Chapter 18 Exchange Rate Theories

Copyright © 2007 Pearson Addison-Wesley. All rights reserved Topics to be Covered The Asset Approach The Monetary Approach to the Exchange Rate The Portfolio Balance Approach Sterilization Exchange Rates and the Trade Balance Overshooting Exchange Rates Currency Substitution Role of News Foreign Exchange Market Microstructure

Copyright © 2007 Pearson Addison-Wesley. All rights reserved The Asset Approach The exchange rate is viewed as adjusting to equilibrate global trade in financial assets. An implication of this approach is that exchange rates are more variable than goods prices. See Table The asset approach assumes perfect capital mobility, that is, there are no barriers to international capital flows.

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Copyright © 2007 Pearson Addison-Wesley. All rights reserved Types of Asset Approach Models Monetary Approach to the Exchange Rate—the exchange rate is determined by relative money demand and money supply between two countries (see Chapter 17). Portfolio Balance Approach—a theory of exchange rate determination which argues that the exchange rate is a function of the relative supplies of domestic and foreign bonds.

Copyright © 2007 Pearson Addison-Wesley. All rights reserved Monetary Approach vs. Portfolio Balance Approach The main difference between the two groups of asset approach models is that the monetary approach model assumes domestic and foreign bonds to be perfect substitutes, while the portfolio balance model assumes they are not. See Table 18.2

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Copyright © 2007 Pearson Addison-Wesley. All rights reserved Monetary Approach to the Exchange Rate (MAER) Following the discussion from Chapter 17, the monetary approach equation is (in percentage terms): where R is international reserves, E is exchange rate (domestic currency units per unit of the foreign currency), P F the foreign price level, Y domestic income, and D domestic credit.

Copyright © 2007 Pearson Addison-Wesley. All rights reserved MAER (cont.) With flexible exchange rates, reserves are zero, and the MAER equation becomes: –E = P F + Y – D or, after multiplying both sides by (-1), we get: An increase in domestic credit, other things constant, will result in E increasing (i.e., depreciating at a faster rate), while changes in inflation and income growth will cause changes in E in the opposite direction.

Copyright © 2007 Pearson Addison-Wesley. All rights reserved Portfolio Balance Approach The PB approach assumes that financial assets are imperfect substitutes because investors perceive foreign exchange risk to be linked to foreign currency-denominated bonds. It modifies the MAER equation by adding the percentage changes in the supplies of foreign bonds B F and domestic bonds B: An increase in supply of foreign bonds causes E to fall (domestic currency appreciates faster) while an increase in domestic bond supply raises E, other things constant.

Copyright © 2007 Pearson Addison-Wesley. All rights reserved Sterilization Sterilization refers to central banks offsetting international reserve flows in order to follow an independent monetary policy. Suppose the central bank is following some money supply growth path and then money demand increases, leading to reserve inflows. The central bank will sterilize these reserve inflows by decreasing domestic credit, thus keeping base money and the money supply constant or at desired levels.

Copyright © 2007 Pearson Addison-Wesley. All rights reserved Sterilization (cont.) If sterilization occurs, then the causality implied in the basic monetary approach equation no longer holds. This is because sterilization implies that there is also a causality running from reserve changes to domestic credit, as in: where β is the sterilization coefficient, ranging from 0 (no sterilization) to 1 (complete sterilization).

Copyright © 2007 Pearson Addison-Wesley. All rights reserved Sterilized Intervention Sterilized Intervention—refers to a foreign exchange market intervention that leaves the domestic money supply unchanged.

Copyright © 2007 Pearson Addison-Wesley. All rights reserved Exchange Rates and the Trade Balance It is useful to incorporate trade flows into the asset approach models because trade flows have implications for financial asset flows. If the exchange rate adjusts so that the stocks of domestic and foreign money are willingly held, then the country with a trade surplus will be accumulating foreign currency. As holdings of foreign money increase relative to domestic money, then the foreign currency will depreciate.

Copyright © 2007 Pearson Addison-Wesley. All rights reserved Exchange Rates and the Trade Balance (cont.) Refer to Figure 18.1 An unexpected event causes a trade deficit. The resulting outflow of money leads to depreciation of the domestic currency and to a new exchange rate equilibrium.

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Copyright © 2007 Pearson Addison-Wesley. All rights reserved Overshooting Exchange Rates Since exchange rates are more volatile and adjust more quickly than goods prices, this differential speed of adjustment can lead to a situation where it appears that spot exchange rates move too much for a given disturbance. This is called overshooting exchange rates.

Copyright © 2007 Pearson Addison-Wesley. All rights reserved Overshooting Exchange Rate Model Money demand (L) is positively related to income Y and negatively to interest rate i: In the short run, as money supply increases, income and price level are constant. Consequently, interest rates must fall to equate money demand and money supply.

Copyright © 2007 Pearson Addison-Wesley. All rights reserved Overshooting XR Model (cont.) The drop in interest rate will have a direct effect on the exchange rate via the interest rate parity relation: With the increase in money supply in country A, prices will be expected to rise. This higher future price will imply a higher long run exchange rate to achieve PPP:

Copyright © 2007 Pearson Addison-Wesley. All rights reserved Overshooting XR (cont.) The spot exchange rate will increase above the long run equilibrium exchange rate due to a need to maintain interest parity. Over time, as prices increase, the interest rate rises, and the exchange rate converges to its new equilibrium level. Refer to Figure 18.2

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Copyright © 2007 Pearson Addison-Wesley. All rights reserved Currency Substitution An advantage of flexible exchange rates is that countries can pursue independent monetary policy. This advantage is reduced if there is an international demand for currencies. Currency substitution deals with the substitutability of currencies on the demand side of the market. So long as people believe that the exchange value between two currencies will never change, then money demanders will be indifferent between holding the two currencies.

Copyright © 2007 Pearson Addison-Wesley. All rights reserved Currency Substitution (cont.) If money demanders are no longer indifferent between two currencies, then currency substitution becomes another source of exchange rate variability. Regions with a high degree of currency substitution may benefit from currency unions where countries coordinate monetary policies and fix exchange rates.

Copyright © 2007 Pearson Addison-Wesley. All rights reserved The Role of News The real world is characterized by unpredictable shocks or surprises. As such, predicting future spot rates is difficult because the exchange rate is partly determined by unforeseen events. Exchange rates are more sensitive, and respond more quickly, to expectations and new information (e.g., unemployment rates).

Copyright © 2007 Pearson Addison-Wesley. All rights reserved Foreign Exchange Market Microstructure At the micro level, exchange rates can be determined by interactions among traders. A foreign exchange trader may be influenced to change his exchange rate quotes even in the absence of news regarding exchange rate fundamentals.

Copyright © 2007 Pearson Addison-Wesley. All rights reserved FEM Microstructure Effects Inventory control effect—traders will want to have no inventory at the end of the day, so that their quotes reflect this desire. Asymmetric information effect— traders fear that they are trading with agents who have better information than they do.