1. International Economics Tenth Edition
CHAPTER F I F T E E N 15
International Economics Tenth Edition
Exchange Rate Determination
Dominick Salvatore
John Wiley & Sons, Inc.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

2. Learning Goals:
Understand the purchasing power parity theory and why it does not work in the short run
Understand how the monetary and the portfolio balance models of the exchange rate work
Understand the causes of exchange rate overshooting
Understand why exchange rates are so difficult to forecast
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

3. Introduction
Since floating rates began in 1973, international financial flows are now larger than trade flows, shifting the focus to monetary theories of exchange rates.
Monetary exchange rate theories view the exchange rate as a purely financial phenomenon, and tend to explain exchange rate volatility and disequilibria in the short run.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

4. Purchasing-Power Parity Theory
Absolute Purchasing Power Parity
The equilibrium exchange rate between two currencies equals the ratio of price levels in both nations.
R= P/P*
Where R = exchange rate or spot rate
P = general price level in home nation
P* = general price level in foreign nation
Example: If the price of a bushel of wheat is $1 in the United States and €1 in the European Monetary Union, then the exchange rate between the dollar and the euro should be R = $1/ €1 = 1.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

5. Purchasing-Power Parity Theory
The law of one price
A given commodity should have the same price (so that the purchasing power of the two currencies is at parity) in both countries when expressed in terms of the same currency.
Caused by commodity arbitrage.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

6. Purchasing-Power Parity Theory
Absolute PPP theory can be misleading because:
Appears to give exchange rate that equilibrates trade in goods and services while ignoring capital account.
At exchange rate that equilibrates trade in goods and services, capital inflows would produce surplus in balance of payments, while capital outflows would lead to deficits.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

7. Purchasing-Power Parity Theory
Absolute PPP theory can be misleading because:
Will not even give exchange rate that equilibrates trade in goods and services because of existence of nontraded goods.
International trade tends to equalize prices of traded goods and services, not nontraded goods.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

8. Purchasing-Power Parity Theory
Relative Purchasing-Power Parity
The change in the exchange rate over a period of time should be proportional to the relative change in the price levels of two nations over the same time period.
R1 = x R0
P1 / P0
P*1 / P*0
where R1 and R0 = exchange rates in period 1 and base period
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

9. Purchasing-Power Parity Theory
Relative Purchasing-Power Parity
Example: If the general price level does not change in the foreign nation, from base period to period 1 (P*1/P*0 = 1), while the general price level in the home nation increases 50%, the relative PPP theory says the exchange rate should be 50% higher (home currency should depreciate 50%) in period 1 as compared to base period.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

10. Purchasing-Power Parity Theory
Empirical Relevance
PPP Works
Well
Less Well
Not So Well
for highly traded individual commodities
for all traded goods together
for all goods (including nontraded goods).
over long periods of time (many decades)
for one or two decades
in the short run
in cases of purely monetary disturbances and inflationary periods
in periods of monetary stability
in situations of major structural change
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

11. Monetary Approach to the Balance of Payments and Exchange Rates
The monetary approach to the balance of payments views the balance of payments as a monetary phenomenon.
Money plays crucial role in the long run as both a disturbance and an adjustment.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

12. Monetary Approach to the Balance of Payments and Exchange Rates
Under Fixed Exchange Rates
A balance of payments surplus results from excess stock of money demanded that is not satisfied by domestic monetary authorities.
A balance of payments deficit results from excess in stock of money supplied that is not eliminated by monetary authorities.
Surplus/deficit is temporary and self-correcting in the long run.
Except for currency-reserve nation, the nation has no control over its money supply in the long run under fixed exchange system.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

13. Monetary Approach to the Balance of Payments and Exchange Rates
Under Flexible Exchange Rates
Balance of payments disequilibria are immediately corrected by automatic changes in exchange rates without international flow of money or reserves.
Nation retains dominant control over its money supply and monetary policy.
Adjustment occurs as result of the change in domestic prices accompanying the change in exchange rate.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

14. FIGURE 15-3 Relative Money Supplies and Exchange Rates.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

15. Monetary Approach to the Balance of Payments and Exchange Rates
If PPP holds, P = RP*, and R = 𝑃 𝑃∗
Money demand in each country can be represented as 𝑀 𝑑 =𝑘𝑃𝑌
In equilibrium, money supply must equal money demand, yielding:
𝑀 ∗ 𝑠 𝑀 𝑠 = 𝑘 ∗ 𝑃 ∗ 𝑌 ∗ 𝑘𝑃𝑌
𝑃 𝑃 ∗ = 𝑀 𝑠 𝑘 ∗ 𝑌 ∗ 𝑀 𝑠 ∗𝑘𝑌
𝑅 = 𝑀 𝑠 𝑘 ∗ 𝑌 ∗ 𝑀 𝑠 ∗𝑘𝑌
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

16. Portfolio Balance Model and Exchange Rates
Portfolio Balance Approach
The exchange rate is determined in the process of equilibrating or balancing the stock or total demand and supply of financial assets (of which money is only one) in each country.
Regarded as a more realistic and satisfactory version of the monetary approach.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

17. Portfolio Balance Model and Exchange Rates
Expectations, Interest Differentials, and Exchange Rates
The exchange rate is determined not only by the relative growth of money supply and money demand but also by inflation expectations and expected changes.
As long as domestic and foreign bonds are assumed to be perfect substitutes, (i-i*) = EA, where EA is the expected appreciation of the foreign currency.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

18. Portfolio Balance Model and Exchange Rates
Portfolio Balance Approach
If investors demand more of a foreign asset, either because of higher relative foreign interest rates or increased wealth, demand for foreign currency will increase, depreciating domestic currency.
If investors sell foreign assets, either because of lower relative foreign interest rates or decreased wealth, supply of foreign currency will increase, appreciating domestic currency.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

19. Portfolio Balance Model and Exchange Rates
Portfolio Balance Approach
Domestic and foreign bonds are assumed to be imperfect substitutes; domestic investors require a higher return to compensate for the risk of holding foreign bonds.
Stock model rather than a flow model.
The exchange rate is determined in the process of reaching equilibrium in each financial market.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

20. Portfolio Balance Model and Exchange Rates
Extended Portfolio Balance Model
From the uncovered interest parity condition,
(i-i*) =EA.
Since domestic and foreign bonds are assumed to be imperfect substitutes,
(i-i*) =EA – RP,
where RP is the risk premium on holding the foreign bond.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

21. Portfolio Balance Model and Exchange Rates
Extended Demand Functions
𝑀=𝑓 𝑖, 𝑖∗, 𝐸𝐴, 𝑅𝑃, 𝑌, 𝑃, 𝑊 (money demand)
𝐷=𝑓 𝑖, 𝑖∗, 𝐸𝐴, 𝑅𝑃, 𝑌, 𝑃, 𝑊 (domestic bond demand)
F =𝑓 𝑖, 𝑖∗, 𝐸𝐴, 𝑅𝑃, 𝑌, 𝑃, 𝑊 (foreign bond demand)
where Y is income, P is the price level, and W is wealth.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

22. Portfolio Balance Model and Exchange Rates
Extended Demand Functions
M is a positive function of RP, Y, P, and W, and a negative function of i, i*, and EA.
D is a positive function of i, RP, and W, and a negative function of i*, EA, Y, and P.
F is a positive function of i*, EA, and W, and a negative function of i, RP, Y, and P.
Supplies of all assets are assumed to be exogenous.
Exchange rate changes are the result of portfolio adjustment.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

23. Exchange Rate Dynamics
Exchange Rate Overshooting
Stock adjustments in financial assets are usually much larger and quicker to occur than adjustments in trade flows.
Most of the burden of adjustments in exchange rates comes from financial markets in short run.
Thus, exchange rate must overshoot or bypass its long run equilibrium level for equilibrium to be quickly reestablished in financial markets.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

24. FIGURE 15-6 Exchange Rate Overshooting.
(Figure continues on next slide)
FIGURE 15-6 Exchange Rate Overshooting.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

25. FIGURE 15-6 (continued)
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

26. Empirical Tests of the Monetary and Portfolio Balance Models and Exchange Rate Forecasting
Models of exchange rates have not been very successful at predicting future exchange rates.
Reasons:
Exchange rates are highly influenced by new information.
Expectations in exchange rate markets tend to be self-fulfilling (at least in the short-run).
This may lead to speculative bubbles, generate movements in the market contrary to what is expected by theory.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

27. Case Study 15-1 Absolute Purchasing Power Parity in the Real World
FIGURE 15-1 Actual and PPP Exchange Rate of the Dollar,
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

28. Case Study 15-2 The Big Mac Index and the Law of One Price
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

29. Case Study 15-2 The Big Mac Index and the Law of One Price
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

30. Case Study 15-3 Relative Purchasing-Power Parity in the Real World
FIGURE 15-2 Inflation Differentials and Exchange Rates,
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

31. Case Study 15-4 Monetary Growth and Inflation
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

32. Case Study 15-5 Nominal and Real Exchange Rates, and the Monetary Approach
FIGURE 15-4 Nominal and Real Exchange Rate Indices Between the Dollar and the Mark,
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

33. Case Study 15-6 Interest Differentials, Exchange Rates, and the Monetary Approach
FIGURE 15-5 Nominal Interest Rate Differentials and Exchange Rate Movements,
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

34. Case Study 15-7 Exchange Rate Overshooting of the U.S. Dollar
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

35. Case Study 15-8 The Euro Exchange Rate Defies Forecasts
FIGURE 15-8 The Euro/Dollar Exchange Rate since the Introduction of the Euro.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

36. Appendix: Formal Monetary Approach Model
𝑀 𝑑 = 𝑃 𝑎 𝑌 𝑏 𝑢 𝑖 𝑐
where a is the price elasticity of demand for money, b is the income elasticity of demand for money, c is the interest elasticity of demand for money, and u is the error term.
𝑀 𝑠 =𝑚 𝐷+𝐹
where m is the money multiplier, D is the domestic component of the monetary base, and F is the international component of the monetary base.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

37. Appendix: Formal Monetary Approach Model
Let D + F = H, for simplification.
Setting money supply equal to money demand, taking the logarithm of both sides, and differentiating with respect to time yields
𝐹 𝐻 𝑔𝐹 −𝑎𝑔𝑃+𝑏𝑔𝑌+𝑔𝑢 −𝑐𝑔𝑖−𝑔𝑚= − 𝐷 𝐻 𝑔𝐷
where g is the rate of growth.
The weighted growth rate of the international component of the nation’s monetary base is equal to the negative weighted growth rate of the domestic component, if all other growth rates are zero.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

38. Appendix: Formal Monetary Approach Model
Thus, all other things equal, when the nation’s monetary authorities change D, the reverse change will automatically take place in F, when exchange rates are fixed.
Thus under fixed rates, monetary authorities determine the composition but not the size of the monetary base.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

39. Appendix: Formal Portfolio Balance Model and Exchange Rates
Write the basic equations of the model as
M = a(i, i*)W
D = b(i, i*)W
RF = c(i, i*)W
W = M + D + RF
where M is the quantity demanded of money by domestic residents, D is the demand for domestic bonds, RF is the demand for foreign bonds, and W is wealth.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

40. Appendix: Formal Portfolio Balance Model and Exchange Rates
The model assumes that the three portfolio components represent a fixed proportion of wealth.
M is inversely related to both interest rates; D is directly related to i and inversely related to i*; RF is directly related to i* and inversely related to i.
Increases in wealth increase the demand for all assets.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

41. Appendix: Formal Portfolio Balance Model and Exchange Rates
Assuming that all three markets are in equilibrium and solving for RF yields
RF = (1-a-b)W – f(i, i*)W
and
R = f(i,i*)W/F
Thus the exchange rate is directly related to i* and W and inversely related to I and F.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

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Case studies and tables.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.