Econ 141 Fall 2015 Slide Set 5 Asset approach to the exchange rate

Econ 141 Fall 2015

Slide Set 5Asset approach to the exchange rate

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 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.

Exchange Rates and Interest Rates in the Short Run

• We start with the uncovered interest parity (UIP) equation. This is the fundamental equation of the asset approach to exchange rates.

€/$

€/$€$ E

Eii

e

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.

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.

The U.S. interest rate is 5% and the Eurozone interest rate is 3%. The future expected is 1.224

€/$E €/$E

€/$E

Changes in Home and Foreign Bond Returns

How does the exchange rate respond to changes in interest rates and expectations?

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 (Ee

$/€ = 1.20)

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.

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.


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.


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.

PP

MUS

P US

U.S. supply ofreal money balances

L(i$ )YUS

U.S. demand forreal money balances

balancesmoney realfor demandEuropean

balancesmoney realofsupply European

)( EUREUR

EUR YiLP

M

The expressions for money market equilibrium in the two countries are as follows:

Money Market Equilibrium in the Short Run: Nominal Interest Rates

Money Market Equilibrium in the Short Run



Can Central Banks Always Control the Interest Rate?

• 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.

• 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.


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.


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

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.

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.

Monetary policy and the exchange rate


• 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 in the short run – increase in Home money

An increase in the U.S. money supply MUS raises real money balances, MUS /PUS in the short run. This leads to a drop in the U.S. interest rate, iUS .

To maintain equality between domestic returns (DR) and foreign returns (FR), the current exchange rate, , must fall given the future expected exchange rate, . eE €/$

€/$E

Monetary policy in the short run – increase in Home money

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 i1

€ to i2€.

Monetary policy in the short run – increase in Foreign money

If the exchange rate does not change, the foreign return in dollars, i€ + (Ee$/ €

− 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 E1

$/€ to E2$/€. The

new equilibrium is at point 2 .′

Monetary policy in the short run – increase in Foreign money

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.

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:

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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.

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Putting the Monetary and Asset Approaches Together:

The monetary and asset approaches together

Permanent expansion in the home money supply in the short run – first effects.

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 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.


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.


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.

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Overshooting

Permanent increase in MUS

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.

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.

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.

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: EDKr/€

Interest rates and the DKr-euro exchange rate

1999

M01

1999

M06

1999

M11

2000

M04

2000

M09

2001

M02

2001

M07

2001

M12

2002

M05

2002

M10

2003

M03

2003

M08

2004

M01

2004

M06

2004

M11

2005

M04

2005

M09

2006

M02

2006

M07

2006

M12

2007

M05

2007

M10

2008

M03

2008

M08

2009

M01

2009

M06

2009

M11

2010

M04

2010

M09

2011

M02

2011

M07

0

1

2

3

4

5

6

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8

euro interest rate krone interest rate exchange rate (DKr per euro)

Interest differentials and the DKr-euro exchange rate

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interest differential rate of depreciation

• 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, MDEN .

That is, Denmark gives up monetary policy autonomy by adopting the peg.

EURDKrDEN PEP €/

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Fixed rates and monetary policy autonomy in the long run

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The chain of causality for the long run exchange rate differs between a floating exchange rate and the pegged exchange rate:

• With a floating exchange rate, the Danish central bank can choose the Danish money supply MDEN.

• In the long run, the money supply growth rate determines the interest rate i (via the Fisher effect) and the price level PDEN.

• Through PPP, the level of PDEN determines the exchange rate EDKr/€. • The money supply is a policy instrument (an exogenous variable), and

the exchange rate is an outcome from a policy choice (an endogenous variable).


• With a fixed exchange rate, this logic is reversed. • The Danish central bank chooses the exchange rate EDKr/€. • In the long run, the choice of E determines the price level PDEN through

PPP, and the interest rate iDKr through UIP.• The necessary level of the money supply MDEN 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).


.)( €/ DENEURDENEURDKrDEN YiLPEM

Consequences of the trilemma for Denmark

• By maintaining a fixed rate for the krone against the euro, Denmark seeks to minimize fluctuations in the relative prices of its traded goods vis-à-vis the Eurozone.

• Denmark also ties inflation expectations for the krone to Eurozone inflation.

• By choosing the exchange rate for its nominal anchor, Denmark loses the ability to vary the domestic interest rate, iDKr , in the short run to influence GDP growth and unemployment.

• Sweden, by contrast, lets the Swedish krona float against the euro.

The exchange rate as the nominal anchor and the trilemma

• Several countries have used crawling exchange rate bands pegs to reduce inflation. In the process, capital controls were limited.

• Chile and Israel in the 1990s are two examples in which exchange rate bands were used to guide disinflation.

• 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

• Each of these policy goals is represented by an relationship:

• A fixed exchange rate

• International capital mobility

• Monetary policy autonomy

The Trilemma

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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

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0€ €/

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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

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€/€/

DKr

DKreDKr

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The trilemma in a cute diagram

China’s management of the yuan

.

China’s management of the yuan

Managed float – Bretton Woods (another cute diagram!)

How Bretton Woods ended

How Bretton Woods ended

From Bretton Woods to the euro

Major European Currencies (pre-euro): exchange rates against the Deutsche mark

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Econ 141 Fall 2015 Slide Set 5 Asset approach to the exchange rate