Upload
others
View
1
Download
0
Embed Size (px)
Citation preview
MS&E247s International Investments Handout #8 Page 1 of 56Thursday July 9, 2009
Course web page: http://Stanford2009.pageout.net
ID: mse247s; PASSWORD: Stanford88
Handout #8
Foreign Exchange MarketsSpot Exchange Rate Determination
TTh 3:15-4:30 Gates B01on Tuesday July 7, 2009
Slides to highlight: 1-56, 60-77, 94-165, 200-210.
6-2
Levich
Luenberger
Solnik
Eun
Wooldridge
Reading Assignments for this Week
Chap 6
Chap
Chap 3
Chap 7
Scan Read
Pages
Pages
Pages
Pages
Chap 21 Pages
Foreign Exchange Determination and Forecasting
Spot Exchange Rate Determination
Multiple Regression Analysis with Qualitative Information: Binary (or Dummy) Variables
http://highered.mcgraw-hill.com/sites/dl/free/0072521279/91312/eun21279_ch21_dr.pdf
6-3
Reading assignments for this week last year
Monetary Policy Report to the CongressSubmitted pursuant to section 2B of the Federal Reserve Act, July 15, 2008http://www.federalreserve.gov/boarddocs/hh/2008/july/FullReport.pdfhttp://www.federalreserve.gov/printable.htm
WSJ 1024 2005: The Greenspan Era
WSJ 0516 2008: Bernanke's Bubble Laboratory
Federal Reserve System 0710 2008:Bernanke on Regulatory Restructuring
IHT 0528 2008: With bold steps, Bernanke revamps Fed rule book
6-4
Mankiw on Macroeconomics
(great optional reading)
Chapter 4 Money and Inflation
http://www.bfwpub.com/pdfs/mankiw/0716752379_04.pdf
6-5
Stephen G. Cecchetti on
Central Banks, Monetary Policy, and
Financial Stability
(must read)
Chapter 15 Central Banks in the World Today
http://highered.mcgraw-hill.com/sites/dl/free/0072452692/238721/cec5269
2_ch15.pdf
6-6
http://highered.mcgraw-hill.com/sites/dl/free/0072452692/238721/cec52692_ch15.pdf
MS&E247s International Investments Handout #8 Page 2 of 56Thursday July 9, 2009
6-7
Stephen G. Cecchetti on
Central Banks, Monetary Policy, and
Financial Stability
(great optional reading)
Chapter 16 The Structure of Central Banks:
The Federal Reserve and the European Central Bank
http://highered.mcgraw-hill.com/sites/dl/free/0072452692/238721/cec5269
2_ch16.pdf6-8http://highered.mcgraw-hill.com/sites/dl/free/0072452692/238721/cec52692_ch16.pdf
Foreign Exchange Markets
Spot Exchange Rate Determination
MS&E 247S International InvestmentsYee-Tien Fu
6-10
6-11
The famous random walk hypothesis holds that the best guess about tomorrow’s stock price is today’s stock price (plus a bit of upward drift to reward patience and risk taking).
According to the random-walk theory, stock prices should move in response to news about the value of the underlying companies.
Introduction
6-12
To many economists, exchange rate models built around a set of structural macroeconomic variables seems to have little power to explain the patterns of short-term exchange rate behavior.
For most countries, the exchange rate is the single most important price in the economy. The daily trading is over US$1 trillion. (1 trillion = 1000 billion = 1,000,000 million = 1012)
Introduction
MS&E247s International Investments Handout #8 Page 3 of 56Thursday July 9, 2009
6-13
The depth to which market economists follow macroeconomic developments suggests that an understanding of the macroeconomic news is critical for understanding (and perhaps predicting) exchange rate behavior.
Financial economists at banks, securities firms, and elsewhere also have been hard at work analyzing the variables that might impact foreign exchange rates.
Introduction
6-14
The view that exchange rates follow a simple random walk and evolve without regard to macroeconomic fundamentals is an extreme characterization, and we believe a false one.
We will see that the presence of nonrandom-walk behavior offers market economists an opportunity to add value. While the link between exchange rates and macroeconomic variables may be difficult to uncover, there is evidence that such a link exists in the short run and to a greater extent in the long run.
Introduction
6-15
Financial market economists are trained to be skeptical.
The principal result from models of exchange rate determination is that the exchange rate is a forward-looking variable that should be priced in the same way as other financial assets.
The current price of foreign exchange can be shown to equal (in theory) the net present value of all the fundamental variables that affect the exchange rate. This suggests why the exchange rate would be difficult to model and even more so to forecast.
Introduction
6-16
The current exchange rate already reflects the expected values of future macroeconomic variables.
We will use several news items about macroeconomic events to show the forward-looking nature of the foreign exchange market and the difficulties we face in modeling exchange rates.
Introduction
6-17
We will survey some of the stylized models of exchange rate determination developed over the past 20 years.
We outline the broad predictions of these models and then we analyze the empirical evidence to determine whether these models offer a satisfactory explanation for exchange rate behavior.
Introduction
6-18
Measure Amount (billions) What’s Included
M1 1995: $1,148 Currency, Traveler’s checks1998: $1,081 Demand deposits
Other checkable deposits
M2 1995: $3,630 M1 plus Saving deposits1998: $4,165 Retail money market mutual funds
Small time deposits
M3 1995: $4,357 M2 plus Large time deposits1998: $5,574 Repurchase agreements
Eurodollars, Institution-onlymoney market mutual funds
L 1995: $5,426 M3 plus Other liquid assets1998: $6,826 such as savings bonds and
short-term Treasury securities
Four Measures of the Money Stock for the US Economy
MS&E247s International Investments Handout #8 Page 4 of 56Thursday July 9, 2009
6-19Source: http://www.newyorkfed.org/aboutthefed/fedpoint/fed49.html
U.S. Money Aggregates
Money Supply MeasuresSeptember 2001
Savings Deposits
Small Time Deposits
Retail Money Funds
$5.3 trillion
M2
Large Time Deposits
Institutional MMFsEuros & Repos
$7.8 trillion
M2 M3
Bil
lions
of
Dol
lars
9,000
8,000
7,000
6,000
5,000
4,000
3,000
2,000
1,000
0
$1.2 trillion
M1
M1CurrencyCheckable Deposits
6-20http://www.bfwpub.com/pdfs/mankiw/0716752379_04.pdf
6-21
▪ For decades, the Federal Reserve has published data on the money supply, and for many years the Fed set targets for money supply growth.
▪ In the past two decades, a number of developments have broken down the relationship between money supply growth and the performance of the U.S. economy.
▪ In July 2000, the Federal Reserve announced that it was no longer setting target ranges for money supply growth.
Source: http://www.newyorkfed.org/aboutthefed/fedpoint/fed49.html 6-22
News and Foreign Exchange Rates:An Introduction
• Financial markets are preoccupied with news.
• However, we usually cannot find a simple unambiguous link between a news announcement and an exchange rate reaction.
¤ The market is forward-looking, and permanentchanges versus transitory phenomena are viewed differently.
¤ While two news announcements may seem similar, their underlying aspects may be in fact different.
6-23
News and Foreign Exchange Rates - Hindsight Smart?
Example 1:In a period of floating exchange rates we might have read that following an increase in the US money supply, the US$ fell because the news generated inflationary expectations.
But on another occasion, we might have read that following a similar increase in the US money supply, the US$ rose because the news generated expectations that the Federal Reserve would tighten money growth and raise interest rates.
6-24
• The Fed has three tools in its monetary toolbox:
Open-market operations
Changing the reserve requirement
Changing the discount rate
The Fed’s Tools of Monetary Control
MS&E247s International Investments Handout #8 Page 5 of 56Thursday July 9, 2009
6-25
The Fed’s Tools of Monetary Control
Open-Market Operations: the purchase and sale of U.S. government bonds by the Fed
Reserve Requirements: regulations on the minimum amount of reserves that banks must hold against deposits
The Discount Rate: the interest rate on the loans that the Fed makes to banks
6-26
Open-Market Operations
• The Fed conducts open-market operations when it buys government bonds from or sells government bonds to the public:When the Fed buys government bonds, the
money supply increases (helicopter).
The money supply decreases when the Fed sells government bonds (vacuum cleaner).
6-27
Changing the Discount Rate
• The reserve requirement is the amount (%) of a bank’s total reserves that may not be loaned out. Increasing the reserve requirement
decreases the money supply.
Decreasing the reserve requirement increases the money supply.
6-28
Changing the Discount Rate
• The discount rate is the interest rate the Fed charges banks for loans. Increasing the discount rate decreases the
money supply.
Decreasing the discount rate increases the money supply.
6-29
Problems in Controlling the Money Supply
• The Fed’s control of the money supply is not precise.
• The Fed must wrestle with two problems that arise due to fractional-reserve banking.
The Fed does not control the amount of money that households choose to hold as deposits in banks.
The Fed does not control the amount of money that bankers choose to lend.
6-30
http://money.cnn.com/markets/IRC/economic.htmlhttp://money.cnn.com/news/specials/eyes_on_fed/http://money.cnn.com/news/economy/
Markets: Investor Research Center - Economic Calendar
MS&E247s International Investments Handout #8 Page 6 of 56Thursday July 9, 2009
6-31
http://money.cnn.com/markets/IRC/economic.htmlhttp://money.cnn.com/news/specials/eyes_on_fed/http://money.cnn.com/news/economy/
Markets: Investor Research Center - Economic Calendar
6-32http://money.cnn.com/markets/IRC/
6-33http://money.cnn.com/markets/IRC/ 6-34http://money.cnn.com/markets/IRC/
6-35http://money.cnn.com/markets/IRC/ 6-36http://woodrow.mpls.frb.fed.us/research/data/us/charts/int1.cfm
MS&E247s International Investments Handout #8 Page 7 of 56Thursday July 9, 2009
6-37http://woodrow.mpls.frb.fed.us/research/data/us/charts/int1.cfm 6-38http://woodrow.mpls.frb.fed.us/research/data/us/charts/int1.cfm
6-39http://woodrow.mpls.frb.fed.us/research/data/us/charts/int1.cfm 6-40http://woodrow.mpls.frb.fed.us/research/data/us/charts/int1.cfm
6-41
http://www.federalreserve.gov/econresdata/default.htm
Research Data
http://www.federalreserve.gov/econresdata/researchdata.htm
6-42http://woodrow.mpls.frb.fed.us/research/data/us/charts/int2.cfm
MS&E247s International Investments Handout #8 Page 8 of 56Thursday July 9, 2009
6-43http://woodrow.mpls.frb.fed.us/research/data/us/charts/int2.cfm 6-44http://woodrow.mpls.frb.fed.us/research/data/us/charts/int2.cfm
6-45http://woodrow.mpls.frb.fed.us/research/data/us/charts/int2.cfm 6-46http://woodrow.mpls.frb.fed.us/research/data/us/charts/int2.cfm
6-47
http://www.federalreserve.gov/econresdata/default.htm
Research Data
http://www.federalreserve.gov/econresdata/researchdata.htm
6-48http://woodrow.mpls.frb.fed.us/research/data/us/charts/exc1.cfm
Index of weighted average exchange value of U.S. dollar against currencies of other G-10 countries.Source: Board of Governors, Federal Reserve System
MS&E247s International Investments Handout #8 Page 9 of 56Thursday July 9, 2009
6-49http://woodrow.mpls.frb.fed.us/research/data/us/charts/exc1.cfm
Index of weighted average exchange value of U.S. dollar against currencies of other G-10 countries.Source: Board of Governors, Federal Reserve System
6-50http://woodrow.mpls.frb.fed.us/research/data/us/charts/exc1.cfm
Index of weighted average exchange value of U.S. dollar against currencies of other G-10 countries.Source: Board of Governors, Federal Reserve System
6-51
Index of weighted average exchange value of U.S. dollar against (in terms of) currencies of other G-10 countries. (note: US$ is in the denominator here)Source: Board of Governors, Federal Reserve System
http://woodrow.mpls.frb.fed.us/research/data/us/charts/exc1.cfm 6-52
Index of weighted average exchange value of U.S. dollar against (in terms of) currencies of other G-10 countries. (note: US$ is in the denominator here)Source: Board of Governors, Federal Reserve System
http://woodrow.mpls.frb.fed.us/research/data/us/charts/exc1.cfm
6-53
http://www.federalreserve.gov/econresdata/default.htm
Research Data
http://www.federalreserve.gov/econresdata/researchdata.htm
6-54
Figure 1, Box 7-5 in Dornbusch: Macroeconomics 8EUnemployment Rates For Selected European Countries and the United States, 1960-2000
Source: European Economy, 1998
Germanunemploymentrate is up!
http://www.mhhe.com/economics/dornbusch8e/
MS&E247s International Investments Handout #8 Page 10 of 56Thursday July 9, 2009
6-55
WHAT'S NEW as of July 13, 2007
Retail sales drop worst in 2 years: Sales drop 0.9 percent, much weaker than forecasts - a signal consumers are tired after years of heavy spending. (July 13 2007: 10:40 AM EDT)
Retail sales posted the biggest drop in nearly two years in June, the government reported Friday, fanning worries that consumers were starting to feel the pinch of higher gas prices and the slumpinghousing market.
http://money.cnn.com/news/economy/ 6-56
WHAT'S NEW as of July 12, 2007
The greatest economic boom ever: A lot could go wrong. And it may not feel like a day at the beach to most Americans. But for your average globetrotting Fortune 500 CEO, right now is about as good as it gets, says Fortune's Rik Kirkland. (July 12 2007: 9:46 AM EDT)(Fortune Magazine) -- Just how red-hot is the current worldwide expansion? "This is far and away the strongest global economy I've seen in my business lifetime," U.S. Treasury Secretary HankPaulson declared on a recent visit to Fortune's offices.
http://money.cnn.com/news/economy/
6-57 6-58
6-59 6-60
WHAT'S NEW as of July 11, 2007
Hank Paulson takes on the world: In a wide-ranging interview with Fortune, the U.S. Secretary of the Treasury explains why, despite the “strongest global economy” he has ever seen, it still “pays to be vigilant.” (July 11 2007: 4:59 PM EDT)
http://money.cnn.com/news/economy/
MS&E247s International Investments Handout #8 Page 11 of 56Thursday July 9, 2009
6-61
Paulson On risks: We haven't had a global financial shock since 1998. I believe that these large and dramatic increases in private pools of capital [hedge funds and private equity] and in the credit derivatives markets since then have helped manage and disperse risk and make the economy more efficient. When we do have one - and it's when, not if; that's not me being negative, it's just that we're not going to defy economic gravity -we'll be seeing for the first time how some of these instruments perform under stress.
6-62
Paulson On U.S. competitiveness: I believe economic integration is inevitable, and it's good for our country, because I believe no other country is better positioned than the U.S. to compete long term and win. I just dismiss the notion that somehow or other China - with all the issues it has - or anyone else is going to take its growth rate, and extrapolate it, and pass the U.S. in ten or 20 years.
6-63
WHAT'S NEW as of July 13, 2008
U.S. plan to save Fannie and Freddie
Paulson and Bernanke proposal would give mortgage finance giants bigger line of credit with Treasury
and open NY Federal Reserve lending window.
By Tami Luhby, CNNMoney.com senior writerLast Updated: July 13, 2008: 8:54 PM EDT
6-64
6-65
Chairman Ben S. Bernanke
Regulatory restructuring“Work is also ongoing to strengthen
the framework for prudential oversight of financial institutions.”
Before the Committee on Financial Services, U.S. House of Representatives
July 10, 2008
WHAT'S NEW as of July 10, 2008
6-66
WHAT'S NEW as of July 16, 2008
Chairman Ben S. Bernankedelivered the
Semiannual Monetary Policy Report to the Congress
Before the Committee on Financial Services, U.S. House of Representatives
on Tuesday July 15, 2008
Chairman Bernanke presented testimony before the Committee on Banking, Housing, and Urban Affairs,
U.S. Senateon Tuesday July 15, 2008
http://www.federalreserve.gov/boarddocs/hh/2008/july/fullreport.htmhttp://www.federalreserve.gov/newsevents/testimony/bernanke20080715a.htm
MS&E247s International Investments Handout #8 Page 12 of 56Thursday July 9, 2009
6-67
Fed Officials See Stronger Growth and Higher Inflation
Fed officials suggested that, in near term, they were growing more concerned about inflation than economic growth, while still seeing "significant downside risks" to growth. The expectation is that overall inflation will moderate in 2009 and 2010,
What are two ways to alleviate inflation woes? Higher interest rate or Stronger $?
WHAT'S NEW as of July 16, 2008
6-68
Despite the expectation that overall inflation will moderate in 2009 and 2010, Mr. Bernanke told lawmakers on July 16, 2008, officials “viewed the inflation outlook as unusually uncertain and cited the possibility that commodity prices will continue to rise as an important risk to the inflation forecast.”
Why? Higher wages will be paid to alleviate workers’ suffering; higher wages in turn add to production costs and higher product prices.
WHAT'S NEW as of July 16, 2008
6-69
In these circumstances, the Federal Reserve will employ all available tools to promote economic recovery and to preserve price stability. The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.
http://www.federalreserve.gov/newsevents/press/monetary/20090624a.htm
WHAT'S NEW as of June 24, 2009
6-70
As previously announced, to provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Federal Reserve will purchase a total of up to $1.25 trillion of agency mortgage-backed securities and up to $200 billion of agency debt by the end of the year. In addition, the Federal Reserve will buy up to $300 billion of Treasury securities by autumn. The Committee will continue to evaluate the timing and overall amounts of its purchases of securities in light of the evolving economic outlook and conditions in financial markets. The Federal Reserve is monitoring the size and composition of its balance sheet and will make adjustments to its credit and liquidity programs as warranted.
http://www.federalreserve.gov/newsevents/press/monetary/20090624a.htm
6-71
News and Foreign Exchange Rates - Hindsight Smart?
Example 2:
We might have read that following an upsurge in the US fiscal budget deficit, the US$ fellbecause the news generated expectations that the Fed would monetize the deficit; but on another occasion, we might have read that the US$ rose because the news generated expectations that further government borrowing and higher interest rates would result.
6-72
There are two reasons explaining why we do not find a simple unambiguous link between a news announcement and an exchange rate reaction.
News and Foreign Exchange Rates - Hindsight Smart?
First, the foreign exchange market, like other financial markets, is a forward-looking market.
Once a news item has occurred, traders are concerned whether the news represents a permanent change or only a transitory phenomenon.
MS&E247s International Investments Handout #8 Page 13 of 56Thursday July 9, 2009
6-73
An increase in the current account deficit between the United States and Japan may have resulted from an increase in US imports from Japan or a decrease in Japanese imports from the US.
Second, while two news announcements may seem similar, on closer examination we may conclude that they are not.
News and Foreign Exchange Rates - Hindsight Smart?
6-74
- is a Balance Of Payment account- records transactions in goods and services- a simple way of understanding how transactions
are recorded is to think of debits as arising when money flows out of US or in foreign currencies, and credits when money flows intothe US or in dollars.
- credits result from purchases by foreigners; they give rise to inflows or sources of foreignexchange. Debits result from purchases bydomestic residents; they give rise to outflows or uses of foreign exchange.
The Current Account
6-75
CURRENT ACCOUNT(a) ‘TRADE BALANCE’
(goods, services, transfers)
(b) ‘DEBT SERVICE’
import of a Japanese car; foreign aid to Israel
exports of PC’s; money transfers from abroad to local students
Payments of dividends & interest to foreigners
Receipts from dividends, interest payments on overseas investments by US citizens
DEBIT (-)
Imports
CREDIT (+)
Exports
6-76
Exchange Rates and News Stories: Illustrations
The news service puts us in a
ceteris paribus (all other things
being equal) setting common to
macroeconomic analysis.
6-77
Story: An Increase in the US Money Supply
News announced at t1 :
US money supply grew by $3 billion in the most recent week.
Assuming that the consensus market forecast on money supply growth was $2 billion,
=> realized money growth is a “positive surprise”
Exchange Rates and News Stories: Illustrations
6-78
Story: An Increase in the US Money Supply
- the market feels that the higher moneysupply will be maintained
- with national output constant, a largermoney supply leads to a higher price level
- if both prices and exchange rates are perfectly flexible, then the US$ will weaken immediately
Why might the US$ weaken in response to this news?
MS&E247s International Investments Handout #8 Page 14 of 56Thursday July 9, 2009
6-79
U.S.money supply
Figure 6.2
The Reaction of the US$ to a Money Supply Announcement:Scenario (a)
Timet1 t2
$ interest rate
U.S. price level
Nominal exchangerate ($ /FC)
4. the interest rate does not change since the price level isconstant after the monetary shock
1. realized money growth is a “positive surprise”; the market feels that the higher money supply will be maintained
2. if both prices and exchange rates are perfectly flexible, then the US$ will weaken immediately
3. at the same time, with national output constant, a larger money supply leads to a higher price level
6-80
- yes, if market participants believe that theFederal Reserve will drain reserves from thebanking sector in the coming weeks to makeup for its past excessive money supply creation
Story: An Increase in the US Money Supply
Could the US$ strengthen in response to the same news item?
6-81
U.S.money supply
Figure 6.2
The Reaction of the US$ to a Money Supply Announcement:Scenario (b)
Timet1 t2
$ interest rate
U.S. price level
Nominal exchangerate ($ /FC)
1. assume that market participants believe thatthe Federal Reserve will drain reserves from thebanking sector in the coming weeks
2. market projects an low growth in the money supplyand interest rates are projected to rise; interest ratesrise immediately in anticipation
3. higher US$ interest rates attract capital, and the US$ rises
4. since market believes excessive money creationwill be corrected soon, U.S. price level does not change
6-82
What if a permanent change in the rate of growth of the money supply is expected?
- in this scenario, inflation turns positive after t1, the interest rate jumps, and the US$ steadily depreciates.
Story: An Increase in the US Money Supply
6-83
U.S.money supply
Figure 6.2
The Reaction of the US$ to a Money Supply Announcement:Scenario (c)
Timet1 t2
$ interest rate
U.S. price level
Nominal exchangerate ($ /FC)
1. assume a permanent change in the rate of growthof the money supply is expected
2. then, inflation turns positive after t1 (prices rise when the government prints too much money)
3. and the interest rate jumps (Fisher Closed)
4. at the same time, the US$ steadily depreciates(relative PPP)
6-84
Which is the correct response of the exchange rate to the news?
- all the responses are correct, but with respectto different scenarios derived from the same news announcement.
Story: An Increase in the US Money Supply
MS&E247s International Investments Handout #8 Page 15 of 56Thursday July 9, 2009
6-85
U.S.money supply
Figure 6.2
The Reaction of the US$ to a Money Supply Announcement:Alternative Scenarios
Timet1 t2
$ interest rate
U.S. price level
Nominal exchangerate ($ /FC)
a
a
a
a
b
b
b
b
c
c
c
c
The Modern Art of Exchange Rates! 6-86
Story: An Increase in U.S. Interest Rates
News: U.S. interest rates at all maturities along the term structure of interest rates have risen by 0.10 percent or 10 basis points (bp).
Assume that the market consensus was for no change in interest rates, so the entire 10 bpincrease comes as an unexpected surprise.
Could the US$ be weaker as a result of this news? Could the US$ be stronger as a result of this news? Which is the correct response of the exchange rate to an increase in the level of interest rates - a weaker currency or a stronger currency?
6-87
It could be that US$ interest rates could have risen because of concern about rising U.S. inflation (the Fisher Effect). Following purchasing power parity, a weaker US$ would be expected - call this path d.
Could the US$ be weaker as a result of this news?
The weaker US$ (path d) assumes that the rise in U.S. interest rates is stemming from inflationary concerns, and therefore a rise in the nominalinterest rate, but not necessarily the real interest rate.
FOREIGNUSSpot PP %%%
USE Pri~
$$ 6-88
Might the US$ strengthen in response to the same news item?
If market participants were attracted by the higher yields now available to US$ securities, capital flows to the United States would contribute to a stronger US$ - call this path e.
The stronger US$ (path e) assumes that inflation is under control, so the higher interest rate corresponds to an increase in the real interest rate. And a higher real interest rate draws in foreign capital and raises the foreign exchange value of domestic currency.
6-89
Which is the correct response of the exchange rate to an increase in the level of interest rates -a weaker currency or a stronger currency?
Because nominal U.S. interest rates respond to both real and inflationary factors, the exchange rate response must be ambiguous.
6-90
From 1976 to 1978, the differential between U.S. and foreign interest rates rose from -3 percentage points to +4 percentage points.
Despite this sharp increase in interest rates, the trade-weighted value of the dollar depreciated by almost 20 percent, from 105.0 in mid-1976 to 85.0 by November 1978.
This is certainly an example of negative correlation between interest rates and exchange rates as in path d.
MS&E247s International Investments Handout #8 Page 16 of 56Thursday July 9, 2009
6-91
In the following 2 years (1979-80), the correlation between exchange and interest rates turned significantly positive. Certainly, higher U.S. interest rates were stimulating US$ currency purchases.
The policy events behind this change include:
(1) Nov 1, 1978’s intervention, which was intended to convince the market that U.S. policymakers were serious about controlling inflation and arresting the downward slide in the US$;
(2) Oct. 6, 1979’s announcement by the U.S. Federal Reserve about a change in its operating procedure -the new policy emphasized containing the growth rate of monetary aggregates within announced limits, allowing interest rates to take on greater volatility.
6-92
= exports – imports + unilateral transferscurrentaccount = government (tax collections – expenditures)
+ private (savings – investments)
¤ Case I: The shortfall in exports or increase in imports is viewed as permanent and the US$ weakens.
¤ Case II: The change is due to greater private sector investments, and the US$ strengthens as foreign capital flows in to finance the investments.
Story: It is announced that the U.S. current account deficit will reach an annual rate of $250 billion. ( The
consensus was $200 billion.)
6-93
FIGURE 1, BOX 19-5 in Dornbusch/Macroeconomics
THE U.S. CURRENT ACCOUNT AS A PERCENTAGE OF GDP, 1970-2000
Source: DRI/McGraw-Hill Macroeconomic Databasehttp://www.mhhe.com/economics/dornbusch8e/ 6-94
Only unanticipated events cause exchange rates to deviate from their expected path of movement.
Factors that increase the demand for a currency tend to raise the price of that currency.
The demand for a nation’s money as a currency or as an investment choice depends on a small group of factors including...
Foreign Exchange Rate Behavior: Major Concepts
6-95
...national income, real interest rates, inflation rate, changes in national wealth (through the current account), preferred currency mix for holding financial wealth, financial risk factors, political risk factors etc.
Foreign Exchange Rate Behavior: Major Concepts
The “character” and the “context” of the economic news item will greatly influence the “nature” of the exchange rate response that follows.
6-96
By “character,” we mean whether the news item was representing:
- an unanticipated or anticipated disturbance- a permanent or transitory disturbance- a shock affecting the level of a variable or its
rate of change- a real or nominal (monetary) disturbance- a shock affecting a single industry sector or
an economy-wide shock- a shock to beliefs that were weakly held
or strongly held.
Foreign Exchange Rate Behavior: Major Concepts
MS&E247s International Investments Handout #8 Page 17 of 56Thursday July 9, 2009
6-97
Foreign Exchange Rate Behavior: Major Concepts
By “context,” we mean a variety of factors including:
- whether the monetary authorities are perceivedto have discipline relative to their targets
- whether foreign demand for home country currency & securities is satiated or growing
- whether prices in the economy are free to adjustquickly instead of being sticky
- whether the shock resulted from a change inexports instead of imports, a change in public savings instead of private savings, etc.
6-98
By “nature” of the exchange rate response, we mean:
Foreign Exchange Rate Behavior: Major Concepts
- whether the exchange rate jumps at once to its next long-term equilibriumand stays there at rest
- or whether the exchange rate overshoots its next long-run equilibriumand continues to adjust following its initial jump
6-99
Economic fundamentals form the backdrop for asset markets and, indeed, ultimately determine financial asset returns.
Key U.S. Economic Indicators & Their Interpretation
Financial market participants are increasingly called on to monitor economic indicators and interpret the data to determine the likely impact that new information will have on financial markets.
6-100
Growth determines profits and real returns while inflation features prominently in setting the discount that is embedded, explicitly or implicitly, in every investment decision.
Key U.S. Economic Indicators & Their Interpretation
The focus is on the implications for growth and inflation.
6-101
Barometric Indicators
Fig 6.5
Coincidentindicator(peak & trough)
Ind
icat
or
leve
l (va
lue)
Businesscycle
peak date
Businesscycle
trough date
Leadingindicator(peak & trough)
Laggingindicator(peak & trough)
Time
Note that an indicator may be peak-leading & trough-lagging.
6-102
The composite index of leading indicators is composed of 10 equally weighted indicators that lead the economy:
1. Average weekly hours of production workers inmanufacturing.
2. Initial unemployment claims.3. Manufacturers’ new orders for consumer goods4. Vendor performance.5. Plant and equipment orders.6. Building permits. 7. S&P 500 Index of stock prices.8. M2 money supply.9. Interest rate spread, 10-year Treasury bonds less the
federal funds rate.10. Index of consumer expectations.
MS&E247s International Investments Handout #8 Page 18 of 56Thursday July 9, 2009
6-103
Average weekly hours in manufacturing
This certainly is a key indicator since the more people working regularly, the more likely they will be consumers of goods and services. The question I would raise is if the U.S. is a service economy with six times more service hours than manufacturing hours (www.BLS.GOV/CES, see table six), then why not include the service hours worked as well as manufacturing hours?
6-104
Manufacturer’s new orders, non-defense capital goods
This is an excellent indicator for future capital investment. It could be asked whether this is really a leading indicator anymore. Most manufacturers I speak with tell me they will not be expanding their capital budgets for equipment until the general economy shows solid signs of improvement. If that’s the case, then this may be a lagging indicator during this particular business cycle.Just-in-time manufacturing would dictate no new plant and equipment until market demand says to invest. As long as deliveries stay short on capital equipment, manufacturers can get away with this strategy.
6-105
Stock prices, 500 common stocks
S&P 500 Index of stock prices is a leading indicator.
Another strictly manufacturing-focused stock index you might want to follow is the Heavy Metal 40 index maintained on website www.winningstrategy.com. Forty large manufacturing companies comprise the Heavy Metal Index, the HM40 index. Since stock prices reflect investor’s opinions about the earnings outlook for companies over the mid- to long-term, movements in stock prices generally precede the actual changes in the performance of the companies and are a very good leading indicator.
6-106
Money supply, M2
This is an indicator that the Federal Reserve can manage to reinforce monetary policy. M2 is the sum of all cash, checking accounts, and money market funds in the economy available for purchases or investments. The Fed can juice up the money supply by purchasing treasury notes and bills and so releasing more cash into the economy. With Federal budget deficits forecast as far as the calculator can calculate, the Treasury will have ample opportunity to issue debt, and the Fed will have ample opportunity to purchase it along with individuals, both here and abroad.This cost is not bad when interest rates are low, but gets pretty scary when rates start to climb. The money supply should stay generous in a deficit-driven economy such as the future portends unless excessive inflation returns and then the money supply will tighten.
6-107
Interest rate spread, 10-year treasury bonds less federal funds
This indicator is a measure of the risk perceived by investors as they follow the prospects of the economy for the near and longer term. When the rate spread between the 10-year note (a longer term debt instrument) and the federal funds rate (a very safe short term debt instrument) is large, then the market is betting that the economy is in for future difficulties and investment and growth will be hard to sustain.When the spread narrows, the market is betting that economic results are destined to become stronger and so risk in investing has diminished.
6-108
Heading Off DangerSince the mid-1990s, the Fed has moved in an aggressive, pre-emptive fashion to maintain growth and price stability.
Source: WSJ: The Greenspan Era
MS&E247s International Investments Handout #8 Page 19 of 56Thursday July 9, 2009
6-109
8324.87As of 0706 2009
1787.40As of 0706 2009
6-110
The composite index of coincident (at the same time) indicators is comprised of only four indicators:
1. Employees on nonagricultural payrolls.
2. Personal income.
3. Index of industrial production.
4. Manufacturing and trade sales.
6-111
The composite index of lagging (following) indicators has seven items:
1. Average unemployment duration.2. Manufacturing inventories/sales ratio.3. Changes in per-unit labor cost.4. Prime rate changes.5. Commercial and industrial loan outstanding6. Ratio of consumer installment credit
outstanding to personal income.7. Changes in the consumer price index
for services.
6-112
Measuring Exchange Rate Movements
• An exchange rate measures the value of one currency in units of another currency.
• A decline in a currency’s value is referred to as depreciation, while an increase is referred to as appreciation.
• % in foreign currency value = (S - St-1) / St-1
• A positive % represents appreciation of the foreign currency, while a negative % represents depreciation.
Exchange Rate Determination
6-113
Exchange Rate Equilibrium
• An exchange rate represents the price of a currency, which is determined by the demand for that currency relative to supply.
Value of £
Quantity of £
equilibrium exchange
rate
S
D
Exchange Rate Determination 6-114
Factors that Influence Exchange Rates
• Relative Inflation Rates
¤ A relative increase in U.S. inflation will increase the U.S. demand for British goods, and hence the U.S. demand for British pounds.
¤ In addition, the British desire for U.S. goods, and hence the supply of pounds, will drop.
Value of £
Quantity of £
S
DD2
S2
r2
r
Exchange Rate Determination
MS&E247s International Investments Handout #8 Page 20 of 56Thursday July 9, 2009
6-115
Factors that Influence Exchange Rates
• Relative Interest Rates
¤ A relative rise in U.S. interest rates will decrease the U.S. demand for British pounds.
¤ In addition, the supply of pounds by British corporations will increase.
Value of £
Quantity of £
S
DD2
S2rr2
Exchange Rate Determination 6-116
Real Interest Rates
¤ A relatively high interest rate may reflect expectations of relatively high inflation, which may discourage foreign investment.
¤ Real interest rates adjusts nominal interest rates for inflation:
real nominalinterest = interest - inflation
rate rate rate
This relationship is sometimes called the Fisher effect.
Factors that Influence Exchange Rates
Exchange Rate Determination
6-117
Factors that Influence Exchange Rates
Value of £
Quantity of £
S
DD2
rr2
• Relative Income Levels
¤ A relative increase in the U.S. income level will increase the U.S. demand for British goods, and hence the demand for British pound.
¤ The supply of pounds does not change.
Exchange Rate Determination 6-118
• Government Controls
¤ Governments can influence the equilibrium exchange rate in many ways, including :
– the imposition of foreign exchange barriers,
– the imposition of foreign trade barriers,
– intervening in the foreign exchange market, and
– affecting macro variables such as inflation, interest rates, and income levels.
Factors that Influence Exchange Rates
Exchange Rate Determination
6-119
• Expectations
¤ Foreign exchange markets react to any news that may have a future effect.
¤ Institutional investors often take currency positions based on anticipated interest rate movements in various countries too.
¤ Because of speculative transactions, foreign exchange rates can be very volatile.
Factors that Influence Exchange Rates
Exchange Rate Determination 6-120
Factors that Influence Exchange Rates
Trade-RelatedFactors
1. Inflation Differential
2. Income Differential
3. Gov’t Trade Restrictions
FinancialFactors
1. Interest Rate Differential
2. Capital FlowRestrictions
U.S. demand for foreign goods, i.e. demand for
foreign currency
Foreign demand for U.S. goods, i.e. supply of
foreign currency
U.S. demand for foreign securities, i.e. demand
for foreign currency
Foreign demand for U.S. securities, i.e. supply of
foreign currency
Exchange rate
between foreign
currency and the dollar
Exchange Rate Determination
MS&E247s International Investments Handout #8 Page 21 of 56Thursday July 9, 2009
6-121
• Interaction of Factors
¤ Trade-related factors and financial factors sometimes interact. For example, an increase in income levels sometimes causes expectations of higher interest rates.
¤ Over a particular period, different factors may place opposing pressures on the value of a foreign currency. The sensitivity of the exchange rate to these factors is dependent on the volume of international transactions between the two countries.
Factors that Influence Exchange Rates
Exchange Rate Determination 6-122
Factors that Influence Exchange Rates
Rx
• Economic Factors
¤ relative interest rates
¤ purchasing power parity (PPP)
¤ economic conditions (balance of payments, economic growth, rate of inflation, money supply, unemployment figures, rates of taxation)
¤ supply and demand for capital (capital flows to a country where investors see opportunities)
6-123
Factors that Influence Exchange Rates
Rx
• Political Factors
¤ the type of economic policies pursued by the government
¤ the amount of uncertainty in the political situation
¤ the regulatory policies followed by central banks and/or other regulatory bodies
¤ central bank intervention in the foreign exchange market to strengthen or weaken its currency
6-124
Factors that Influence Exchange Rates
Rx
• “People” Factors
¤ market sentiment (the perception traders have of the short-term prospects for the movement in a currency)
¤ technical analysis (many market participants trade on the basis of past price movements)
6-125
How Factors Have Influenced Exchange Rates
¤ Because the dollar’s value changes by different magnitudes relative to each foreign currency, analysts measure the dollar’s strength with an index.
60
100
140
180
1972 1977 1982 1987 1992 1997
Do
llar’
s In
de
x
Year
high U.S.inflation
high U.S. interest rates, a somewhat depressed U.S. economy, and low inflation
large balance of trade deficit
high U.S. interest rates
Persian Gulf War
Exchange Rate Determination 6-126
Speculating on Anticipated Exchange Rates
Chicago Bank expects the exchange rate of the New Zealand dollar to appreciate from its present level of $0.50 to $0.52 in 30 days.
Exchange Rate Determination
1. Borrows $20 million
2. Holds NZ$40 million
Exchange at $0.50/NZ$
Lends at 6.48% for 30 days 3. Receives
NZ$40,216,000
Exchange at $0.52/NZ$
4. Holds $20,912,320
Borrows at 7.20% for 30 days
Returns $20,120,000Profit of $792,320
Start here
MS&E247s International Investments Handout #8 Page 22 of 56Thursday July 9, 2009
6-127
Speculating on Anticipated Exchange Rates
Chicago Bank expects the exchange rate of the New Zealand dollar to depreciate from its present level of $0.50 to $0.48 in 30 days.
Exchange Rate Determination
1. Borrows NZ$40 million
2. Holds $20 million
Exchange at $0.50/NZ$
Lends at 6.72% for 30 days 3. Receives
$20,112,000
Exchange at $0.48/NZ$
4. Holds NZ$41,900,000
Borrows at 6.96% for 30 days
Returns NZ$40,232,000Profit of NZ$1,668,000
or $800,640
Start here
6-128
Flow versus Stock Models of the Exchange Rate
A model of exchange rate determination requires the specification of demand and supply curves, the intersection of which determines a price.
Flows approach concentrates on the flows of currency passing through the foreign exchange market. Foreign exchange was thought to be in demand or supply largely as a medium of exchange for executing international trade transactions.
6-129
The flow demand for UK£ represents American demand for British goods and services. The supply of UK£ represents the demand for American goods by British residents. The intersection of the two determines the exchange rate.
Flow versus Stock Models of the Exchange Rate
Priceof £
Quantityof £/Time
Demand
Supply
6-130
Flow versus Stock Models of the Exchange Rate
Stock approach focuses on the total quantity of currency outstanding at a moment in time.
Currency is treated as an asset - durable and transferable.
At a moment in time, the stock of currency is in fixed supply.
At the equilibrium currency price, the stock of currency is willingly held.
6-131
Figure 6.4 provides an example of the stock approach for the static case where the supply of currency is fixed.
Holding demand constant, an increase in the supply of £ to S’ (through money creation or retiring £ bonds) leads to a fall in the price of £to point b.
Holding supply constant, an increase in the demand for £ leads to a rise in the price of £ to point c.
Flow versus Stock Models of the Exchange Rate
6-132
Determination of Exchange Rates: A Stock Approach
Price ofsterling
Quantity of sterlingat a moment in time
$2.82
$2.78
S S ’D D ’
D
D ’
a
c
b
Figure 6.4
MS&E247s International Investments Handout #8 Page 23 of 56Thursday July 9, 2009
6-133
Flow versus Stock Models of the Exchange Rate
The stock approach is also known as the asset approach - where the current exchange rate is set to equilibrate the (risk-adjusted) expected rate of return on assets denominated in different currencies.
In the asset approach the current spot exchange rate is set equal to the present discounted value of the expected future spot exchange rate.
6-134
From current spot rate, the expected US$-denominated return on a UK £ investment can be obtained.
);~
()1(
)1(1
$
£
tt SEi
iS
£
$50.1
)1(
%)101(
£
$4474.1
$
i
Recall that from the International Fisher Effect:
Flow versus Stock Models of the Exchange Rate
%6.3£$
4474.1)£$
4474.1£$
50.1(
An US investor would earn about 3.6% on the expected exchange rate change:
6-135
%1411.1£$4474.1
£$50.1$ i
To produce a US$ return of 14 percent on UK assets:
Flow versus Stock Models of the Exchange Rate
However, if St= $1.5421/£ (point B), the corresponding numbers are:
£
$50.1
)1(
%)101(
£
$5421.1
$
i
%73.2£$
5421.1)£$
5421.1£$
50.1(
6-136
%711.1£$5421.1
£$50.1$ i
To produce a US$ return of 7 percent on UK assets:
Flow versus Stock Models of the Exchange Rate
However, if St= $1.5421/£ (point B), the corresponding numbers are:
-2.73% on the expected exchange rate change, and a US$ return of only 7% on UK assets
=> current US$/£ exchange rate and expected US$ return on UK assets are negatively related.
6-137
The Current US$/£ Exchange Rate and the Expected US$ Return on UK Assets
Figure 6.5
1.35
1.40
1.45
1.50
1.55
1.60
Cur
rent
US$
/£E
xcha
nge
Rat
e
Expected US$ Return on UK Assets
B
0.06 0.08 0.10 0.12 0.14
A
Assumptions1. The expected future
spot rate is $1.50/£.2. The nominal interest
rate on £ is 10.0%.
6-138
Foreign exchange is used as both a medium of exchange and a store of value, so an overall equilibrium in the foreign exchange market requires balance in both flow and stock aspects of the market.
- stock concept (as in the asset approach) are important for the determination of exchange rate in the short run.
- flow imbalance can be maintained over the short run as long as surplus (deficit) countries are willing to accumulate (run down) assets.
Combining Flow and Stock Concepts of the Exchange Rate
MS&E247s International Investments Handout #8 Page 24 of 56Thursday July 9, 2009
6-139
No deficit country wants to accumulate liabilities to foreigners forever either since the marginal cost of debt is rising, and will finally cut into present consumption.
Combining Flow and Stock Concepts of the Exchange Rate
In the long run, no surplus country wants to accumulate foreign assets forever since the risks of counterparty default are high and the cost of forgone consumption is high.
6-140
A country that runs a current account surplus accumulates wealth, and may use this wealth to bid for international assets; a deficit country relinquishes its wealth.
Combining Flow and Stock Concepts of the Exchange Rate
Thus transfers of wealth through the current account may tilt the demand for currencies in the foreign exchange market.
6-141
Asset Modelsof the Spot Exchange Rate
Small Country Model
Preferred LocalHabitat Model
Uniform PreferenceModel
Portfolio-Balance Approach Monetary Approach
imperfect capital substitutability perfect capital substitutability
Monetarist Model
Overshooting Model
completely flexiblecommodity prices
sticky commodity prices
Asset Model Approach
perfect capital mobility
6-142
Models based on the asset approach begin by specifying a menu of assets. The interrelationship between the demand and the supply of those assets determines the price of foreign exchange.
In the monetary approach, the menu is short and simple - just the domestic and foreign money, M and M*.
In the portfolio-balance approach, the menu of assets include M, M*, and domestic and foreign bonds (B and F).
Asset Models of the Spot Exchange Rate
6-143
The Monetary Approach to Exchange Rate Determination is derived directly from…
1. purchasing power parity, and
2. the quantity theory of money (the quantity of money available determinesthe price level and the growth rate in thequantity of money available determines theinflation rate)
The Monetary Approach
6-144
PPP concludes that the exchange rate is the relative price of goods in two countries; monetary theory suggests that spot exchange rates are the relative price of two monies.
It follows that exchange rate behavior reflects the evolution of the relative supplies and demands for two monies.
The Monetary Approach
Within the monetary approach are two models, the flexible-price model and the sticky-price model.
MS&E247s International Investments Handout #8 Page 25 of 56Thursday July 9, 2009
6-145
Assuming that domestic good prices are fully flexible (i.e., if domestic money supply => domestic currency value proportionately), then the implication is that PPP holds continuously and the real exchange rate never changes.
demandmoney
supplymoney
),(level price
iYL
MP
For the home country,
where Y is domestic real income (real GDP)
Flexible-Price Models
6-146
countryforeign for the),( **
**
iYL
MP
)assumption(by 0 0; where
i
L
Y
L
Y represents transactions demand for money; i is opportunity cost of holding money balances.
By PPP condition,
),(
),(****gnhome/forei iYLM
iYLM
P
PS
Flexible-Price Models
i decreases => demand of local currency increases or L(Y, i) increases => S decreases => foreign currency depreciates
6-147
countryforeign for the),( **
**
iYL
MP
)assumption(by 0 0; where
i
L
Y
L
Y represents transactions demand for money; i is opportunity cost of holding money balances.
By PPP condition,
),(
),(****gnhome/forei iYLM
iYLM
P
PS
Flexible-Price Models
i* decreases => demand of foreign currency increases or L(Y*, i*) increases => S increases => foreign currency appreciates 6-148
A common specification of the money demand
function is ieKYiYL ),(
hands changesmoney rate
1
money ofvelocity
1K
income%
demandedmoney ofquantity %
D
Y
Y
D
YY
DD
= income elasticity of DMoney
MoneyDi ofcity semielasti
Flexible-Price Models
6-149
(6.3) * *
**
* i
i
eKYM
eYMK
P
PS
ttttt iikkyymmS )()()()(ln ****
YyKkMm ln,ln,ln
(6.3) and (6.4) =>predictions of theflexible-price monetary model => if M 2M -> (1/S), domestic
currency value 1/2 (1/S)
Flexible-Price Models
(6.4)
6-150
Flexible-Price Monetary Model
• A common specification of L(Y,i) is K Ye– i
K - constant (the inverse of the velocity of money)
- income elasticity of the demand for money - interest rate semielasticity of the demand for
money
• By PPP, * *
**
*gnhome/forei i
i
eKYM
eYMK
P
PS
ttttt iikkyymmS **** ln
subscript timea is ln ,ln ,ln where
tYyKkMm
MS&E247s International Investments Handout #8 Page 26 of 56Thursday July 9, 2009
6-151
(6.3) predicts that the domestic currency will appreciate in response to a rise in domestic real income (Y) or a fall in domestic interest rate (i), because both changes will increase the demand for domestic money.
While a rise in US real income will lead to greater demand for imports and an increased demand for foreign currency, it is only a partial equilibrium result that neglects capital flows that also respond to an increase in US income.
Flexible-Price Models
6-152
Monetary theory argues that in general equilibrium, the net effect of higher US income should be a US$ appreciation because the increase in the demand for money and the corresponding improvement in the financial account (formerly called the capital account) exceeds the decline in the trade balance.
The Monetary Approach
6-153
- another Balance of Payment (BOP) account- asset (real & financial) transactions- payment flows from current account transactions
- the way they are recorded on the US BOP account is US assets abroad (net), Foreign assets in the US (net)
- don’t interpret these terms as ‘physically’ beingabroad, e.g., a US bank in New York acquiringDM increases the item ‘US assets abroad’
- anything that is capital inflow is a credit, anything that is a capital outflow (“capital export”) is a debit
Financial Account
6-154
DEBIT (-) CREDIT (+)CAPITAL EXPORT(-) CAPITAL IMPORT(+)
US assets abroad foreign assets in thee.g. US citizens buy U.S. e.g. Japanese firmJapanese stocks/bonds buys Sears tower
foreign assets in the US assets abroad US e.g. Japanese e.g. US firm sells stake citizens sell US stocks in British firm
Financial Account
6-155
- introduced by Rudiger Dornbusch (1976)
- highlight the impact of assuming that the speedof adjustment of goods prices is slow relative tothe speed of adjustment of asset prices
- when a central bank announces its money supply figures, the traders in financial marketsrespond quickly, adjusting the prices of varioussecurities and their portfolio positions until a new equilibrium is reached; while Wal-Mart,McDonalds’ prices remain virtually the same and change only gradually in response to general inflationary pressures
- research: what’s new in Internet era? Amazon?
Sticky-Price (Overshooting) Monetary Models
6-156
Sticky-Price (Overshooting) Monetary Models
When good prices are sticky, Dornbusch showed that it is necessary for asset prices to move by more than in the flexible price case, in order for markets to reach a temporary equilibrium.
He also showed that the gradual adjustment of goods prices following a monetary shock reveals a dynamic adjustment path to the exchange rate,
so that while the real exchange rate changes in the short run, it reverts to its original level in the long run.
MS&E247s International Investments Handout #8 Page 27 of 56Thursday July 9, 2009
6-157
i.e. the only time sequence of exchange rates that accurately reflects the nature of the shock and removes all unusual profit opportunities in financial markets.
Sticky-Price (Overshooting) Monetary Models
The Dornbusch model assumes perfect certainty.
The exchange rate path derived is the only equilibrium path...
6-158
Sticky-Price (Overshooting) Monetary Models
Prior to this monetary shock, assume i = i* and exchange rate is at PPP rate S0. The shock occurs at t1, raising the domestic money supply M0 to M1 (liquidity effect occurs).
In response to a one-time, permanent, unanticipated jump in the domestic money supply, iUS, US$ value and capital flows out of US to foreign countries with higher i*.
6-159
Traders dilemma: How can they willingly hold domestic currency that will depreciate over the long term and also pay a low interest rate?
In the short run S0>> S1 [(1/S0) << (1/S1) US$ depreciates too much]. Over the long term (1/S1) < (1/SN) (US$ appreciates) => IRP will hold:
*1 ][ iiSSF ttt
Sticky-Price (Overshooting) Monetary Models
Over time, the excess money supply leads to US price inflation, and iUS gradually as the liquidity effect goes away and the US$ gradually appreciates.
6-160
In the long run, the economy is once again in equilibrium at a higher price level (PN) and higher (depreciated) exchange rate (SN), but at the same real exchange rate as before the shock.
In the long run, iUS returns to its original level and the US$ has depreciated in nominal terms, but the real exchange rate is unaffected.
Sticky-Price (Overshooting) Monetary Models
6-161
US price level
$ Interest rate
US money supply
Timet 1 t N
Time-Series Pattern of Variables in the Sticky-Price (Overshooting) Monetary Model
Figure 6.7
Nominal exchange rate ($/FC)
M 0
P 0
S 0
M 1
P N
S 1
S N
iUS, …
US$ value and capital flows out of US to foreign countries with higher i*.
In response to a one-time, permanent, unanticipated jump in the domestic money supply, …
In the long run, the economy is once again in equilibrium at a higher price level (PN)
In the long run, the economy is once again in equilibrium at a higher SN , …
6-162
U.S.money supply
Figure 6.2
The Reaction of the US$ to a Money Supply Announcement:Scenario (a)
Timet1 t2
$ interest rate
U.S. price level
Nominal exchangerate ($ /FC)
4. the interest rate does not change since the price level isconstant after the monetary shock
1. realized money growth is a “positive surprise”; the market feels that the higher money supply will be maintained
2. if both prices and exchange rates are perfectly flexible, then the US$ will weaken immediately
3. at the same time, with national output constant, a larger money supply leads to a higher price level
MS&E247s International Investments Handout #8 Page 28 of 56Thursday July 9, 2009
6-163
This relationship, where the immediate, short-run change in the nominal exchange rate exceeds the long-run change in the nominal exchange rate, is defined as overshooting.
Because goods prices are sticky in the short run, the real exchange rate also follows an overshooting path.
Thus, a monetary disturbance which in the long run has only nominal effect (changing the price level and the nominal exchange rate) has real effect in the short run by changing the real exchange rate and the competitiveness of firms in international trade.
Sticky-Price (Overshooting) Monetary Models
6-164
Sticky-Price (Overshooting) Monetary Model
• Both the nominal and real exchange rates follow an overshooting path. (The immediate, short-run change exceeds the long-run change.)
• The path of the exchange rate is given by:
tttt iiyymms *
*
*
1
where is the rate at which the exchange rate adjuststoward its long-run equilibrium.
6-165
“Overshooting” defined - prices move by “too much” in the short-run relative to some benchmark» Relative to the movement if markets had full
information» Relative to the movement needed to establish PPP» Our def’n: Relative to the movement required in the
long-run You have encountered overshooting before in the
market for goods that are in limited supply when there is a sudden demand shock» “Overshooting” of this sort is not bad, an equilibrium
result caused by rigidities of some sort Typical microeconomics example: Rigidities in
supply International finance example: Stickiness in goods
prices
Price Dynamics and “Overshooting”
6-166
Initial equilibrium at “A”, then sudden shift in demand from D to D’
In the short-run prices “overshoot” to $12,000 and gradually adjust to their long-term equilibrium at $11,000
Price Dynamics in the Marketfor Honda Insight Hybrid Automobiles
(http://automobiles.honda.com/insight-hybrid/)
Price/Unit
$12,000
$11,000
$10,000
S (Very short-run)
S (Long-run)
8,000 10,000 Quantity/Time
B
C
D
D’A
6-167
As an empirical regularity, we find that prices of goods are less variable in the short-run than exchange rates. Domestic prices of goods are described as “sticky” or “rigid” but in the long-run, goods prices become more flexible.
Inflation and Exchange Rate Dynamics
6-168
Exchange Rate Overshooting (1 of 2)
US pricelevel
$ Interest
rate
US moneysupply
TimeT(1) T(N)
Nominalexchangerate ($/FC)
Consider the following “experiment”.Assume i($)=i(£) and exchange rate is flat and not expected to change.
NOW, let the US money supply rise unexpectedly by 1% at time T(1), while conditions in the rest of the world stay unchanged.
The surplus of money leads $ interest rates to fall, but goods prices are sticky.
As a result, capital flows out of US, and toward foreign investments, and $ depreciates.
MS&E247s International Investments Handout #8 Page 29 of 56Thursday July 9, 2009
6-169
US pricelevel
$ Interest
rate
US moneysupply
TimeT(1) T(N)
Nominalexchangerate ($/FC)
Long-Run value
Exchange Rate Overshooting (2 of 2)
$ has two strikes against it
(1) Low interest rates
(2) Excess money supply likely to cause inflation in the long run
Puzzle: How to get investors to willingly hold US$ assets?
Answer: Let the US$ depreciate immediately by “too much”, to “overshoot.
Then in the medium run, the US$ can appreciate, and compensate investors for the low $ interest rate.
6-170
Why does exchange rate “overshooting” occur?
» Goods prices are sticky in the short run. If goods prices were completely flexible, then M(US) by x%, P(US) by x%, and S($/£) by x% in an instant. (Monetary approach + PPP)
» Capital is very mobile, and asset prices adjust quickly.
» The world is noisy. Unexpected macroeconomic shocks.
Is overshooting a bad thing? In our context, “No”
» It is an natural process to equilibrate returns in US assets and foreign assets, and remove arbitrage profits
» It reflects full information, and not confusion
» Would be better to have fewer macroeconomic surprises (less exchange rate volatility), but surprises happen.
Even with overshooting, PPP holds in long run
Lessons of Exchange Rate Overshooting
6-171
Should be very difficult to predict changes» Asset markets tend to be efficient, prices reflect
information» Short-run price changes caused by “news” -
unpredictable Short-run prediction
» Many analysts use technical, trend-following models to predict the direction (but not magnitude) of changes
» No traditional economic foundation for these models, but studies find that they are often useful & profitable.
Medium to Long-run prediction» Some evidence that exchange rates gravitate toward
the values indicated by structural, monetary models» Short-run deviations are temporary, in the medium to
longer run, fundamentals matter for exchange rates
Predicting Exchange Rate Changes
6-172
Asset Modelsof the Spot Exchange Rate
Small Country Model
Preferred LocalHabitat Model
Uniform PreferenceModel
Portfolio-Balance Approach Monetary Approach
imperfect capital substitutability perfect capital substitutability
Monetarist Model
Overshooting Model
completely flexiblecommodity prices
sticky commodity prices
Asset Model Approach
perfect capital mobility
6-173
- focuses on the excess demand for financialassets
- money & bonds assets; home & foreigncountries
- assume that home country agent are free toallocate their wealth (W) among three holdings: domestic money (M), domestic bonds (B), foreign bonds(F / valued at SF)
- home country wealth W M + B + SF- the greater the country’s fiscal deficit, the
larger the supply of government bonds
The Portfolio Balance Approach
6-174
- domestic interest rate i => domestic demandfor domestic bonds B (1)
- [foreign interest rate i* + expected exchangerate change E(s)] => domestic demand for foreign bonds F (2)
- [ Ø = i - i* - E(s)] => [domestic demand for B –domestic demand for F] (1) - (2)
- Ø represents the expected excess return ondomestic currency bonds over foreign currency bonds
The Portfolio Balance Approach
MS&E247s International Investments Handout #8 Page 30 of 56Thursday July 9, 2009
6-175
The Portfolio Balance Approach
The second element in the demand for bonds is wealth itself.
As W, (M, B, F).
How individuals spread their wealth across M, B, F has an important impact on the exchange rate.
6-176
Under this model, if wealth grows faster in the home or foreign country, there is no exchange rate impact because investors from both countries bid for assets in the same proportions.
The Portfolio Balance Approach
The Uniform Preference Model makes sense if both domestic and foreign investors consumed the same basket of goods and therefore found it sensible to hold identical investment portfolios.
6-177
The Preferred Local Habitat Model assumes that BH/WH > FH/WH and FF/WF > BF/WF where the subscripts H and F indicate home and foreign residents. That is, both the home and foreign countries prefer to hold a larger fraction of their wealth in local bonds. Assume as follows:
bond portfolios compositionsin US$ in Yen
US investor 90% 10%Japan investor 30% 70%
The Portfolio Balance Approach
A yen-denominated bond issued in Tokyo by a non-Japanese company and subject to Japanese regulations, Samurai Bond, has hence prospered.
6-178
If US runs $1 billion current account deficit, then(0.9 billion US$ + 0.1 billion Yen) moves from US hands to Japanese hands to become (0.3 billion US$ + 0.7 billion Yen). The transfer of wealth would tend to shift demand toward the Japanese Yen (and Yen assets) and away from US$ assets.
The portfolio balance model, with demand given by preferred local habitat, predicts a correlation between current account surpluses (deficits) and strong (weak) currencies.
The Portfolio Balance Approach
6-179
Assumption: all other aspects of the economy are unchanged.
The Portfolio Balance Approach
Effects of Macroeconomic Shocks on the Exchange Rate
BFii*E(s)
WCA
supply of home country bondssupply of foreign country bondsdomestic interest ratesforeign interest rateexpected rate of home currencydepreciation
home country wealthhome country current account surplus
S+ hc depreciatesS- hc appreciatesS- hc appreciatesS+ hc depreciatesS+ hc depreciates
S- hc appreciatesS- hc appreciates
Increase inImpact on
home currency
all
preferredlocal
habitat
Model
6-180
W(US wealth) => S => (1/S) => US$ appreciates
and
CA(US current account surplus) => S => (1/S)
The Portfolio Balance Approach: Effects of Macroeconomic Shocks on the Exchange Rate
Preferred local habitat version, US is home country
MS&E247s International Investments Handout #8 Page 31 of 56Thursday July 9, 2009
6-181
The portfolio balance approach highlights the role of wealth and views assets as imperfect substitutes.
The exchange rate and interest rates have to adjust to ensure portfolio equilibrium at which the assets are willingly held by investors.
The Portfolio Balance Approach: Effects of Macroeconomic Shocks on the Exchange Rate
All versions, US is home country
6-182
The Portfolio Balance Approach: Effects of Macroeconomic Shocks on the Exchange Rate
All versions, US is home country
Let’s consider a very simple version of the portfolio balance model:
B/SF = Exp { + [ i - i* - E(S)]}
ln [B/SF] = ln { Exp { + [ i - i* - E(S)] } }
lnB - lnS - lnF = + [ i - i* - E(S)]
S equation: s = - - [ i - i* - E(S)] + b - fwhere b = lnB, f = lnF, s= lnS
What if bond-financed gov’t deficits ?
6-183
(Note that S => (1/S) => US$ depreciates andS => (1/S) => US$ appreciates)
B(Supply of US bonds) => S => (1/S)F(Supply of Foreign bonds) => S => (1/S)i (US interest rate) => S => (1/S)i* (Foreign interest rate) => S => (1/S) E(s) Expected rate of US$ depreciation
=> S => (1/S)Note: B(Supply of US bonds) => S => (1/S)
by assuming i fixed and all the adjustment takesplace in S
The Portfolio Balance Approach: Effects of Macroeconomic Shocks on the Exchange Rate
All versions, US is home country
6-184
Monetary approach assumes perfect substitutability between domestic and foreign currency bonds. That is to say, an investor will be indifferent between holding B and F if Ø = 0, or i - i* = E(s) = expected %S
Ø = i - i* - E(s) defines the exchange risk premium
ttt SSSE ])~
([ 1
(International Fisher Effect)
Monetary Approach v.s. Portfolio Balance Approach
6-185
Portfolio balance approach allows imperfect substitutability between domestic and foreign currency bonds, with Ø = i - i* - E(s) 0.
It makes sense with the differences : liquidity, tax treatment, default risk, political risk, and exchange risk.
Monetary Approach v.s. Portfolio Balance Approach
6-186
MS&E247s International Investments Handout #8 Page 32 of 56Thursday July 9, 2009
6-187
An overall equilibrium in the foreign exchange market would balance both flow and stock dimensions of the market.
Figure 6A.1 has positive numbers emanating from the origin. Take the initial condition as an equilibrium in both the stock market (at point A) and in the flow market (at point a), where each show an exchange rate of $0.50/DM.
The supply curve in Figure 6A.1 represents the supply of German government bonds offered to non-German investors.
The Implications of Flow and Stock Equilibrium onthe Foreign Exchange Rate
6-188
Determination of Exchange Rates:A Simultaneous Stock and Flow Approach
Quantity of DMper unit of time
Quantity of DM at a moment in time
$/DMFlow Stock
$0.50a A
s
dS
D
Figure 6A.1
++0
s
d S
D
6-189
Figure 6A.2 represents a shock to the stock demand schedule - investors seek to increase permanently their holdings of DM-denominated assets.
The stock demand schedule shifts outward to D’D’ and intersects the stock supply schedule at $0.52/DM. DM appreciates immediately to clear the stock market.
The Implications of Flow and Stock Equilibrium onthe Foreign Exchange Rate
6-190
With the weaker dollar, the US runs a current account surplus equal to the amount bc per period. The current account surplus implies that the US is accumulating foreign assets, so over time the stock supply schedule shifts outward, eventually reaching S’S’.
On the flow side, the stronger DM has resulted in an excess flow supply of DM in the amount bc. The flow demand for German goods has fallen with the appreciating DM, while the flow supply for US goods has risen along with the depreciating dollar.
6-191
Stock and Flow Reactions to Permanent Increase in the Stock Demand for German Assets
Quantity of DMper unit of time
Quantity of DM at a moment in time
$/DMFlow Stock
$0.50aA
s
dS
D
Figure 6A.2
$0.52
b cB
C
S’
D’
0 ++
s
d S
D D’
S’
6-192
A stylized version of the time path of the exchange rate following this permanent stock demand shock is shown in Figure 6A.3.
The jump in the exchange rate occurs immediately to clear the stock market.
Since the US cannot run a current account surplus indefinitely - nor Germany a current account deficit indefinitely - the exchange rate changes gradually to bring about a long-run equilibrium in both the stock and flow dimensions.
The Implications of Flow and Stock Equilibrium onthe Foreign Exchange Rate
MS&E247s International Investments Handout #8 Page 33 of 56Thursday July 9, 2009
6-193
Exchange Rate Response to Permanent Increase in the Stock Demand for German Assets
Figure 6A.3
$/DM
$0.52
$0.50
TimeT0 T1
6-194
Next consider a shock to the flow demand schedule.
Suppose that consumers seek to increase permanently their purchase of German goods and services.
This is shown in Figure 6A.4 by an outward shift in the flow demand schedule to d’d’, such that the intersection with the flow supply schedule occurs at $0.52/DM.
The Implications of Flow and Stock Equilibrium onthe Foreign Exchange Rate
6-195
With the increase in demand for German goods, the US runs a current account deficit equal to the amount ba per period.
The current account deficit implies that the US is reducing its stock of foreign assets, so over time the stock supply schedule shifts inward, eventually reaching S’S’.
The appreciation of the DM does not occur immediately because in this stylized model the exchange rate is determined in the stock market, which is unaffected.
With the exchange rate at $0.50/DM, there is excess flow demand for DM in the amount ba.
6-196
Stock and Flow Reactions to Permanent Increase in the Flow Demand for German Goods
Quantity of DMper unit of time
Quantity of DM at a moment in time
$/DMFlow Stock
$0.50a A
s
dS’
D
Figure 6A.4
$0.52
b
c B
S
d’
0 ++
s
dd’ S’
S
D
6-197
Figure 6A.5 contains a stylized version of the time path of the exchange rate following this permanent flow demand shock.
The exchange rate changes gradually to clear the flow market, while the stock market is cleared at all times.
Again the logic is that the current account imbalance cannot persist indefinitely, so that the exchange rate must eventually bring about a long-run equilibrium in both stock and flow dimensions.
The Implications of Flow and Stock Equilibrium onthe Foreign Exchange Rate
6-198
Exchange Rate Response to Permanent Increase in the Flow Demand for German Goods
Figure 6A.5
$/DM
$0.52
$0.50
TimeT0 T1
MS&E247s International Investments Handout #8 Page 34 of 56Thursday July 9, 2009
6-199
Because asset portfolios can be rebalanced quickly and at a low cost, these actions will influence exchange rate behavior (and vice versa) over the short run.
The Implications of Flow and Stock Equilibrium onthe Foreign Exchange Rate
Figure 6A.4 and 6A.5 illustrate one important stylized finding in models of exchange rate determination.
The stock side is of primary importance for the determination of exchange rates in the short run.
6-200
Flow imbalances can be maintained over the short run as long as surplus countries are willing to accumulate assets and deficit countries are willing to run down assets.
The Implications of Flow and Stock Equilibrium onthe Foreign Exchange Rate
Eventually, flow imbalances cannot be left unchecked. The flow side becomes an anchor for the exchange rate in the long run.
6-201
A speculative bubble is measured by the difference between the present spot rate and the fundamental equilibrium rate.
A speculative bubble could develop if traders buy a currency not based on a determination that it undervalued on the basis on fundamentals, but solely on the basis that the currency is expected to appreciate in tomorrow’s market.
Speculative Bubbles
6-202
Fundamentals: The basic economic, financial, and operating factors that influence the success of a business and the price of its securities. Fundamentals of a security include the price-earnings ratio, dividend payout, and earnings-per-share growth.
If other traders also buy based on the expectation of further appreciation, rather than on the basis of fundamentals, a bubble may develop between the actual spot rate and its fundamental value.
Speculative Bubbles
6-203
note that there is no bubble on oil, the strong support of "demand" pushes up the price; the demand comprises real and speculators' demand
Source: WSJ 0516 2008 Bernanke's Bubble Laboratory; Princeton Proteges of Fed Chief Study the Economics of Manias 6-204
The Market for Loanable Funds
Saving =Domestic
investmentNet foreigninvestment+
S = I + NFI
Net foreign investment is the purchase of foreign assets by domestic residents minus the purchase of domestic assets by foreigners.
MS&E247s International Investments Handout #8 Page 35 of 56Thursday July 9, 2009
6-205
Equilibriumquantity
Quantity ofLoanable Funds
RealInterest
Rate
Equilibriumreal interest
rate
Supply of loanable funds(from national saving)
Demand for loanable funds (for domestic investment
and net foreign investment)
A MACROECONOMIC THEORY OF THE OPEN ECONOMY
The Market for Loanable Funds
6-206
The Market for Loanable Funds
The interest rate in an open economy, as in a closed economy, is determined by the supply and demand for loanable funds.
National saving is the source of the supply of loanable funds. Domestic investment and net foreign investment are the sources of the demand for loanable funds.
At the equilibrium interest rate, the amount that people want to save exactly balances the amount that people want to borrow for the purpose of buying domestic capital and foreign assets.
6-207
The Market for Foreign Currency Exchange
Net foreign investment = Net exports
NFI = NX
Suppose that Boeing sells some planes to a Japanese airline for yens. This sale increases U.S. net exports and U.S. net foreign investment by the same amount. Boeing then exchanges its yen for dollars with a U.S. mutual fund that wants the yen to buy stock in Sony (Japan). NX and NFI rise by an equal amount again!
6-208
Equilibriumquantity
Quantity of Dollars Exchangedinto Foreign Currency
RealExchange
Rate
Equilibrium real
exchange rate
Supply of dollars(from net foreign investment)
Demand for dollars(for net export toforeign countries)
A MACROECONOMIC THEORY OF THE OPEN ECONOMY
The Market for Foreign Currency Exchange
Quantity of US Cadilacsexchanges for German Mercedes Benz
6-209
The Market for Foreign Currency Exchange
The real exchange rate is determined by the supply and demand for foreign-currency exchange.
The supply of dollars comes from net foreign investment (NFI). Because NFI does not depend on the real exchange rate, the supply curve is vertical. The demand for dollars comes from net exports. Because a lower real exchange rate stimulates net exports (and thus increases the quantity of dollars demanded to pay for these net exports), the demand curve is downward sloping.
At the equilibrium real exchange rate, the number of dollars people supply to buy foreign assets exactly balances the number of dollars people demand to buy net exports.
6-210
Net Foreign Investment :The Link Between the Two Markets
S = I + NFI
NFI = NX
MS&E247s International Investments Handout #8 Page 36 of 56Thursday July 9, 2009
6-211
0 Net ForeignInvestment
Net foreign investmentis negative.
Net foreign investmentis positive.
RealInterest
Rate
A MACROECONOMIC THEORY OF THE OPEN ECONOMY
How Net Foreign Investment Depends on the Interest Rate
6-212
How Net Foreign InvestmentDepends on the Interest Rate
Because a higher domestic real interest rate makes domestic assets more attractive, it reduces net foreign investment.
Note the position of zero on the horizontal axis: Net foreign investment can be either positive or negative.
6-213
Equilibrium in the Open Economy
Prices in the loanable funds market and the foreign-currency exchange market adjust simultaneously to balance supply and demand in these two markets.
As they do, they determine the macroeconomic variables of national saving, domestic investment, net foreign investment, and net exports.
6-214
(a) The Market for Loanable Funds (b) Net Foreign Investment
(c) The Market for Foreign-Currency Exchange
Quantity ofLoanable Funds
Demand
Supply
Quantity of Dollars
Demand
Supply
Net ForeignInvestment
Net foreign investment, NFI
Real Exchange
Rate
Real Interest
Rate
Real Interest
Rate
r1
E1
r1
The Real Equilibrium in an Open Economy
US$ is in the denominator,As in Econ Literature
6-215
How Changes in Policies and Events Affect an Open Economy
The magnitude and variation in important macroeconomic variables depend on the following:Government budget deficits
Trade policies
Political and economic stability
6-216
Government Budget Deficits
In an open economy, government budget deficits . . .
reduces the supply of loanable funds,
drives up the interest rate,
crowds out domestic investment,
cause net foreign investment to fall.
MS&E247s International Investments Handout #8 Page 37 of 56Thursday July 9, 2009
6-217
r2 r2
E2
1. A budget deficit reduces the supply of loanable funds...
S2
B
(a) The Market for Loanable Funds (b) Net Foreign Investment
(c) The Market for Foreign-Currency Exchange
Quantity ofLoanable Funds
Demand
S1
Quantity of Dollars
Demand
S1S2
Net ForeignInvestment
NFI
5. …which causes the real exchange rate to appreciate.
Real Exchange
Rate
Real Interest
Rate
Real Interest
Rate
3. ...which in turn reduces net foreign investment.
4. The decrease in net foreign investment reduces the supply of dollars to be exchanged into foreign currency…
r1
A
E1
r1
The Effects of Government Budget Deficit
2. ...which increases the real interest...
US$ is in the denominator,As in Econ Literature 6-218
Effect of Budget Deficits on the Loanable Funds Market
A government budget deficit reduces national saving, which . . .
. . . shifts the supply curve for loanable funds to the left, which
. . . raises interest rates.
6-219
Effect of Budget Deficits on Net Foreign Investment
Higher interest rates reduce net foreign investment.
6-220
Effect on the Foreign-Currency Exchange Market
A decrease in net foreign investment reduces the supply of dollars to be exchanged into foreign currency.
This causes the real exchange rate to appreciate.
6-221
Trade Policy
A trade policy is a government policy that directly influences the quantity of goods and services that a country imports or exports.
Tariff: A tax on an imported good.
Import quota: A limit on the quantity of a good produced abroad and sold domestically.
6-222
Trade Policy
Because they do not change national saving or domestic investment, trade policies do not affect the trade balance.
For a given level of national saving and domestic investment, the real exchange rate adjusts to keep the trade balance the same.
Trade policies have a greater effect on microeconomic than on macroeconomic markets.
MS&E247s International Investments Handout #8 Page 38 of 56Thursday July 9, 2009
6-223
Effect of an Import Quota
Because foreigners need dollars to buy U.S. net exports, there is an increased demand for dollars in the market for foreign-currency.
This leads to an appreciation of the real exchange rate.
6-224
Effect of an Import Quota
There is no change in the interest rate because nothing happens in the loanable funds market.
There will be no change in net exports.
There is no change in net foreign investment even though an import quota reduces imports.
6-225
Effect of an Import Quota
An appreciation of the dollar in the foreign exchange market encourages imports and discourages exports.
This offsets the initial increase in net exports due to import quota.
6-226
1. An import quota increases the demand for dollars…
(a) The Market for Loanable Funds (b) Net Foreign Investment
(c) The Market for Foreign-Currency Exchange
Quantity ofLoanable Funds
Demand
S1
Quantity of Dollars
Demand
Supply
Net ForeignInvestment
NFI
Real Exchange
Rate
Real Interest
Rate
Real Interest
Rate
r1
E1
r1
The Effects of an Import Quota
E2 2. …and causes the real exchange rate to appreciate.
3. Net exports, however, remain the same.
US$ is in the denominator,As in Econ Literature
6-227
Effect of an Import Quota
Trade policies do not affect the trade balance.
6-228
Political Instability and Capital Flight
Capital flight is a large and sudden movement of funds out of a country, usually due to political instability.
MS&E247s International Investments Handout #8 Page 39 of 56Thursday July 9, 2009
6-229
Political Instability and Capital Flight
Capital flight has its largest impact on the country from which the capital is fleeing, but it also affects other countries.
If investors become concerned about the safety of their investments, capital can quickly leave an economy.
Interest rates increase and the domestic currency depreciates.
6-230
Political Instability in Mexico & Capital Flight
When investors around the world observed political problems in Mexico in 1994, they sold some of their Mexican assets and used the proceeds to buy assets of other countries.
This increased Mexican net foreign investment.
The demand for loanable funds in the loanable funds market increased, which increased the interest rate.
This increased the supply of pesos in the foreign-currency exchange market.
6-231
NFI1
1. An increase in net foreign investment...
2. …increases the demand for loanable funds...
D2
(a) The Market for Loanable Funds (b) Mexican Net Foreign Investment
(c) The Market for Foreign-Currency Exchange
Quantity ofLoanable Funds
D1
S1
Quantity of Pesos
Demand
S1
Net ForeignInvestment
NFI1
Real Exchange
Rate
Real Interest
Rate
Real Interest
Rate
E1
r1 r1
S2
r2 r2
E2
The Effects of Capital Flight
5. …which causes the real exchange rate to appreciate.
4. At the same time, the increase in net foreign investment increases the supply of pesos...
3. …which increases the interest rate.
Peso is in the denominator,As in Econ Literature 6-232
An Example of Interest Rate Parity
Suppose an investor with $1,000,000 to invest for 90 days is trying to decide between investing in U.S. dollars at 8% per annum (2% for 90 days) or in DM at 6% per annum (1.5% for 90 days).
The current spot rate is DM 1.5311/$ and the 90-day forward rate is DM 1.5236/$.
As shown in the next slide, regardless of the investor’s currency choice, his hedged return will be identical.
Multinational Financial Management
6-233
An Example of Interest Rate Parity
Multinational Financial Management Ex 5.7
Alternative investment:Invest $1,000,000 in
New York for 90 days at 2%and receive $1,020,000 in 90 days
New York
Start$1,000,000
Finish$1,020,000
Convert $1,000,000to DM at DM 1.5311/$ for DM 1,531,100
1.
DM 1,531,100Frankfurt: today
DM 1,554,066.50Frankfurt: 90 days
Invest DM 1,531,100 at 1.5%for 90 days, yielding DM 1,554,066.50 in 90 days
2.
Simultaneously with the DMinvestment, sell the DM1,554,066.50 forward at arate of DM 1.5236/$ for delivery in 90 days, &receive $1,020,000in 90 days
3.
6-234
An Example of Covered Interest Arbitrage
Suppose the interest rate on pounds sterling is 12% in London, and the interest rate on a comparable dollar investment in New York is 7%. The pound spot rate is $1.75 and the one-year forward rate is $1.68. These rates imply a forward discount on sterling of 4% [(1.68 - 1.75) / 1.75] and a covered yield on sterling approximately equal to 8% (12% - 4%). Because there is a covered interest differential in favor of London, funds will flow from New York to London.
To illustrate the profits associated with covered interest arbitrage, we will assume that the borrowing and lending rates are identical and the bid-ask spread in the spot and forward markets is zero.
Multinational Financial Management
MS&E247s International Investments Handout #8 Page 40 of 56Thursday July 9, 2009
6-235
An Example of Covered Interest Arbitrage
Multinational Financial Management Ex 5.8
New York
todayone year
Borrow $1 million at an interestrate of 7%, owing $1,070,000at year end
1.
London : todayLondon: one year
Start:
Convert the $1 million to pounds at $1.75/£ for£571,428.57
2.
Invest the £571,428.57in London at 12%,generating £640,000by year end
3.
Simultaneously, sell the £640,000 in principal plus interest forward at a rate of $1.68/£ for delivery in year, yielding $1,075,200 at year end
4.
Net profit equals$5,200
7.Finish:
Repay the loan plus interest of $1,070,000 out of the $1,075,200
6.
Collect the £640,000 and deliver it to the bank’s foreign exchange department in return for $1,075,200
5.
6-236
A Formula for the Government Purchases Multiplier
• The formula for the multiplier is:
Multiplier = 1/(1 - MPC)• An important number in this formula is the
marginal propensity to consume (MPC).¤ This is the fraction of extra income that a household
consumes rather than saves.
¤ With an MPC of 3/4, when the workers and owners of McDonnell Douglas earn $20 billion from a government contract, they increase their consumer spending by 3/4 x $20 billion, or $15 billion, which in turn raises the income for the workers and owners of the firms that produce the consumption goods.
6-237
A Formula for the Government Purchases Multiplier
Change in government purchasesFirst change in consumptionSecond change in consumptionThird change in consumption
= $20 billion= MPC x $20 billion= MPC2 x $20 billion= MPC3 x $20 billion
Total change in demand =(1 + MPC + MPC2 + MPC3 + …) x $20 billion
The government-purchases multiplier, 1 + MPC + MPC2 + MPC3 + …, tells us the demand for goods and services that each dollar of government purchases generates.
6-238
A Formula for the Government Purchases Multiplier
For , 11 x
The infinite geometric series xxxx 111 32
Thus,
Multiplier = 1 / (1 - MPC)
For example, if MPC is 3/4, then the government-purchases multiplier is 1/(1 - 3/4) = 4.In this case, the $20 billion of government spending generates $80 billion of demand for goods and services.
6-239
The Structure of the IS-LM Model
The term IS is a shorthand representation of the relationship investment (Investment, I ) equals saving (Saving, S ) - the goods market equilibrium.
The term LM is a shorthand representation of the relationship money demand (Liquidity, L) equals money supply (Money, M ) - the money market equilibrium.
The IS-LM model emphasizes the interaction between the goods and assets markets. Spending, interest rates, and income are determined jointly by equilibrium in the goods and assets markets.
Dornbusch: Figure 10.3 6-240
The Structure of the IS-LM Model
DemandSupply
Money market Bond market
DemandSupply
Assets market Goods market
Aggregate demandOutput
Income
Interest ratesMonetary policy Fiscal policy
http://www.mhhe.com/economics/dornbusch8e/
MS&E247s International Investments Handout #8 Page 41 of 56Thursday July 9, 2009
6-241
FIGURE 10-11 in Dornbusch
GOODS AND MONEY MARKET EQUILIBRIUM
http://www.mhhe.com/economics/dornbusch8e/ 6-242
Money Supply, Money Demand, and Monetary Equilibrium
In the long run, the overall level of prices adjusts to the level at which the demand for money equals the supply.
6-243
Quantity fixedby the Fed
Quantity ofMoney
Value ofMoney (1/P) Price
Level (P)
A
Money supply
0
1
(Low)
(High)
(High)
(Low)
1/2
1/4
3/4
1
1.33
2
4Moneydemand
Money Supply, Money Demand, and the Equilibrium Price Level
Eq
uili
bri
um
va
lue
of
mo
ne
y
Eq
uilib
rium
p
rice level
6-244
Quantity ofMoney
Value ofMoney (1/P) Price
Level (P)
A
MS1
0
1
(Low)
(High)
(High)
(Low)
1/2
1/4
3/4
1
1.33
2
4Moneydemand
The Effects of Monetary Injection
M1
MS2
1. An increase in the money supply...
2. ..
.dec
reas
es t
he
valu
e o
f m
on
ey
... 3. …an
d in
c rea ses th
e pric e le ve l
M2
B
6-245
PPP does not mean that commodity price changes are the underlying fundamental cause of exchange rate changes.
PPP is an “equilibrium” condition, not a model of cause and effect.
Examples:
» Under pegged rates, a country experiences inflation, loss of international competitiveness, then devalues home currency
Inflation comes before devaluation
» Or country devalues, imports more expensive, workers feel poorer, wage demands, home country inflation accelerates
Devaluation comes before inflation
From PPP to the Monetary Approach (1 of 3)
6-246
What determines the price level in an economy?
» Relationship between Money Supply (MS ) and Money Demand (MD )
» MD = f (velocity(-), price level(+), real income(+))
= k x P x Y
» In equilibrium, MS = MD = k P Y
» P = MS / k Y
Assume the above relationship exist in the US & UK
» P($) = M($)S / k($) Y($)
» P(£) = M(£)S / k(£) Y(£)
Returning to PPP, we had Spot ($/£) = P($) / P(£)
By substitution
» Spot ($/£) = (M($)S / M(£)S) (k(£) / k($)) (Y(£) / Y($))
From PPP to the Monetary Approach (2 of 3)
MS&E247s International Investments Handout #8 Page 42 of 56Thursday July 9, 2009
6-247
Repeating:
Spot($/£) =
Interpretation:
» Spot rate (in $/£) positively related to:
Increases in M($) and Y(£)
» Spot rate (in $/£) negatively related to:
Increases in M(£) and Y($)
MS, Y, k and their determinants are more fundamental causes (drivers) of spot exchange rate.
Changes in MS, Y, and k [at home or other country] will impact the exchange rate in the long run (& perhaps short-run).
From PPP to the Monetary Approach (3 of 3)
M($) x k(£) x Y(£)M(£) x k($) x Y($)
6-248
Spot rates display large changes over last 25 years» Some currencies appreciated vs. US$, others
depreciated» Changes in nominal rates, real rates, real effective rates
What factors lie behind exchange rate changes?» Inflation differences are a “proximate” factor (not a
cause)» PPP works well in the long run for many exchange rates» Money, income, and velocity are more fundamental
factors Critical to understand difference between nominal and real
exchange rate changes» Possible to have nominal exchange rate change without
real exchange rate change (or vice versa)» Only real exchange rate change in competitiveness
Summary: Exchange Rates in the Long Run
6-249
Most tantalising of all, there is the huge mountain ofJapanese personal savings, estimated at ¥1300 trillion ($12 trillion), much of it stacked up in the postal savings system, and ¥106 trillion of which is expected to mature over the next two years. As these deposits made at relatively high interest rates a decade ago mature, the post office will be able to offer only nugatory yields on reinvested or new deposits. Some of this money is expected to find its way into the stockmarket, so the financial industry is scrambling for a chunk of the assets.
The Economist: Survey Online Finance May 20, 20006-250
Assignment for Chapter 6
Exercises 3, 7, 10, 14.
http://www.mhhe.com/business/finance/levich2e/
-or-
http://pages.stern.nyu.edu/~rlevich/links.html
http://pages.stern.nyu.edu/~rlevich/datafile.html
6-251
Chapter 6. Stock Models of Foreign ExchangePricing
Hint:
You keep an asset in your portfolio as long as the return is commensurate with the return on other financial assets.
6-252
Chapter 6. Monetary Approach v.s. the PortfolioBalance Approach
Hint:
Both models assume forward looking, rational behavior in which the exchange rate reflects the present value of all future exogenous variables.
MS&E247s International Investments Handout #8 Page 43 of 56Thursday July 9, 2009
6-253
Chapter 6. Speculative Bubble in the ForeignExchange Market
Hint:A speculative bubble is measured by the difference between the present spot rate and the fundamental equilibrium rate.
A speculative bubble could develop if traders buy a currency not based on a determination that it is undervalued on the basis on fundamentals, but solely on the basis that the currency is expected to appreciate in tomorrow’s market.
If other traders also think and behave so...
WSJ.com
The Greenspan Era Print this.IN 18 YEARS AT THE HELM of the Federal Reserve, Alan Greenspan faced nearly every challenge possible for an economic policy maker. Review Mr. Greenspan's long stewardship of the U.S. central bank. — Compiled by Tim Annett
1987 – 1991
MERE MONTHS after being tapped by President Reagan to succeed Paul Volcker as Federal Reserve chairman, Alan Greenspan would face his first big test: preventing the October 1987 stock-market crash from becoming a full-blown economic slump. Under his leadership the Fed responded to the market's dive by driving down interest rates and averting a credit crunch. The Fed tamped down another potential crackup by helping to stanch a sharp decline in the dollar. Those rescue missions helped solidify Mr. Greenspan's standing with Wall Street early on.
By the spring of 1988, the Fed had begun to raise rates in a bid to keep core inflation under wraps, but prices kept rising and growth sputtered in 1989. Then, the August 1990 start of the Gulf War complicated the balancing act by driving up energy prices, leading households and businesses to forestall spending. As a result, the economy dipped into a recession that lasted through the first quarter of 1991. But the Fed's hawkish policy stance helped push down inflation, and the central bank was able to slash interest rates rapidly in the second half of 1991, from 6% down to 4% at year's end.
Boom and Bust Economic growth was strong despite the stock-market crash, but higher energy prices
tipped the economy into recession.
http://online.wsj.com/documents/info-fedchair05.html?printVersion=true (1 of 13)10/24/2005 3:13:43 PM
WSJ.com
http://online.wsj.com/documents/info-fedchair05.html?printVersion=true (2 of 13)10/24/2005 3:13:43 PM
Sources: U.S. Bureau of Economic Analysis, Bureau of Labor Statistics
Inflation Creeps Prices crept higher in the late 1980s, and war-churned oil prices led the consumer-price
index to a crescendo in 1990.
Source: Bureau of Labor Statistics
Hawkish Tone The Fed kept interest-rates high to tamp down inflation, but eased off as high oil prices
faded.
Sources: Federal Reserve Board, Economy.com
Crisis & Recovery The market crashed and slowly recovered until war and recession swamped equities
again in mid-1990.
Source: WSJ Markets Data
1992 – 1996
THE FED CONTINUED to cut rates through October of 1992, bringing the fed-funds rate to 3%, where it would remain for 16 months. Inflation continued to recede, falling to
WSJ.com
http://online.wsj.com/documents/info-fedchair05.html?printVersion=true (3 of 13)10/24/2005 3:13:43 PM
WSJ.com
around 3% in 1992. Accommodative monetary policy helped ease concerns about high unemployment.
The economic recovery continued throughout 1993, and by February 1994 the Fed had once again become concerned about higher prices and moved to preempt inflation by raising interest rates. The Fed would tighten the funds rate from 3% to 6%, and inflation idled while economic growth picked up and the unemployment rate fell.
The beginning of the Fed's preemptive tightening cycle marked another change: the Fed's increased effort to be more transparent. At the February 1994 meeting, the Fed began to announce its the funds-rate target after each meeting, along with its assessment of economic conditions and its policy bias moving forward. The change meant that the once-mysterious proceedings at the central bank were now better understood by markets and the public.
Steady March Economic growth was strong through most of the early 90s, though the jobless rate was
slow to fall.
Sources: U.S. Bureau of Economic Analysis, Bureau of Labor Statistics
Under Control Inflation pressures remained largely under control as the Fed moved to cut off any
threat from rising prices.
http://online.wsj.com/documents/info-fedchair05.html?printVersion=true (4 of 13)10/24/2005 3:13:43 PM
Source: Bureau of Labor Statistics
Preemptive Moves The Fed moved rates higher as it sought to head inflation off before it could slow
economic growth.
Sources: Federal Reserve Board, Economy.com
Climbing Higher With the Fed on inflation watch and productivity growing, stocks began a long voyage
higher.
WSJ.com
http://online.wsj.com/documents/info-fedchair05.html?printVersion=true (5 of 13)10/24/2005 3:13:43 PM
Source: WSJ Markets Data
1997 – 2000
WITH INFLATION seemingly under lock and key, the stage was set for the long technology-led boom. Economists had hoped technological improvements would help productivity recover from a long decline that started in the 1970s. They would get their wish, as between 1996 and 2000 productivity grew by 2.4% a year on average. Wages also rose, stimulating demand, and company's earnings and share prices grew. The "productivity miracle" reinforced the view of some that inflation was permanently under control. But the boom had a dark side, and Mr. Greenspan gave it a name: "irrational exuberance." The Fed faced a choice: keep monetary policy accommodative and risk feeding an asset bubble, or tighten rates and risk causing a slowdown. The Fed thus did relatively little tinkering with rates from 1996 through 1999, with the exception of three consecutive quarter-point cuts in the fall of 1998 after Russia defaulted on its debt. The Fed unwound those reductions with three quarter-point increases in June, August and November of 1999, and raised the funds rate by another full point to 6.5% by May 2000. The Fed held steady there even as growth dipped in late 2000.
Dot-Com Driven The economy continued its robust expansion and the jobless rate dwindled, but signs of
weakness would emerge.
WSJ.com
http://online.wsj.com/documents/info-fedchair05.html?printVersion=true (6 of 13)10/24/2005 3:13:43 PM
WSJ.com
http://online.wsj.com/documents/info-fedchair05.html?printVersion=true (7 of 13)10/24/2005 3:13:43 PM
Sources: U.S. Bureau of Economic Analysis, Bureau of Labor Statistics
Price Stability Inflation remained at bay, but pressure grew slightly more intense as tech stocks
peaked.
Source: Bureau of Labor Statistics
Steady Hand The Fed made little movement in interest rates, risking fanning an asset bubble.
Sources: Federal Reserve Board, Economy.com
Peak and Plunge Stocks continued their long rally, led by the boom in technology shares. But in 2000,
tech stocks fell back sharply.
Source: WSJ Markets Data
2001 – 2005
THE ECONOMIC EXPANSION continued to falter in 2001 as it became clear that many businesses had overzealously increased capacity during the boom, and recession set
WSJ.com
http://online.wsj.com/documents/info-fedchair05.html?printVersion=true (8 of 13)10/24/2005 3:13:43 PM
WSJ.com
in. Consumers became more cautious, curbing spending, and many firms put investment plans on hold. Then, the Sept. 11, 2001, attacks further cast a pall over the economy, wrecking consumer confidence and leading to the loss of 800,000 jobs in October and November. The Fed, already in the midst of a string of rate cuts, took rates down as far as 1.75% by December.
Policy makers would eventually bring the funds rate down to 1%, a 46-year low. Growth recovered in 2002 and 2003, but critics charged the rate reductions had simply replaced one asset bubble in equity markets with another asset bubble in housing. The Fed began to raise rates in 2004, but long-term borrowing costs, including mortgage rates, failed to follow suit as bond yields remained low -- a phenomenon Mr. Greenspan called a "conundrum." The failure of long rates to respond to the Fed's tightening led some economists to worry the spread between short and long interest rates would invert -- typically a signal of recession.
Terror's Toll The economy dipped into recession and the Sept. 11 attacks damped sentiment. But by
2003, the recovery gained steam.
Sources: U.S. Bureau of Economic Analysis, Bureau of Labor Statistics
Deflation vs. Oil Policy makers began the period worried about falling prices, but rising oil costs would
change that bias.
http://online.wsj.com/documents/info-fedchair05.html?printVersion=true (9 of 13)10/24/2005 3:13:43 PM
Source: Bureau of Labor Statistics
Accomodation The Fed aggressively slashed rates amid slowing growth and 9/11. In June 2004, a long
tightening campaign began.
Sources: Federal Reserve Board, Economy.com
All Over the Map The markets took a wild ride, but began to bounce back as major combat in Iraq wound
down.
WSJ.com
http://online.wsj.com/documents/info-fedchair05.html?printVersion=true (10 of 13)10/24/2005 3:13:43 PM
Source: WSJ Markets Data
Conclusion
AS MR. GREENSPAN turns over the reins to the next chairman, there is little sign that the central bank will alter its present policy course. Forecasters and financial markets expect that the Fed will continue to raise rates, with economists surveyed this month by the Wall Street Journal Online predicting that the federal-funds rate will be equal to 4.25% at the end of this year and 4.5% by June 2006. Though many observers had expected the Fed to tap on the brakes following Hurricane Katrina, policy makers have made clear that they are more worried about inflation than they are about any short-term decrease in economic growth.
To be sure, the new chairman will face many of the same challenges that Mr. Greenspan did in assuring markets that he is committed to the Fed's mandate, and that he will remain impervious to outside pressure if the nation's economic headaches require what may be politically unpopular prescriptions. That adjustment period could come at some cost to the markets -- transitions at the Fed have typically been met with some unease. But many of the innovations that Mr. Greenspan has brought to the Fed, including its greater public transparency, will aid his successor.
Long-Run Strength The Greenspan Era saw two brief recessions and one of the longest periods of
expansion in U.S. History.
WSJ.com
http://online.wsj.com/documents/info-fedchair05.html?printVersion=true (11 of 13)10/24/2005 3:13:43 PM
WSJ.com
http://online.wsj.com/documents/info-fedchair05.html?printVersion=true (12 of 13)10/24/2005 3:13:43 PM
Sources: U.S. Bureau of Economic Analysis, Bureau of Labor Statistics
Stable Prices Greenspan's Fed kept a vigilant focus on controlling inflation throughout his term.
Source: Bureau of Labor Statistics
Heading Off Danger Since the mid-1990s, the Fed has moved in an aggressive, pre-emptive fashion to
maintain growth and price stability.
Sources: Federal Reserve Board, Economy.com
Trending Higher Stocks were roiled at times by war, terrorism and recession, but over the long term
moved upward.
Source: WSJ Markets Data
WSJ.com
http://online.wsj.com/documents/info-fedchair05.html?printVersion=true (13 of 13)10/24/2005 3:13:43 PM