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International Finance

Chapter 4 Exchange Rates II:

The Asset Approach in the Short Run

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Model of Foreign Exchange Markets

• If the risk of investing in dollar deposits is the same as that in euro deposits, the expected returns earned from the two kinds of deposits should be the same.

• An difference in expected returns would produce an arbitrage opportunity.

• Any arbitrage will eventually equate rate of returns between dollar deposits and euro deposits.

• The model of foreign exchange markets analyzes the equilibrium where deposits of all currencies offer the same expected rate of return.

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Model of Foreign Exchange Markets (cont.)

• Interest parity.– Interest parity implies that deposits in all currencies are equally

desirable assets.– Interest parity implies that arbitrage in the foreign exchange

market is not possible.– R$ = R€ + (Ee

$/€ - E$/€)/E$/€

Depreciation of the domestic currency today lowers the expected rate of return on foreign currency deposits.

Appreciation of the domestic currency today raises the expected return of deposits on foreign currency deposits.

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Today’s Dollar/Euro Exchange Rate and the Expected Dollar Return on Euro Deposits When Ee

$/€ = $1.05 per Euro

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The Relation Between the Current Dollar/Euro Exchange Rate and the Expected Dollar Return on Euro Deposits

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The Current Exchange Rate and the Expected Rate of Return on Dollar Deposits

Expected dollar return on dollar deposits, R$

Current exchange rate, E$/€

1.02

1.03

1.05

1.07

0.031 0.050 0.069 0.079 0.100

1.00

R$

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Determination of the Equilibrium Dollar/Euro Exchange Rate

No one is willing to hold euro deposits

No one is willing to hold dollar deposits

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Model of Foreign Exchange Markets (cont.)

• The effects of changing interest rates: – an increase in the interest rate paid on deposits

denominated in a particular currency will increase the rate of return on those deposits.

– This leads to an appreciation of the currency.

– Higher interest rates on dollar-denominated assets causes the dollar to appreciate.

– Higher interest rates on euro-denominated assets causes the dollar to depreciate.

The Effect of an Expected Appreciation of the Euro

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Simultaneous Equilibrium in the U.S. Money Market and the Foreign Exchange Market

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Effect on the Dollar/Euro Exchange Rate and Dollar Interest Rate of an Increase in the U.S. Money Supply

Effect of an Increase in the European Money Supply on the Dollar/Euro Exchange Rate

Long-Run and Short-Run Effects of a Change in Money Supply

• In the short run, prices do not have sufficient time to adjust to market conditions. – the analysis so far has been a short run analysis.

• In the long run, prices of factors of production and of output have sufficient time to adjust to market conditions.

• In the long run, the quantity of money supplied is predicted not to influence the amount of output, (real) interest rates, and the aggregate demand of real monetary assets L(R,Y).

• However, the quantity of money supplied is predicted to make level of average prices adjust proportionally in the long run.

Average Money Growth and Inflation in Western Hemisphere Developing Countries, by Year, 1987–2007

Source: IMF, World Economic Outlook, various issues. Regional aggregates are weighted by shares of dollar GDP in total regional dollar GDP.

Long-Run and Short-Run Effects of a Change in Money Supply

• A permanent increase in a country’s money supply causes a proportional long run depreciation of its currency.– However, the dynamics of the model predict a large depreciation

first and a smaller subsequent appreciation.

• A permanent decrease in a country’s money supply causes a proportional long run appreciation of its currency.– However, the dynamics of the model predict a large appreciation

first and a smaller subsequent depreciation.

Short-Run and Long-Run Effects of an Increase in the U.S. Money Supply (Given Real Output, Y)

Time Paths of U.S. Economic Variables After a Permanent Increase in the U.S. Money Supply

Exchange Rate Overshooting

• The exchange rate is said to overshoot when its immediate response to a change is greater than its long run response.

• Overshooting is predicted to occur when monetary policy has an immediate effect on interest rates, but not on prices and (expected) inflation.

• Overshooting helps explain why exchange rates are so volatile.

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Month-to-Month Variability of the Dollar/Yen Exchange Rate and of the U.S./Japan Price Level Ratio, 1980–2009

Changes in price levels are less volatile, suggestingthat price levelschange slowly.

Exchange rates are influenced by interest rates and expectations, which may change rapidly, making exchange rates volatile.

Source: International Monetary Fund, International Financial Statistics

Fixed Exchange Rates and the Trilemma

Three desirable policy goals:

1. Fixed exchange rates – remove uncertainty in international transactions;

2. Free capital movements – capital flows freely in and out of a country capital market, creating international investment opportunities;

3. Independent monetary policy – a country’s monetary authority has the autonomy in controlling money supply, which in turn affects interest rates. Can three goals be achieved all together?

Fixed Exchange Rates and the Trilemma

Consider the following three equations and parallel statements about desirable policy goals.

A fixed exchange rate• May be desired as a means to promote

stability in trade and investment• Represented here by zero expected

depreciation

0 €/$

€/$€/$

E

EE e

€/$

€/$ €/$€$ E

EEii

e

1.

2.International capital mobility• May be desired as a means to promote

integration, efficiency, and risk sharing• Represented here by uncovered

interest parity, which results from arbitrage

Fixed Exchange Rates and the Trilemma

Consider the following three equations and parallel statements about desirable policy goals.

Monetary policy autonomy• May be desired as a means to manage

the Home economy’s business cycle

• Represented here by the ability to set the Home interest rate independently of the foreign interest rate

3.

€$ ii

Fixed Exchange Rates and the Trilemma

The Trilemma

o 1 and 2 imply not 3 (1 and 2 imply interest equality, contradicting 3).

o 2 and 3 imply not 1 (2 and 3 imply an expected change in E, contradicting 1).

o 3 and 1 imply not 2 (3 and 1 imply a difference between domestic and foreign returns, contradicting 2).

• Formulae 1, 2, and 3 show that it is a mathematical impossibility as shown by the following statements:

• This result, known as the trilemma, is one of the most important ideas in international macroeconomics.

Fixed Exchange Rates and the Trilemma

The Trilemma

The Trilemma Each corner of the triangle represents a viable policy choice. The labels on the two adjacent edges of the triangle are the goals that can be attained; the label on the opposite edge is the goal that has to be sacrificed.