Economic models represent an attempt to explain various phenomena with observable variables.
Economic Model
Exogenous Variables
Endogenous Variables
These variables are what we are trying to explain
These variables are what we are taking as “given”
An economic model is simply a set of assumptions
Lets start with a simply one…
Demand is an economic model to explain consumer choices.
Exogenous Variables
Income
Price
Economic Model Endogenous Variable
Consumers maximize utility
IPDQd ,( Quantity demanded is a function of income and price)
dQ ID
dQ
P
ID 'ID
II 'P
P'P
'dQ dQ
P
'dQdQ
Equilibrium models use supply and demand to explain price
Exogenous Variables
Income
Costs
Economic Model Endogenous Variable
Price adjusts to clear the market
( Price is a function of income and costs)
CIPP ,
CS
ds QQ
dQ ID
P
P
sd QQ
IPDQd ,
CPSQ s ,
Ultimately, the point is to use the economic model to pricing function that we can estimate empirically
CS
dQ ID
P
P
sd QQ
CICIP 210,
Parameters to be estimated
(+) (+)
Once we have an estimated pricing function, we can use it to forecast
1121101 tttt CIP
Forecasts for income and costs
General Equilibrium Models try to explain multiple prices simultaneously using multiple markets
PepsiCoke PCIPP ,,
IPPDQ PepsiCokedCoke ,,
CokePepsi PCIPP ,,
IPPDQ PepsiCokedPepsi ,,
CPPDQ PepsiCokesCoke ,, CPPDQ PepsiCoke
sPepsi ,,
CS
dQ ID
P
P
sd QQ
CS
dQ ID
P
P
sd QQ
Home Currency (M) Pays no interest, but needed to buy goods
Domestic Bonds (B) Pays interest rate (i)
Foreign Bonds (B*) Pays interest rate (i*), payable in foreign currency
Foreign Currency (M*) Pays no interest, but needed to buy foreign goods
Any international general equilibrium must have at least four commodities
Foreign Bond Market
Domestic Money Market
Domestic Bond Market
Households choose a combination of the four assets for their portfolios
Foreign Money Market
Currency Market
BennyFluffy
Foreign Bond Market
Domestic Money Market
Domestic Bond Market
We need five prices to clear all five markets
Foreign Money Market
Currency Market
eiiPP ,,,, **
Purchasing Power Parity
Currency Markets
Uncovered Interest Parity
*ePP
eEii %*
The parity conditions can make things a lot simpler!
Foreign Bond Market
Domestic Money Market
Domestic Bond Market
Foreign Money Market
Currency Market
The parity conditions eliminate the need for three markets!!
*,PP
Hence, this story is called “The Monetary Approach”
Cash is used to buy goods (transaction motive), but pays no interest
- +
Money Demand Higher interest
rates lower money demand
Higher real income raises money demand
Higher prices raises money demand
+ yiPLM d ,,
Money supply is assumed to be purely exogenous (a policy variable of the government)
MM s
++ - yiL ,M
M
P
P
An equilibrium price level clears the money market (i.e. supply equals demand)
If prices are too high, there won’t be enough money available to buy all the goods and services available
If prices are too low, there is excess money floating around
yiMPP ,,
++ - yiL ,M
M
P
P
An increase in money supply raises the price level
As the government makes more currency available, demand for goods and services increases. This allows suppliers to raise their prices.
At the initial price, there is an excess supply of currency
yiL ,M
M
P
PAn increase in interest rates lowers money demand – this raises the price level (holding money supply fixed)
yiL ,M
M
P
P An increase in real income raises the demand for money – this lowers the price level (holding money supply fixed)
++ - yiL ,M
M
P
P
If we assign a particular functional form to money demand, we can solve for the equilibrium price level analytically.
MM
i
PYM
s
d
1
If we set money supply equal to money demand and solve for price, we get
y
MiP 1
Domestic Money Market Foreign Money Market
PPP
*
*** 1y
MiP
y
MiP 1
*ePP
*
**11y
Mie
y
Mi
We can assume that the foreign money market is identical to the domestic money market. Using PPP and the two Money Market equilibrium conditions, we get the “fundamentals” for a currency
Now, solve for the exchange rate
Relative Money Stocks
Relative Outputs
Relative Interest Rates
*
*
* 1
1
i
i
Y
Y
M
Me
Taking the previous expression and solving for the exchange rate, we get
These are known as currency “fundamentals”
A regression using fundamentals would generally take the form:
tttttttt iiyyMMe *3
*2
*1 %%%%%
Percentage change in exchange rate (dollars per foreign currency) – an increase is a dollar depreciation
Parameters to be estimated
0
0,
2
31
Estimated parameters of this regression are often statistically insignificant:
Implied by the monetary framework
50
100
150
200
250
300
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Note that while the “fundamentals” seem to track the general trend of the dollar, they don’t pick up the shorter term movements
Fundamentals
USD/JPY
0.4
0.5
0.6
0.7
0.8
0.9
1
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The fact is that fundamentals just don’t exhibit enough variance to explain exchange rate movements in the short term
Fundamentals
USD/GBP
Real Exchange Rate
Recall that PPP often fails in the short run. This is possibly due to trading friction or relative price changes
*
*
* 1
1
i
i
Y
Y
M
MRERe
Real exchange rate changes create a problem…they tend to follow random walks (i.e. unit root processes for you statistics buffs) and are, hence, unpredictable.
50
100
150
200
250
300
Jan-80 Jan-84 Jan-88 Jan-92 Jan-96
Real depreciation of the dollar relative to the Yen
Does anybody remember why the dollar depreciated sharply in the mid-eighties?
Recall that UIP implies that the differences in nominal interest rates reflects expectations of currency price changes (countries with high interest rates should expect their currencies to depreciate
1* % teEiiUncovered Interest Parity
*** %%%%% ttttttt iiyyMMe
1** %%%%%% tttttt eEyyMMe
This incorporates an expectation of the future into the fundamentals
Suppose that expectations are stable (i.e. coincide with future fundamentals
1** %%%%%% tttttt eEyyMMe
211 %% ttt eEfEeEtf
Continue the substitution process forward
21 % tttt eEfEfe
1iitt fEe Today’s currency price depends on
ALL future fundamentals!
Alternatively, its possible for expectations to be destabilizing (i.e. speculative bubbles)
1** %%%%%% tttttt eEyyMMe
2111 %% tttt eENFfEeE
tf
Continue the substitution process forward
211 % ttttt eENFfEfe
11 iit
iitt NFfEe
Some “non-fundamental” factor
A “Bubble” Term!!
*ePP
Why don’t trade deficits matter in the monetary approach? Remember, this framework assumes that PPP and UIP always hold
Trade deficits aren’t a consequence of the price of foreign goods relative to US goods – PPP assures that these prices are the same
Instead, trade deficits are motivated by real interest rates – low interest rates will lower domestic saving and increase domestic spending. This creates a trade deficit.
r
SI ,
wr TGI
SBut with globally integrated capital markets, every country takes the world interest rate as a constant.
Normally, we think of a country’s currency appreciating during an expansion while its trade deficit worsens.
r
SI ,
wr TGI
S Trade deficits are determined in asset markets. Rising income tends to raise investment expenditures and lowers savings – the world interest rate remains unaffected, but the trade deficit worsens
yiL ,M
M
P
P
Meanwhile, in the domestic money market, an increase in income raises money demand and lowers prices
A drop in the domestic price level causes the dollar to appreciate
If commodity prices are free to adjust, then commodity markets/money markets take center stage in currency price determination (PPP)
There is no correlation between trade deficits and currency prices
Volatility in currency markets is created by relative price changes (real exchange rate changes) or speculative behavior
These relative price changes are passed onto nominal exchange rates
The Bottom Line…