1. Econ 141 Fall 2013 Slide Set 5 Asset approach to the exchange rate

2. The Asset Approach to Exchange Rates Substantial deviations from purchasing power parity (PPP) occur in the short run: the same basket of goods generally does not cost the same everywhere at all times. These short-run failures of the monetary approach prompted economists to develop an alternative theory to explain exchange rates in the short run: the asset approach to exchange rates, the subject of this chapter. The asset approach is based on the idea that currencies are assets. The price of the asset in this case is the spot exchange rate, the price of one unit of foreign exchange.

3. Exchange Rates and Interest Rates in the Short Run The beginning point is to return to the uncovered interest parity (UIP) equation. This is the fundamental equation of the asset approach to exchange rates.

4. Interest Rates, Exchange Rates, Expected Returns, and FX Market Equilibrium This table is a numerical example from the text. It shows how the current exchange rate depends on the expected future exchange rate.

5. Equilibrium in the FX market The foreign return given the expected future exchange rate is downward sloping in the current exchange rate. In this graph, the home and foreign nominal interest rates are given.

6. Changes in Home and Foreign Bond Returns To illustrate how the exchange rate responds to changes in interest rates and expectations, we can use the numerical example. We consider three different shocks: a.A higher domestic interest rate (i $ = 7%) b.A lower foreign interest rate (i € = 1%) c.A lower expected future exchange rate (E e $/€ = 1.20)

7. Changes in Domestic and Foreign Returns and FX Market Equilibrium a. A rise in the U.S. interest rate from 5% to 7% shifts up the horizontal line which indicates U.S. returns to U.S. bonds. The exchange rate today is lower.

8. b. A fall in the euro interest rate from 3% to 1% lowers returns to holding euros and reduces the expected return in dollars from holding euro bonds unless the exchange falls. It must fall in equilibrium. Changes in Domestic and Foreign Returns and FX Market Equilibrium

9. c. A fall in the expected future exchange rate from 1.224 to 1.20 lowers expected dollar returns to holding euro bonds. The equilibrium exchange rate must again fall. Changes in Domestic and Foreign Returns and FX Market Equilibrium

10. Money Market Equilibrium in the Short Run: Nominal Interest Rates The short run vs. the long run: 1.In the short run, the price level is sticky; it is a known predetermined variable, 2.In the short run, the nominal interest rate i is fully flexible and adjusts to bring the money market to equilibrium. The assumption of sticky prices is also called nominal rigidity.

11. The expressions for money market equilibrium in the two countries are as follows: Money Market Equilibrium in the Short Run: Nominal Interest Rates

12. Money Market Equilibrium in the Short Run

14. Can Central Banks Always Control the Interest Rate? A Lesson from the Crisis of 2008–2009 In the United States, the Federal Reserve sets as its policy rate the interest rate that it charges banks for overnight loans. In normal times, changes in this cost of short-term funds for the banks are usually passed through into the market rates the banks charge to borrowers as well as on interbank loans between the banks themselves. This process is one of the most basic elements in the so-called transmission mechanism through which the effects of monetary policy are eventually felt in the real economy.

15. In the recent crisis, although the Fed lowered the Fed Funds Rate from 5.25% to 0% during 2007 and 2008, there was no similar decrease in market rates. A second problem arises once policy rates hit the zero lower bound (ZLB). At that point, central banks exhaust their capacity to lower policy rates further. However, many central banks wanted to keep reducing market interest rates to ease financial markets. The Fed’s response was a policy of quantitative easing. Can Central Banks Always Control the Interest Rate? A Lesson from the Crisis of 2008–2009

16. The Fed undertook several extraordinary policy actions to increase the money supply rapidly: 1. It expanded the range of credit securities it would accept as collateral to include lower-grade, private-sector bonds. 2. It expanded the range of securities that it would buy outright to include private-sector credit instruments such as commercial papers and mortgage-backed securities. 3. It expanded the range of counterparties from which it would buy securities to include some nonbank institutions such as primary dealers and money market funds. Can Central Banks Always Control the Interest Rate? A Lesson from the Crisis of 2008–2009

17. Broken monetary transmission: the Fed’s extraordinary interventions did little to change private credit market interest rates in 2008–2009. Interest rates during the crisis of 2008–2009

18. The Monetary Model: The Short Run versus the Long Run To understand how the short run and long run exchange rates are related, we consider how monetary policy in one country affects the exchange rate. To begin, we look at how a change in monetary policy affects the interest rate in the long run and short run. For a single economy: Increasing the money supply growth rate raises the long-run nominal interest rate through the Fisher effect. Raising the current money supply lowers the interest rate when prices are sticky. A higher growth money supply growth rate also increases real balances in the short run and lowers the interest rate.

19. Monetary expansions and interest rates Suppose the growth rate of the home money supply has been zero. The central bank now increases its money supply growth rate to 5%. 1. If the expansionary monetary policy is expected to be a permanent (that is, for the long run), the long-run monetary approach tells us that the home nominal interest rate will rise by 5% in the long run. 2. If the monetary expansion is expected to be temporary, then (all else equal) the real money balances rise in the short run. The home interest rate will fall in the short run.

20. Monetary policy and the exchange rate

21. The importance of capital mobility The domestic return (DR) equals the foreign return (FR) in equilibrium because financial capital is perfectly mobile. Foreigners can buy U.S. assets and U.S. residents can buy foreign assets. If capital controls are imposed, financial market arbitrage is not possible and there is no reason why DR has to equal FR. Monetary policy and the exchange rate

22. Monetary policy in the short run An increase in the U.S. money supply M US raises real money balances, M US /P US in the short run. This leads to a drop in the U.S. interest rate, i US.

23. To maintain equality between domestic returns (DR) and foreign returns (FR), the current exchange rate,, must fall given the future expected exchange rate,. Monetary policy in the short run

24. In graph (a), the U.S. (home) money supply does not change. Graph (b) shows an increase in the European (foreign) money supply leading to a fall in the euro interest rate from i 1 € to i 2 €.

25. If the exchange rate does not change, the foreign return in dollars, i € + (E e $/ € − E $/€ )/E $/€, falls as i € falls. For domestic and foreign returns in the FX market to be equal, the exchange rate falls (the dollar appreciates) from E 1 $/€ to E 2 $/€. The new equilibrium is at point 2′. Monetary policy in the short run

26. The euro and the dollar, 1999-2004 The dollar appreciated against the euro from 1999 to 2001. The Fed Funds Rate was reduced starting in early 2001 and the dollar depreciated against the euro from 2001 to 2004.

27. Putting the Monetary and Asset Approaches Together: a) The asset approach: The monetary approach tells us how exchange rates are determined in the long run. The asset approach tells us how they are determined in the short run. To link the long and short runs, begin in the short run with short-run money market equilibrium and uncovered interest parity:

28. b) The monetary approach: To forecast the future expected exchange rate, we use the long-run monetary model and purchasing power parity: Using both parts as building blocks, we will be able to understand how the two key mechanisms of expectations and arbitrage work to determine exchange rates in the short run and in the long run. Putting the Monetary and Asset Approaches Together:

29. The monetary and asset approaches together Permanent expansion in the home money supply in the short run – first effects.

30. Permanent expansion in home money supply – the exchange rate depreciates in the short run and the expected future exchange rate depreciates. The change in expectations shifts the FR line upward. The monetary and asset approaches together

31. The long-run adjustment: In the long-run all prices are flexible so the home price level and the long-run exchange rate rise in proportion to the permanent increase in the home money supply. Real money balances eventually return to their original level. The monetary and asset approaches together

32. Long-run adjustment: As home real money balances and interest rates return to their original levels. The FR curve remains shifted outward, and the long-run exchange rate has depreciated. The monetary and asset approaches together

33. Overshooting What happened when the home money supply rose permanently? 1. Home real money balances rose, reducing the home interest rate, in the short run. 2. In the long-run, real money balances and the interest rate return to their initial levels. 3. The exchange rate rises in the short run and in the long run. 4. But in the short run it is higher than in the long run: falls first and then rises toward the long run.

34. Overshooting Permanent increase in M US In graph (a), there is a one-time permanent increase in U.S. nominal money supply at time T. In graph (b), the real money supply rises in the short run and the U.S. interest rate falls because prices are sticky in the short run.

35. Overshooting In graph (c), prices rise in the same proportion as the money supply in the long run. In graph (d), the exchange rate overshoots its long-run value (the dollar depreciates a lot) in the short run, but in the long run, the exchange rate rises only in proportion to changes in money and prices.

36. Is there overshooting in the data? Exchange rates for major currencies under Bretton Woods and after. Exchange rates were stable under adjustable pegs from 1950 to 1973. In 1973, these currencies officially floated against the dollar.

37. Fixed Exchange Rates and the ‘Trilemma’ Fixed exchange rate regimes We next learn how fixed rate regimes without capital controls operate. Capital is mobile and the foreign exchange market is open to arbitrage. Exchange rate intervention takes the form of the central bank buying and selling foreign currency at a fixed price so as to keep the market exchange rate equal to the fixed level, E. For example, the Foreign country is the Eurozone, and the Home country is Denmark. What happens when Denmark decides to peg the krone to the euro at a fixed rate: E DKr/€

38. Interest rates and the DKr-euro exchange rate

39. Interest differentials and the DKr-euro exchange rate

40. The Danish price level is determined by PPP in the long run. With the exchange rate is pegged, the long-run price level for Denmark is and the long-run inflation rate is The long-run nominal interest for Denmark equals the Eurozone rate Because the long-run price level and interest rate are outside Danish control, the Danish central bank cannot choose the money supply, M DEN. That is, Denmark gives up monetary policy autonomy by adopting the peg. Fixed rates and monetary policy autonomy in the long run

41. The long-run theory still works, but with the chain of causality changes: With a floating exchange rate, the Danish central bank can choose the Danish money supply M DEN. In the long run, the money supply growth rate determines the interest rate i (via the Fisher effect) and the price level P DEN. Through PPP, the level of P DEN determines the exchange rate E DKr/€. The money supply is a policy instrument (an exogenous variable), and the exchange rate is an outcome from a policy choice (an endogenous variable). Fixed rates and monetary policy autonomy in the long run

42. The long-run theory still works, but with the chain of causality changes: With a fixed exchange rate, this logic is reversed. The Danish central bank chooses the exchange rate E DKr/€. In the long run, the choice of E determines the price level P DEN through PPP, and the interest rate i DKr through UIP. The necessary level of the money supply M DEN is determined by the price level and interest rate as The exchange rate is now the policy instrument, and the money supply is an outcome of that choice (an endogenous variable). Fixed rates and monetary policy autonomy in the long run

43. The central bank can consider the three desirable policy goals: A fixed exchange rate may be desired to promote stability in trade and investment. International capital mobility may be desired as a means to promote economic integration, efficiency and risk sharing. Monetary policy autonomy may be desired as a means for managing the domestic business cycle and maintain low unemployment. The Trilemma

44. Each of these policy goals is represented by an relationship: A fixed exchange rate International capital mobility Monetary policy autonomy The Trilemma

45. These three relationships cannot all be satisfied at the same time. We can have capital mobility and a fixed exchange rate, by always letting Or, we can have capital mobility and monetary autonomy by letting The Trilemma

46. These three relationships cannot all be satisfied at the same time. We cannot choose a fixed exchange rate and monetary autonomy, without possibly violating UIP. Thus, arbitrage in foreign exchange cannot be allowed – capital mobility must be restricted. This idea of having to choose two of three in open economy monetary policy is called the trilemma. The Trilemma

47. The trilemma in a cute diagram

48. Managed float – Bretton Woods

49. How Bretton Woods ended

51. From Bretton Woods to the euro

52. Who started it Harry Dexter White and J.M. Keynes were the U.S. and U.K. negotiators. Who ended it Richard Nixon