tuesday october 13, 2009 international investments handout #8 … 2009 posting... · tuesday...

International Investments Handout #8 of 43Tuesday October 13, 2009

Handout #8

Foreign Exchange MarketsSpot Exchange Rate Determination

Slides to highlight: 1-56, 60-77, 94-165, 200-210.

Tuesdays 6:10-9:00 p.m.Commerce 260306

Wednesdays 9:10 a.m.-12 noonCommerce 260508

Course web pages:http://finance2010.pageout.net

ID: California2010 Password: blueskyID: Oregon2010 Password: greenland

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Levich

Luenberger

Solnik

Eun

Wooldridge

Reading Assignments for this Week

Chap 6

Chap

Chap 3

Chap 7

Scan Read

Pages

Pages

Pages

Pages

Chap 21 Pages

Foreign Exchange Determination and Forecasting

Spot Exchange Rate Determination

Multiple Regression Analysis with Qualitative Information: Binary (or Dummy) Variables

http://highered.mcgraw-hill.com/sites/dl/free/0072521279/91312/eun21279_ch21_dr.pdf

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Reading assignments for this week (2008)

Monetary Policy Report to the CongressSubmitted pursuant to section 2B of the Federal Reserve Act, July 15, 2008http://www.federalreserve.gov/boarddocs/hh/2008/july/FullReport.pdfhttp://www.federalreserve.gov/printable.htm

WSJ 1024 2005: The Greenspan Era

WSJ 0516 2008: Bernanke's Bubble Laboratory

Federal Reserve System 0710 2008:Bernanke on Regulatory Restructuring

IHT 0528 2008: With bold steps, Bernanke revamps Fed rule book

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Reading assignments for this week (2009)

Chairman Ben S. Bernanke Current Monetary Policy Report: July 21, 2009Part 1: Overview of Monetary Policy and the Economic OutlookPart 2: Recent Financial and Economic DevelopmentsPart 3: Monetary Policy: Recent Developments and OutlookPart 4: Summary of Economic ProjectionsAbbreviationshttp://www.federalreserve.gov/monetarypolicy/mpr_default.htm

Chairman Ben S. Bernanke At the Federal Reserve Board Conference on Key Developments in Monetary Policy, Washington, D.C.October 8, 2009 The Federal Reserve's Balance Sheet: An Updatehttp://www.federalreserve.gov/newsevents/speech/bernanke20091008a.htm

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Mankiw on Macroeconomics

(great optional reading)Chapter 4 Money and Inflation

http://www.bfwpub.com/pdfs/mankiw/0716752379_04.pdf

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Stephen G. Cecchetti on Central Banks, Monetary Policy, and

Financial Stability

(must read)Chapter 15 Central Banks in the World Today

http://highered.mcgraw-hill.com/sites/dl/free/0072452692/238721/cec5269

2_ch15.pdf


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http://highered.mcgraw-hill.com/sites/dl/free/0072452692/238721/cec52692_ch15.pdf

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Stephen G. Cecchetti on Central Banks, Monetary Policy, and

Financial Stability

(great optional reading)Chapter 16 The Structure of Central Banks:

The Federal Reserve and the European Central Bankhttp://highered.mcgraw-

hill.com/sites/dl/free/0072452692/238721/cec52692_ch16.pdf

6-9http://highered.mcgraw-hill.com/sites/dl/free/0072452692/238721/cec52692_ch16.pdf

Foreign Exchange MarketsSpot Exchange Rate Determination

MS&E 247S International InvestmentsYee-Tien Fu

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The famous random walk hypothesis holds that the best guess about tomorrow’s stock price is today’s stock price (plus a bit of upward drift to reward patience and risk taking).

According to the random-walk theory, stock prices should move in response to news about the value of the underlying companies.

Introduction


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To many economists, exchange rate models built around a set of structural macroeconomic variables seems to have little power to explain the patterns of short-term exchange rate behavior.

For most countries, the exchange rate is the single most important price in the economy. The daily trading is over US$1 trillion. (1 trillion = 1000 billion = 1,000,000 million = 1012)

Introduction

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The depth to which market economists follow macroeconomic developments suggests that an understanding of the macroeconomic news is critical for understanding (and perhaps predicting) exchange rate behavior.

Financial economists at banks, securities firms, and elsewhere also have been hard at work analyzing the variables that might impact foreign exchange rates.

Introduction

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The view that exchange rates follow a simple random walk and evolve without regard to macroeconomic fundamentals is an extreme characterization, and we believe a false one.

We will see that the presence of nonrandom-walk behavior offers market economists an opportunity to add value. While the link between exchange rates and macroeconomic variables may be difficult to uncover, there is evidence that such a link exists in the short run and to a greater extent in the long run.

Introduction

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Financial market economists are trained to be skeptical.The principal result from models of exchange rate determination is that the exchange rate is a forward-looking variable that should be priced in the same way as other financial assets.The current price of foreign exchange can be shown to equal (in theory) the net present value of all the fundamental variables that affect the exchange rate. This suggests why the exchange rate would be difficult to model and even more so to forecast.

Introduction

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The current exchange rate already reflects the expected values of future macroeconomic variables.

We will use several news items about macroeconomic events to show the forward-looking nature of the foreign exchange market and the difficulties we face in modeling exchange rates.

Introduction

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We will survey some of the stylized models of exchange rate determination developed over the past 20 years.

We outline the broad predictions of these models and then we analyze the empirical evidence to determine whether these models offer a satisfactory explanation for exchange rate behavior.

Introduction


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Measure Amount (billions) What’s IncludedM1 1995: $1,148 Currency, Traveler’s checks

1998: $1,081 Demand depositsOther checkable deposits

M2 1995: $3,630 M1 plus Saving deposits1998: $4,165 Retail money market mutual funds

Small time depositsM3 1995: $4,357 M2 plus Large time deposits

1998: $5,574 Repurchase agreementsEurodollars, Institution-onlymoney market mutual funds

L 1995: $5,426 M3 plus Other liquid assets1998: $6,826 such as savings bonds and

short-term Treasury securities

Four Measures of the Money Stock for the US Economy

6-20Source: http://www.newyorkfed.org/aboutthefed/fedpoint/fed49.html

U.S. Money Aggregates

Money Supply MeasuresSeptember 2001

Savings Deposits

Small Time Deposits

Retail Money Funds$5.3 trillion

M2

Large Time DepositsInstitutional MMFs

Euros & Repos$7.8 trillion

M2 M3

Bill

ions

of D

olla

rs

9,0008,0007,0006,0005,0004,0003,0002,0001,000

0

$1.2 trillion

M1

M1CurrencyCheckable Deposits

6-21http://www.bfwpub.com/pdfs/mankiw/0716752379_04.pdf 6-22

▪ For decades, the Federal Reserve has published data on the money supply, and for many years the Fed set targets for money supply growth.

▪ In the past two decades, a number of developments have broken down the relationship between money supply growth and the performance of the U.S. economy.

▪ In July 2000, the Federal Reserve announced that it was no longer setting target ranges for money supply growth.

Source: http://www.newyorkfed.org/aboutthefed/fedpoint/fed49.html

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News and Foreign Exchange Rates:An Introduction

• Financial markets are preoccupied with news.• However, we usually cannot find a simple

unambiguous link between a news announcement and an exchange rate reaction.¤ The market is forward-looking, and permanent

changes versus transitory phenomena are viewed differently.

¤ While two news announcements may seem similar, their underlying aspects may be in fact different.

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News and Foreign Exchange Rates - Hindsight Smart?

Example 1:In a period of floating exchange rates we might have read that following an increase in the US money supply, the US$ fell because the news generated inflationary expectations.

But on another occasion, we might have read that following a similar increase in the US money supply, the US$ rose because the news generated expectations that the Federal Reserve would tighten money growth and raise interest rates.


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• The Fed has three tools in its monetary toolbox:

Open-market operationsChanging the reserve requirementChanging the discount rate

The Fed’s Tools of Monetary Control

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The Fed’s Tools of Monetary Control

Open-Market Operations: the purchase and sale of U.S. government bonds by the Fed

Reserve Requirements: regulations on the minimum amount of reserves that banks must hold against deposits

The Discount Rate: the interest rate on the loans that the Fed makes to banks

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Open-Market Operations

• The Fed conducts open-market operations when it buys government bonds from or sells government bonds to the public:

When the Fed buys government bonds, the money supply increases (helicopter).The money supply decreases when the Fed sells government bonds (vacuum cleaner).

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Changing the Discount Rate

• The reserve requirement is the amount (%) of a bank’s total reserves that may not be loaned out.

Increasing the reserve requirement decreases the money supply. Decreasing the reserve requirement increases the money supply.

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Changing the Discount Rate

• The discount rate is the interest rate the Fed charges banks for loans.

Increasing the discount rate decreases the money supply. Decreasing the discount rate increases the money supply.

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Problems in Controlling the Money Supply

• The Fed’s control of the money supply is not precise.

• The Fed must wrestle with two problems that arise due to fractional-reserve banking.

The Fed does not control the amount of money that households choose to hold as deposits in banks.The Fed does not control the amount of money that bankers choose to lend.


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http://money.cnn.com/markets/IRC/economic.htmlhttp://money.cnn.com/news/specials/eyes_on_fed/http://money.cnn.com/news/economy/

Markets: Investor Research Center - Economic Calendar

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http://money.cnn.com/markets/IRC/economic.htmlhttp://money.cnn.com/news/specials/eyes_on_fed/http://money.cnn.com/news/economy/

Markets: Investor Research Center - Economic Calendar

6-33http://money.cnn.com/markets/IRC/ 6-34http://money.cnn.com/markets/IRC/

6-35http://money.cnn.com/markets/IRC/ 6-36http://money.cnn.com/markets/IRC/


6-37http://woodrow.mpls.frb.fed.us/research/data/us/charts/int1.cfm 6-38http://woodrow.mpls.frb.fed.us/research/data/us/charts/int1.cfm


6-41http://woodrow.mpls.frb.fed.us/research/data/us/charts/int1.cfm 6-42

http://www.federalreserve.gov/econresdata/default.htm

Research Data

http://www.federalreserve.gov/econresdata/researchdata.htm




6-47http://woodrow.mpls.frb.fed.us/research/data/us/charts/int2.cfm 6-48


Research Data



6-49http://woodrow.mpls.frb.fed.us/research/data/us/charts/exc1.cfm

Index of weighted average exchange value of U.S. dollar against currencies of other G-10 countries.Source: Board of Governors, Federal Reserve System





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Index of weighted average exchange value of U.S. dollar against (in terms of) currencies of other G-10 countries. (note: US$ is in the denominator here)Source: Board of Governors, Federal Reserve System

http://woodrow.mpls.frb.fed.us/research/data/us/charts/exc1.cfm

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Index of weighted average exchange value of U.S. dollar against (in terms of) currencies of other G-10 countries. (note: US$ is in the denominator here)Source: Board of Governors, Federal Reserve System

http://woodrow.mpls.frb.fed.us/research/data/us/charts/exc1.cfm 6-54


Research Data



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Figure 1, Box 7-5 in Dornbusch: Macroeconomics 8EUnemployment Rates For Selected European Countries and the United States, 1960-2000

Source: European Economy, 1998

Germanunemploymentrate is up!

http://www.mhhe.com/economics/dornbusch8e/ 6-56

WHAT'S NEW as of July 13, 2007

Retail sales drop worst in 2 years: Sales drop 0.9 percent, much weaker than forecasts - a signal consumers are tired after years of heavy spending. (July 13 2007: 10:40 AM EDT)Retail sales posted the biggest drop in nearly two years in June, the government reported Friday, fanning worries that consumers were starting to feel the pinch of higher gas prices and the slumpinghousing market.

http://money.cnn.com/news/economy/

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The greatest economic boom ever: A lot could go wrong. And it may not feel like a day at the beach to most Americans. But for your average globetrotting Fortune 500 CEO, right now is about as good as it gets, says Fortune's Rik Kirkland. (July 12 2007: 9:46 AM EDT)(Fortune Magazine) -- Just how red-hot is the current worldwide expansion? "This is far and away the strongest global economy I've seen in my business lifetime," U.S. Treasury Secretary HankPaulson declared on a recent visit to Fortune's offices.

http://money.cnn.com/news/economy/ 6-58

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Hank Paulson takes on the world: In a wide-ranging interview with Fortune, the U.S. Secretary of the Treasury explains why, despite the “strongest global economy” he has ever seen, it still “pays to be vigilant.” (July 11 2007: 4:59 PM EDT)

http://money.cnn.com/news/economy/ 6-62

Paulson On risks: We haven't had a global financial shock since 1998. I believe that these large and dramatic increases in private pools of capital [hedge funds and private equity] and in the credit derivatives markets since then have helped manage and disperse risk and make the economy more efficient. When we do have one - and it's when, not if; that's not me being negative, it's just that we're not going to defy economic gravity -we'll be seeing for the first time how some of these instruments perform under stress.

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Paulson On U.S. competitiveness: I believe economic integration is inevitable, and it's good for our country, because I believe no other country is better positioned than the U.S. to compete long term and win. I just dismiss the notion that somehow or other China - with all the issues it has - or anyone else is going to take its growth rate, and extrapolate it, and pass the U.S. in ten or 20 years.

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U.S. plan to save Fannie and Freddie

Paulson and Bernanke proposal would give mortgage finance giants bigger line of credit with Treasury

and open NY Federal Reserve lending window.

By Tami Luhby, CNNMoney.com senior writerLast Updated: July 13, 2008: 8:54 PM EDT

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Chairman Ben S. Bernanke

Regulatory restructuring“Work is also ongoing to strengthen

the framework for prudential oversight of financial institutions.”

Before the Committee on Financial Services, U.S. House of Representatives

July 10, 2008



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WHAT'S NEW as of July 16, 2008Chairman Ben S. Bernanke

delivered theSemiannual Monetary Policy Report to the Congress

Before the Committee on Financial Services, U.S. House of Representatives

on Tuesday July 15, 2008

Chairman Bernanke presented testimony before the Committee on Banking, Housing, and Urban Affairs,

U.S. Senateon Tuesday July 15, 2008

http://www.federalreserve.gov/boarddocs/hh/2008/july/fullreport.htmhttp://www.federalreserve.gov/newsevents/testimony/bernanke20080715a.htm

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Fed Officials See Stronger Growth and Higher Inflation

Fed officials suggested that, in near term, they were growing more concerned about inflation than economic growth, while still seeing "significant downside risks" to growth. The expectation is that overall inflation will moderate in 2009 and 2010,

What are two ways to alleviate inflation woes? Higher interest rate or Stronger $?


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Despite the expectation that overall inflation will moderate in 2009 and 2010, Mr. Bernanke told lawmakers on July 16, 2008, officials “viewed the inflation outlook as unusually uncertain and cited the possibility that commodity prices will continue to rise as an important risk to the inflation forecast.”

Why? Higher wages will be paid to alleviate workers’ suffering; higher wages in turn add to production costs and higher product prices.


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In these circumstances, the Federal Reserve will employ all available tools to promote economic recovery and to preserve price stability. The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.

http://www.federalreserve.gov/newsevents/press/monetary/20090624a.htm

WHAT'S NEW as of June 24, 2009

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As previously announced, to provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Federal Reserve will purchase a total of up to $1.25 trillion of agency mortgage-backed securities and up to $200 billion of agency debt by the end of the year. In addition, the Federal Reserve will buy up to $300 billion of Treasury securities by autumn. The Committee will continue to evaluate the timing and overall amounts of its purchases of securities in light of the evolving economic outlook and conditions in financial markets. The Federal Reserve is monitoring the size and composition of its balance sheet and will make adjustments to its credit and liquidity programs as warranted.

http://www.federalreserve.gov/newsevents/press/monetary/20090624a.htm6-72

The Federal Reserve Board on Wednesday warned consumers about fraudulent solicitations that appear to be made with the approval or involvement of the Federal Reserve, Federal Reserve officials, or other U.S. government officials. These solicitations promise bogus financial services or large sums of money in exchange for either payment or personal information that can then be used to access a consumer's bank account.

http://www.federalreserve.gov/newsevents/press/other/20090826a.htm

WHAT'S NEW as of August 26, 2009


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The Federal Reserve is advising consumers that it has no involvement in these solicitations. Consumers are strongly urged to verify the legitimacy of potential service providers before entering into a business transaction. Individuals seeking help with repairing their credit history, avoiding home mortgage foreclosure, finding mortgage refinance options, or managing their credit card debt should do business only with reputable service providers. Information related to these issues may be found on the Federal Reserve Board's website at: http://www.federalreserve.gov/consumerinfohttp://www.federalreserve.gov/newsevents/press/other/20090826a.htm

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Example 2:

We might have read that following an upsurge in the US fiscal budget deficit, the US$ fellbecause the news generated expectations that the Fed would monetize the deficit; but on another occasion, we might have read that the US$ rose because the news generated expectations that further government borrowing and higher interest rates would result.

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There are two reasons explaining why we do not find a simple unambiguous link between a news announcement and an exchange rate reaction.


First, the foreign exchange market, like other financial markets, is a forward-looking market.

Once a news item has occurred, traders are concerned whether the news represents a permanent change or only a transitory phenomenon.

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An increase in the current account deficit between the United States and Japan may have resulted from an increase in US imports from Japan or a decrease in Japanese imports from the US.

Second, while two news announcements may seem similar, on closer examination we may conclude that they are not.


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- is a Balance Of Payment account- records transactions in goods and services- a simple way of understanding how transactions

are recorded is to think of debits as arising when money flows out of US or in foreign currencies, and credits when money flows intothe US or in dollars.

- credits result from purchases by foreigners; they give rise to inflows or sources of foreignexchange. Debits result from purchases bydomestic residents; they give rise to outflows or uses of foreign exchange.

The Current Account

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CURRENT ACCOUNT(a) ‘TRADE BALANCE’

(goods, services, transfers)

(b) ‘DEBT SERVICE’

import of a Japanese car; foreign aid to Israel

exports of PC’s; money transfers from abroad to local students

Payments of dividends & interest to foreigners

Receipts from dividends, interest payments on overseas investments by US citizens

DEBIT (-)

Imports

CREDIT (+)

Exports


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Exchange Rates and News Stories: Illustrations

The news service puts us in a ceteris paribus (all other things being equal) setting common to macroeconomic analysis.

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Story: An Increase in the US Money Supply

News announced at t1 :

US money supply grew by $3 billion in the most recent week.

Assuming that the consensus market forecast on money supply growth was $2 billion,

=> realized money growth is a “positive surprise”

Exchange Rates and News Stories: Illustrations

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- the market feels that the higher moneysupply will be maintained

- with national output constant, a largermoney supply leads to a higher price level

- if both prices and exchange rates are perfectly flexible, then the US$ will weaken immediately

Why might the US$ weaken in response to this news?

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U.S.money supply

Figure 6.2

The Reaction of the US$ to a Money Supply Announcement:Scenario (a)

Timet1 t2

$ interest rate

U.S. price level

Nominal exchangerate ($ /FC)

4. the interest rate does not change since the price level isconstant after the monetary shock

1. realized money growth is a “positive surprise”; the market feels that the higher money supply will be maintained

2. if both prices and exchange rates are perfectly flexible, then the US$ will weaken immediately

3. at the same time, with national output constant, a larger money supply leads to a higher price level

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- yes, if market participants believe that theFederal Reserve will drain reserves from thebanking sector in the coming weeks to makeup for its past excessive money supply creation


Could the US$ strengthen in response to the same news item?

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U.S.money supply

Figure 6.2

The Reaction of the US$ to a Money Supply Announcement:Scenario (b)

Timet1 t2

$ interest rate

U.S. price level


1. assume that market participants believe thatthe Federal Reserve will drain reserves from thebanking sector in the coming weeks

2. market projects an low growth in the money supplyand interest rates are projected to rise; interest ratesrise immediately in anticipation

3. higher US$ interest rates attract capital, and the US$ rises

4. since market believes excessive money creationwill be corrected soon, U.S. price level does not change


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What if a permanent change in the rate of growth of the money supply is expected?- in this scenario, inflation turns positive after t1, the interest rate jumps, and the US$ steadily depreciates.


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U.S.money supply

Figure 6.2

The Reaction of the US$ to a Money Supply Announcement:Scenario (c)

Timet1 t2

$ interest rate

U.S. price level


1. assume a permanent change in the rate of growthof the money supply is expected

2. then, inflation turns positive after t1 (prices rise when the government prints too much money)

3. and the interest rate jumps (Fisher Closed)

4. at the same time, the US$ steadily depreciates(relative PPP)

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Which is the correct response of the exchange rate to the news?

- all the responses are correct, but with respectto different scenarios derived from the same news announcement.


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U.S.money supply

Figure 6.2

The Reaction of the US$ to a Money Supply Announcement:Alternative Scenarios

Timet1 t2

$ interest rate

U.S. price level


a

a

aa

b

b

b

b

c

c

c

c

The Modern Art of Exchange Rates!

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Story: An Increase in U.S. Interest Rates

News: U.S. interest rates at all maturities along the term structure of interest rates have risen by 0.10 percent or 10 basis points (bp).

Assume that the market consensus was for no change in interest rates, so the entire 10 bpincrease comes as an unexpected surprise.

Could the US$ be weaker as a result of this news? Could the US$ be stronger as a result of this news? Which is the correct response of the exchange rate to an increase in the level of interest rates - a weaker currency or a stronger currency?

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It could be that US$ interest rates could have risen because of concern about rising U.S. inflation (the Fisher Effect). Following purchasing power parity, a weaker US$ would be expected - call this path d.

Could the US$ be weaker as a result of this news?

The weaker US$ (path d) assumes that the rise in U.S. interest rates is stemming from inflationary concerns, and therefore a rise in the nominalinterest rate, but not necessarily the real interest rate.

FOREIGNUSSpot PP Δ−Δ=Δ %%%

( )USE Pri~

$$ Δ+=


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Might the US$ strengthen in response to the same news item?

If market participants were attracted by the higher yields now available to US$ securities, capital flows to the United States would contribute to a stronger US$ - call this path e.

The stronger US$ (path e) assumes that inflation is under control, so the higher interest rate corresponds to an increase in the real interest rate. And a higher real interest rate draws in foreign capital and raises the foreign exchange value of domestic currency.

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Which is the correct response of the exchange rate to an increase in the level of interest rates -a weaker currency or a stronger currency?

Because nominal U.S. interest rates respond to both real and inflationary factors, the exchange rate response must be ambiguous.

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From 1976 to 1978, the differential between U.S. and foreign interest rates rose from -3 percentage points to +4 percentage points.

Despite this sharp increase in interest rates, the trade-weighted value of the dollar depreciated by almost 20 percent, from 105.0 in mid-1976 to 85.0 by November 1978.

This is certainly an example of negative correlation between interest rates and exchange rates as in path d.

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In the following 2 years (1979-80), the correlation between exchange and interest rates turned significantly positive. Certainly, higher U.S. interest rates were stimulating US$ currency purchases.

The policy events behind this change include: (1) Nov 1, 1978’s intervention, which was intended to convince the market that U.S. policymakers were serious about controlling inflation and arresting the downward slide in the US$; (2) Oct. 6, 1979’s announcement by the U.S. Federal Reserve about a change in its operating procedure -the new policy emphasized containing the growth rate of monetary aggregates within announced limits, allowing interest rates to take on greater volatility.

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= exports – imports + unilateral transferscurrentaccount = government (tax collections – expenditures)

+ private (savings – investments)

¤ Case I: The shortfall in exports or increase in imports is viewed as permanent and the US$ weakens.

¤ Case II: The change is due to greater private sector investments, and the US$ strengthens as foreign capital flows in to finance the investments.

Story: It is announced that the U.S. current account deficit will reach an annual rate of $250 billion. ( The

consensus was $200 billion.)

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FIGURE 1, BOX 19-5 in Dornbusch/MacroeconomicsTHE U.S. CURRENT ACCOUNT AS A PERCENTAGE OF GDP, 1970-2000

Source: DRI/McGraw-Hill Macroeconomic Databasehttp://www.mhhe.com/economics/dornbusch8e/


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Only unanticipated events cause exchange rates to deviate from their expected path of movement.

Factors that increase the demand for a currency tend to raise the price of that currency.

The demand for a nation’s money as a currency or as an investment choice depends on a small group of factors including...

Foreign Exchange Rate Behavior: Major Concepts

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...national income, real interest rates, inflation rate, changes in national wealth (through the current account), preferred currency mix for holding financial wealth, financial risk factors, political risk factors etc.


The “character” and the “context” of the economic news item will greatly influence the “nature” of the exchange rate response that follows.

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By “character,” we mean whether the news item was representing:- an unanticipated or anticipated disturbance- a permanent or transitory disturbance- a shock affecting the level of a variable or its

rate of change- a real or nominal (monetary) disturbance- a shock affecting a single industry sector or

an economy-wide shock- a shock to beliefs that were weakly held

or strongly held.


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By “context,” we mean a variety of factors including:- whether the monetary authorities are perceived

to have discipline relative to their targets- whether foreign demand for home country

currency & securities is satiated or growing- whether prices in the economy are free to adjust

quickly instead of being sticky- whether the shock resulted from a change in

exports instead of imports, a change in public savings instead of private savings, etc.

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By “nature” of the exchange rate response, we mean:


- whether the exchange rate jumps at once to its next long-term equilibriumand stays there at rest

- or whether the exchange rate overshoots its next long-run equilibriumand continues to adjust following its initial jump

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Economic fundamentals form the backdrop for asset markets and, indeed, ultimately determine financial asset returns.

Key U.S. Economic Indicators & Their Interpretation

Financial market participants are increasingly called on to monitor economic indicators and interpret the data to determine the likely impact that new information will have on financial markets.


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Growth determines profits and real returns while inflation features prominently in setting the discount that is embedded, explicitly or implicitly, in every investment decision.

Key U.S. Economic Indicators & Their Interpretation

The focus is on the implications for growth and inflation.

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Barometric Indicators

Fig 6.5

Coincidentindicator(peak & trough)

Indi

cato

r lev

el (v

alue

)

Businesscycle

peak date

Businesscycle

trough date

Leadingindicator(peak & trough)

Laggingindicator(peak & trough)

Time

Note that an indicator may be peak-leading & trough-lagging.

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The composite index of leading indicators is composed of 10 equally weighted indicators that lead the economy:

1. Average weekly hours of production workers inmanufacturing.

2. Initial unemployment claims.3. Manufacturers’ new orders for consumer goods4. Vendor performance.5. Plant and equipment orders.6. Building permits. 7. S&P 500 Index of stock prices.8. M2 money supply.9. Interest rate spread, 10-year Treasury bonds less the

federal funds rate.10. Index of consumer expectations.

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Average weekly hours in manufacturing

This certainly is a key indicator since the more people working regularly, the more likely they will be consumers of goods and services. The question I would raise is if the U.S. is a service economy with six times more service hours than manufacturing hours (www.BLS.GOV/CES, see table six), then why not include the service hours worked as well as manufacturing hours?

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Manufacturer’s new orders, non-defense capital goods

This is an excellent indicator for future capital investment. It could be asked whether this is really a leading indicator anymore. Most manufacturers I speak with tell me they will not be expanding their capital budgets for equipment until the general economy shows solid signs of improvement. If that’s the case, then this may be a lagging indicator during this particular business cycle.Just-in-time manufacturing would dictate no new plant and equipment until market demand says to invest. As long as deliveries stay short on capital equipment, manufacturers can get away with this strategy.

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Stock prices, 500 common stocks

S&P 500 Index of stock prices is a leading indicator.

Another strictly manufacturing-focused stock index you might want to follow is the Heavy Metal 40 index maintained on website www.winningstrategy.com. Forty large manufacturing companies comprise the Heavy Metal Index, the HM40 index. Since stock prices reflect investor’s opinions about the earnings outlook for companies over the mid- to long-term, movements in stock prices generally precede the actual changes in the performance of the companies and are a very good leading indicator.


6-109

Money supply, M2This is an indicator that the Federal Reserve can manage to reinforce monetary policy. M2 is the sum of all cash, checking accounts, and money market funds in the economy available for purchases or investments. The Fed can juice up the money supply by purchasing treasury notes and bills and so releasing more cash into the economy. With Federal budget deficits forecast as far as the calculator can calculate, the Treasury will have ample opportunity to issue debt, and the Fed will have ample opportunity to purchase it along with individuals, both here and abroad.This cost is not bad when interest rates are low, but gets pretty scary when rates start to climb. The money supply should stay generous in a deficit-driven economy such as the future portends unless excessive inflation returns and then the money supply will tighten.

6-110

Interest rate spread, 10-year treasury bonds less federal funds

This indicator is a measure of the risk perceived by investors as they follow the prospects of the economy for the near and longer term. When the rate spread between the 10-year note (a longer term debt instrument) and the federal funds rate (a very safe short term debt instrument) is large, then the market is betting that the economy is in for future difficulties and investment and growth will be hard to sustain.When the spread narrows, the market is betting that economic results are destined to become stronger and so risk in investing has diminished.

6-111

Heading Off DangerSince the mid-1990s, the Fed has moved in an aggressive, pre-emptive fashion to maintain growth and price stability.

Source: WSJ: The Greenspan Era6-112

8324.87As of 0706 2009

1787.40As of 0706 2009

6-113

The composite index of coincident (at the same time) indicators is comprised of only four indicators:

1. Employees on nonagricultural payrolls.2. Personal income. 3. Index of industrial production.4. Manufacturing and trade sales.

6-114

The composite index of lagging (following) indicators has seven items:

1. Average unemployment duration.2. Manufacturing inventories/sales ratio.3. Changes in per-unit labor cost.4. Prime rate changes.5. Commercial and industrial loan outstanding6. Ratio of consumer installment credit

outstanding to personal income.7. Changes in the consumer price index

for services.


6-115

Measuring Exchange Rate Movements

• An exchange rate measures the value of one currency in units of another currency.

• A decline in a currency’s value is referred to as depreciation, while an increase is referred to as appreciation.

• % Δ in foreign currency value = (S - St-1) / St-1

• A positive % Δ represents appreciation of the foreign currency, while a negative % Δrepresents depreciation.

Exchange Rate Determination 6-116

Exchange Rate Equilibrium

• An exchange rate represents the price of a currency, which is determined by the demand for that currency relative to supply.

Value of £

Quantity of £

equilibrium exchange

rate

S

D

Exchange Rate Determination

6-117

Factors that Influence Exchange Rates

• Relative Inflation Rates¤ A relative increase in U.S. inflation will increase

the U.S. demand for British goods, and hence the U.S. demand for British pounds.

¤ In addition, the British desire for U.S. goods, and hence the supply of pounds, will drop.

Value of £

Quantity of £

S

DD2

S2

r2r



• Relative Interest Rates¤ A relative rise in U.S. interest rates will

decrease the U.S. demand for British pounds. ¤ In addition, the supply of pounds by British

corporations will increase.

Value of £

Quantity of £

S

DD2

S2rr2


6-119

Real Interest Rates¤ A relatively high interest rate may reflect

expectations of relatively high inflation, which may discourage foreign investment.

¤ Real interest rates adjusts nominal interest rates for inflation:

real nominalinterest = interest - inflation

rate rate rateThis relationship is sometimes called the Fisher effect.




Value of £

Quantity of £

S

DD2

rr2

• Relative Income Levels¤ A relative increase in the U.S. income level will

increase the U.S. demand for British goods, and hence the demand for British pound.

¤ The supply of pounds does not change.



6-121

• Government Controls¤ Governments can influence the equilibrium

exchange rate in many ways, including :– the imposition of foreign exchange barriers,– the imposition of foreign trade barriers,– intervening in the foreign exchange market, and– affecting macro variables such as inflation, interest

rates, and income levels.



• Expectations¤ Foreign exchange markets react to any

news that may have a future effect.¤ Institutional investors often take currency

positions based on anticipated interest rate movements in various countries too.

¤ Because of speculative transactions, foreign exchange rates can be very volatile.



6-123

Factors that Influence Exchange RatesTrade-Related

Factors1. Inflation

Differential2. Income

Differential3. Gov’t Trade

Restrictions

FinancialFactors

1. Interest Rate Differential

2. Capital FlowRestrictions

U.S. demand for foreign goods, i.e. demand for

foreign currency

Foreign demand for U.S. goods, i.e. supply of

foreign currency

U.S. demand for foreign securities, i.e. demand

for foreign currency

Foreign demand for U.S. securities, i.e. supply of

foreign currency

Exchange rate

between foreign

currency and the dollar


• Interaction of Factors¤ Trade-related factors and financial factors

sometimes interact. For example, an increase in income levels sometimes causes expectations of higher interest rates.

¤ Over a particular period, different factors may place opposing pressures on the value of a foreign currency. The sensitivity of the exchange rate to these factors is dependent on the volume of international transactions between the two countries.



6-125


Rx

• Economic Factors¤ relative interest rates¤ purchasing power parity (PPP)¤ economic conditions (balance of payments,

economic growth, rate of inflation, money supply, unemployment figures, rates of taxation)

¤ supply and demand for capital (capital flows to a country where investors see opportunities)

6-126


Rx

• Political Factors¤ the type of economic policies pursued by the

government¤ the amount of uncertainty in the political

situation¤ the regulatory policies followed by central banks

and/or other regulatory bodies¤ central bank intervention in the foreign

exchange market to strengthen or weaken its currency


6-127


Rx

• “People” Factors¤ market sentiment (the perception traders have

of the short-term prospects for the movement in a currency)

¤ technical analysis (many market participants trade on the basis of past price movements)

6-128

How Factors Have Influenced Exchange Rates

¤ Because the dollar’s value changes by different magnitudes relative to each foreign currency, analysts measure the dollar’s strength with an index.

60

100

140

180

1972 1977 1982 1987 1992 1997

Dol

lar’s

Inde

x

Year

high U.S.inflation

high U.S. interest rates, a somewhat depressed U.S. economy, and low inflation

large balance of trade deficit

high U.S. interest rates

Persian Gulf War


6-129

Speculating on Anticipated Exchange Rates

Chicago Bank expects the exchange rate of the New Zealand dollar to appreciate from its present level of $0.50 to $0.52 in 30 days.


1. Borrows $20 million

2. Holds NZ$40 million

Exchange at $0.50/NZ$

Lends at 6.48% for 30 days 3. Receives

NZ$40,216,000


4. Holds $20,912,320

Borrows at 7.20% for 30 days

Returns $20,120,000Profit of $792,320

Start here

6-130

Speculating on Anticipated Exchange Rates

Chicago Bank expects the exchange rate of the New Zealand dollar to depreciate from its present level of $0.50 to $0.48 in 30 days.


1. Borrows NZ$40 million

2. Holds $20 million


Lends at 6.72% for 30 days 3. Receives

$20,112,000


4. Holds NZ$41,900,000

Borrows at 6.96% for 30 days

Returns NZ$40,232,000Profit of NZ$1,668,000

or $800,640

Start here

6-131

Flow versus Stock Models of the Exchange Rate

A model of exchange rate determination requires the specification of demand and supply curves, the intersection of which determines a price.

Flows approach concentrates on the flows of currency passing through the foreign exchange market. Foreign exchange was thought to be in demand or supply largely as a medium of exchange for executing international trade transactions.

6-132

The flow demand for UK£ represents American demand for British goods and services. The supply of UK£ represents the demand for American goods by British residents. The intersection of the two determines the exchange rate.


Priceof £

Quantityof £/Time

Demand

Supply


6-133


Stock approach focuses on the total quantity of currency outstanding at a moment in time.

Currency is treated as an asset - durable and transferable.

At a moment in time, the stock of currency is in fixed supply.

At the equilibrium currency price, the stock of currency is willingly held.

6-134

Figure 6.4 provides an example of the stock approach for the static case where the supply of currency is fixed.

Holding demand constant, an increase in the supply of £ to S’ (through money creation or retiring £ bonds) leads to a fall in the price of £to point b.

Holding supply constant, an increase in the demand for £ leads to a rise in the price of £ to point c.


6-135

Determination of Exchange Rates: A Stock Approach

Price ofsterling

Quantity of sterlingat a moment in time

$2.82

$2.78

S S ’D D ’

D

D ’

a

c

b

Figure 6.4 6-136


The stock approach is also known as the asset approach - where the current exchange rate is set to equilibrate the (risk-adjusted) expected rate of return on assets denominated in different currencies.

In the asset approach the current spot exchange rate is set equal to the present discounted value of the expected future spot exchange rate.

6-137

From current spot rate, the expected US$-denominated return on a UK £ investment can be obtained.

);~()1()1(

1$

£+×

++

= tt SEiiS

£$50.1

)1(%)101(

£$4474.1

$

×+

+=

i

Recall that from the International Fisher Effect:


%6.3£$4474.1)

£$4474.1

£$50.1( =−

An US investor would earn about 3.6% on the expected exchange rate change:

6-138

%1411.1£$4474.1

£$50.1$ =−×=i

To produce a US$ return of 14 percent on UK assets:


However, if St= $1.5421/£ (point B), the corresponding numbers are:

£$50.1

)1(%)101(

£$5421.1

$

×+

+=

i

%73.2£$5421.1)

£$5421.1

£$50.1( −=−


6-139

%711.1£$5421.1

£$50.1$ =−×=i

To produce a US$ return of 7 percent on UK assets:


However, if St= $1.5421/£ (point B), the corresponding numbers are:

-2.73% on the expected exchange rate change, and a US$ return of only 7% on UK assets

=> current US$/£ exchange rate and expected US$ return on UK assets are negatively related.

6-140

The Current US$/£ Exchange Rate and the Expected US$ Return on UK Assets

Figure 6.5

1.35

1.40

1.45

1.50

1.55

1.60

Cur

rent

US$

/£E

xcha

nge

Rat

e

Expected US$ Return on UK Assets

B

0.06 0.08 0.10 0.12 0.14

A

Assumptions1. The expected future

spot rate is $1.50/£.2. The nominal interest

rate on £ is 10.0%.

6-141

Foreign exchange is used as both a medium of exchange and a store of value, so an overall equilibrium in the foreign exchange market requires balance in both flow and stock aspects of the market.- stock concept (as in the asset approach) are important for the determination of exchange rate in the short run.

- flow imbalance can be maintained over the short run as long as surplus (deficit) countries are willing to accumulate (run down) assets.

Combining Flow and Stock Concepts of the Exchange Rate

6-142

No deficit country wants to accumulate liabilities to foreigners forever either since the marginal cost of debt is rising, and will finally cut into present consumption.


In the long run, no surplus country wants to accumulate foreign assets forever since the risks of counterparty default are high and the cost of forgone consumption is high.

6-143

A country that runs a current account surplus accumulates wealth, and may use this wealth to bid for international assets; a deficit country relinquishes its wealth.


Thus transfers of wealth through the current account may tilt the demand for currencies in the foreign exchange market.

6-144

Asset Modelsof the Spot Exchange Rate

Small Country Model

Preferred LocalHabitat Model

Uniform PreferenceModel

Portfolio-Balance Approach Monetary Approach

imperfect capital substitutability perfect capital substitutability

Monetarist Model

Overshooting Model

completely flexiblecommodity prices

sticky commodity prices

Asset Model Approach

perfect capital mobility


6-145

Models based on the asset approach begin by specifying a menu of assets. The interrelationship between the demand and the supply of those assets determines the price of foreign exchange.

In the monetary approach, the menu is short and simple - just the domestic and foreign money, M and M*.In the portfolio-balance approach, the menu of assets include M, M*, and domestic and foreign bonds (B and F).

Asset Models of the Spot Exchange Rate

6-146

The Monetary Approach to Exchange Rate Determination is derived directly from…

1. purchasing power parity, and 2. the quantity theory of money

(the quantity of money available determinesthe price level and the growth rate in thequantity of money available determines theinflation rate)

The Monetary Approach

6-147

PPP concludes that the exchange rate is the relative price of goods in two countries; monetary theory suggests that spot exchange rates are the relative price of two monies.

It follows that exchange rate behavior reflects the evolution of the relative supplies and demands for two monies.


Within the monetary approach are two models, the flexible-price model and the sticky-price model.

6-148

Assuming that domestic good prices are fully flexible (i.e., if domestic money supply↑ => domestic currency value ↓ proportionately), then the implication is that PPP holds continuously and the real exchange rate never changes.

demandmoney supplymoney

),(level price ===

iYLMP

For the home country,

where Y is domestic real income (real GDP)

Flexible-Price Models

6-149

countryforeign for the),( **

**

iYLMP =

)assumption(by 0 0; where <∂∂

>∂∂

iL

YL

Y represents transactions demand for money; i is opportunity cost of holding money balances.

By PPP condition,

),(),(****gnhome/forei iYLM

iYLMPPS ==


i decreases => demand of local currency increases or L(Y, i) increases => S decreases => foreign currency depreciates 6-150

countryforeign for the),( **

**

iYLMP =

)assumption(by 0 0; where <∂∂

>∂∂

iL

YL

Y represents transactions demand for money; i is opportunity cost of holding money balances.

By PPP condition,

),(),(****gnhome/forei iYLM

iYLMPPS ==


i* decreases => demand of foreign currency increases or L(Y*, i*) increases => S increases => foreign currency appreciates


6-151

A common specification of the money demandfunction is ieKYiYL ),( εη −=

hands changesmoney rate1

money ofvelocity 1

==K

income%demandedmoney ofquantity %

ΔΔ

=η

DY

YD

YYDD

•∂∂

=ΔΔ

=η = income elasticity of DMoney

MoneyDi ofcity semielasti =ε


6-152

(6.3) * *

**

* i

i

eKYMeYMK

PPS

εη

εη

==

ttttt iikkyymmS )()()()(ln **** −+−+−+−= εη

YyKkMm ln,ln,ln ===

(6.3) and (6.4) =>predictions of theflexible-price monetary model => if M ↑ 2M -> (1/S), domestic

currency value ↓ 1/2 (1/S)


(6.4)

6-153

Flexible-Price Monetary Model

• A common specification of L (Y,i ) is K Yηe– ε i

K - constant (the inverse of the velocity of money)

η - income elasticity of the demand for moneyε - interest rate semielasticity of the demand for

money

• By PPP, * *

**

*gnhome/forei i

i

eKYMeYMK

PPS εη

εη

==

( ) ( ) ( ) ( )ttttt iikkyymmS **** ln −+−+−+−=⇒ εη

subscript timea is ln ,ln ,ln where

tYyKkMm ===

6-154

(6.3) predicts that the domestic currency will appreciate in response to a rise in domestic real income (Y) or a fall in domestic interest rate (i), because both changes will increase the demand for domestic money.

While a rise in US real income will lead to greater demand for imports and an increased demand for foreign currency, it is only a partial equilibrium result that neglects capital flows that also respond to an increase in US income.


6-155

Monetary theory argues that in general equilibrium, the net effect of higher US income should be a US$ appreciation because the increase in the demand for money and the corresponding improvement in the financial account (formerly called the capital account) exceeds the decline in the trade balance.


6-156

- another Balance of Payment (BOP) account- asset (real & financial) transactions- payment flows from current account transactions

- the way they are recorded on the US BOP account is US assets abroad (net), Foreign assets in the US (net)

- don’t interpret these terms as ‘physically’ beingabroad, e.g., a US bank in New York acquiringDM increases the item ‘US assets abroad’

- anything that is capital inflow is a credit, anything that is a capital outflow (“capital export”) is a debit

Financial Account


6-157

DEBIT (-) CREDIT (+)CAPITAL EXPORT(-) CAPITAL IMPORT(+)

↑US assets abroad ↑foreign assets in thee.g. US citizens buy U.S. e.g. Japanese firmJapanese stocks/bonds buys Sears tower

↓foreign assets in the ↓US assets abroad US e.g. Japanese e.g. US firm sells stake citizens sell US stocks in British firm

Financial Account

6-158

- introduced by Rudiger Dornbusch (1976)- highlight the impact of assuming that the speedof adjustment of goods prices is slow relative tothe speed of adjustment of asset prices

- when a central bank announces its money supply figures, the traders in financial marketsrespond quickly, adjusting the prices of varioussecurities and their portfolio positions until a new equilibrium is reached; while Wal-Mart,McDonalds’ prices remain virtually the same and change only gradually in response to general inflationary pressures

- research: what’s new in Internet era? Amazon?

Sticky-Price (Overshooting) Monetary Models

6-159


When good prices are sticky, Dornbusch showed that it is necessary for asset prices to move by more than in the flexible price case, in order for markets to reach a temporary equilibrium.

He also showed that the gradual adjustment of goods prices following a monetary shock reveals a dynamic adjustment path to the exchange rate,

so that while the real exchange rate changes in the short run, it reverts to its original level in the long run.

6-160

i.e. the only time sequence of exchange rates that accurately reflects the nature of the shock and removes all unusual profit opportunities in financial markets.


The Dornbusch model assumes perfect certainty.

The exchange rate path derived is the only equilibrium path...

6-161


Prior to this monetary shock, assume i = i* and exchange rate is at PPP rate S0. The shock occurs at t1, raising the domestic money supply M0 to M1 (liquidity effect occurs).

In response to a one-time, permanent, unanticipated jump in the domestic money supply, iUS↓, US$ value↓ and capital flows out of US to foreign countries with higher i*.

6-162

Traders dilemma: How can they willingly hold domestic currency that will depreciate over the long term and also pay a low interest rate?

In the short run S0>> S1 [(1/S0) << (1/S1) US$ depreciates too much]. Over the long term (1/S1) < (1/SN) (US$ appreciates) => IRP will hold:

*1 ][ iiSSF ttt −=−+


Over time, the excess money supply leads to US price inflation, and iUS↑ gradually as the liquidity effect goes away and the US$ gradually appreciates.


6-163

In the long run, the economy is once again in equilibrium at a higher price level (PN) and higher (depreciated) exchange rate (SN), but at the same real exchange rate as before the shock.

In the long run, iUS returns to its original level and the US$ has depreciated in nominal terms, but the real exchange rate is unaffected.


6-164

US price level

$ Interest rate

US money supply

Timet 1 t N

Time-Series Pattern of Variables in the Sticky-Price (Overshooting) Monetary Model

Figure 6.7

Nominal exchange rate ($/FC)

M 0

P 0

S 0

M 1

P N

S 1

S N

iUS↓, …

US$ value↓ and capital flows out of US to foreign countries with higher i*.

In response to a one-time, permanent, unanticipated jump in the domestic money supply, …

In the long run, the economy is once again in equilibrium at a higher price level (PN)

In the long run, the economy is once again in equilibrium at a higher SN , …

6-165

U.S.money supply

Figure 6.2

The Reaction of the US$ to a Money Supply Announcement:Scenario (a)

Timet1 t2

$ interest rate

U.S. price level


4. the interest rate does not change since the price level isconstant after the monetary shock

1. realized money growth is a “positive surprise”; the market feels that the higher money supply will be maintained

2. if both prices and exchange rates are perfectly flexible, then the US$ will weaken immediately

3. at the same time, with national output constant, a larger money supply leads to a higher price level

6-166

This relationship, where the immediate, short-run change in the nominal exchange rate exceeds the long-run change in the nominal exchange rate, is defined as overshooting. Because goods prices are sticky in the short run, the real exchange rate also follows an overshooting path.Thus, a monetary disturbance which in the long run has only nominal effect (changing the price level and the nominal exchange rate) has real effect in the short run by changing the real exchange rate and the competitiveness of firms in international trade.


6-167

Sticky-Price (Overshooting) Monetary Model

• Both the nominal and real exchange rates follow an overshooting path. (The immediate, short-run change exceeds the long-run change.)

• The path of the exchange rate is given by:( ) ( ) ( ) tttt iiyymms

*

*

* 1 −+−+−=θ

η

where θ is the rate at which the exchange rate adjuststoward its long-run equilibrium.

6-168

“Overshooting” defined - prices move by “too much” in the short-run relative to some benchmark» Relative to the movement if markets had full

information» Relative to the movement needed to establish PPP» Our def’n: Relative to the movement required in the

long-runYou have encountered overshooting before in the market for goods that are in limited supply when there is a sudden demand shock» “Overshooting” of this sort is not bad, an equilibrium

result caused by rigidities of some sortTypical microeconomics example: Rigidities in supplyInternational finance example: Stickiness in goods prices

Price Dynamics and “Overshooting”


6-169

Initial equilibrium at “A”, then sudden shift in demand from D to D’In the short-run prices “overshoot” to $12,000 and gradually adjust to their long-term equilibrium at $11,000

Price Dynamics in the Marketfor Honda Insight Hybrid Automobiles

(http://automobiles.honda.com/insight-hybrid/)

Price/Unit

$12,000

$11,000

$10,000

S (Very short-run)

S (Long-run)

8,000 10,000 Quantity/Time

BC

DD’

A

6-170

As an empirical regularity, we find that prices of goods are less variable in the short-run than exchange rates. Domestic prices of goods are described as “sticky” or “rigid” but in the long-run, goods prices become more flexible.

Inflation and Exchange Rate Dynamics

6-171

Exchange Rate Overshooting (1 of 2)

US pricelevel

$ Interestrate

US moneysupply

TimeT(1) T(N)

Nominalexchangerate ($/FC)

Consider the following “experiment”.Assume i($)=i(£) and exchange rate is flat and not expected to change.

NOW, let the US money supply rise unexpectedly by 1% at time T(1), while conditions in the rest of the world stay unchanged.The surplus of money leads $ interest rates to fall, but goods prices are sticky.As a result, capital flows out of US, and toward foreign investments, and $ depreciates.

6-172

US pricelevel

$ Interestrate

US moneysupply

TimeT(1) T(N)

Nominalexchangerate ($/FC) Long-Run value

Exchange Rate Overshooting (2 of 2)$ has two strikes against it(1) Low interest rates(2) Excess money supply

likely to cause inflation in the long run

Puzzle: How to get investors to willingly hold US$ assets?

Answer: Let the US$ depreciate immediately by “too much”, to “overshoot.Then in the medium run, the US$ can appreciate, and compensate investors for the low $ interest rate.

6-173

Why does exchange rate “overshooting” occur?» Goods prices are sticky in the short run. If goods

prices were completely flexible, then M(US)↑ by x%, P(US)↑ by x%, and S($/£)↑ by x% in an instant. (Monetary approach + PPP)

» Capital is very mobile, and asset prices adjust quickly.» The world is noisy. Unexpected macroeconomic shocks.Is overshooting a bad thing? In our context, “No”» It is an natural process to equilibrate returns in US

assets and foreign assets, and remove arbitrage profits» It reflects full information, and not confusion» Would be better to have fewer macroeconomic surprises

(less exchange rate volatility), but surprises happen.Even with overshooting, PPP holds in long run

Lessons of Exchange Rate Overshooting

6-174

Should be very difficult to predict changes» Asset markets tend to be efficient, prices reflect

information» Short-run price changes caused by “news” -

unpredictableShort-run prediction» Many analysts use technical, trend-following models

to predict the direction (but not magnitude) of changes» No traditional economic foundation for these models,

but studies find that they are often useful & profitable.Medium to Long-run prediction» Some evidence that exchange rates gravitate toward

the values indicated by structural, monetary models» Short-run deviations are temporary, in the medium to

longer run, fundamentals matter for exchange rates

Predicting Exchange Rate Changes


6-175

Asset Modelsof the Spot Exchange Rate

Small Country Model

Preferred LocalHabitat Model

Uniform PreferenceModel

Portfolio-Balance Approach Monetary Approach

imperfect capital substitutability perfect capital substitutability

Monetarist Model

Overshooting Model

completely flexiblecommodity prices

sticky commodity prices

Asset Model Approach

perfect capital mobility

6-176

- focuses on the excess demand for financialassets

- money & bonds assets; home & foreigncountries

- assume that home country agent are free toallocate their wealth (W) among three holdings: domestic money (M), domestic bonds (B), foreign bonds(F / valued at SF)

- home country wealth W ≡ M + B + SF- the greater the country’s fiscal deficit, the

larger the supply of government bonds

The Portfolio Balance Approach

6-177

- ↑domestic interest rate i => ↑domestic demandfor domestic bonds B (1)

- ↑[foreign interest rate i* + expected exchangerate change E(s)] => ↑domestic demand for foreign bonds F (2)

- ↑[ Ø = i - i* - E(s)] => ↑[domestic demand for B –domestic demand for F] (1) - (2)

- Ø represents the expected excess return ondomestic currency bonds over foreign currency bonds


6-178


The second element in the demand for bonds is wealth itself.

As W↑, (M, B, F)↑.

How individuals spread their wealth across M, B, F has an important impact on the exchange rate.

6-179

Under this model, if wealth grows faster in the home or foreign country, there is no exchange rate impact because investors from both countries bid for assets in the same proportions.


The Uniform Preference Model makes sense if both domestic and foreign investors consumed the same basket of goods and therefore found it sensible to hold identical investment portfolios.

6-180

The Preferred Local Habitat Model assumes that BH/WH > FH/WH and FF/WF > BF/WF where the subscripts H and F indicate home and foreign residents. That is, both the home and foreign countries prefer to hold a larger fraction of their wealth in local bonds. Assume as follows:

bond portfolios compositionsin US$ in Yen

US investor 90% 10%Japan investor 30% 70%


A yen-denominated bond issued in Tokyo by a non-Japanese company and subject to Japanese regulations, Samurai Bond, has hence prospered.


6-181

If US runs $1 billion current account deficit, then(0.9 billion US$ + 0.1 billion Yen) moves from US hands to Japanese hands to become (0.3 billion US$ + 0.7 billion Yen). The transfer of wealth would tend to shift demand toward the Japanese Yen (and Yen assets) and away from US$ assets.

The portfolio balance model, with demand given by preferred local habitat, predicts a correlation between current account surpluses (deficits) and strong (weak) currencies.


6-182Assumption: all other aspects of the economy are unchanged.


Effects of Macroeconomic Shocks on the Exchange Rate

BFii*E(s)

WCA

supply of home country bondssupply of foreign country bondsdomestic interest ratesforeign interest rateexpected rate of home currencydepreciation

home country wealthhome country current account surplus

S+ hc depreciatesS- hc appreciatesS- hc appreciatesS+ hc depreciatesS+ hc depreciates

S- hc appreciatesS- hc appreciates

Increase inImpact on

home currency

all

preferredlocal

habitat

Model

6-183

↑W(US wealth) => ↓S => ↑ (1/S) => US$ appreciates

and

↑CA(US current account surplus) => ↓S => ↑ (1/S)

The Portfolio Balance Approach: Effects of Macroeconomic Shocks on the Exchange Rate

Preferred local habitat version, US is home country

6-184

The portfolio balance approach highlights the role of wealth and views assets as imperfect substitutes.

The exchange rate and interest rates have to adjust to ensure portfolio equilibrium at which the assets are willingly held by investors.


All versions, US is home country

6-185



Let’s consider a very simple version of the portfolio balance model:B/SF = Exp {α + β [ i - i* - E(ΔS)]}

ln [B/SF] = ln { Exp {α + β [ i - i* - E(ΔS)] } }

lnB - lnS - lnF = α + β [ i - i* - E(ΔS)]

S equation: s = -α - β [ i - i* - E(ΔS)] + b - fwhere b = lnB, f = lnF, s= lnS

What if bond-financed gov’t deficits ↑?

6-186

(Note that ↑S => ↓(1/S) => US$ depreciates and↓S => ↑(1/S) => US$ appreciates)

↑B(Supply of US bonds) => ↑S => ↓ (1/S)↑F(Supply of Foreign bonds) => ↓S => ↑ (1/S)↑i (US interest rate) => ↓S => ↑ (1/S)↑i* (Foreign interest rate) => ↑S => ↓ (1/S)↑ E(s) Expected rate of US$ depreciation

=> ↑S => ↓ (1/S)Note: ↑B(Supply of US bonds) => ↑S => ↓ (1/S)

by assuming i fixed and all the adjustment takesplace in S




6-187

Monetary approach assumes perfect substitutability between domestic and foreign currency bonds. That is to say, an investor will be indifferent between holding B and F if Ø = 0, or i - i* = E(s) = expected %ΔS

Ø = i - i* - E(s) defines the exchange risk premium

ttt SSSE ])~([ 1 −= +

(International Fisher Effect)

Monetary Approach v.s. Portfolio Balance Approach

6-188

Portfolio balance approach allows imperfect substitutability between domestic and foreign currency bonds, with Ø = i - i* - E(s) ≠ 0.

It makes sense with the differences : liquidity, tax treatment, default risk, political risk, and exchange risk.

Monetary Approach v.s. Portfolio Balance Approach

6-189 6-190

An overall equilibrium in the foreign exchange market would balance both flow and stock dimensions of the market.Figure 6A.1 has positive numbers emanating from the origin. Take the initial condition as an equilibrium in both the stock market (at point A) and in the flow market (at point a), where each show an exchange rate of $0.50/DM. The supply curve in Figure 6A.1 represents the supply of German government bonds offered to non-German investors.

The Implications of Flow and Stock Equilibrium onthe Foreign Exchange Rate

6-191

Determination of Exchange Rates:A Simultaneous Stock and Flow Approach

Quantity of DMper unit of time

Quantity of DM at a moment in time

$/DMFlow Stock

$0.50a A

s

dS

D

Figure 6A.1

++0

s

d S

D

6-192

Figure 6A.2 represents a shock to the stock demand schedule - investors seek to increase permanently their holdings of DM-denominated assets.The stock demand schedule shifts outward to D’D’ and intersects the stock supply schedule at $0.52/DM. DM appreciates immediately to clear the stock market.



6-193

With the weaker dollar, the US runs a current account surplus equal to the amount bc per period. The current account surplus implies that the US is accumulating foreign assets, so over time the stock supply schedule shifts outward, eventually reaching S’S’.

On the flow side, the stronger DM has resulted in an excess flow supply of DM in the amount bc. The flow demand for German goods has fallen with the appreciating DM, while the flow supply for US goods has risen along with the depreciating dollar.

6-194

Stock and Flow Reactions to Permanent Increase in the Stock Demand for German Assets



$/DMFlow Stock

$0.50aA

s

dS

D

Figure 6A.2

$0.52b c

BC

S’

D’

0 ++

s

d S

D D’

S’

6-195

A stylized version of the time path of the exchange rate following this permanent stock demand shock is shown in Figure 6A.3. The jump in the exchange rate occurs immediately to clear the stock market.Since the US cannot run a current account surplus indefinitely - nor Germany a current account deficit indefinitely - the exchange rate changes gradually to bring about a long-run equilibrium in both the stock and flow dimensions.


6-196

Exchange Rate Response to Permanent Increase in the Stock Demand for German Assets

Figure 6A.3

$/DM

$0.52

$0.50

TimeT0 T1

6-197

Next consider a shock to the flow demand schedule.

Suppose that consumers seek to increase permanently their purchase of German goods and services.This is shown in Figure 6A.4 by an outward shift in the flow demand schedule to d’d’, such that the intersection with the flow supply schedule occurs at $0.52/DM.


6-198

With the increase in demand for German goods, the US runs a current account deficit equal to the amount ba per period.The current account deficit implies that the US is reducing its stock of foreign assets, so over time the stock supply schedule shifts inward, eventually reaching S’S’.

The appreciation of the DM does not occur immediately because in this stylized model the exchange rate is determined in the stock market, which is unaffected. With the exchange rate at $0.50/DM, there is excess flow demand for DM in the amount ba.


6-199

Stock and Flow Reactions to Permanent Increase in the Flow Demand for German Goods



$/DMFlow Stock

$0.50a A

s

dS’

D

Figure 6A.4

$0.52

bc B

S

d’

0 ++

s

dd’ S’

S

D

6-200

Figure 6A.5 contains a stylized version of the time path of the exchange rate following this permanent flow demand shock.The exchange rate changes gradually to clear the flow market, while the stock market is cleared at all times.Again the logic is that the current account imbalance cannot persist indefinitely, so that the exchange rate must eventually bring about a long-run equilibrium in both stock and flow dimensions.


6-201

Exchange Rate Response to Permanent Increase in the Flow Demand for German Goods

Figure 6A.5

$/DM

$0.52

$0.50

TimeT0 T1

6-202

Because asset portfolios can be rebalanced quickly and at a low cost, these actions will influence exchange rate behavior (and vice versa) over the short run.


Figure 6A.4 and 6A.5 illustrate one important stylized finding in models of exchange rate determination. The stock side is of primary importance for the determination of exchange rates in the short run.

6-203

Flow imbalances can be maintained over the short run as long as surplus countries are willing to accumulate assets and deficit countries are willing to run down assets.


Eventually, flow imbalances cannot be left unchecked. The flow side becomes an anchor for the exchange rate in the long run.

6-204

A speculative bubble is measured by the difference between the present spot rate and the fundamental equilibrium rate.

A speculative bubble could develop if traders buy a currency not based on a determination that it undervalued on the basis on fundamentals, but solely on the basis that the currency is expected to appreciate in tomorrow’s market.

Speculative Bubbles


6-205

Fundamentals: The basic economic, financial, and operating factors that influence the success of a business and the price of its securities. Fundamentals of a security include the price-earnings ratio, dividend payout, and earnings-per-share growth.

If other traders also buy based on the expectation of further appreciation, rather than on the basis of fundamentals, a bubble may develop between the actual spot rate and its fundamental value.

Speculative Bubbles

6-206

note that there is no bubble on oil, the strong support of "demand" pushes up the price; the demand comprises real and speculators' demand

Source: WSJ 0516 2008 Bernanke's Bubble Laboratory; Princeton Proteges of Fed Chief Study the Economics of Manias

6-207

The Market for Loanable Funds

Saving = Domesticinvestment

Net foreigninvestment+

S = I + NFI

Net foreign investment is the purchase of foreign assets by domestic residents minus the purchase of domestic assets by foreigners.

6-208

Equilibriumquantity

Quantity ofLoanable Funds

RealInterest

Rate

Equilibriumreal interest

rate

Supply of loanable funds(from national saving)

Demand for loanable funds (for domestic investment

and net foreign investment)

A MACROECONOMIC THEORY OF THE OPEN ECONOMY

The Market for Loanable Funds

6-209

The Market for Loanable FundsThe interest rate in an open economy, as in a closed economy, is determined by the supply and demand for loanable funds.National saving is the source of the supply of loanable funds. Domestic investment and net foreign investment are the sources of the demand for loanable funds.At the equilibrium interest rate, the amount that people want to save exactly balances the amount that people want to borrow for the purpose of buying domestic capital and foreign assets.

6-210

The Market for Foreign Currency Exchange

Net foreign investment = Net exports

NFI = NX

Suppose that Boeing sells some planes to a Japanese airline for yens. This sale increases U.S. net exports and U.S. net foreign investment by the same amount. Boeing then exchanges its yen for dollars with a U.S. mutual fund that wants the yen to buy stock in Sony (Japan). NX and NFI rise by an equal amount again!


6-211

Equilibriumquantity

Quantity of Dollars Exchangedinto Foreign Currency

RealExchange

Rate

Equilibrium real

exchange rate

Supply of dollars(from net foreign investment)

Demand for dollars(for net export toforeign countries)


The Market for Foreign Currency Exchange

Quantity of US Cadilacsexchanges for German Mercedes Benz

6-212

The Market for Foreign Currency ExchangeThe real exchange rate is determined by the supply and demand for foreign-currency exchange.The supply of dollars comes from net foreign investment (NFI). Because NFI does not depend on the real exchange rate, the supply curve is vertical. The demand for dollars comes from net exports. Because a lower real exchange rate stimulates net exports (and thus increases the quantity of dollars demanded to pay for these net exports), the demand curve is downward sloping.At the equilibrium real exchange rate, the number of dollars people supply to buy foreign assets exactly balances the number of dollars people demand to buy net exports.

6-213

Net Foreign Investment :The Link Between the Two Markets

S = I + NFI

NFI = NX

6-214

0 Net ForeignInvestment

Net foreign investmentis negative.

Net foreign investmentis positive.

RealInterest

Rate


How Net Foreign Investment Depends on the Interest Rate

6-215

How Net Foreign InvestmentDepends on the Interest Rate

Because a higher domestic real interest rate makes domestic assets more attractive, it reduces net foreign investment.Note the position of zero on the horizontal axis: Net foreign investment can be either positive or negative.

6-216

Equilibrium in the Open Economy

Prices in the loanable funds market and the foreign-currency exchange market adjust simultaneously to balance supply and demand in these two markets.As they do, they determine the macroeconomic variables of national saving, domestic investment, net foreign investment, and net exports.


6-217

(a) The Market for Loanable Funds (b) Net Foreign Investment

(c) The Market for Foreign-Currency Exchange


Demand

Supply

Quantity of Dollars

Demand

Supply

Net ForeignInvestment

Net foreign investment, NFI

Real Exchange

Rate

Real Interest

Rate

Real Interest

Rate

r1

E1

r1

The Real Equilibrium in an Open Economy

US$ is in the denominator,As in Econ Literature 6-218

How Changes in Policies and Events Affect an Open Economy

The magnitude and variation in important macroeconomic variables depend on the following:

Government budget deficitsTrade policiesPolitical and economic stability

6-219

Government Budget Deficits

In an open economy, government budget deficits . . . …reduces the supply of loanable funds,…drives up the interest rate,…crowds out domestic investment,…cause net foreign investment to fall.

6-220

r2 r2

E2

1. A budget deficit reduces the supply of loanable funds...

S2

B




Demand

S1

Quantity of Dollars

Demand

S1S2


NFI

5. …which causes the real exchange rate to appreciate.

Real Exchange

Rate

Real Interest

Rate

Real Interest

Rate

3. ...which in turn reduces net foreign investment.

4. The decrease in net foreign investment reduces the supply of dollars to be exchanged into foreign currency…

r1

A

E1

r1

The Effects of Government Budget Deficit

2. ...which increases the real interest...

US$ is in the denominator,As in Econ Literature

6-221

Effect of Budget Deficits on the Loanable Funds Market

A government budget deficit reduces national saving, which . . .. . . shifts the supply curve for loanable funds to the left, which. . . raises interest rates.

6-222

Effect of Budget Deficits on Net Foreign Investment

Higher interest rates reduce net foreign investment.


6-223

Effect on the Foreign-Currency Exchange Market

A decrease in net foreign investment reduces the supply of dollars to be exchanged into foreign currency.This causes the real exchange rate to appreciate.

6-224

Trade Policy

A trade policy is a government policy that directly influences the quantity of goods and services that a country imports or exports. Tariff: A tax on an imported good.Import quota: A limit on the quantity of a good produced abroad and sold domestically.

6-225

Trade Policy

Because they do not change national saving or domestic investment, trade policies do not affect the trade balance.

For a given level of national saving and domestic investment, the real exchange rate adjusts to keep the trade balance the same.

Trade policies have a greater effect on microeconomic than on macroeconomic markets.

6-226

Effect of an Import Quota

Because foreigners need dollars to buy U.S. net exports, there is an increased demand for dollars in the market for foreign-currency.

This leads to an appreciation of the real exchange rate.

6-227


There is no change in the interest rate because nothing happens in the loanable funds market.There will be no change in net exports. There is no change in net foreign investment even though an import quota reduces imports.

6-228


An appreciation of the dollar in the foreign exchange market encourages imports and discourages exports.This offsets the initial increase in net exports due to import quota.


6-229

1. An import quota increases the demand for dollars…




Demand

S1

Quantity of Dollars

Demand

Supply


NFI

Real Exchange

Rate

Real Interest

Rate

Real Interest

Rate

r1

E1

r1

The Effects of an Import Quota

E2 2. …and causes the real exchange rate to appreciate.

3. Net exports, however, remain the same.

US$ is in the denominator,As in Econ Literature 6-230


Trade policies do not affect the trade balance.

6-231

Political Instability and Capital Flight

Capital flight is a large and sudden movement of funds out of a country, usually due to political instability.

6-232

Political Instability and Capital Flight

Capital flight has its largest impact on the country from which the capital is fleeing, but it also affects other countries.If investors become concerned about the safety of their investments, capital can quickly leave an economy.Interest rates increase and the domestic currency depreciates.

6-233

Political Instability in Mexico & Capital FlightWhen investors around the world observed political problems in Mexico in 1994, they sold some of their Mexican assets and used the proceeds to buy assets of other countries.This increased Mexican net foreign investment.

The demand for loanable funds in the loanable funds market increased, which increased the interest rate.

This increased the supply of pesos in the foreign-currency exchange market.

6-234

NFI1 1. An increase in net foreign investment...

2. …increases the demand for loanable funds...

D2

(a) The Market for Loanable Funds (b) Mexican Net Foreign Investment



D1

S1

Quantity of Pesos

Demand

S1


NFI1

Real Exchange

Rate

Real Interest

Rate

Real Interest

Rate

E1

r1 r1

S2

r2 r2

E2

The Effects of Capital Flight

5. …which causes the real exchange rate to appreciate.

4. At the same time, the increase in net foreign investment increases the supply of pesos...

3. …which increases the interest rate.

Peso is in the denominator,As in Econ Literature


6-235

An Example of Interest Rate Parity

Suppose an investor with $1,000,000 to invest for 90 days is trying to decide between investing in U.S. dollars at 8% per annum (2% for 90 days) or in DM at 6% per annum (1.5% for 90 days).The current spot rate is DM 1.5311/$ and the 90-day forward rate is DM 1.5236/$.As shown in the next slide, regardless of the investor’s currency choice, his hedged return will be identical.

Multinational Financial Management 6-236

An Example of Interest Rate Parity

Multinational Financial Management Ex 5.7

Alternative investment:Invest $1,000,000 in

New York for 90 days at 2%and receive $1,020,000 in 90 days

New York

Start$1,000,000

Finish$1,020,000

Convert $1,000,000to DM at DM 1.5311/$ for DM 1,531,100

1.

DM 1,531,100Frankfurt: today

DM 1,554,066.50Frankfurt: 90 days

Invest DM 1,531,100 at 1.5%for 90 days, yielding DM 1,554,066.50 in 90 days

2.

Simultaneously with the DMinvestment, sell the DM1,554,066.50 forward at arate of DM 1.5236/$ for delivery in 90 days, &receive $1,020,000in 90 days

3.

6-237

An Example of Covered Interest ArbitrageSuppose the interest rate on pounds sterling is 12% in London, and the interest rate on a comparable dollar investment in New York is 7%. The pound spot rate is $1.75 and the one-year forward rate is $1.68. These rates imply a forward discount on sterling of 4% [(1.68 - 1.75) / 1.75] and a covered yield on sterling approximately equal to 8% (12% - 4%). Because there is a covered interest differential in favor of London, funds will flow from New York to London.To illustrate the profits associated with covered interest arbitrage, we will assume that the borrowing and lending rates are identical and the bid-ask spread in the spot and forward markets is zero.

Multinational Financial Management 6-238

An Example of Covered Interest Arbitrage

Multinational Financial Management Ex 5.8

New Yorktodayone year

Borrow $1 million at an interestrate of 7%, owing $1,070,000at year end

1.

London : todayLondon: one year

Start:

Convert the $1 million to pounds at $1.75/£ for£571,428.57

2.

Invest the £571,428.57in London at 12%,generating £640,000by year end

3.

Simultaneously, sell the £640,000 in principal plus interest forward at a rate of $1.68/£ for delivery in year, yielding $1,075,200 at year end

4.

Net profit equals$5,200

7.Finish:

Repay the loan plus interest of $1,070,000 out of the $1,075,200

6.

Collect the £640,000 and deliver it to the bank’s foreign exchange department in return for $1,075,200

5.

6-239

A Formula for the Government Purchases Multiplier

• The formula for the multiplier is:Multiplier = 1/(1 - MPC)

• An important number in this formula is the marginal propensity to consume (MPC).¤ This is the fraction of extra income that a household

consumes rather than saves.¤ With an MPC of 3/4, when the workers and owners of

McDonnell Douglas earn $20 billion from a government contract, they increase their consumer spending by 3/4 x $20 billion, or $15 billion, which in turn raises the income for the workers and owners of the firms that produce the consumption goods.

6-240


Change in government purchasesFirst change in consumptionSecond change in consumptionThird change in consumption

= $20 billion= MPC x $20 billion= MPC2 x $20 billion= MPC3 x $20 billion

Total change in demand =(1 + MPC + MPC2 + MPC3 + …) x $20 billion

The government-purchases multiplier, 1 + MPC + MPC2 + MPC3 + …, tells us the demand for goods and services that each dollar of government purchases generates.


6-241


For , 11 +≤≤− xThe infinite geometric series ( )xxxx −=++++ 111 32 K

Thus,

Multiplier = 1 / (1 - MPC)

For example, if MPC is 3/4, then the government-purchases multiplier is 1/(1 - 3/4) = 4.In this case, the $20 billion of government spending generates $80 billion of demand for goods and services.

6-242

The Structure of the IS-LM ModelThe term IS is a shorthand representation of the relationship investment (Investment, I ) equals saving (Saving, S ) - the goods market equilibrium.

The term LM is a shorthand representation of the relationship money demand (Liquidity, L) equals money supply (Money, M ) - the money market equilibrium.

The IS-LM model emphasizes the interaction between the goods and assets markets. Spending, interest rates, and income are determined jointly by equilibrium in the goods and assets markets.

Dornbusch: Figure 10.3

6-243

The Structure of the IS-LM Model

DemandSupply

Money market Bond market

DemandSupply

Assets market Goods market

Aggregate demandOutput

Income

Interest ratesMonetary policy Fiscal policy

http://www.mhhe.com/economics/dornbusch8e/ 6-244

FIGURE 10-11 in Dornbusch

GOODS AND MONEY MARKET EQUILIBRIUM

http://www.mhhe.com/economics/dornbusch8e/

6-245

Money Supply, Money Demand, and Monetary Equilibrium

In the long run, the overall level of prices adjusts to the level at which the demand for money equals the supply.

6-246

Quantity fixedby the Fed

Quantity ofMoney

Value ofMoney (1/P) Price

Level (P)

A

Money supply

0

1

(Low)

(High)

(High)

(Low)

1/2

1/4

3/4

1

1.33

2

4Moneydemand

Money Supply, Money Demand, and the Equilibrium Price Level

Equi

libriu

m

valu

e of

mon

ey Equilibrium

price level


6-247

Quantity ofMoney

Value ofMoney (1/P) Price

Level (P)

A

MS1

0

1

(Low)

(High)

(High)

(Low)

1/2

1/4

3/4

1

1.33

2

4Moneydemand

The Effects of Monetary Injection

M1

MS2

1. An increase in the money supply...

2. ..

.dec

reas

es th

e va

lue

of m

oney

... 3. …

an d inc rea se s th e p ric e l eve l

M2

B

6-248

PPP does not mean that commodity price changes are the underlying fundamental cause of exchange rate changes.PPP is an “equilibrium” condition, not a model of cause and effect.Examples:» Under pegged rates, a country experiences inflation,

loss of international competitiveness, then devalues home currency

Inflation comes before devaluation» Or country devalues, imports more expensive,

workers feel poorer, wage demands, home country inflation accelerates

Devaluation comes before inflation

From PPP to the Monetary Approach (1 of 3)

6-249

What determines the price level in an economy?» Relationship between Money Supply (MS ) and Money

Demand (MD )» MD = f (velocity(-), price level(+), real income(+))

= k x P x Y» In equilibrium, MS = MD = k P Y» ⇒ P = MS / k YAssume the above relationship exist in the US & UK» P($) = M($)S / k($) Y($)» P(£) = M(£)S / k(£) Y(£)Returning to PPP, we had Spot ($/£) = P($) / P(£)By substitution» Spot ($/£) = (M($)S / M(£)S) (k(£) / k($)) (Y(£) / Y($))


6-250

Repeating:

Spot($/£) =

Interpretation:» Spot rate (in $/£) positively related to:

Increases in M($) and Y(£)» Spot rate (in $/£) negatively related to:

Increases in M(£) and Y($)MS, Y, k and their determinants are more fundamental causes (drivers) of spot exchange rate.Changes in MS, Y, and k [at home or other country] will impact the exchange rate in the long run (& perhaps short-run).


M($) x k(£) x Y(£)M(£) x k($) x Y($)

6-251

Spot rates display large changes over last 25 years» Some currencies appreciated vs. US$, others

depreciated» Changes in nominal rates, real rates, real effective ratesWhat factors lie behind exchange rate changes?» Inflation differences are a “proximate” factor (not a

cause)» PPP works well in the long run for many exchange rates» Money, income, and velocity are more fundamental

factorsCritical to understand difference between nominal and real exchange rate changes» Possible to have nominal exchange rate change without

real exchange rate change (or vice versa)» Only real exchange rate Δ ⇒ change in competitiveness

Summary: Exchange Rates in the Long Run

6-252

Most tantalising of all, there is the huge mountain ofJapanese personal savings, estimated at ¥1300 trillion ($12 trillion), much of it stacked up in the postal savings system, and ¥106 trillion of which is expected to mature over the next two years. As these deposits made at relatively high interest rates a decade ago mature, the post office will be able to offer only nugatory yields on reinvested or new deposits. Some of this money is expected to find its way into the stockmarket, so the financial industry is scrambling for a chunk of the assets.

The Economist: Survey Online Finance May 20, 2000


6-253

Assignment for Chapter 6 Exercises 3, 7, 10, 14.

http://www.mhhe.com/business/finance/levich2e/-or-

http://pages.stern.nyu.edu/~rlevich/links.htmlhttp://pages.stern.nyu.edu/~rlevich/datafile.html

6-254

Question #3. "The stock models of foreign exchange pricing sees foreign exchange primarily as a medium of exchange for executing international trade transactions." Is this statement true or false? Explain.

Hint: False. The stock model of foreign exchange pricing views foreign exchange as an asset …

6-255

Question #7. Discuss the similarities and differences between the monetary approach and the portfolio balance approach to the determination of exchange rates. Hint:

6-256

Question #10. "According to the monetarist model, a rise in the domestic interest rate will result in a fall in the domestic currency." True or false. Explain.Hint:

6-257

Question 14. Define the term "speculative bubble." Explain how a speculative bubble could develop in the foreign exchange market.Hint: Pages 217-8 of text –or– pages 256-7 of course reader

A speculative bubble is measured by the difference between the present spot rate and the fundamental equilibrium rate.A speculative bubble could develop if traders buy a currency not based on a determination that it is undervalued on the basis on fundamentals, but solely on the basis that the currency is expected to appreciate in tomorrow’s market.If other traders also think and behave so...

6-258

¤ Indeed, the Big Mac has had several forecasting successes.

¤ When the euro was launched at the start of 1999, most forecasters predicted that it would rise. But the euro has instead tumbled -exactly as the Big Mac index had signaled. At the start of 1999, euro burgers were much dearer than American ones.

An example of rosy prospect which didn’t realize as expected ...

tuesday october 13, 2009 international investments handout #8 … 2009 posting... · tuesday...

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