• Given the large amount of economic activity that takes place across borders, we need to consider the effects of monetary policy on this activity
• Monetary policy principally affects international finance through exchange rates
– When a central bank increases the money supply, a country’s currency will depreciate, all else being equal
– Because of sticky prices and expectations, the exchange rate will actually overshoot its long run value in response to monetary policy.
• Monetary Policy may be guided by exchange rate targets
– Maintaining exchange rate stability
– Fixed exchange rates
– Currency Unions
– Dollarization

• An exchange rate is just the rate at which one currency trades for another
• Exchange rates fluctuate based on the relative demand and supply of one currency relative to another.
• These rates will move due to…
– Deviations from Purchasing Power Parity (Long Term Movements)
– Business Cycle Asymmetries (Medium Term)
– Interest Rate Differentials (Short Term)
• Monetary Policy principally affects exchange rates through the interest rate channel.
• People choose to hold a currency for the same reason that they choose to hold money.
– The choice of which currency to hold as money is subject to these same motivations.
– On top of this, people can also choose to hold non-monetary assets in foreign currency

• Changes in exchange rates affect the returns on foreign currency deposits.
– An appreciation of the foreign currency causes the return on foreign deposits to rise
– An appreciation of the domestic currency causes the return on foreign deposits to fall
• Suppose that an American bond costs $100 to buy and will pay annual interest of 6%
• Suppose that a British bond costs ₤50 to buy and will pay annual interest of 4%
• Can we definitively say that the American bond yields the higher return?
– NO! We need to have some measure of expected exchange rate changes.

• American bond costs $100 and pays 6% interest
• British bond costs ₤50 and pays 4% interest
• Suppose the exchange rate is 2$/₤
• Suppose that the expected exchange rate next year is 2.2$/₤
American Perspective
• American bond is worth $100 this year and $106 next year
• British bond is worth $100 this year and…
– ₤50*1.04 = ₤52  ₤52*2.2₤/$ = $114.4 next year!
British Perspective
• American bond is worth ₤50 this year and…
– $100*1.06 = $106  $106/2.2
₤/$ = ₤48.2 next year
• British bond is worth ₤50 this year and ₤52 next year

• The return on foreign currency is a function of…
– the local interest rate
– Expected appreciations or depreciations in the foreign currency
• Exchange rate changes affect returns through two channels
– They change the baseline foreign value of the asset
– They change the foreign currency interest earned on that asset
• This second channel is generally much smaller than the first, so we ignore it when defining the local return on foreign currency deposits:
R
D , F

R
F , F

E
D e
/ F

E
D / F
E
D / F
• The domestic currency return on a foreign asset is equal to the foreign currency return plus the expected percentage appreciation of the foreign currency

R
D , F

R
F , F

E
D e
/ F

E
D / F
E
D / F
UK,UK
– R
US,UK
$/₤
e
$/₤
US,UK
= 3% + (2.1 – 2)/2 = 3% + 5% = 8%
EU,EU
– R
US,EU
$/ €
e
$/ €
US,EU
= 5% + (0.95 – 1)/1 = 5% - 5% = 0%
US,EU
$/ €
e
$/ €
– 10% = R
EU,EU
– R
EU,EU
+ (1.08-1)/1
= 10% - 8% = 2%
EU,EU

R
D , D

R
D , F

R
F , F

E
D e
/ F

E
D / F
E
D / F
• Suppose that the US Dollar return on a British asset is 5%, while the US
Dollar return on an American asset is 3%
• The higher rate of return on British assets will induce investors to purchase British assets in lieu of American assets
• Increased demand for British assets will drive up the current value of the pound (E
$/₤ will increase)
• This will continue until both the American and British assets offer the same return when expressed in a common currency

Predict what will happen to the current value of the Dollar
• Mexican and US interest rates are both at 5%. New discoveries of gold in Mexico make investors expect a 6% appreciation of the peso.
• The interest rate on Australian assets is 4% above that on
American assets. People expect the Australian dollar to depreciate by 7% against the US dollar.
• The expected depreciation of the dollar against the yen is 2%. The
U.S. central bank announces that it will cut interest rates to 3%.
The Central Bank of Japan offers a 1% interest rate on assets.

• The return on a Mexican bond is 7%. The return on an equally risky British bond is 3%. The spot exchange rate is 20 pesos per pound. The forward exchange rate is
20.8 pesos per pound. Does I.P. hold?
• The return on a German bond is 5%. The current exchange rate is 1.5 dollars per euro. The forward exchange rate is 1.8 dollars per euro. What U.S. interest rate would satisfy I.P.?
• The return on a German bond is 8%. The return on a
French bond is 4%. What does I.P. suggest is the expected appreciation of the French currency?

Spot Exchange Rate
(E h/f
)
R h,f e
Home Currency Return on Foreign Assets = R h , f

R f , f

E h e
/ f

E h / f
E h / f

Spot Exchange Rate
(E h/f
)
R h,h
Home assets have a higher return on foreign assets – the foreign currency will depreciate today, leading to a higher expected appreciation of the foreign currency
E h/f
High
E h/f
*
E h/f
Low
Foreign assets have a higher return than home assets.
Investors will bid up the price of foreign currency, thereby increasing the expected appreciation of the home currency
R h,f e
R h,h
= R h,f Rates of Return in home currency

• In the short run, the exchange rate between currencies are determined by two factors:
– The interest rates that can be earned on deposits in each currency
– The expected future exchange rate (appreciation or depreciation)
• With open capital markets and low transactions costs, interest rate parity suggests that the common currency return on assets must be the same across countries
• Otherwise, investors would flock to the highest return assets, driving up the price of that country’s current currency.
• A rise in the current exchange rate is also a decrease in the expected appreciation of that currency. This lowers the expected common currency return until I.P. holds.
• We have taken interest rates and expectations as given.
• We now need to look closely at how interest rates and expectations are formed.

•
Interest rates within a country are primarily affected by the domestic money market
– Less true for small countries, where the policies of a large neighboring country can have profound effects on the domestic market.
• We know that interest rate differentials can lead to exchange rate changes – interest rate parity.
• Suppose the Federal Reserve increased the U.S. money supply.
• In the short run (fixed prices), this would lower U.S. interest rates
• What would happen to the value of the dollar against the British pound assuming the Bank of England did not pursue a similar policy and that interest rate parity initially holds?
• Relatively lower U.S. interest rates (in dollars) suggest that American investors will demand British assets.
• To get these assets, they will bid up the current value of the pound against the dollar.
• This will continue until the expected appreciation of the pound falls enough to offset the lower domestic currency interest rate in the U.S.

• In the short run, prices are sticky and monetary policy can have real effects.
• In the long run, the economy is running at full employment, with real interest rates and output determined solely by the economy’s fundamentals (capital, labor, technology, property rights, etc.)
• In the long run, any increase in the money supply will be met with a proportionate increase in the price level.
– People expect prices to rise in the future.
– Higher prices in the future suggest a lower future value for the exchange rate.
• An increase in the money supply will therefore have two effects on exchange rates in the short run:
– Domestic interest rates fall
– With higher price expectations, the expected future exchange rate also falls.
• Lower current interest rates and lower expected exchange rates causes the currency to fall considerably in the short run.
• In the long run, prices rise, pushing domestic interest rates up. This will lead to an appreciation of the currency
– However, the currency will not recover its full value since expectations do not change.

M s
2
R
M s
1
1. The Central Bank increases the money supply. With sticky short run prices, the interest rate falls.
1
2. In the long run, the price level will rise in proportion to the increase in the nominal money supply. Higher prices induce an increase in money demand, bringing interest rates back to
R1
R
1
R
2
2 M d
2
M
1
M
2
M d
1
M

E h/f
E h/f
2
1,2
3
E h/f
3
E h/f
1
R h,h
1
3
1. The home money supply rises, causing home interest rates to fall in the short run.
2. In anticipation of higher future prices in home, people expect the home currency to depreciate against foreign.
This raises the expected home currency return on foreign assets.
3. Eventually, prices in the home country rise. As these prices rise, the home interest rate goes up (real money supply falls).
2
R h,f e
R h,h
= R h,f
Home Currency Returns

• Since expectations adjust immediately, but prices change only gradually, exchange rates tend to fluctuate wildly in response to changes in monetary policy.
• Expansionary monetary policy has two effects on the exchange rate market:
– Lowers domestic interest rates
– Increases the expected appreciation of foreign currency.
• Lower domestic interest rates induce investors to buy into foreign assets, causing an appreciation of the foreign currency.
• At the same time, people expect that looser money in the domestic country will eventually lead to a weaker currency in that country. They expect the currency to depreciate in the future too.
• As a result, the short-run response of the exchange rate to monetary policy is very large.
• In the long run, the domestic interest rate effect goes away because prices rise to offset the increase in the money supply.
• The long-run response of the exchange rate to monetary policy is smaller than the short run effect.

Changes in price levels are less volatile, suggesting that price levels change slowly.
Exchange rates are influenced by interest rates and expectations, which may change rapidly, making exchange rates volatile.

• If a central bank wants to pursue a fixed exchange rate, they must work within the foreign exchange market
• Suppose the Fed wanted to maintain a fixed exchange rate of 1.2
$/ €.
– The Fed must be willing to buy or sell as many dollars or euros as the market will bear at this fixed exchange rate.
– If they do not meet the market’s excess supply or demand at the desired fixed rate, the exchange rate will change.
– Even if the government mandates and sets an “official” exchange rate, the market will set the “practical” or black-market rate based on equilibrium in the asset market (interest rate parity).
• To maintain a fixed exchange rate, the central bank must ensure that the asset market is in equilibrium at that fixed exchange rate.

• The asset market is in equilibrium when interest rate parity holds:
– R
$,US
= R
€,EU
+ (E e
$/ €
- E
$/ €
– To simplify notation: R
US
)/E
$/ €
= R
EU
+ (E e – E)/E
• The Fed sets a fixed exchange rate of E = E 0 .
• Assume that this fixed exchange rate is credible , such that people expect the exchange rate to be E 0 in the future as well.
• The interest rate parity condition is now…
– R
US
– R
US
= R
EU
= R
EU
+ (E 0 – E 0 )/E 0
• If you are going to maintain a fixed exchange rate with a foreign currency, then equilibrium in the asset market is only achieved when your interest rate equals the interest rate in the foreign country.

• Sometimes governments decide to change the fixed exchange rate
– A Devaluation lowers the currency’s fixed value (E h/f
– A Revaluation raises the currency’s fixed value (E h/f rises) falls)
• If a country devalues its currency, there is an increase in output
– The Central Bank devalues the currency by purchasing foreign assets, leading to an increase in the money supply.
– With the weaker currency, exports are cheaper and imports are more expensive.
– This leads to increased demand and a rise in output.
– In the long run, the devaluation of the country’s currency will just lead to a price increase proportionate to how much the money supply went up.
– Countries that consistently devalue their currencies also see consistent inflation.

• So far, we have been assuming that the government’s commitment to a fixed exchange rate is credible
– Investors believe that the exchange rate is truly fixed; they expect that the exchange rate in the future will be the same as the exchange rate today.
• What if expectations change?
• Suppose a country is facing serious unemployment problems and running a fixed exchange rate regime.
• There is mounting pressure on this country to devalue its currency, since this will lead to a (short-run) increase in output and employment.
• What happens if investors expect the government to devalue the currency in the future (i.e. E e is larger than E)?
• What does the government have to do to maintain the current
Exchange rate?

E
$/ €
E>E 0
E = E 0
R
US,1
R
US,2
Investors expect the dollar to be devalued, so the expected future rate rises from E 0 to E 1 . This shifts the expected dollar return on an EU bond up.
The relatively higher return on EU bonds creates an excess demand for euros. To maintain the fixed exchange rate, the Fed must offer to buy dollars and sell EU assets.
This lowers the U.S. money supply and raises U.S. interest rates
R
EU
+ (E 1 -E)/E
R
EU
+ (E 0 -E)/E
The adjustment by the Fed is contingent on them having enough reserves of EU assets to satisfy the excess demand for euros. What if they don’t? Then they must devalue the dollar!
Returns

• The expectation of an impending devaluation will lead to a capital flight
– The expected return on foreign assets increases when people expect the domestic currency to be devalued.
– Investors rush to convert their wealth from the domestic asset to the foreign asset
– To maintain the fixed exchange rate, the domestic central bank must sell foreign assets to private investors in exchange for domestic currency/assets.
• Why do people change their expectations about a currency’s stability?
– A central bank that is financing a federal government’s budget deficit 
The CB drains its reserves by lending to the gov’t.
– Sluggish growth in the domestic economy  the temptation to devalue increases.
– Contagion from other countries  If neighboring countries have devalued their currencies, the domestic currency is under increasing pressure to devalue or suffer large losses in export revenues.
– Pure speculation  If enough people believe in an impending devaluation and there is a large degree of “hot” money (short-term capital), then a currency crises may become a self-fulfilling prophecy.