Exchange Rates Theories
Asset Approach
Goods flows and Capital flows
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When there is not much international
capital flows,
TB>0  Currency appreciation
TB<0  Currency depreciation
These exchange rate movements
eliminate trade imbalances.
The ex rate adjusts to equilibrate
transaction of goods and services
Goods flows and Capital flows
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International capital transaction has
recently become much larger than
international transaction of goods
services.
Asset approach
1. Financial assets prices adjust more
quickly than goods prices.
 2. Exchange rates are much more variable
than goods prices.
 Ex rates are responding to conditions in
financial-asset markets.
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Perfect Capital Mobility
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No transaction costs and no capital
controls so that capital flows freely
between nations.
Under this assumption, Covered Interest
Parity (CIP) holds, or
i - i* = (F - E)/E.
Changes in interest rates  Changes in
ex rates.
Asset approach
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1. Monetary approach (MAER)
2. Portfolio Balance approach (PB)
1. assumes that domestic and foreign
bonds are perfect substitutes.
2. assumes imperfect substitutability.
MAER and PB
which implies, respectively
 1. No risk premium  Uncovered Interest
Parity (UIP) holds.
 2. Risk premium  UIP does not hold.
PB approach
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According to PB approach, relative
supplies of domestic and foreign bonds, in
addition to domestic and foreign money,
determine the ex rate.
Remember, MAER equation is
-E^ = P*^ + L^ - w•DC^
PB approach (cont’d)
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Let B = supply of domestic bonds
B* = supply of foreign bonds
B*^ - B^ < 0  risk premium on B 
 E^ > 0 or E (depreciation)
E today & Ee unchanged
 expected rate of depreciation 
(expected rate of appreciation )
PB approach (cont’d)
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B*^  E^ appreciate at a faster rate
B^  E^ depreciate at a faster rate
The PB approach is summarized by
-E^ = P*^ + L^ - w•DC^ + B*^ - B^
Sterilization
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According to MABP,
Excess money supply  IR  BOP < 0
Excess money demand  IR  BOP > 0
Is there any way to neutralize IR flows
induced by monetary policy?
 Sterilization
Sterilization (cont’d)
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With sterilization, the monetary authorities can
determine the money supply in the SR without
having reserve flows offset their goal.
If there are barriers to int’l capital mobility, int’l
asset return differential would persist.
 The central bank can change the money
supply growth in the SR without inflicting reserve
flows.
Sterilization (cont’d)
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Is it possible without barriers?
By, for example, decreasing DC by an
amount equal to an increase in IR.
The MABP equation with E^ = 0 is given
by
IR^ = [1/(1-w)]•(P*^ + L^) - [w/(1-w)]•DC^
(+)
(-)
Sterilization in a floating
exchange rate system
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Let E = E¥/$. Suppose E or the yen is
appreciating against the dollar.
The BoJ intervenes in the FX market to stop the
yen appreciation.
buy the dollar-denominated bonds  DC 
MS
 demand for $  E
sell the yen-denominated bonds  DC  MS
Sterilized intervention
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A FX market intervention that leaves the
domestic money supply unchanged.
In essence,
sterilized intervention is an exchange of
domestic bonds for foreign bonds.
How does it have an effect on the
spot exchange rate?
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Under the PB approach,
Sterilized intervention
 (supply of dollar assets relative to yen
assets) 
 the yen depreciates.
Sterilized intervention
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-E^ = P*^ + L^ - w•DC^ + B*^ - B^
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(1): FX market intervention
(2): open market sale
(1) + (2): sterilized intervention
(1)
(2)
Exchange Rates and the Trade
Balance
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When KA is not either increasing or
decreasing,
Trade deficits  Holdings of foreign
money relative to domestic money
 E (depreciation)
Trade surplus  Holdings of foreign
money relative to domestic money
 E (appreciation)
Ex rate and the Trade Balance
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Expected future trade deficits  expected future
holdings of foreign currency  Ee
Future oil price increase  people anticipate a
decrease in holdings of foreign currency  Ee
 F  expected rate of depreciation
 people try to shift from domestic to foreign
money immediately  E (an immediate
depreciation of domestic currency)
Ex rate and TB
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Changes in expectations about future
trade flows  a change in the current spot
rate.
Currency Substitution
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An advantage of flexible exchange rates =
independence of monetary policy
Fixed exchange rates  country A must
follow a monetary policy similar to country
B and vice versa.
What if currencies are substitutable?
Currency Substitution
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Perfectly substitutable currencies:
people are indifferent between the use of one
currency or another  all currencies would have
to have the same inflation rates (why?)
People believe that the relative value of
currency A to currency B will not change  They
are indifferent between holding A or B
 no change in exchange rate
Currency Substitution (cont’d)
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However, suppose inflation rate is higher
for country A.
Then, the cost of holding currency A rises
relative to the cost of holding B
 demand shifts from A to B
 currency A depreciates against B even
more than justified by the inflation
differential.
Currency Substitution (cont’d)
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This creates volatile exchange rates.
A high degree of currency substitution
 more volatile ex rates
 a need for int’l coordination of monetary
policy
 currency unions
Currency Substitution (cont’d)
Examples of a high degree of currency
substitution:
 Among European currencies before the
euro.
 Between the US dollar and the local
currencies in many Latin American
countries.
The Role of News
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News = unpredictable shocks or surprises faced
by int’l economy
Difficulty in predicting future spot rates  ex
rates are affected by news.
News have an immediate impact on ex rates,
while prices of goods and services are slow to
be affected  Large deviations from PPP during
periods dominated by news.