TÀI CHÍNH QUỐC TẾ 6 other exchange rate models

VI Other Exchange Rate Models 1000 realizations of yt = c + yt −1 + vt TS Nguyễn Phúc Hiền - ðại học Ngoại thương Stationary „white noise“ process TS Nguyễn Phúc Hiền - ðại học Ngoại thương Contents Monetary Approach to Exchange Rates Portfolio Balance Approach to Exchange Rates Conclusion TS Nguyễn Phúc Hiền - ðại học Ngoại thương Monetary Approach to Exchange Rates Basic ideas: Exchange rate between two currencies is determined by the relative demand and supply of money in two countries Assumptions • Perfect capital mobility and stable money demand • The country is small and open (international prices and interest rates are given) • In the long term the PPP holds • With equal returns demestic and foreign assets (securities) are perfect substitutes • Investors are indifferent between investment in domestic or foreign currency • There is no risk premium for an investment in foreign country and the uncovered interest rate parity holds TS Nguyễn Phúc Hiền - ðại học Ngoại thương Monetary Approach to Exchange Rates Central Bank Behaviour • The central bank controls the money supply (M) by altering the monetary base (multiplier) • The monetary base can be divided into national and international components (domestic credit and international reserves) • The exchange rate is fully flexible Implications If the domestic money supply (with constant domestic price) rises above the output growth, the domestic currency will depreciate A high inflation rate in foreign country and a high real growth in domestic country would counteract this trend TS Nguyễn Phúc Hiền - ðại học Ngoại thương Monetary Approach to Exchange Rates The flexible price model The Dornbusch overshooting model The interest rate differential by Frankel TS Nguyễn Phúc Hiền - ðại học Ngoại thương The Dornbush Overshooting Model • • • • Disadvantages of „the flexible price model“ does not explain why exchange rat departures from PPP, especially under the flexible exchange rate regime because the assumption that prices of goods and services change in short run → PPP holds in the short term Dornbusch overshooting model (sticky price) How is the adjustment path of the exchange rate to the new equilibrium after an exonenous shock Why exchange rates are so volatile Why exchange rates departure from PPP The strong correlation between nominal and real exchange rats (EUR/USD) TS Nguyễn Phúc Hiền - ðại học Ngoại thương The Dornbush Overshooting Model • • • • • • • Emprical Observations: In the short run PPP does not hold and the exchange rat shows considerably more volatility than goods prices and inflation differentials would imply Prices of goods and services adjust very slowly (sticky prices) Exchange rats and interest rates adjust fast Assumption PPP and the quantity theory of money hold in the long run Goods prices and wages are fixed in the short run Prices react to exogenous shocks with lags The covered interest rate hold at any time t (full foresight) Expections are rational TS Nguyễn Phúc Hiền - ðại học Ngoại thương The Dornbush Overshooting Model Money Market Equilibrium • Money supply = money demand: M=D • Real money demand function: D/P=aY + bi (Y output, P price level, i interest rate) Short Run Adjustment to Monetary Expansion • In the short run, output and prices are constant when the money supply expands • The interest rate has to decline in order to equal money supply and money demand • The exchange rate has to rise sharply (domestic currency depreciate) TS Nguyễn Phúc Hiền - ðại học Ngoại thương 10 The Dornbush Overshooting Model Long Run Adjustment to Monetary Expansion • In the long run prices will rise and therefore nominal interest rate rise as well • With rising interest rates the exchange rate has to decline (appreciation) to maintain the uncovered interest rate parity • Therefore the exchange rate (e) „overshot“ its long term level and only approaches its equilibrium in the long run TS Nguyễn Phúc Hiền - ðại học Ngoại thương 11 The Dornbush Overshooting Model Eo t Po t io t1 t t0 TS Nguyễn Phúc Hiền - ðại học Ngoại thương 12 Portfolio Balance Approach to Exchange Rates (Branson 1977) Basic idea • The relative supply and demand in financial markets as well as the relative conditions in money markets determines exchange rates • In contrast to the monetary exchange rate model, investors have a preference for domestic investments and hold foreign assets only for a premium • The approach is based on divercification of portfolios and has a requirement that markets balance explains its name, portfolio-balance approach TS Nguyễn Phúc Hiền - ðại học Ngoại thương 13 Portfolio Balance Approach to Exchange Rates Hence • • The uncovered interest rate parity holds only with a risk premium The absolute change of net foreign assets is equal to the current account balance of a country NF t − NF t −1 = CA t • • With flexible exchange rate the central bank does not intervene in foreign exchange markets The current account is equal to the capital account Because goods and services are considerably slower than capital flows, variations of the capital account not immediately result in adjustment of the current account TS Nguyễn Phúc Hiền - ðại học Ngoại thương 14 Portfolio Balance Approach to Exchange Rates Adjustment to Money Supply Shock • • • • • Short term adjustment (e.g the same day) If the interest rate declines in the domestic market (expansion of the money supply), domestic agents want to hold more assets in the foreign markets This is not possible because the current account stays unchanged in the short term (adjustment of production etc ) The net foreign assets are constant in the short term as well The exchange rate has to adjust immediately to give an incentive to hold more domestic assets The depreciation of the domestic currency makes foreign assets more expensive and reduces the incentive to hold them TS Nguyễn Phúc Hiền - ðại học Ngoại thương 15 Portfolio Balance Approach to Exchange Rates Long Term Adjustment • In the long run the depreciation leads to a current surplus and a capital account deficit • The exchange rate converges to its original level (appreciation) • The adjustment process continues until agents hold the desired level of foreign assets TS Nguyễn Phúc Hiền - ðại học Ngoại thương 16 Conclusion Exchange rates are random processes, which are not predictable Short term and long term volatility is very high In the short term, PPP does not contain any explanatory content The monetary approach explains the exchange rat as ratio between two money supplies The overshooting solution result from the lagged adjustment of goods prices to exogenous shocks In the portfolio-balance approach the current account surpluses are correlated with appreciation pressure TS Nguyễn Phúc Hiền - ðại học Ngoại thương 17 ... Approach to Exchange Rates Portfolio Balance Approach to Exchange Rates Conclusion TS Nguyễn Phúc Hiền - ðại học Ngoại thương Monetary Approach to Exchange Rates Basic ideas: Exchange rate between... the exchange rate to the new equilibrium after an exonenous shock Why exchange rates are so volatile Why exchange rates departure from PPP The strong correlation between nominal and real exchange. .. nominal interest rate rise as well • With rising interest rates the exchange rate has to decline (appreciation) to maintain the uncovered interest rate parity • Therefore the exchange rate (e) „overshot“