A Literature Review of the Efficiency of the Foreign Exchange Market

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Lecture 5

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Revision

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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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AS(LR)

P = SP*0

undercompetitive

overcompetitive

IS(G0,Q0)

(a)

(b)

(c)

(d)

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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Figure 7.3 dynamics of a money supply increase

7.3 Dynamics

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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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Figure 8.1 Short-run equilibrium in the portfolio balance model

8.1 Specification of asset markets

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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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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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Chapter 9

Currency Substitution

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Introduction

This is about money (currency, not exchange rates) which is a non-interest baring store of value.

The question is should you hold domestic or foreign currency and what determines this, e.g. the use of dollars in Russia is an extreme case.

So again current account imballances drive the flows

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9.1 The model

Assumptions

1. two goods, a tradeable and non-tradeable, are produced.

2. price of the non-tradeable, PN determined in the domestic economy

3. price of tradeable exogenous (set PT = 1)

4. portfolio choice between two assets: foreign v domestic money

5. wealth, W, measured w.r.t. the traded good:

(9.1)

6. expected exchange rate depreciation = actual (perfect foresight)

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9.1.2 Non-traded goods sector

clears at all times, so:

(9.2)

where is excess supply in non-traded goods sector

is real exchange rate (price of traded relative to non-traded goods)

since higher price of traded goods reduces supply of non-traded goods and increases demand

since greater wealth increases demand in both sectors, reducing net excess supply

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9.1.2 Traded goods sector

In long run – equilibrium, zero current account balance

In short run - excess supply/demand = current account surplus/deficit:

(9.3)

is excess supply in the trade goods sector

is foreign currency gain/loss via current account since

since higher price of traded goods increases supply and decreases demand

since greater wealth increases demand in both sectors, reducing net excess supply

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9.1.3 Money markets

Relative demand for money

(9.4)

where

- the ratio of real domestic balances to foreign currency - the rate of change of the nominal exchange rate.

Reverse holds as well:

(9.5)

- higher (lower) rates of depreciation associated with

lower (higher) values of m/F.

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9.1.3 Money markets

To remove m in Eq. (9.5)

(9.6)

For wealth to be static: (9.7)

Increase in real domestic currency balances can be written:

(9.8)

Desired relationship between

(9.9)

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Figure 9.1 Long-run equilibrium in the currency substitution model

9.1 The model

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Change in Monetary Policy

What happens if there is a change in the rate of growth of money

MM shifts to the right

Real production unchanged in the long run

Increase in the proportion of foreign money

Exchange rate depreciates and overshoots

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Figure 9.2 Monetary acceleration in the currency substitution model

9.1.4 Change in monetary policy

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Evidence on currency substitution

Is this effect significant and does the model accurately describe events

Evidence suggests this effect not normally very important but at special times very powerful, Russia, Latin America etc.

Overall the model is a conceptual description of what goes on but still not rich enough to model real events

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Conclusions

A model with demand for money at its core

But these effects may be swamped by other portfolio considerations

Overall an important part of the storey but only part

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Chapter 11

Optimum currency areas

and

monetary union

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Single Currency Zone (Monetary Union)

Region with a single currency or with multiple currencies linked by exchange rate fixed (at 1:1) forever

Examples: USA, UK, Eurozone have a number of different banks issuing money, but freely exchangeable 1 for 1. A number of countries use dollars as national currency.

Currency union as limiting case of fixed exchange rate regime

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Figure 11.1 Exchange rate regimes

The Spectrum of Exchange Rate Regimes

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Benefits of Monetary Union

Microeconomic: lower transaction costs

Fewer exchange rates: union of N countries eliminates N-1 exchange rates against $ and N(N-1)/2 cross rates

For Europe: possibly around 0.25-0.5% of EU GDP

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Other Cost Savings

Uncertainty costs: currency exposure for international trade/investment – but savings not likely to be large since pre-union:

Only net exposure relevant

Managed by firms as one type of risk exposure (alongside exposure to interest rates, commodity prices etc etc)

Largely hedgeable by use of forwards or money market hedges (costless) or options

Unit of account: single currency reduces number of prices needed

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Costs of Monetary Union (MU)

Macroeconomic: adjustment to shocks under permanently fixed (versus floating) exchange rate

Price/wage flexibility critical

Labour: either wage or employment varies after shock.

With floating rates, fall in demand causes depreciation and price level rise, reducing real wage, as required to reinstate equilibrium (“full employment”), without need for reduction in money wage

With fixed rates, if money wages not fully flexible, real wage fails to adjust, so result is unemployment

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Mundell: Optimal Currency Area (OCA)

OCA defined by labour mobility e.g. fall in demand for labour in one US region causes migration to high-demand region, so migration even if wages inflexible (contrast with Europe)

Conclusion: optimal currency zone is area small enough for labour to be mobile

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McKinnon: OCA

Devaluation ineffective if labour suppliers respond to price level rise by raising money wage

In large country with relatively small open sector, imports have small weight in price index, so workers barely notice price rise caused by devaluation

OCA should be big enough for labour suppliers to behave as if in a closed economy (USA, Europe, China?)

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Political Economy of Monetary Union Fixed Exchange Rate versus Single Currency

Mundell: asymmetry, since fixed exchange rate system has inbuilt deflationary bias, MU has inflationary bias

Reason: fixed exchange rates force deficit countries to restrain demand, single currency forces policymakers to equalize demand at level of lowest-unemployment country

Evidence: mixed e.g. under Bretton Woods, deficit countries deflated, but USA exempt

Importance of automatic fiscal stabilisers

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Is Fiscal Sovereignty Compatible with MU?

In MU, national budget deficits funded by borrowing in common “foreign” currency, so greatly increased risk of insolvency of overspending governments

In EMU, overspending supposed to be banned (subject to fine!) by Stability Pact, and bailout ruled out by earlier treaties establishing EMU

Fiscal indiscipline likely to be contagious, leading to repeated bailouts and monetary indiscipline

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Credibility and MU

Fixing exchange rate means surrendering monetary sovereignty – which may be desirable for country with history of inflation

Tying exchange rate to country with credible monetary policy may permit high-inflation low-credibility country to reduce inflation with less need to demonstrate commitment to lower monetary growth rate

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Costs of Transition

The costs of joining will depend crucially on how similar the economies are before the start

Micro cost of changing the currency (and benefits e.g. reduce fraud)

Need for convergence

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11.3.4 Costs of Transition

Table 11.1 EMU convergence criteria
Fiscal Policy
Budget deficit	< 3% of GDP
Government debt	< 60% of GDP
Monetary Policy
Inflation (RPI)	< 1.5% above 3 best performing countries
Long-term interest rates	< 2% above 3 best performing countries

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Common Currency and common market

everyone (virtually) agrees that more trade and removing barriers is good

But this does not in itself imply a single currency

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Currency Boards

Half way between fixed exchange rate and a single currency

Domestic money is backed by a foreign currency one for one. So if necessary could buy back the whole domestic money stock.

The Gold standard is a special type of currency board

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Conclusion

The arguments for and against a monetary union range beyond positive economics

The book does not like EMU

Ultimately it depends on a question of federation and forming one political entity

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