WHY CURRENCIES OVERSHOOT Currency Fluctuations And Rational Too Defining Equilibrium Remedies

Currency Fluctuations End of the Bretton Woods pegged exchange rate system. Introduction of floating rates, long supported by most economists, proved to be a disappointment. Economists underestimated the power of capital mobility.

Asset Markets Asset markets are more important in determining exchange rates than trade. With perfect capital mobility, capital will move until interest rates are equal in all countries plus a term allowing for expected appreciation or depreciation of the currencies: r us - r j = ($/¥) e

Asset Markets In the long-run, rational expectations would lead investors to believe that the exchange rate will return to PPP. In the short-run, asset markets dominate the exchange rate. In the intermediate run, the two forces interact.

The Monetary Model Following a sudden, unexpected increase in the nominal money supply, markets expect the real money stock, prices, the interest rate and the exchange rate to return to their original levels. In the long run, the exchange rate will return to PPP. True? No! We assumed implicitly that wages & prices are flexible.

Sticky Prices Again Immediately after the money supply change, prices remain below equilibrium; the real money supply is up & the interest rate is down. Rational expectations enable investors to know that prices will rise eventually and that the currency will depreciate.

Now, Let’s be Investors Inland has become a terrible place to put or keep our money. The currency value is expected to fall taking our asset values with it; and the interest rate has already fallen, reducing returns (but increasing asset values). Timing is of the essence! Let’s get out of here!

We Are Still Investors Our sudden exodus from Inland’s capital markets will rapidly suppress its currency value to below PPP. At some point below PPP, a delicate, temporary balance can be achieved. Interest rates are still down, but now the currency is expected to

Impact of the Undershot Rate Note, now, that investors will cease racing for the exits. Although the interest rate remains unattractive, they are compensated by the expectation that the exchange value (Outland currency value) of their assets will rise.

Symmetry? Now, let’s reduce the money supply; the real money supply, of course, falls but the interest rate rises. Inland is a great place to put your money: the interest rate is up; asset values are down but probably will appreciate; the exchange rate undervalues the currency.

Symmetry? Investors with money in Outland can now purchase Inland money and securities, which are likely to appreciate and enjoy a high interest rate while waiting. Money rushes in; the currency appreciates beyond PPP even to a point at which it becomes more likely to depreciate.

The Currency Overshot Now what? The interest rate remains temporarily high, assets prices are still low, but the currency is overvalued and likely to depreciate. These various pluses and minuses in Inland, add up to be equal to the pluses & minuses existing in Outland, so capital markets are in equilibrium.

Is There Any Evidence? United States in the early 1980s. This story is complicated by double digit inflation, but the main facts are there. Money supply growth slowed => high real interest rates without immediate impact on expected or actual inflation. Capital rushed in => high valued dollar (= ¥250 and over DM3).

More Evidence? ASIA 1997 Sudden change from tight money, to keep currencies pegged, to easy money, & no pegs. Investors had expected the change, so the case is far from pure. Investors dump Asian currencies & attempt to get money out. Asian currencies undershoot until remaining investors stabilize their holdings. Then currencies recover, partly.

Conclusions Market determined exchange rates might be quite stable if governments would follow stable monetary & fiscal policies. Government determined exchange rates are not likely to promote stability in any arena.