2. Exchange Rate Models With Nominal Rigidities

3. 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

4. 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

5. 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

6. Lets simplify things!! Lets assume that foreign variables (i* and P*) are constant. That way, we can ignore the foreign markets! P* and i* are fixed

7. Down to three!!! Foreign Bond Market Domestic Money Market Domestic Bond Market Now we only need three prices (P, i,and e) to clear the two remaining markets!! Foreign Money Market Currency Market

8. 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 +

9. Fixed Prices Its assumed that prices in commodity markets are fixed in the short run (P is constant) Its assumed that prices in commodity markets are fixed in the short run (P is constant) Nominal exchange rate changes Real Exchange Rate changes RER = eP* P (PPP fails) Real Interest rates can vary across countries Real incomes are no longer constant 1) 2) 3)

10. The Domestic Money Market Cash is Supplied by the Federal Reserve L (i, Y ) +P M S M 1 - Now, assume that the price level is fixed at P = 1

11. Money Supply Changes Suppose the Fed increases the money supply by 10% L (i, Y ) +P M S M 1 - Because prices can’t adjust, the interest rate drops. This encourages people to hold the extra money that’s now available

12. The Domestic Bond Market i S,I Savings Investment S < I(A Trade Deficit is created – or worsened) Lower interest rates promote both domestic consumption spending as well as investment spending Higher demand for goods and services raises real incomes

13. The Domestic Money Market The Fed increases the money supply L (i, Y ) +P M S M 1 - Higher incomes increase money demand even more until the money market clears

14. Currency Markets Asset DemandTrade Balance Currency Markets lower interest rates decreases the demand for domestic assets – currency demand drops Increased trade deficit increases supply of currency Dollar Depreciates

15. Currency Fundamentals (long Run) It is always assumed that a currency will eventually return to its fundamental value It is always assumed that a currency will eventually return to its fundamental value Y M (1+i) = Y* M*(1+i*) e A 10% increase in the money supply results is a long run 10% depreciation of the currency.

16. Short run dynamics While commodity prices are fixed, we need to rely on currency markets and asset markets. While commodity prices are fixed, we need to rely on currency markets and asset markets. A 10% increase in the money supply results is a long run 10% depreciation of the currency. (Long Run) Currency markets generate a short run depreciation (Trade deficit plus low interest rates) Bond markets suggest that if US interest rates are low, then the dollar should appreciate at some point (Uncovered Interest Parity) (Short Run)

17. Short Run Dynamics e ($/F) Time Money Shock occurs here Eventual 10% depreciation (long run) Short Run “Overreaction” Appreciation back to long run level

18. Income Changes L (i, Y ) +P M S M 1 - Again, assume that the price level is fixed at P = 1 A 10% increase in domestic income raises money demand Excess demand for money pushes interest rates up (this returns money demand to its original position)

19. The Domestic Bond Market i S,I Savings Investment S < I(A Trade Deficit is created – or worsened) Interest rates are pushed up, but savings drops and investment rises (due to higher income)

20. Currency Markets Asset DemandTrade Balance Currency Markets Higher interest rates increase the demand for domestic assets – currency demand increases Increased trade deficit increases supply of currency ?????

21. Two Cases Capital is relatively immobile between countries Capital is relatively immobile between countries Capital is very mobile between countries Trade deficit effect wins out (currency depreciates) UIP does not hold Capital inflow wins out (Currency appreciates) UIP holds

22. High Capital Mobility It is always assumed that a currency will eventually return to its fundamental value It is always assumed that a currency will eventually return to its fundamental value Y M (1+i) = Y* M*(1+i*) e A 10% increase in income results is a long run 10% appreciation of the currency.

23. High Capital Mobility While commodity prices are fixed, we need to rely on currency markets and asset markets. While commodity prices are fixed, we need to rely on currency markets and asset markets. A 10% increase in income results is a long run 10% appreciation of the currency. (Long Run) Currency markets generate a short run appreciation (Trade deficit is more than financed by capital inflows) Bond markets suggest that if US interest rates are high, then the dollar should depreciate at some point (Uncovered Interest Parity) (Short Run)

24. Short Run Dynamics (High Mobility) e ($/F) Time Income Shock occurs here Eventual 10% appreciation (long run) Short Run “Overreaction”depreciation back to long run level

25. Low Capital Mobility While commodity prices are fixed, we need to rely on currency markets and asset markets. While commodity prices are fixed, we need to rely on currency markets and asset markets. A 10% increase in income results is a long run 10% appreciation of the currency. (Long Run) Currency markets generate a short run depreciation (Trade deficit dominates) UIP does not hold (Short Run)

26. Short Run Dynamics (Low Mobility) e ($/F) Time Income Shock occurs here Eventual 10% appreciation (long run) Short Run Overreaction (UIP fails in this region)

27. Bottom Line When commodity prices are not allowed to adjust, asset/currency markets take over to determine exchange rates When commodity prices are not allowed to adjust, asset/currency markets take over to determine exchange rates This interplay between currency markets and commodity markets creates excessive short run volatility This interplay between currency markets and commodity markets creates excessive short run volatility Real exchange rate changes are due to fixed commodity prices Real exchange rate changes are due to fixed commodity prices