Transcript 7.4 Asset Market Approach

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


1 r
Ee f  e

（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.