A Literature Review of the Efficiency of the Foreign Exchange Market
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lecture4.pptxLecture 4
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Lecture 3 revision
The monetary model and the MF model
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5.1.2 Monetary model 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.
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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
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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.
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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
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M-F setting
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)
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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
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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
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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
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Chapter 7
Sticky Prices: the Dornbusch Model
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Introduction
Both the monetary and MF models really ignore the role of expectations and this may be the main reason why they fail to account for most f the variation in exchange rates
This model is a Hybrid of the monetary and M-F models with expectations as well
It rests on the idea that real markets adjust slowly while financial markets adjust very rapidly
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Overview of Dornbusch Model
Weaknesses of preceding models:
Monetary Model: exchange rate far more volatile than monetary variables (and prices)
M-F Model: fixed prices and flow equilibrium valid only in short run
Dornbusch (1976) hybrid:
Short run properties of Keynesian models
Long run properties of Monetary Model
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Empirical observation: financial markets adjust to shocks far more rapidly than goods markets
Consequence for the model: in the short run, financial markets have to overadjust in order to compensate for sluggish goods markets (OVERSHOOTING)
With prices fixed in the short run, any change in the nominal money supply changes real balances, requiring the interest rate to adjust to clear the money market (Liquidity Effect).
In the long run, prices adjust fully, returning all real variables to their pre-shock levels, but leaving the nominal exchange rate at the new equilibrium level predicted by the simple Monetary Model
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7.1 Outline of the model
Assumptions
1. Small open economy (so P*, r* exogenous)
2. At outset, inflation and exchange rate depreciation zero
3. Aggregate demand is determined by the standard open
economy IS-LM mechanism.
4. Financial markets adjust instantaneously.
Investors are risk neutral, so that UIRP holds always.
(7.1)
5. Investors’ exchange rate expectations formed adaptively i.e. by
(7.2)
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Expectations
Agents expect the future exchange rate to move smoothly back towards its equilibrium (7.2 above)
In the next slide from equilibrium at A if r falls the exchange rate jumps to m and then appreciates back to the equilibrium
And similarly for other points
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Figure 7.1 short-run equilibrium in the securities market
7.1.1 Financial markets and expectations
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7.1.2 Goods markets
Deviations from the equilibrium exchange rate result from the
following assumption:
Assumption 7.3
The price level is sticky.
Aggregate supply curve is
- horizontal in the immediate impact phase
- increasingly steep in the adjustment phase
- vertical in long-run equilibrium.
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P
P0
P0
AS(LR)
P = SP*0
P
S
undercompetitive
overcompetitive
D
r
r
S
IS(G0,Q0)
S2
S2
r*
r*
(a)
(b)
(c)
(d)
A
B
C
AS(SR)
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Figure 7.2 money supply increase in the Dornbusch model
7.1.2 Goods markets
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7.3 A formal explanation
Equations:
Uncovered interest rate parity (7.1)
Expectations (7.2)
Demand for money (7.3)
Demand for UK output (7.4)
Demand adjustment (7.5)
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7.3 A formal explanation
Eliminate domestic interest rate from Equation (7.3) by substituting from
equations (7.1) and (7.2):
(7.6)
where .
Using equation (7.4) to replace in Equation (7.5)
(7.7)
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7.3.1 Long-run equilibrium
In long-run equilibrium, the following conditions apply:
Rate of inflation = 0
(7.8)
(2) Expected rate of depreciation = 0
(7.9)
Using Eq.(7.9) in Eq.(7.8), nominal exchange rate settles at the level:
(7.10)
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7.3.2 Disequilibrium
How the model behaves out of equilibrium?
Equation (7.7) implies, in equilibrium:
(7.11)
Subtract Eq. (7.11) from Eq. (7.7)
(7.12)
Conditions necessary for short-run equilibrium in money market
(7.13)
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Figure 7.3 dynamics of a money supply increase
7.3 Dynamics
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7.4 Oil and the UK economy
If the discovery of oil amounted to a sudden increase in UK endowments or wealth.
This implies an appreciation in the exchange rate with all other elements remaining in equilibrium
Hence the economy stays at the long run level of output and the exchange rate instantly appreciates
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Oil and the UK
If oil has no permanent effect on income, then the long run real equilibrium exchange rate remains unchanged
Increased short run demand for money however implies higher interest rates.
So the nominal exchange rate overshoots the long run appreciation
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7.5 Empirical tests: the Frankel model Notation:
Equation (7.2), with sticky prices (7.14)
UIRP and solving for (7.15)
Demand for money determines equilibrium exchange rate : (7.16)
(7.15) + (7.16) (7.18)
i.e. exchange rate depends on relative money stocks and income (as in monetary model), and also:
real interest rate differential
expected inflation differential
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A Test
Equation 7.18 is an equation for the exchange rate which may be estimated and tested.
Frankel found this fitted the data reasonably well
Later researchers however have not confirmed this
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Chapter 8
Portfolio Balance and the Current Account
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Introduction
Again we assume that financial markets adjust quickly while real ones are sticky.
However now we assume that UIP does not hold due to large risk premia effects.
We then have to think of an internationally diversified portfolio with risk averse investors
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General Features
Demand for money generalised to demand for assets i.e. proportions of wealth allocated to
Money M/W
domestic currency bonds B/W
foreign currency bonds SF/W
Imperfect capital mobility (as in M-F), so risk aversion prevents UIRP
Sticky prices (as in Dornbusch), so balance of payments in temporary disequilibrium
Current account surplus/deficit capital in/outflow increasing/decreasing stock of FX assets and changing equilibrium wealth allocation
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exogenous (issued by domestic country Government)
exogenous - set in (large) foreign country, or rest of world
endogenous – determined by model in short run
Exogenous in short run – fixed by accumulation of current account balances in past years
endogenous in long run – determined by accumulation of current account balances over sequence of short runs
F, P, W
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Other Assumptions
Domestic investors hold foreign assets, but not vice versa i.e. foreigners hold no domestic assets
Other forms of wealth (e.g. equity, human capital) can be ignored: all wealth is allocated to money, domestic or foreign bonds
Bonds short term – so capital gains/losses resulting from interest rate changes are negligible
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Portfolio balance
Risk averse agents will take account of both risk and return, diversifying their asset portfolio to attain best (i.e utility-maximising) risk-return combination (see Ch.14)
Equilibrium in asset markets involves different (expected) rates of return to compensate for risk differences between assets
Given risks associated with each asset class, small increase in return on asset j (relative to competing assets) increases demand for j
Given wealth in short run, increase in demand for j implies fall in demand for other assets cet par.
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8.1 Specification of asset markets
UK nominal wealth (in pounds) consists of:
(8.1)
where the bars denote exogenous variables.
Equilibrium in each market is defined by following equations:
(8.2)
(8.3)
(8.4)
In addition, we assume own-return effects dominate cross-return effects:
Constant wealth in the short run total effect of a return change = 0:
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We can ignore the price level as;
Prices fixed in the short run
We are only interested in real quantities hence prices cancel out.
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Model assumptions
S and r adjust in the short run
W, F, P and expected rate of depreciation all exog in the short run but endog in the long run (hence sticky)
Exogenous foreign variables and UK policy variables M and B
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analysis
We derive three lines which each represent combinations of S and r which imply equilibrium in the 3 markets
Money
Bonds
Foreign bonds
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Figure 8.1 Short-run equilibrium in the portfolio balance model
8.1 Specification of asset markets
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Open market operations
Suppose the UK buys its own bonds, so bonds goes down money goes up
Excess supply of money and demand for bonds
Interest rate falls and exchange rate rises
See following diagram
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Figure 8.2 Open market purchase of domestic bonds
8.2.1 Case 1:
money supply increase, domestic asset decrease
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UK buys foreign bonds
Money schedule moves in the same way
Excess demand for foreign bonds so for a given exchange rate interest rates must be higher FF line moves right
Exchnage rate rises interest rates fall
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Figure 8.3 Open market purchase of foreign bonds
8.2.2 Case 2:
money supply increase, foreign currency asset decrease
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Increase in stock of foreign assets
More assets in total so more wealth
Accumulation of foreign assets implies current account surplus and hence a capital account deficit.
FF falls as S appreciates
MM and BB both move downwards as increased demand (more wealth) increases interest rates
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Figure 8.4 Increase in the stock of foreign bonds
8.2.3 Wealth effects:
an increase in the stock of foreign currency assets
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8.4 Evidence on Portfolio Balance Model
It is hard to give a formal convincing test of portfolio balance models as there are variables which are hard to measure such as wealth.
However a current account surplus should be associated with appreciation and vice versa
The following figures show that this relationship is far from obvious in the data
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Conclusion
Portfolio Balance and the Dornbusche model add some interesting real world aspects of financial markets to the model.
However these models are still far from providing a good explanation of exchange markets
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Figure 8.5 Current Account versus Effective Exchange Rate: UK 1972-98
-25000
-20000
-15000
-10000
-5000
0
5000
10000
1972
1973
1974
1975
1976
1977
1978
1979
1980
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1995
1996
1997
1998
Year
Current Account Surplus (£m)
0
50
100
150
200
250
Effective Exchange Rate
1995 = 100
Current a/c balance (LHS scale)
£ effective (RHS scale)
Figure 8.6 Current Account versus Effective Exchange Rate: USA 1972-98
-250
-200
-150
-100
-50
0
50
1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
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1995
1996
1997
1998
Year
Current Account Surplus ($000m)
0
20
40
60
80
100
120
140
160
180
Effective Exchange Rate
1995 = 100
US CURRENT A/c
BALANCE (LHS Scale)
$ EFFECTIVE (RHS scale)
Figure 8.7 Current Account versus Effective Exchange Rate: Germany 1972-98
-60
-40
-20
0
20
40
60
80
100
120
1972
1973
1974
1975
1976
1977
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1995
1996
1997
1998
Year
Current Account Surplus (DM 000m)
0
20
40
60
80
100
120
Effective Exchange Rate
1995 = 100
GERMAN CURRENT ACCOUNT BALANCE
(LHS Scale)
DM EFFECTIVE (RHS Scale)
Figure 8.8 Current Account versus Effective Exchange Rate: Japan 1972-98
-4000
-2000
0
2000
4000
6000
8000
10000
12000
14000
16000
18000
1972
1973
1974
1975
1976
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1995
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1997
1998
Year
Current Account Surplus (Yen 000m)
0
20
40
60
80
100
120
140
Effective Exchange Rate
1995 = 100
Japanese CURRENT ACCOUNT
BALANCE (LHS Scale)
YEN EFFECTIVE (RHS Scale)
Figure 8.9 Current Account versus Effective Exchange Rate: France 1972-98
-60
-40
-20
0
20
40
60
80
100
120
1972
1973
1974
1975
1976
1977
1978
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1980
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1995
1996
1997
1998
Year
Current Account Surplus (FFr 000m)
0
20
40
60
80
100
120
140
Effective Exchange Rate
1995 = 100
FRENCH CURRENT ACCOUNT BALANCE
(LHS Scale)
FFR EFFECTIVE (LHS Scale)
Figure 8.10 Current Account versus Effective Exchange Rate: Switzerland 1972-98
-60
-40
-20
0
20
40
60
80
100
120
1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
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1987
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1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
Year
Current Account Surplus (SFr m)
0
20
40
60
80
100
120
Effective Exchange Rate
1995 = 100
SWISS CURRENT ACCOUNT BALANCE
(LHS Scale)
SFr EFFECTIVE (LHS Scale)
