A Literature Review of the Efficiency of the Foreign Exchange Market

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Lecture 3.*

Lecture 3

Lecture 3.*

Lecture 2 revision

Lecture 3.*

3.1.3 Uncovered Interest Rate Parity

(3.1)

where

r - interest rate in the UK

r* - interest rate in the US

- ratio of the expected exchange rate at the end of the year

to the actual rate at the time of the decision

Lecture 3.*

3.2 Covered Interest Rate Parity

Using the forward exchange rate F in place of

(3.5)

Defining f as the forward premium)

(3.8),

and ignoring the final term,

(3.9)

- the normal formulation of the CIRP hypothesis.

Lecture 3.*

4.1.1 IS curve (continued)

Figure 4.1 The IS curve

Lecture 3.*

4.1.2 Money market: LM curve

Figure 4.3 the LM curve

Lecture 3.*

4.1.3 Aggregate demand

Figure 4.4 derivation of the aggregate demand curve

Lecture 3.*

Figure 4.5 derivation of the classical aggregate supply curve

Lecture 3.*

Chapter 5

Flexible Prices: the Monetary Model

Lecture 3.*

Monetary Model: General Features

Originates from Hume’s Theory of Price-specie Flow
Links exchange rate movements to balance of payments equilibrium
Dominant Theory of 1970s
Still used for medium- to long term forecasting

Lecture 3.*

5.1 the simple monetary model of
a floating exchange rate

5.1.1 Setting

The Monetary model rests on three assumptions:

1. the aggregate supply curve is vertical;

2. the demand for real money balances is a stable function of

only a few domestic macroeconomic variables – using the

Cambridge quantity equation (4.7), in equilibrium,

where y is real national income;

3. PPP obtains at all times.

Lecture 3.*

Nominal income Y along AD0 is measured by the area of the rectangle between any point and the axis e.g. P0Ay00 or P2Dy10.

AD0(Ms0)

AD1(Ms1)

Lecture 3.*

Disturbance: M0s increases to M1s

Result: AD0 shifts to AD1

How big is shift? Compare points A and B. P1 must be higher than P0 by the same proportion as M1s is greater than M0s

e.g. if money supply doubles, so must aggregate demand. With constant real income and output, this must imply doubling the price level.

Conclusion: PPP preserved

Lecture 3.*

Figure 5.2 money supply increase under floating rates

Lecture 3.*

5.1.2 Equilibrium

Combining Equations 2.4 (PPP) and 5.1,

(5.2)

which is solved for S as:

(5.3)

The exchange rate is the ratio of the money stock to the demand,

measured at the foreign price level.

Lecture 3.*

Predictions of Monetary Model:

Home currency will depreciate (S will increase) whenever:

Home money stock increases
Home real income decreases
Foreign price level falls fall

Lecture 3.*

Figure 5.3 income increase under floating exchange rates

5.1.4 Income increase under floating exchange rates

Lecture 3.*

Figure 5.4 foreign price increases under floating rates

5.1.5 Foreign price increase under floating exchange rates

Lecture 3.*

5.1.6 Two-country model of a floating exchange rate

The foreign-country version of the quantity equation (4.7):

(5.4)

- foreign demand for money, proportional to foreign nominal

income

Dividing the UK demand for money equation (4.7) by (5.4) and

setting the demands for money equal to supply in each country,

(5.5)

Lecture 3.*

5.1.6 Two-country model of a floating exchange rate
(continued)

Under PPP, , and (5.5) can be rewritten as:

(5.6)

Solving for S,

(5.7)

- the exchange rate equals the ratio of the relative money stocks

to the relative real demands.

Lecture 3.*

Fixed exchange rates

Money stock endogenous, since monetary policy needed to defend the fixed exchange rate
Money stock contains FX component which increases (decreases) when there is excess demand (supply) for domestic currency, so domestic credit is the monetary policy instrument – not the money supply as a whole.
Endogenous: P, FX
Exogenous: y, P*, DC,

Lecture 3.*

Figure 5.5 domestic credit increase under fixed rates

Lecture 3.*

5.2.1 Money supply increase

If reserves =

Money stock: (5.9)

Under a fixed exchange rate regime, the policy variable for the

money supply is domestic credit, DC0

Lecture 3.*

5.2.1 money supply increase (continued)

If the exchange rate is pegged at , under PPP,

(5.10)

(5.12)

(5.13)

The foreign currency reserves must be equal to the gap between

- given demand for domestic money

- supply generated by the local banking system.

Lecture 3.*

Conclusions re Fixed Exchange Rates:

In a fixed exchange rate system, the (change in the) stock of reserves simply fills the gap between the demand for money and the domestically generated supply (DC)
Domestic credit expansion changes nothing, except composition of money stock: increase (decrease) in DC offset by fall (rise) in reserves, so post-expansion money stock is:

Ms1 = FX1+DC1

Lecture 3.*

Q. What happens if authorities prevent money stock returning to its previous level by further increases in DC ?

Sterilisation can only work in the short run, if at all. Pushing the Ms curve back out simply repeats same process of balance of payments deficit followed by reserve loss.
The longer the policy is sustained, the greater the domestic credit component of Ms and the smaller the reserve backing
At some point, fall in reserves leads to collapse of fixed exchange rate as speculators sell currency (see Chapter 17)

Lecture 3.*

Change in real income under fixed exchange rate

Initial situation: Ms0 ⁭ = P0 = 1 → ky0 = 1, since Ms0 = kP0y0
Now y changes, so above equation no longer holds, and link between second and third graphs broken!
Disturbance: shift in AS-curve

AS0

Ms0

Ms1

FX+DC0

FX1

FX0

Yr0

DC0

P = SP0*

P0=1

AS1

Yr1

Ms1

Lecture 3.*

When AS (Real Output) increases in fixed exchange rate regime:

Conclusion

In short run

AS moves to right causing temporary increase in output
Prices fall in response to excess supply, so domestic economy overcompetitive
Balance of payment surplus as exports boom, imports fall
FX reserves increase.

In long run

As FX reserves increase, so does domestic money stock, causing effects 1–3 to go into reverse, until we end up back where we started.

Lecture 3.*

China 1995–2005

Q. With rapid growth in China’s GDP as its AS curve moved out to the right, why did mechanism on previous slide fail to operate?

A1. (Joint USA+PRC) AS curve was effectively flat in these years, as there was an almost-unlimited supply of labour at constant wages, due to mass migration from countryside to China’s. manufacturing (export) industries. So wages and prices barely rose

A2. Chinese authorities successfully sterilised the reserve inflow in two ways:

Domestically, by raising bank reserve ratios in China, preventing banks from lending the dollar inflows and hence expanding money stock.
Using the dollars to buy foreign assets, especially US Government bonds, boosting exchange rate of $ and reducing US interest rates cet par.

See next slide 

Lecture 3.*

China and USA under fixed exchange rate 1995–2005

Figure 5.6 China and the USA under a fixed exchange rate

ASUSA + ASPRC

(a)

(b)

(c)

FX1

PRC

–

Lecture 3.*

Figure 5.6 devaluation under fixed rates

5.2.4 devaluation under fixed exchange rates

Lecture 3.*

Conclusion re devaluation

Devaluation raises domestic competitiveness creating temporary balance of payments surplus and consequent reserve increase, until money stock increases in same proportion as devaluation
Final outcome: higher domestic price level with cheaper domestic currency means real exchange rate (competitiveness) unchanged, balance of payments back in balance
Only change: one-off increase in reserves

Lecture 3.*

Figure 5.7 interest rate decrease under floating exchange rates

5.3 interest rates in the monetary model

Lecture 3.*

Conclusion

The basic monetary model has been outlined

In practise this does not seem to explain anything but very long run fluctuations in the exchange rate

Lecture 3.*

Chapter 6

Fixed Prices: the Mundell-Fleming Model

Lecture 3.*

Introduction

The Mundell-Fleming model is the opposite extreme to the monetary model

It adheres to the Keynesian tradition

May be used for fixed and floating exchange rates

Lecture 3.*

6.1 Setting

Assumptions

1. The aggregate supply curve is flat (i.e. prices/wages fixed, as in Keynesian paradigm). Set domestic, foreign price level = 1 (for simplicity), so Q = SP*/P = S

2. Short run view: instead of PPP, current account equilibrium condition:

(6.1)

- the current account surplus (B) depends

positively on the real exchange rate (competitiveness)

negatively on real income via consumption effect

(contrast with monetary model)

3. Exchange rate expectations are static

4. Capital mobility is less than perfect, so interest rate differential in favour of domestic country causes finite capital inflow

Lecture 3.*

6.1 setting (continued)

Pure floating exchange rate regime requires balance of payments (BP) to be in equilibrium at all times: i.e.,

(6.3)

where B is current account surplus and K is capital account surplus. i.e. capital account surplus (deficit) must offset current account deficit (surplus). Home country’s capital account surplus positively (negatively) related to home (foreign) interest rate.

Taking foreign interest rate r* as given:

(6.4)

Values of y and r satisfying (6.4) for two different values of S are plotted in BP lines in Figure 6.1(b)

Lecture 3.*

Diagrammatic Apparatus: IS-LM-BP
Figure 6.1: Monetary Expansion under a Float

NW corner: FF line plots r, S combinations consistent with balance of payments equilibrium (equation (6.4)) – slopes down: lower interest ratesmaller capital inflowsmaller current account deficit/larger surplusgreater exchange rate (cheaper currency)

NE corner: IS-LM plus BP line plotting r, y combinations consistent with balance of payments equilibrium (equation (6.4)) – slopes up: lower interest ratesmaller capital inflowsmaller current account deficit/larger surpluslower income level (lower net imports)

SW corner: TT line plots S, y combinations consistent with balance of payments current account equilibrium (equation (6.1)) – slopes up: higher income levelsmaller current account deficit/larger surplushigher exchange rate (cheaper currency)

SE corner: 450 line

Lecture 3.*

Figure 6.1 monetary expansion under floating rates in the M-F Model

Lecture 3.*

6.3 Conclusion: Monetary expansion with a floating exchange rate

Proposition 6.1 In the M-F model of a floating exchange rate,

money supply increase causes:

a depreciation in the exchange rate

an increase in income

a fall in the interest rate, provided capital is not completely mobile

an improvement in the current account of the balance of payments

Lecture 3.*

Figure 6.2 fiscal expansion under floating rates in the M-F model

6.4 Fiscal expansion with a floating exchange rate

Lecture 3.*

6.5 Fiscal expansion with a floating exchange rate

Proposition 6.2 In the M-F model of a floating exchange rate,

fiscal expansion causes:

an appreciation in the exchange rate

an increase in income provided capital is not completely mobile

a rise in the interest rate provided capital is not completely mobile

a deterioration in the current account of the balance of payments

Lecture 3.*

Fiscal Expansion With A Floating Exchange Rate
And Perfect Capital Mobility

LM0

IS(G0, S0)

IS1(G1, S0)

r = r*

BP(S0) = BP(S1)

Lecture 3.*

Figure 6.3 monetary expansion under fixed rates in the M-F model

6.5 Monetary expansion with a fixed exchange rate

Lecture 3.*

6.5 monetary expansion with a fixed exchange rate
(continued)

Proposition 6.3 In the M-F model of a fixed exchange rate,

a money supply increase causes:

In the short term (and provided capital is not completely mobile)

a fall in the interest rate

a rise in income

a deterioration of the balance of payments on both current and capital accounts

In the long term

a fall in the foreign currency reserves

no change in income, the interest rate or the balance of payments

Lecture 3.*

6.6 fiscal expansion with a fixed exchange rate

Figure 6.4 fiscal expansion under fixed rates in the M-F model

Lecture 3.*

6.6 fiscal expansion with a fixed exchange rate

Proposition 6.4 In the M-F model of a fixed exchange rate,

fiscal expansion causes the following changes:

In the short run

a rise in the interest rate and income

an overall surplus on the balance of payments (net reserve gain)

In the long run

a further increase in income

a fall in the interest rate

a fall in the balance of payments surplus to zero, leading to a substantial current account deficit.

Lecture 3.*

6.7 The monetary model and the M-F model compared

The M-F model, in contrast to the monetary model

- emphasises the level of activity and interest rates

rather than the price level

- concentrates on flows of spending and capital rather than on stocks of assets

- gives a central role to the crowding-out mechanism

Lecture 3.*

Conclusion

Neither the monetary nor the M-F model provide a good account of real world events

They are however two extreme versions of how the world might work and provide a good starting point to understand exchange rates more fully

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Fig 5.8 UK Money, Income and Exchange Rate 1975 - 99

1995 = 100

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£ per $

Figure 5.9 German Money, Income and Exchange Rate 1975 - 99

1995 = 100

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DM per $

Figure 5.10 Japanese Money, Income and Exchange Rate 1975 - 99

1995 = 100

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Yen per $

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