Exchange Rate Determination(3) Monetary Approach

Slides:



Advertisements
Similar presentations
Copyright ©2004, South-Western College Publishing International Economics By Robert J. Carbaugh 9th Edition Chapter 13: Exchange-Rate Determination.
Advertisements

Interest Rates in the Classical Model Nominal vs.. Real Interest Rates Real interest rate =Nominal rate - Inflation rate  = r- 
FIN 40500: International Finance Nominal Rigidities and Exchange Rate Volatility.
Why trade? Buy/import resources one is lacking, sell/export those one has in abundance Buy/import goods which are relatively inefficient to produce, sell/export.
Chapter 16 Price Levels and the Exchange Rate in the Long Run.
Chapter 17 The Foreign Exchange Market. Copyright © 2007 Pearson Addison-Wesley. All rights reserved Foreign Exchange I Exchange rate—price of one.
Preview: 9/29, 10/1 Quiz: Yfe … P … E
Unit 7 Foreign Exchange Rate Determination. I. What determines the exchange rates?
14-1 Money, Interest Rates, and Exchange Rates Chapter 14.
Chapter 18 Exchange Rate Theories. Copyright © 2007 Pearson Addison-Wesley. All rights reserved Topics to be Covered The Asset Approach The Monetary.
Determination of FX Rate: Financial Investment Theory J.D. Han King’s College UWO.
Exchange Rate Determination (1) International Investment/Arbitrage J.D. Han King’s University College 13-1.
Economics 282 University of Alberta
1 Section 4 The Exchange Rate in the Long Run. 2 Content Objectives Purchasing Power Parity A Long-Run PPP Model The Real Exchange Rate Summary.
Exchange Rate Volatility and Keynesian Economics.
The Foreign Exchange Market
Review: Exchange Rates Roberto Chang March Material for Midterm Basic: chapters 1-4 of FT Plus: what we have discussed in class (applying the theory.
Chapter 20 The Foreign Exchange Market. © 2013 Pearson Education, Inc. All rights reserved.20-2 Foreign Exchange Market Exchange rate: price of one currency.
The Foreign Exchange Market
The Role of Exchange Rate Chapter  Currencies are traded in the foreign exchange market.  The prices at which currencies trade are known as exchange.
International Economics
Copyright © 2006 Pearson Addison-Wesley. All rights reserved Chapter 15 Price Levels and the Exchange Rate in the Long Run.
Classical Economics & Relative Prices. Classical Economics Classical economics relies on three main assumptions: Classical economics relies on three main.
Copyright © 2010 Pearson Addison-Wesley. All rights reserved. Chapter 17 The Foreign Exchange Market.
OPEN ECONOMY MACRO AND THE EXCHANGE RATE (1) Up to now, we have ignored the exchange rate: i.e. the price of foreign currency in terms of domestic currency.
Fundamental Analysis Classical vs. Keynesian. Similarities Both the classical approach and the Keynesian approach are macro models and, hence, examine.
Macro Chapter 14 Modern Macroeconomics and Monetary Policy.
Chapter 15 Supplementary Notes.
1 Exchange Rate Dynamics(I) Dr. J. D. Han King’s College U.W. O.
1 Exchange Rate Determination(2) Trade Approach Dr. J. D. Han King’s College U.W. O.
Outline 4: Exchange Rates and Monetary Economics: How Changes in the Money Supply Affect Exchange Rates and Forecasting Exchange Rates in the Short Run.
1 Exchange Rate Determination(4) Real Factor Approach Dr. J. D. Han King’s College U.W. O.
1 International Finance Chapter 16 Price Levels and the Exchange Rate in the Long Run.
1 Exchange Rate Determination(3) Monetary Approach Dr. J. D. Han King’s College U.W. O.
ECON 511 International Finance & Open Macroeconomy CHAPTER THREE The Monetary Approach to Flexible Exchange Rates.
Chapter 17 The Foreign Exchange Market. © 2013 Pearson Education, Inc. All rights reserved.14-2 Foreign Exchange I Exchange rate: price of one currency.
Exchange Rate Dynamics(I) Dr. J. D. Han King’s College U.W. O.
Managing an Open Economy Small Open Economy. Learning Objectives Introduce the concept of the small open economy. Develop the IS and LM models for a small.
Copyright © 2010 Pearson Addison-Wesley. All rights reserved. Chapter 17 The Foreign Exchange Market.
Slides prepared by Thomas Bishop Chapter 15 Price Levels and the Exchange Rate in the Long Run.
Prices and Exchange Rates: Purchasing Power Parity
Prices and Exchange Rates: Purchasing Power Parity
Exchange Rate Determination(2) Trade Approach
International Economics By Robert J. Carbaugh 9th Edition
How the Economy Reaches Equilibrium in the Short Run
An Introduction to International Economics
Exchange Rate Theories
Relationships Between Inflation, Interest Rates, and Exchange Rates
Chapter 18 The Foreign Exchange Market
19 International Finance CHAPTER CHECKLIST When you have completed your study of this chapter, you will be able to 1 Define exchange rates and demonstrate.
Review of the previous lecture
Exchange Rate Determination(4) Real Factor Approach
The Foreign Exchange Market
INTERNATIONAL FINANCIAL POLICY
Exchange Rates and The Open Economy
Exchange Rates in the Long Run
9 OPEN ECONOMY THE EXCHANGE RATE AND THE BALANCE OF PAYMENTS
Price Levels and the Exchange Rate in the Long Run
Capital Flows and the Balance of Payments and The Foreign Exchange Market Lesson 39 Sections 41, 42.
Foreign Exchange Markets,
The Foreign Exchange Market
ECO 401: International Economics
The Foreign Exchange Market (외환시장)
Foreign Exchange Rates
The Foreign Exchange Market
© 2008 Pearson Education Canada
Open-Economy Macroeconomics: Basic Concepts
The Foreign Exchange Market
Exchange Rate Dynamics(II)
9 OPEN ECONOMY THE EXCHANGE RATE AND THE BALANCE OF PAYMENTS
Presentation transcript:

Exchange Rate Determination(3) Monetary Approach Dr. J. D. Han King’s College U.W. O.

1. “Money is all that matters” “Just every road leads to Rome, every theory becomes monetary theory.” -A Monetarist

2. Interest Parity and Money Supply: Short-run analysis In the short-run, interest rate is negatively correlated with Money Suppy (-) in the IS-LM or Neo-Classical approach. - An increase in Money Supply leads to a lower interest rate, which results in a lower Rate of Return on domestic assets, and thus into capital outflows. This leads to a depreciation of domestic currency or a rise in FOREX Rates.

In short, a country with a relatively liberal monetary policy will experience Depreciation of its own currency and a rise in FOREX rate.

3. PPP and Money Supply Purchasing Power Parity is fundamentally broken down to 1) Nominal Factor such as Money Supply; and “Monetary Approach” -> Focus of this chapter 2) Real Factors such as Demand and Supply of Trade Goods(‘Tradables’) Excess Supply lowers P domestic <-Excess Supply can happen due to i) innovation on the supply side and/or ii) suppressed demand -> Real Factor Analysis of FOREX Rate as a separate PPP(next one)

1) Monetary Theory relates Price Level to Money Supply : Long-run Analysis FOREX rate = Relative Value of Two Currencies = Relative Worth of Two Monies = Relative Inverse of Price Levels = Relative Money Supplies (M) - Relative Real Economic Perfomance/Growth (y) + Relative Stability of Monetary Situations(V) between domestic and foreign countries

2) Quantity Theory of Exchange M V = P y (absolute version) P = M V / y D% M + D% V = D%P+ D% y (relative version) p = D% M + D% V - D% y

(1) Absolute Quantity Equation of Exchange + PPP: Absolute PPP M V = P y P = M V/y Mf Vf = Pf yf Pf = Mf Vf/yf S = P/Pf = (M V/y)/ (Mf Vf//yf ) if we assume V = Vf = 1 for now S = (M / y) / (Mf /yf ) = (M/M f ) ( yf / y)

*Impacts of Money Supply and Growth on FOREX rates S = (M / y) / (Mf /yf ) tells us If M rises while Mf remains constant, E rises. If y rises faster than yf , then E falls.

(2) Relative PPP + QEE D% S = D%P - D %Pf - (1) D%P = D% M - D% y (+ D% V) - (2) D%Pf = D% Mf - D % yf ( + D % Vf ) - (3) Pluging (2) and (3) into (1) , we get D % S= (D % M- D % Mf ) - (D % y - D % yf ) In the short-run, changes in y or yf would be relatively smaller than changes in M or Mf. Thus, primarily, changes in FOREX are due to differences in the rates of money creation between domestic and foreign countries.

Next 3 slides of Proof are a repetition of the previous slide Next 3 slides of Proof are a repetition of the previous slide. If you have understood it, you may skip it.

Step 1: relative PPP D% S = D%P - D %Pf = π - π f

Step 2: Monetary Theory of Quantity Equation of Exchange Money supply mainly determines Price Level: M V = P y Mf Vf = P f yf Speed of money creation mainly determines Inflation Rate Δ%P = p = Δ% M - Δ% y + Δ%V Δ%Pf = p f= Δ% Mf - Δ% yf + Δ%Vf

Step 3: PPP + Quantity Equation of Exchange Combining the above two equations, we get Δ % S = π e - π ef = Δ% M- Δ % Mf - (Δ% y - Δ%yf), if Δ%V - Δ%Vf = 0. FOREX rate depends mainly on Money Supply conditions.

Note: Precisely speaking, FOREX rates are determined by i) the difference in money creation (between the domestic and the foreign countries) and ii) the difference in economic growth.

* FOREX and Monetary Policy: Country with an Easy Monetary Policy faces a rising FOREX Rate: Easy Monetary Policies – A Large Quantity of Money – Low Value of Money – High Price of Foreign Currency in that Domestic Money – High FOREX Rate

* Inflation Rate, Relative Speed of Money Creation, and FOREX Rate: FX rate depends mainly on inflation differential, which in turn depends on Relative Speeds of Money Creation between two countries. -> A country with a higher speed of money creation will experience Depreciation of its own currency, or a rise in FOREX rates