Chapter 12 Theories of Exchange Rate Determination Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Learning Objectives Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Exchange Rate Models Purchasing Power Parity Monetary Models of Exchange Rate Determination The ‘Flexible-Price’ Monetary Model The ‘Sticky-Price’ Monetary Model ‘Real Interest-Rate-Differential’ Model Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Purchasing Power Parity Purchasing Power Parity: The theory that exchange rates will adjust, to ensure that the prices of goods in different countries will trade at similar prices when expressed in a common currency. Ex: Assume that a car costs £20,000 in the UK and $26,000 in the USA. According to PPP PPP Exchange Rate= £20,000 / $25,000 = £0.8/$1. Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Absolute Purchasing Power Parity S: Exchange rate defined as domestic currency units per unit of foreign currency P: Price of an identical bundle of goods expressed in the domestic currency P*: Price of a bundle of goods in the foreign country expressed in terms of the foreign currency Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Relative Purchasing Power Parity Relative Purchasing Power Parity: The exchange rate adjusts by the amount of the inflation differential between two economies. Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Measurement Problems in Testing for PPP The first problem is to decide whether or not the theory is applicable to all goods or whether distinction is necessary between traded and non-traded goods. The second problem is whether PPP should hold on a monthly basis or longer time period such as quarterly, six-month or yearly. Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Hamburgers & Purchasing Power Parity The Economist magazine launched a Big Mac Index in 1986. It is the price index measuring PPP being simply the price of a Big Mac hamburger. Example In January 2017, the average price of Big Mac in the US was $5.06, in Mexico the price was 49 pesos. Implied PPP= 49 peso/$5.06= 9.68 pesos per dollar Actual rate was 21.95 pesos per dollar This yields 56% undervaluation of the peso. Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Hamburgers and PPP Euro area is a weighted average price based on the price in the 19 Eurozone countries. PPP= Local price divided by price in the USA Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Graphical Evidence on Purchasing Power Parity Figures 12.1 to 12.7 plot the actual rate and the exchange rate implied by PPP using 1973 as the base rate. The plots show that exchange rates diverge considerably from the ones suggested by PPP. PPP does not work well for dollar-pound, dollar-deutschmark and yen-dollar rates. It is somewhat better for countries that are geographically close and have high trade linkages such as deutschemark-pound, French mark-deutschemark and lira-deutschemark. Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Figure 12.1 The actual exchange rate and the PPP dollar-pound rate Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Figure 12.2 The actual exchange rate and the PPP deutschmark-dollar rate Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Figure 12.3 The actual exchange rate and the PPP yen-dollar rate Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Figure 12.4 The actual exchange rate and the PPP dollar-euro rate

Figure 12.5 The actual exchange rate and the PPP deutschmark-pound rate ( equivalents post 1 January 1999) Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Figure 12.6 The actual exchange rate and the PPP French franc-deutschmark rate ( equivalents post 1 January 1999) Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Figure 12.7 The actual exchange rate and the PPP lira-deutschmark rate (equivalents post 1 January 1999) Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Summary of the Empirical Evidence on PPP PPP performs better for countries that are geographically close to one another and where trade linkages are high. PPP holds better in the long run than short run. PPP holds better for the traded goods than non-traded ones. Countries that have high inflation rates tend to experience relatively weak currencies. Exchange rates are much more volatile than the corresponding national price levels. Keith Pilbeam ©: Finance and Financial Markets 4th Edition

The Poor Performance of PPP Statistical Problems Transport Costs and Trade Impediments Imperfect Competition Differences between Capital and Goods Markets Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Uncovered Interest Rate Parity (UIP) The theory that exchange rates will change at a rate that offsets the interest rate differential. The high interest rate is expected to depreciate. The low interest rate currency is expected to appreciate. is the expected appreciation (-)/expected depreciation (+) of the pound where the exchange rate is defined as pounds per dollar ruk is the UK interest rate rus is the US interest rate Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Uncovered Interest Rate Parity Example: Interest rate in the UK: 10% per annum Interest rate in the USA: 4% per annum Hence, on average the pound is expected to depreciate 6 % per annum against the US dollar. Keith Pilbeam ©: Finance and Financial Markets 4th Edition

The Carry Trade Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Figure 12.9 The yen-euro exchange rate 2001-2010 Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Exchange Rate Models Monetary Models of Exchange Rate Determination The ‘Flexible-Price’ Monetary Model The ‘Sticky-Price’ Monetary Model ‘Real Interest-Rate-Differential Model Keith Pilbeam ©: Finance and Financial Markets 4th Edition

The Flexible Price Monetary Model Keith Pilbeam ©: Finance and Financial Markets 4th Edition

The Flexible Price Monetary Model It is assumed that purchasing power parity holds continuously s = p – p* where s is the log of the exchange rate defined as domestic currency per unit of domestic currency It is assumed that domestic and foreign bonds are perfect substitutes and UIP holds on a continuous basis. Expected rate of depreciation of the domestic currency is equal to the interest-rate differential between domestic and foreign bonds. Keith Pilbeam ©: Finance and Financial Markets 4th Edition

The Flexible Price Monetary Model Spot Exchange Rate is determined by: Relative money supplies Relative levels of real national income Relative interest rates Keith Pilbeam ©: Finance and Financial Markets 4th Edition

The Flexible Price Monetary Model The spot exchange can be written in another way related to expected inflation rate. Nominal interest rate is made up of two components; the real interest rate and expected inflation rate. The flexible price monetary model is based on the premise that All prices in an economy are flexible. Domestic and foreign bonds are perfect substitutes. The demand for money in relation to the supply of money is important in the exchange rate determination. Keith Pilbeam ©: Finance and Financial Markets 4th Edition

The Dornbusch Sticky-Price Monetarist Model This model is the phenomenon that a currency may appreciate or depreciate following a economic shock in the short run by a greater percentage than required in the long run. Therefore, it overshoots its long-run value. Assumptions of the model: PPP does not hold continuously it holds in the long run only UIP on the other hand holds on a continuous basis Prices of goods and wages are sticky The financial markets that is the money markets and the foreign exchange market respond instantly to policy changes or economic shocks. The exchange rate is flexible both upward and downwards in the short and long run. According to model, prices in the goods market and wages in the labor market are determined in sticky-price markets . They only tend to change slowly over time in response to various shocks such as changes in the money supply. Keith Pilbeam ©: Finance and Financial Markets 4th Edition

The dynamics of the Dornbusch overshooting model Keith Pilbeam ©: Finance and Financial Markets 4th Edition

The Dornbusch Sticky-Price Monetarist Model Keith Pilbeam ©: Finance and Financial Markets 4th Edition

The Dornbusch Stick-Price Monetarist Model Expected rate of depreciation of a currency is determined by the speed of adjustment parameter and the gap between the current exchange rate s and its long run equilibrium value. Keith Pilbeam ©: Finance and Financial Markets 4th Edition

The Dornbusch Sticky-Price Monetarist Model The goods market equilibrium schedule shows that the equality of demand and supply for goods in the price-exchange rate plane. The rate of price inflation is determined by the gap between aggregate demand and supply. Keith Pilbeam ©: Finance and Financial Markets 4th Edition

The Dornbusch Stick-Price Monetarist Model After the derivations, the slope of the schedule is obtained with the formula below: This formula gives the slope of the Goods Market Equilibrium Schedule. As shown in Figure 12.11, it is upward-sloping from left to the right, and has a slope of less than unity. To the left of the schedule, there is an excess supply of goods. Assuming output to be fixed for any given price level, an exchange rate appreciation (fall) reduces aggregate demand. The excess supply of goods puts downward pressure on prices. To the right of the schedule, for any given price level, exchange rate depreciation (rise) leads to an excess demand for domestic goods, causing upward pressure on prices. Keith Pilbeam ©: Finance and Financial Markets 4th Edition

The Dornbusch Sticky-Price Monetarist Model The money market schedule shows different combinations of the price level and exchange rate that are consistent with equilibrium in the money market; that is equilibrium of the supply and demand for money.

The Dornbusch Sticky-Price Monetarist Model The money market schedule has a negative slope. A fall in the price level implies a relatively high real money stock. High real money balances is held if the domestic interest rate falls. A fall in the domestic interest rate requires an expected appreciation of the currency to compensate holders of the domestic currency. Given that exchange rate depreciation is regressive, such an expected appreciation can only occur if the exchange rate depreciates. Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Figure 12.11 The goods market equilibrium schedule Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Figure 12.12 The money market equilibrium schedule Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Figure 12.13 Equilibrium in the Dornbusch model Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Equilibrium in the Dornbusch Model In Figure 12.13; both goods and money markets are in equilibrium and the exchange rate is at its PPP value. According to PPP line, if domestic price level increases x%, exchange rate must depreciate by x% to maintain PPP. According to GG schedule, if x% rise in the price level needs to be accompanied by a greater than x% depreciation of the exchange rate. The economy is in full equilibrium when the exchange rate corresponds to PPP, aggregate supply equals aggregate demand, and there is asset-market equilibrium. This occurs where all three schedules intersect at point A. Keith Pilbeam ©: Finance and Financial Markets 4th Edition

A Money Supply Expansion and Exchange Rate Overshooting According to Figure 12.14; In the Long-run Initially the economy is in full equilibrium at point A where G1G1 schedule intersects M1M1 schedule. Money supply is expanded x% by the authorities unexpectedly. In the long-run, domestic prices will rise by the same percentage as the rise in the money stock. Long run price is x % above p1. As PPP holds in the long run, a rise in the domestic price level of x% requires a depreciation of the exchange rate by x%, that gives a long run equilibrium rate. Keith Pilbeam ©: Finance and Financial Markets 4th Edition

Figure 12.14 Exchange rate overshooting Keith Pilbeam ©: Finance and Financial Markets 4th Edition

A Money Supply Expansion and Exchange Rate Overshooting According to Figure 12.14; In the Short-run x% increase in the money supply results in a rightward shift of the M1M1 schedule to M2M2. Domestic prices are sticky in the short-run. This means that economy is always on the new market equilibrium schedule M2M2. Domestic prices initially does not change. The price level remains at p1 with a jump in the exchange rate from s1 to s2 on the money market schedule M2M2. As the short-run equilibrium exchange rate s2 exceeds the long-run equilibrium rate, this is the phenomenon of exchange rate “overshooting.”. Keith Pilbeam ©: Finance and Financial Markets 4th Edition

The Frankel Real Interest Rate Differential Model Keith Pilbeam ©: Finance and Financial Markets 4th Edition

The Frankel Real Interest Rate Differential Model If there is a disequilibrium set of real interest rates, then the real exchange rate will deviate from its long-run equilibrium value. If the real domestic interest rate is below the real foreign interest rate, the real exchange rate of the domestic currency will be undervalued in relation to its long-run equilibrium value. Hence there is an expected appreciation of the real exchange rate of the domestic currency to compensate. Short-run exchange rate overshoots its long-run equilibrium value, depreciating proportionately more than the increase in the money stock. Hence there are expectations of a future real appreciation of the currency to compensate for the lower real rate of return on domestic bonds. Keith Pilbeam ©: Finance and Financial Markets 4th Edition