Exchange Rate
Determination
4
Chapter Objective:
•Reviews PPP and understands
•Examines MABP and exchange rate
determination.
•Understands portfolio balance approach
•Knows exchange rate dynamics and
overshooting
Exchange Rate
Determination
PPP
IRP
Monetary Ms , M
d
approach
portfolio balance
approach
asset
Elasticity
Sticky
Different
Exchange rate
system
Exchange
rate and
BP
Chapter Three
Outline





1.Purchasing Power Parity
2.Monetary Approach to the Balance of payments
and Exchange Rate Determination
3. Exchange Rate Dynamics
4. Asset Market model and Exchange
Rates.Portfolio-Balance Approach
5.Empirical tests and Exchange Rates Forecasting
1. Purchasing

Power Parity
(1)A law of one price
 (2)Absolute and relative PPP
 (3) PPP Deviations and Evidence on it
 (4) Empirical tests of Purchasing Power
Parity
(1) a

law of one price
1)In one country
 P=P’+c
 P=P’+c(cost)+L(law)+A(arrest)
 Non traded goods: Real estate haircuts
 2)In an open economy
 P=RP’+c
(2) Absolute

and relative PPP
The exchange rate between two currencies should equal the
ratio of the countries’ price levels.
R  P / P*

Relative PPP states that the rate of change in an exchange
rate is equal to the differences in the rates of inflation.
R1 
P1 / P 0  R 0
P / P 
*
1

*
0
If U.S. inflation is 5% and U.K. inflation is 8%, the pound
should depreciate by 3%.
(4)Evidence on PPP
PPP probably doesn’t hold precisely in the real
world for a variety of reasons.
– Haircuts cost 10 times as much in the
developed world as in the developing world.
– Film, on the other hand, is a highly
standardized commodity that is actively traded
across borders.
– Shipping costs, as well as tariffs and quotas can
lead to deviations from PPP.
 PPP-determined exchange rates still provide a
valuable benchmark.

Total GDP 2006
 PPP GDP 2006
(millions of
 (millions of dollars)
Ranking Economy US dollars)
 1 United States 13,201,819
1 United States 13,201,819
 2 China 10,048,026 a
2 Japan 4,340,133
 3 India 4,247,361 b
3 Germany 2,906,681
 4 Japan 4,131,195
4 China 2,668,071
 5 Germany 2,616,044
5 United Kingdom 2,345,015
 6 United Kingdom 2,111,581
6 France 2,230,721 a
 7 France 2,039,171
7 Italy 1,844,749
 8 Italy 1,795,437
8 Canada 1,251,463
 9 Brazil 1,708,434
9 Spain 1,223,988
 10 Russian Federation 1,704,756 10 Brazil 1,067,962
 11 Spain 1,243,440
11 Russian Federation 986,940
 12 Mexico 1,201,838
12 India 906,268
 13 Korea, Rep. 1,152,356
13 Korea, Rep. 888,024
(4) Empirical tests of
Purchasing Power Parity

See p.508
three points
2.Monetary Approach to the Balance
of Payments and Exchange Rate
Determination

(1)Monetary Approach to the balance of
payments under Fixed Exchange Rates
 (2) Monetary Approach to Exchange Rate
Determination (flexible price)
2.Monetary Approach to the Balance
of Payments and Exchange Rate
Determination
• In the 1970s, the monetary approach to the
balance of payments came to popularity,
that emphasizes the monetary aspects of the
balance of payments.
 Money plays the crucial role in the long run
both as a disturbance and as an adjustment
in the nation’s BP.
2.Monetary Approach to the Balance
of Payments and Exchange Rate
Determination

MABP emphasizes the determinants of
money demand and supply that will
determine the balance of payments.
 Those items that directly affect the money
supply are below the line which MABP
concentrate on.
(1)MABP
Fixed
 Money flowing
between countries
to adjust the
disequilibrium.
 Adjustment to
changes through
international
money flows
Flexible
•At a point where the
flow of exports just
equals the flow of
imports, no net
international money
flows required.
•Adjustment through
exchange rates.
(1)MABP

1)basic concepts and assumptions
 Central bank controls the money supply by
altering base money
 Base money changes, the lending ability of
commercial banks changes.
 Divide base money into domestic and
international components.
(1)MABP

2)framework for the analysis under MABP
 Minimum money model
 Md=kPY
 A stable demand for money
 Ms =m(D+F)
 Md =Ms
(1)MABP

Md=kPY
 P=RP* here P* the foreign price level
R the domestic currency price of foreign
currency
 k RP* Y=m(D+F)
 To discuss the money demand and supply,
in terms of percentage changes, since k, m
is constant, the changes are zero.
(1)MABP

So
ˆR  Pˆ *  Yˆ  Dˆ  Fˆ
•Rearrange
*
ˆ
ˆ
ˆ
F  R  P  Yˆ  Dˆ
(2) Monetary Approach under
Flexible Exchange Rates
 Under flexible
Fˆ  0ˆ
*
ˆ
ˆ
 R  P  Yˆ  Dˆ
•Fixed
^
R0
*
ˆ
ˆ
F  P  Yˆ  Dˆ
(1) MABP


Managed float
ˆR  Pˆ *  Yˆ  Dˆ  Fˆ
Given money demand or money supply
changes, the central bank can choose to let
Rˆ adjust to the free-market level; or by
holding R at some disequilibrium,it will
ˆ to adjust.
allow F
(1)MABP
Fixed
Money supply
adjusts to
demand through
international
money flows
Flexible
Set by the
central bank via
exchange rate
changes
Managed float
Both
international
money flows
and exchange
rate changes
(2)Monetary Approach and Exchange
Rate Determined





1)money plays the crucial role in the long run:
both as a disturbance and as an adjustment in a
nation’s BP
2)The exchange rate is determined by flow of
funds, in the process of balancing the total demand
and supply of the national currency in each
country.
3)money supply and demand:
The supply of monetary determined by the
monetary authorities, the demand for monetary
depending on the level of real income, general
price level and the interest rate.
(2)Monetary Approach and
Exchange Rate Determined(MAER)

The higher are the real income and prices ,the
greater is the demand for monetary balances that
individuals and businesses demand for their day to
day transactions.
 The higher of interest, the greater is the
opportunity cost of holding money.the higher the
rate of interest ,the smaller is the quantity of
money demanded.
 For a given level of real income and prices, the
equilibrium interest rate determined at the
intersection of demand and supply curves of
money.
(2)Monetary Approach and
Exchange Rate Determined

Suppose the FX market being equilibrium or at
IRP, suppose that monetary authorities increase
the money supply, in the long run, leads to a
proportionate increase in the price level in the
home country and depreciation of its currency, as
PPP discussed.
 But it leads to decline of interest and affect
financial markets and exchange rates immediately,
resulting in increased financial investment flows
to the foreign countries.
(2)MAER

Under flexible exchange rate
 Backgrounds : elasticity supply ; stable
demand; markets are competitive and no
tariffs, no obstructions to trade; PPP
 Income and interest are not relative to
money supply. Supply only leads to the
changes of the price.
(2)MAER

Elasticity supply:
M d  kPy
M s  M d  kPy
Y  Py
(2)MAER

Equilibrium :
M s  kPy
M k PY
*
s
*
*
*
(2)MAER

Since
•so
P
R *
P
*
*
M sk Y
R
*
M s kY
(2)MAER

Conclusion
 Changes in R are proportional to changes in
M s inversely.
*
Ms
 It depends on PPP and the law of one price
 Not include interest rate (UIRP)
 Exchange rate to adjustment
i  i  EA
*
•EA is the expected percentage
appreciation per year of the foreign
currency to the home currency.
•UIA formulation
3.Asset Market model and
Exchange Rates

(1)Asset market model
 (2)Extended asset market model
 (3) Portfolio Balance Approach
(1)Asset market model

Asset market model(PB) differs from the
monetary approach(MA)
• Perfect capital flow(MA, PB)
• Perfect substitutes(uncovered interest arbitrage
and no foreign exchange risk premium(MA)
(1)Asset market model

W=M+D+F
 M:domestic currency (transactions)
 D:domestic bonds (return it yields)
 F:foreign bonds (return and spreading risks)
 A change in any of underlying factors will
achieves a new portfolio;
 An increase in wealth increases the demand
for these three assets.
(1)Asset market model

According to asset market
approach ,equilibrium in each financial
market occurs when the quantity demanded
of each financial asset equals its supply.
 The exchange rate is determined in the
process of reaching equilibrium in each
financial market.
(2) Extended asset market model
i  i  EA
*
i  i  EA  RP
*

Book , p.522 models
(2) Extended asset market model

Domestic currency
equilibrium
R
R
M
D
increase
M
F
i
i
(2) Extended asset market model
 Domestic bonds
foreign bonds
R
R
D
F
increase
increase
i
i
(3) Portfolio Balance Approach

open market purchase
M’
R
D
M increases,
E’new equilibrium
Domestic currency
depreciates
Interest decreases
M
E’
E
F’
F
i
(3) Portfolio Balance Approach

(BCA surplus)
R
D’
D
M
F
F’
E
Domestic currency appreciates
M’ Save foreign currency to change M
More foreign currency supply
F depreciates i* increases
If i unchanged, wealth unchanged
E’
i
4.Exchange Rate Dynamics
Exchange Rate Overshooting (sticky
price)
4.Exchange Rate Overshooting

1)concept
 Stock adjustments in financial assets are much
larger and quicker to occur than in trade flows.in
the short run ,changes in R are likely to reflect the
effect of stock adjustments in financial assets and
expectations.but in the long run ,adjustments in
trade flows occurs.
 The immediate flows of financial investment leads
to an immediate depreciation of home currency
which exceeds or overshoots the expected in the
long run according to PPP.
4.Exchange Rate Overshooting

2)Sequence :
 the money supply increases,the interest rate
falls,capital flows out, leads to an
immediate depreciation of the home
currency. In the long run the home
currency’s prices rice and it appreciates to
eliminate the overshooting.
4.Exchange Rate Overshooting


3)model
Regarding a higher trade deficit for the domestic country,
the spot exchange rate will jump immediately above E0
R
R1
R0
t
until the new long run equilibrium E1 is reached. After a
disturbance, the exchange rate may not move in such an
orderly fashion.
4.Exchange Rate Overshooting

PPP doesn’t hold well under flexible exchange
rate. Exchange rates exhibit much more volatile
behavior than prices do. In the short run, following
some disturbance to equilibrium, prices will adjust
slowly to the new equilibrium level, but the
exchange rates and interest rates will adjust
quickly. This different speed of adjustment to
equilibrium allows for behavior regarding rates
and prices.
4.Exchange Rate Overshooting

At times,spot exchange rates move too much
given some economic disturbance.Also, we have
observed instances when country A has a higher
inflation rate than country B, yet A’s currency
appreciates relative to B’s. such anomalies can be
explained in the context of an “overshooting”
exchange rate model. We assume that financial
markets adjust instantaneously to an exogenous
shock, whereas goods markets adjust slowly over
time. With this setting, we analyze what happens
when country A increases its money supply.
4.Exchange Rate Overshooting





For equilibrium, money demand must equal
supply. If the money supply increases, something
must happen to increase demand. Assuming that
people hold money for transactions purposes, and
holding bonds to pay an interest rate i. A money
demand equation: Md=aY+bi
Md,the real stock of money demanded
Y, income
I, interest rate
and i, or b is negative.
4.Exchange Rate Overshooting

As y increases, tend to demand more things
including money. Interest rate is the
opportunity cost of holding money, there is
an inverse relation between money demand.
 In the short run, both income and the price
level are relatively constant.
 Result :interest rate must drop to equate
money demand to supply.
4.Exchange Rate Overshooting





Bring into analysis a second country:
IRP: i=i*+EA
i falls, i* EA(forward premium on foreign
currency ) fall. The money supply in one nation
increases ,expect prices in one nation will rise.
And spot rate expected depreciation. Imply a
higher future exchange rate to achieve PPP, a
long run value of exchange rate
RLR=P/P*
P expected to rise over time, given P*, R will rise.

overshooting R
RLR
R0
t0
i0
P0
t0
t0
5.Forecasting Exchange Rates

Forecasting is difficult, especially with
regard to the future. Two reasons , p.530
 As a whole, forecasters cannot do a better
job of forecasting future exchange rates
than the forward rate.
 The founder of Forbes Magazine once said:
“You can make more money selling advice
than following it.”
Rate
determined
MA
Money supply
and P
PB
Financial assets
Imperfect
Perfect
institutes institutes
PPP always
PPP long
UIAP, EA
CIAP, EA-RP
Ms elastic, Md
W=M+D+F
stable
Ms increases Currency
In short,
sequence
depreciates
depreciates
In long, BCA
and rate affects
each other till
BCA=0
suppose
Overshooting
Different
adjustment speed
and i
Perfect
PPP long
UIAP, EA
P sticky Md
stable
In short,
depreciates over
RLR
In long,
RLR(same as MA)











Arbitrage
Covered and uncovered interest
arbitrage parity
Purchasing power parity
Nominal and real income
Money supply and demand
Base money
MABP
MA
PB
Overshooting
Stock and flow
Key Words

1.While you were visiting London, you
purchased a Jaguar for £35,00, payable in
three months.you have enough cash at
your bank in New York City, which pays
0.35% interest per month, compounding
monthly, to pay for the car.Currently, the
spot exchange rate is $1.45/£ and the
three-month forward exchange rate is
$1.45/£. In London the money market
interest rate is 2.0% for a three-month
investment. Two alternative ways of
paying for your Jaguar.
 1)Keep the funds at your bank in the U.S
and buy £35,000 forward.
 2)Buy a certain pound amount spot today
and invest the amount in the U.K. for
three months so that the maturity value
becomes equal to £35,000.
Which
method
would you
prefer?
Why?

2.Currently ,the spot exchange
rate is $1.50/£ and the threemonth forward exchange rate is
$1.50/£. The three-month
interest rate is 8.0% per annum
in the U.S. and 5.8% in the U.K.
Assume that you can borrow as
much as $1,500,000 or
£1,000,000.
 1)Determine whether IRP is
holding?
 2)If IRP holding ,how would you
carry out covered interest
arbitrage? Show all the steps and
determine the arbitrage profit.
Explain how
IRP will be
restore as a
result of
covered
arbitrage
activities.

True, false, uncertain, explain
 1 PPP holds better in the long
run than in the short run.
 2 PPP is no theory of exchange
rate determination.
 3 If nontradable goods prices rise
faster in country A than B, and if
nontradable goods prices rise
faster than prices in general, the
currency of A will appreciate by
more than is called for by PPP, as
measured by price indexes.

1 For what type of goods does the
law of one price hold quite well?
 2 Why IRP hold better than PPP
over time?
 3 true or false,explain: “lenders
benefit from unexpected inflation,
but borrowers are hurt by it”.
 4 Should we believe that interest
differentials cause exchange rate
changes, or that exchange rate
changes cause interest differentials?

5.What is the difference between the MA and PB.and what
are the similarities between them?
 6.Using MABP or MA model explain how the following
events will affect the foreign-exchange value of domestic
currency (assume flexible rates)
 1)The foreign inflation rate decreases.
 2)A natural disaster destroys a significant fraction of
domestic industry and therefore destroys productive
capacity.
 3)The domestic central bank decreases the growth rate of
the domestic credit component of base money to try to
reduce the domestic inflation rate.
 7.Discuss the value of domestic currency under flexible
rates: A foreign oil cartel succeeds in doubling the market
price of oil, and the domestic economy(such as China) is
heavily dependent on imported oil.