. In the longer run, the excess of domestic over foreign interest
rates is roughly equal to the expected rate of appreciation of
the foreign currency. On a day-to-day basis, however, the
relationship is more tenuous
Mussa’s Stylized Facts and the Asset
Behaviour of Exchange Rates (3)
Mar 23 2004
6. Actual changes in the spot exchange rate will tend to
overshoot any smooth adjusting measure of the equilibrium
exchange rate, the real exchange rate predicted by
fundamentals.
7. The correlation between mon-to-month changes in exchange
rates and monthly trade balances is low. On the other hand, in
the longer run, countries with persistent trade deficits tend to
have depreciating currencies, whereas those with trade
surplus tend to have appreciating currencies.
Unpredictable changes
Mar 23 2004
–
–
–
–
When a variable changes randomly from period to period, it is
said to follow a random walk.
In that case, the only change between its value today and its
value tomorrow will be white noise
Mussa’s first stylized fact
Can we understan the other stylized facts with a simple
economic model?
Money Market Equilibrium (1)
Mar 23 2004
–
–
–
–
Assume that economy can be collapsed into two periods –
today (period 1) and the indefinite future when stationary
equilibrium is reached (period 2)
Assume output is constant Y
The LM curve describes money market equilibrium in each
period
Mt / Pt = L (Y, it )
The UIP conditon links the domestic and foreign interest
rates, for period 1.
Mt / Pt = L (Y, i*- (S2– S1)/ S2)
Money Market Equilibrium (2)
Mar 23 2004
–
–
–
–
–
Given S2 and i*, the money market imposes a positive
relationship between the current exchange rate prices by an
upward sloping MM schedule
Why? Imagine the price level increases, this reduces real
money supply so demand must also decrease.
This occurs if the opportunity cost of holding domestic
money, the nominal interest rate rises
Since foreign rate is constant UIP implies the exchange rate
must be expected to depreciate.
Holding the future exchange rate S2 constant, the current
exchange rate must appreciate.
Money Market Equilibrium (3)
Mar 23 2004
–
–
–
Is this sensible?
Yes. The excess demand for money that follows a price
increase prompts domestic residents to borrow abroad
The ensuing capital inflow leads to an appreciation
Goods Market Equilibrium
Mar 23 2004
–
–
–
–
–
In the long run, goods market equilibrium is characterized by
relative PPP
i.e. A stable real exchange rate
If prices abroad are constant , the real exchange rate remains
unchanged as long as the exchange rate and the price level
move in opposite directions
i.e. An increase in the price level is met by an
equiproportional depreciation
The PPP schedule
General Equilibrium
Mar 23 2004
PPP (long run)
Nominal
exchange
rate
B
A
C
M
Price level
M
Dynamic Adjustment (1)
Mar 23 2004
–
–
–
–
–
The money market is always in equilibrium
The interest rate and exchange rate adjust instantaneously to a
level that guarantees equilibrium between money supply and
demand
As a result, the economy is always located on the MM
schedule.
On the other hand, PPP is expected to hold only in the long
run, because of price stickiness
In the short-run C corresponds to an undervalued exchange
rate
Dynamic Adjustment (2)
Mar 23 2004
–
–
Over time the price level must rise or the exchange rate must
appreciate.
The long-run equilibrium is restored as the economy moves
up the MM curve
Exchange rates with flexible prices
Mar 23 2004
–
–
–
–
–
–
If prices are flexible, the gods market is always in equilibrium
Starting from long run equilibrium at A (so that S2 =S1 and
i=i*), we can consider a 5% increase in the money supply
Long run neutrality implies the price level must increase and
the exchange rate must decrease by 5%
This causes a shift down of the MM curve to M’M’ and a long
run equilibrium at C
With fully flexible prices, neutrality occurs in the short run
and the economy immediately jumps from A to C
Predicts stylized fact 3: Countries with high inflation rates
have depreciating currencies
General Equilibrium
Mar 23 2004
Nominal
exchange
rate
PPP (long run)
M
M’
A
C
M
M’ B
P1 P2
Price level
Exchange rates with sticky prices:
Overshooting
Mar 23 2004
–
–
–
–
–
–
In the short-run (period 1) it is more realistic to think of the
price level as rigid, moving only slowly to eliminate goods
market imbalances and deviations from the equilibrium real
exchange rate.
In the long run prices recover flexibility and increase 5%
In period 1, however, the price remains unchanged at P1.
At the same time, money market equilibrium requires the
economy to jump to M’M’
Overtime the price level adusts and moves from B to C
A key feature is that B is below C. The short run nominal
exchange rate overshoots its long run level. (Stylized Fact 6)
Overshooting over time
Mar 23 2004
S0
S
S1
i
P
M
Time