nternational Monetary Economics
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Topic3PartB2021.pptxExchange Rate Determination The Monetary Model The Dornbusch model
Topic 3: Part B
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Learning outcomes
Understand the monetary theory of the exchange rate
Explain why exchange rates may overshoot their long run level in the short run
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Covered interest parity (CIP)
(1 + i) is the Australian dollar return from a A$1 investment in Australia.
is the AUD return of a A$1 investment overseas
using the forward market.
The return is known with certainty at the beginning of the investment period
This expression is called covered interest parity (CIP) because all exchange rate risk on the foreign currency side has been “covered” by use of the forward contract.
The covered cost (return) of borrowing (lending) in a foreign currency is the same as the domestic cost (return) when it is hedged through the forward market
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UNCOVERED INTEREST PARITY: (i) In terms of Expected Return UIP = The return from one period domestic investment equals the expected return from an unhedged one period investment overseas in the same asset Any difference in expected returns will be offset by a change in e, resulting in equal returns. If UIP does not initially hold there will be an arbitrage opportunity. An increase in the uncovered return on foreign currency assets (for example, due to an increase in foreign interest rates) would put upward pressure on e (downward pressure on the exchange value of the domestic currency).
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UNCOVERED INTEREST PARITY: (ii) In terms of Expected Exchange Rate Changes
The expected change in the exchange rate equals the nominal interest differential.
The country that has the currency that is expected to decrease in value will have the higher nominal rate of interest
The intuition is as follows.
Holding domestic currency or foreign currency deposits rewards the investor with domestic currency interest. Holding foreign currency deposits also rewards investors with the loss or gain on the foreign currency equal to the rate of increase in the foreign currency. Thus, for UIP to hold, and for an investor to be indifferent between domestic deposits and foreign deposits, any expected loss (gain) in the form of an decrease (increase) in the value of the foreign currency must be compensated for by an higher (lower) interest rate on the foreign currency side.
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Fisher Relationship
The Fisher effect illustrates how the nominal interest rate is determined in the long run. It refers to the link between inflation and nominal interest rates under flexible prices.
Recall that according to purchasing power parity:
Recall that according to uncovered interest parity:
Therefore
i – i* = E(p) – E(p*)
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Monetary Model
A long-run exchange rate model based on PPP.
Exchange rate is a monetary phenomenon. Exchange rate movements result from changes in money supply and money demand.
Assumptions
Absolute purchasing power parity holds at all times
The uncovered interest parity condition holds continuously
The international fisher relationship holds continuously
Prices of goods and services are flexible and adjust instantly to a change in the money supply.
Output is fixed at full employment.
The monetary model YT link
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Milton Friedman and the Case for Flexible Exchange Rates and Monetary Rules
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The Monetary Model
The monetary model combines PPP with the quantity theory of the demand for money.
Recall that, according to the quantity theory of money, in any country the money supply is equated with the demand for money, which is directly proportional to the value of GDP.
The quantity theory equation is
Ms = Md = k P Y,
for the domestic economy, where P is the domestic price level, Y is real GDP, Ms is the domestic money supply and k is a positive constant indicating the proportional relationship between money holdings and the value of GDP (ie the reciprocal of the velocity of circulation).
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The Monetary model
We have a corresponding equation for the foreign country
Md* = k* P* Y*
We assume that the money supply is fixed at Ms and that the equilibrium condition in the money market is Md = Ms for each country.
This equilibrium condition gives the domestic and foreign price level as a function of Ms and output. We thus have
P= Ms/kY, P*= Ms*/k*Y*
PPP implies that e is such that
P=eP*
When the domestic price level changes compared to the foreign price level, the exchange rate changes.
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The Monetary Model
By substitution we have
e = P/P* = (Msk*Y* )/(Ms*kY)
e if Ms* Y* or an increase in k*/k ratio
e is thus determined (in the long run) by
relative changes :-
in money supplies, e if Ms
in real national income (due to demographic changes, capital accumulation or technological progress) Y
and by changes in the relative circulation of money inside the economies.
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The Monetary model
Exchange rates are the result of supply and demand for money. Money supply and demand operate through the linkage of prices and inflation rates
e = P/P* = (Msk*Y* )/(Ms*kY)
All else equal, the spot exchange rate is raised by:
A rise in the domestic money supply relative to the foreign money supply,
A rise in the domestic price level relative to the foreign one, or
A rise in foreign real GDP relative to domestic real GDP.
A rise in domestic velocity, or equivalently a decline in the domestic k, relative to domestic velocity or k, e.g., as the result of a change in the domestic payments system
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Example: A permanent increase in the domestic money supply
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Example: A permanent increase in the domestic money supply
An increase in the domestic money supply means that there is an excess supply of money at the original price level.
In order for money market equilibrium to be re-established the demand for nominal money has to go up which is brought about through the domestic price level increasing.
We know that an excess supply of money will induce agents to demand more goods and services to eliminate the excess money holdings. Given our assumption on fixed output at full employment, this will increase the price level. This will increase Md. So money market equilibrium is re-established.
In order for the domestic price level to increase and purchasing power parity to be maintained the exchange rate needs to increase so the value of the domestic currency decreases.
P=eP*
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Problems with the Monetary Approach
Need to allow for sticky prices
The Monetary model does not explain why the exchange rate is more volatile than commodity prices
Link to additional reading on the Dornbusch model
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Dornbusch’s Sticky-Price Model
Can explain exchange rate volatility in the short-run.
In the short run the exchange rate overshoots its long-run value (value consistent with purchasing power parity), and then reverts back to it.
Exchange rate volatility temporarily equilibrates the international system in response to money shocks.
Key assumptions:
Purchasing power parity does not hold in the short run (holds in the long run)
Uncovered interest parity holds continuously.
Suppose the Reserve Bank of Australia embarks on an unanticipated monetary expansion.
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Dornbusch’s Sticky-Price Model Long Run Effects
From the parity conditions we know that in the long run (when all the effects have worked themselves out).
The Australian price level will increase.
Long Run Neutrality of Money Ms P
Australian nominal interest rates will increase
International Fisher Equation i – i* = E(p) – E(p*)
The exchange value of the Australian dollar will be lower.
Absolute Purchasing Power Parity P=P*e
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Dornbusch’s Sticky-Price Model Short Run Effects
In the short run, product prices are somewhat sticky. The price level in the immediate period remains unchanged.
The increase in the money supply drives down the domestic interest rate. Nominal interest rates must fall to ensure that the money market is back in equilibrium. Excess money supply is only willingly held if the nominal rate of interest declines.
As the nominal interest rate has fallen while prices have as yet not changed the real interest rate will decrease.
As a result of reduced capital inflow, the value of the domestic currency must decrease.
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Short run effects in the money market -
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Dornbusch model – time paths
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The Dornbusch model
The 450 line shows the long-run proportionality between the price level and the exchange rate, given that PPP holds in the long run.
The MM schedule captures money market equilibrium with uncovered interest parity holding continuously.
Recall that money demand is a positive function of the price level and a negative function of the interest rate.
If the price level was above PA it would be necessary for the interest rate to increase to restore money market equilibrium.
With uncovered interest parity holding continuously, this can only happen if the value of the domestic currency is currently above its equilibrium value (ie e < eA) and is expected to decrease.
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Dornbusch continued
Consider an unexpected increase in the domestic money supply from the initial equilibrium A.
In the long-run, the exchange rate and the price level must increase in proportion to the money supply, and we will have a new long-run equilibrium B where the MM schedule has shifted rightwards.
In the short-run, prices are sticky, and the money market is cleared by a fall in the domestic interest rate.
The current exchange rate will adjust to allow domestic and foreign interest rates to diverge.
The exchange rate overshoots the long-run equilibrium and jumps from A to C.
The value of the domestic currency is expected to increase as it is currently below the long-run equilibrium value.
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Dornbusch continued
Uncovered Interest Parity suggests that investors will only hold these lower return domestic assets if they expect the domestic currency to increase in value.
How can the prospect of a long-run lower value of the domestic currency and the need to offer investors an increase in the value of the domestic currency be reconciled?
There must be three phases: first,
there must be a sudden increase in e, second,
there must be a subsequent expected increase in the value of the domestic currency; and third,
the long-run increase in e.
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Dornbusch overshooting model
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PPP holds in LR
Overshooting in SR for
UIP to hold
Because P is tied down in the SR, e overshoots its new LR equilibrium.
Excess Demand at C causes P to rise over time until reaching LR equilibrium at B
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Dornbusch continued
In order for Uncovered Interest Parity to hold the initial decrease in the value of the domestic currency (increase in e) must be greater than the long run decrease, so that it has room to increase in value.
The initial change in the exchange rate is greater than the long-run change —that is, the exchange rate “overshoots” its long-run level.
Dornbusch’s insights regarding expectations and exchange rate changes can help to explain why exchange rates are so volatile.
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