The Monetary Approach to Exchange Rates Putting Everything Together

Available Assets Home Currency (M) Pays no interest, but needed to buy goods Domestic Bonds (B) Pays interest rate (i) Foreign Bonds (B*) Pays interest rate (i*), payable in foreign currency Foreign Currency (M*) Pays no interest, but needed to buy foreign goods

Five Markets Foreign Bond Market Domestic Money Market Domestic Bond Market Households choose a combination of the four assets for their portfolios Foreign Money Market Currency Market

General Equilibrium Foreign Bond Market Domestic Money Market Domestic Bond Market We need five prices (P,P*, i, i*,e ) to clear the five markets!! Foreign Money Market Currency Market

Lets simplify things!! Purchasing Power Parity Currency Markets Uncovered Interest Parity P = eP* (i - i*) = Expected Percentage Change in Exchange Rate

Down to two!!! Foreign Bond Market Domestic Money Market Domestic Bond Market Now we only need two prices (P,P*) to clear the two remaining markets!! Foreign Money Market Currency Market

The Domestic Money Market Cash is used to buy goods (transaction motive), but pays no interest M = L ( P, i, Y ) -+ d Real Money Demand Higher interest rates lower money demand Higher real income raises transaction motive for holding cash Higher prices raises money demand +

The Domestic Money Market Cash is Supplied by the Federal Reserve L (i, Y ) +P M S M 1 -

The Domestic Money Market An increase in real income raises the demand for money – this lowers the price level (holding money supply fixed) L (i, Y ) +P M S M 1 -

The Domestic Money Market An increase in interest rates lowers money demand – this raises the price level (holding money supply fixed) L (i, Y ) +P M S M 1 -

The Domestic Money Market An increase in money supply raises the price level L (i, Y ) +P M S M 1 -

The Domestic Money Market Equilibrium L (i, Y ) +P M S 1 - M d =M S PY =M (1+i) Y = M PM

The Foreign Money Market Equilibrium L (i*, Y* ) +P* M *S 1 - M* d = S P*Y* =M* (1+i*) Y* = M*(1+i*) P* M* The foreign money market is perfectly symmetric

Exchange Rate Fundamentals Using PPP and the two Money Market equilibrium conditions, we get the “fundamentals” for a currency Using PPP and the two Money Market equilibrium conditions, we get the “fundamentals” for a currency Y* = M*(1+i*) P* Y = M(1+i) P Domestic Money MarketForeign Money Market PPP P = eP* Y M(1+i) = Y* eM*(1+i*)

Currency Fundamentals Taking the previous expression and solving for the exchange rate, we get Taking the previous expression and solving for the exchange rate, we get Y M (1+i) = Y* M*(1+i*) e Relative Money Stocks Relative Output Relative Interest Rates

Exchange Rates & the Fundamentals (JPY/USD)

Exchange Rates & the Fundamentals (GBP/USD)

Adding Relative Price Changes Recall that PPP often fails in the short run. This is possibly due to trading friction or relative price changes Recall that PPP often fails in the short run. This is possibly due to trading friction or relative price changes Y M (1+i) = Y* M*(1+i*) eRER Real Exchange Rate

Exchange Rates & the Fundamentals (JPY/USD) Real Depreciation of the Dollar

Adding Speculative Bubbles Recall that UIP implies that the differences in nominal interest rates reflects expectations of currency price changes (countries with high interest rates should expect their currencies to depreciate Recall that UIP implies that the differences in nominal interest rates reflects expectations of currency price changes (countries with high interest rates should expect their currencies to depreciate Y M (1+i) = Y* M*(1+i*) eRER Expected change in exchange rate (Speculative term)

What about trade deficits? Trade deficits suggest that a country is spending too much (borrowing from the rest of the world). Therefore, the price adjustment mechanism necessary to eliminate a trade deficit will be one of the following: Trade deficits suggest that a country is spending too much (borrowing from the rest of the world). Therefore, the price adjustment mechanism necessary to eliminate a trade deficit will be one of the following: A country’s currency depreciates – this makes foreign goods more expensive. A country’s currency depreciates – this makes foreign goods more expensive. A country’s interest rate rises – this makes spending in general more expensive A country’s interest rate rises – this makes spending in general more expensive

What about trade deficits? Recall that PPP always holds in this model. Therefore, exchange rates and prices adjust so that foreign goods always cost the same as domestic goods. Recall that PPP always holds in this model. Therefore, exchange rates and prices adjust so that foreign goods always cost the same as domestic goods. P = eP*

What about trade deficits? Further, UIP implies that there is no adjustment mechanism in asset markets either Further, UIP implies that there is no adjustment mechanism in asset markets either Inflation – Inflation* = Expected change in nominal exchange rate =i – i* UIP PPP r = i – Inflation = i* - Inflation* = r* Inflation adjusted returns are equalized across countries!!

One last shot….real income. Currency depreciations are associated with high domestic inflation….shouldn’t rising prices lower the demand for all goods/services? Currency depreciations are associated with high domestic inflation….shouldn’t rising prices lower the demand for all goods/services? Yes, but this particular model assumes that real (inflation adjusted) income is fixed….therefore, a 10% increase in prices will be matched my an equal 10% increase in nominal income.

Bottom Line If commodity prices are free to adjust, then commodity markets take center stage in currency price determination (PPP) If commodity prices are free to adjust, then commodity markets take center stage in currency price determination (PPP) There is no correlation between trade deficits and currency prices There is no correlation between trade deficits and currency prices Volatility in currency markets is created by relative price changes (real exchange rate changes) or speculative behavior Volatility in currency markets is created by relative price changes (real exchange rate changes) or speculative behavior These relative price changes are passed onto nominal exchange rates These relative price changes are passed onto nominal exchange rates