国际金融学课件：IF4 Exchange Rate Determination

1、4Chapter Objective:Reviews PPP and understandsExamines MABP and exchange rate determination.Understands portfolio balance approachKnows exchange rate dynamics and overshootinglIntroduction lUnder different monetary system, BP or exchange rate determination BCA modelBKA modelAdjustment on BPMABPMA, O

2、vershootingPBJames MeadMF modelInteraction on BCA and BKAModel in 1974PPPIRPMonetaryapproachMs , MdExchange rate and BPportfolio balance approachassetDifferentExchange rate systemElasticityStickyl1.Purchasing Power Parityl2.Monetary Approach to the Balance of payments and Exchange Rate Determination

3、 l3. Exchange Rate Dynamicsl4. Asset Market model and Exchange Rates.Portfolio-Balance Approach l5.Empirical tests and Exchange Rates Forecasting l(1)A law of one pricel(2)Absolute and relative PPPl(3) PPP Deviations and Evidence on itl(4) Empirical tests of Purchasing Power Parityl1)In one countryl

4、P=P+clP=P+c(cost)+L(law)+A(arrest)lNon traded goods: Real estate haircutsl2)In an open economylP=RP+clThe exchange rate between two currencies should equal the ratio of the countries price levels. lRelative PPP states that the rate of change in an exchange rate is equal to the differences in the rat

5、es of inflation. lIf U.S. inflation is 5% and U.K. inflation is 8%, the pound should depreciate by 3%.0011*0*1/RPPPPR*/PPR lPPP probably doesnt 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 othe

6、r 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.lPPP-determined exchange rates still provide a valuable benchmark.lPPP GDP 2007l(millions of dollars)l1 United States 13,811,200l2 China 7,0

7、55,079l3 Japan 4,283,529l4 India 3,092,126l5 Germany 2,727,514l6 Russian Federation 2,088,207l7 France 2,061,884l8 United Kingdom 2,046,780l9 Brazil 1,833,601l10 Italy 1,777,353l11 Spain 1,405,262l12 Mexico 1,345,530l13 Korea, Rep. 1,199,270l14 Canada 1,178,205l15 Turkey 922,189 Total GDP 2007(milli

8、ons of US dollars)1 United States 13,811,2002 Japan 4,376,7053 Germany 3,297,2334 China 3,280,0535 United Kingdom 2,727,8066 France 2,562,288 a7 Italy 2,107,4818 Spain 1,429,2269 Canada 1,326,37610 Brazil 1,314,17011 Russian Federation 1,291,01112 India 1,170,96813 Korea, Rep. 969,79514 Mexico 893,3

9、6415 Australia 821,716 lPPP GDP 2010l(millions of dollars)l1 United States 14,624,184 l2 China 10,084,369 l3 Japan 4,308,627 l4 India 4,001,103 l5 Germany 2,932,036 l6 Russia 2,218,764 l7 Brazil 2,181,677 l8 United Kingdom 2,181,069 l9 France 2,146,283 l10 Italy 1,771,140 l11 Mexico 1,549,671 l12 So

10、uth Korea 1,457,063 l13 Spain 1,364,499 l14 Canada 1,330,106 l15 Indonesia 1,027,437 Total GDP 2010(millions of US dollars) 1 United States 14,624,184 2 China 5,745,1333 Japan 5,390,897 4 Germany 3,305,898 5 France 2,555,439 6 United Kingdom 2,258,565 7 Italy 2,036,687 8 Brazil 2,023,528 9 Canada 1,

11、563,664 10 Russia 1,476,912 11 India 1,430,020 12 Spain 1,374,779 13 Australia 1,219,722 14 Mexico 1,004,042 15 South Korea 986,256 lSee p.508 three pointsl(1)Monetary Approach to the balance of payments under Fixed Exchange Ratesl(2) Monetary Approach to Exchange Rate Determination (flexible price)

12、 In the 1970s, the monetary approach to the balance of payments came to popularity, that emphasizes the monetary aspects of the balance of payments. lMoney plays the crucial role in the long run both as a disturbance and as an adjustment in the nations BP.lMABP emphasizes the determinants of money d

13、emand and supply that will determine the balance of payments.lThose items that directly affect the money supply are below the line which MABP concentrate on.Fixed lMoney flowing between countries to adjust the disequilibrium.lAdjustment to changes through international money flowsFlexible At a point

14、 where the flow of exports just equals the flow of imports, no net international money flows required.Adjustment through exchange rates.l1)basic concepts and assumptionslCentral bank controls the money supply by altering base moneylBase money changes, the lending ability of commercial banks changes.

15、lDivide base money into domestic and international components.l2)framework for the analysis under MABPlMinimum money modellMd=kPYlA stable demand for moneylMs =m(D+F)lMd =MslMd=kPYlP=RP* here P* the foreign price levelR the domestic currency price of foreign currencylk RP* Y=m(D+F) lTo discuss the m

16、oney demand and supply, in terms of percentage changes, since k, m is constant, the changes are zero.lSo Rearrange FDYPR*DYPRF*DYPRF0*l Under flexibleDYPFR0*FixedlManaged floatlGiven money demand or money supply changes, the central bank can choose to let adjust to the free-market level; or by holdi

17、ng R at some disequilibrium,it will allow to adjust.FDYPR*RFFixed lMoney supply adjusts to demand through international money flowsFlexible lSet by the central bank via exchange rate changesManaged floatlBoth international money flows and exchange rate changesl1)money plays the crucial role in the l

18、ong run:l both as a disturbance and as an adjustment in a nations BPl2)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.l3)money supply and demand: l The supply of monetary determined by the monetary au

19、thorities, the demand for monetary depending on the level of real income, general price level and the interest rate.lThe 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.lThe higher of inte

20、rest, the greater is the opportunity cost of holding money.the higher the rate of interest ,the smaller is the quantity of money demanded.lFor a given level of real income and prices, the equilibrium interest rate determined at the intersection of demand and supply curves of money.lSuppose the FX ma

21、rket 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. lBut it leads to decline of interest and affect financial marke

22、ts and exchange rates immediately, resulting in increased financial investment flows to the foreign countries. lUnder flexible exchange rate lBackgrounds : elasticity supply ; stable demand; markets are competitive and no tariffs, no obstructions to trade; PPPlIncome and interest are not relative to

23、 money supply. Supply only leads to the changes of the price.lElasticity supply:kPyMdkPyMMdsPyY lEquilibrium : kPyMs*YPkMslSince *PPR sokYMYkMRss*lConclusionlChanges in R are proportional to changes in inversely.lIt depends on PPP and the law of one pricelNot include interest rate (UIRP)lExchange ra

24、te to adjustment*ssMMEAii*EA is the expected percentage appreciation per year of the foreign currency to the home currency.UIA formulationl(1)Asset market modell(2)Extended asset market model l(3) Portfolio Balance Approach lAsset market model(PB) differs from the monetary approach(MA) Perfect capit

25、al flow(MA, PB) Perfect substitutes(uncovered interest arbitrage and no foreign exchange risk premium(MA) lW=M+D+FlM:domestic currency (transactions)lD:domestic bonds (return it yields)lF:foreign bonds (return and spreading risks)lA change in any of underlying factors will achieves a new portfolio;

26、lAn increase in wealth increases the demand for these three assets.lAccording to asset market approach ,equilibrium in each financial market occurs when the quantity demanded of each financial asset equals its supply.lThe exchange rate is determined in the process of reaching equilibrium in each fin

27、ancial market.lBook , p.522 modelsRPEAiiEAii*lDomestic currency equilibrium iRMincreaseDFMRil foreign bondsDomestic bondsRiDincreaseincreaseFRil open market purchase EERiM increases,Enew equilibriumDomestic currency depreciatesInterest decreasesMFMDFl(BCA surplus) MDFFDMERiEDomestic currency appreci

28、ates Save foreign currency to change MMore foreign currency supplyF depreciates i* increasesIf i unchanged, wealth unchangedExchange Rate Overshooting (sticky price)l1)conceptlStock adjustments in financial assets are much larger and quicker to occur than in trade flows.in the short run ,changes in

29、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.lThe immediate flows of financial investment leads to an immediate depreciation of home currency which exceeds or overshoots the expected in the long ru

30、n according to PPP.l2)Sequence :l 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 currencys prices rice and it appreciates to eliminate the overshooting.l3)modellRegarding a higher trade deficit f

31、or the domestic country, the spot exchange rate will jump immediately above E0 R1 R0 until the new long run equilibrium E1 is reached. After a disturbance, the exchange rate may not move in such an orderly fashion. tRlPPP doesnt hold well under flexible exchange rate. Exchange rates exhibit much mor

32、e 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 rate

33、s and prices.lAt 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 As currency appreciates relative to Bs. such anomalies can be explained in the context of an “overshooting” exchang

34、e 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.lFor equilibrium, money demand must equal supply. If the money supply incre

35、ases, 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+bilMd,the real stock of money demandedlY, incomelI, interest rateland i, or b is negative.lAs y increases, tend to de

36、mand more things including money. Interest rate is the opportunity cost of holding money, there is an inverse relation between money demand.lIn the short run, both income and the price level are relatively constant.lResult :interest rate must drop to equate money demand to supply.lBring into analysi

37、s a second country:lIRP: i=i*+EAli 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 ratel RLR

38、=P/P*lP expected to rise over time, given P*, R will rise. l overshooting RR0 t0 i0 t0 t0RLRP0lForecasting is difficult, especially with regard to the future. Two reasons , p.530lAs a whole, forecasters cannot do a better job of forecasting future exchange rates than the forward rate.lThe founder of

39、 Forbes Magazine once said: “You can make more money selling advice than following it.”MA lMoney supply and P lPerfect substituteslPPP alwayslUIAP, EAlMs elastic, Md stablelCurrency depreciates PB lFinancial assetslImperfect substituteslPPP longlCIAP, EA-RPlW=M+D+FlIn short, depreciateslIn long, BCA

40、 and rate affects each other till BCA=0OvershootinglDifferent adjustment speed and ilPerfect substituteslPPP longlUIAP, EAlP sticky Md stablelIn short, depreciates over RLRlIn long, RLR(same as MA) Rate determined Ms increasessequencesupposelArbitrage lCovered and uncovered interest arbitrage parity

41、lPurchasing power paritylNominal and real incomelMoney supply and demandlBase moneylMABPlMAlPBlOvershooting lStock and flowl1.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 mo

42、nth, 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.l1)Keep the funds at your bank i

43、n the U.S and buy 35,000 forward.l2)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. l2.Currently ,the spot exchange rate is $1.50/ and the three-month forward exchange rate is $1.50/. The three-month interes

44、t 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.l1)Determine whether IRP is holding?l2)If IRP holding ,how would you carry out covered interest arbitrage? Show all the steps and determine the arbitrage profit.lTrue, false, uncertain, explainl1 PPP holds better in the long run than in the short run.l2 PPP is no theory of exchange rate determin