国际金融学课件：Chapter 4 Exchange Rate Determination

1、Exchange Rate Determination4Chapter Objective:Reviews PPP and understandsExamines MABP and exchange rate determination.Understands portfolio balance approachKnows exchange rate dynamics and overshootingExchange Rate DeterminationIntroduction Under different monetary system, BP or exchange rate deter

2、mination BCA modelBKA modelAdjustment on BPMABPMA, OvershootingPBJames MeadMF modelInteraction on BCA and BKAModel in 1974Exchange Rate DeterminationPPPIRPMonetaryapproachMs , MdExchange rate and BPportfolio balance approachassetDifferentExchange rate systemElasticitySticky Chapter Three Outline1.Pu

3、rchasing Power Parity2.Monetary Approach to the Balance of payments and Exchange Rate Determination 3. Exchange Rate Dynamics4. Asset Market model and Exchange Rates.Portfolio-Balance Approach 5.Empirical tests and Exchange Rates Forecasting 1. Purchasing Power Parity(1)A law of one price(2)Absolute

4、 and relative PPP(3) PPP Deviations and Evidence on it(4) Empirical tests of Purchasing Power Parity(1) a law of one price1)In one countryP=P+cP=P+c(cost)+L(law)+A(arrest)Non traded goods: Real estate haircuts2)In an open economyP=RP+c(2) Absolute and relative PPPThe exchange rate between two curren

5、cies should equal the ratio of the countries price levels. Relative PPP states that the rate of change in an exchange rate is equal to the differences in the rates of inflation. If U.S. inflation is 5% and U.K. inflation is 8%, the pound should depreciate by 3%.(3)Evidence on PPPPPP probably doesnt

6、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 other hand, is a highly standardized commodity that is actively traded across borders.Shipping costs, as well as tariffs and quotas can lead to devi

7、ations from PPP.PPP-determined exchange rates still provide a valuable benchmark.PPP GDP 2007(millions of dollars)1 United States 13,811,2002 China 7,055,0793 Japan 4,283,5294 India 3,092,1265 Germany 2,727,5146 Russian Federation 2,088,2077 France 2,061,8848 United Kingdom 2,046,7809 Brazil 1,833,6

8、0110 Italy 1,777,35311 Spain 1,405,26212 Mexico 1,345,53013 Korea, Rep. 1,199,27014 Canada 1,178,20515 Turkey 922,189 Total GDP 2007(millions 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

9、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 893,36415 Australia 821,716 PPP GDP 2010(millions of dollars)1 United States 14,624,184 2 China 10,084,369 3 Japan 4,308,627 4 India 4,001,103 5 Germany 2,932,036 6 Ru

10、ssia 2,218,764 7 Brazil 2,181,677 8 United Kingdom 2,181,069 9 France 2,146,283 10 Italy 1,771,140 11 Mexico 1,549,671 12 South Korea 1,457,063 13 Spain 1,364,499 14 Canada 1,330,106 15 Indonesia 1,027,437 Total GDP 2010(millions of US dollars) 1 United States 14,624,184 2 China 5,745,1333 Japan 5,3

11、90,897 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 1,563,664 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 (4) Empirical tests of Purchasing Power ParityS

12、ee p.508 three points2.Monetary Approach to the Balance of Payments and Exchange Rate Determination(1)Monetary Approach to the balance of payments under Fixed Exchange Rates(2) Monetary Approach to Exchange Rate Determination (flexible price) 2.Monetary Approach to the Balance of Payments and Exchan

13、ge Rate DeterminationIn the 1970s, the monetary approach to the balance of payments came to popularity, that emphasizes the monetary aspects of the balance of payments. Money plays the crucial role in the long run both as a disturbance and as an adjustment in the nations BP.2.Monetary Approach to th

14、e Balance of Payments and Exchange Rate DeterminationMABP emphasizes the determinants of money demand and supply that will determine the balance of payments.Those items that directly affect the money supply are below the line which MABP concentrate on.(1)MABPFixed Money flowing between countries to

15、adjust the disequilibrium.Adjustment to changes through international money flowsFlexible At a point where the flow of exports just equals the flow of imports, no net international money flows required.Adjustment through exchange rates.(1)MABP1)basic concepts and assumptionsCentral bank controls the

16、 money supply by altering base moneyBase money changes, the lending ability of commercial banks changes.Divide base money into domestic and international components.(1)MABP2)framework for the analysis under MABPMinimum money modelMd=kPYA stable demand for moneyMs =m(D+F)Md =Ms(1)MABPMd=kPYP=RP* here

17、 P* the foreign price levelR the domestic currency price of foreign currencyk RP* Y=m(D+F) To discuss the money demand and supply, in terms of percentage changes, since k, m is constant, the changes are zero.(1)MABPSo Rearrange (2) Monetary Approach under Flexible Exchange Rates Under flexibleFixed(

18、1) MABPManaged floatGiven money demand or money supply changes, the central bank can choose to let adjust to the free-market level; or by holding R at some disequilibrium,it will allow to adjust.(1)MABPFixed Money supply adjusts to demand through international money flowsFlexible Set by the central

19、bank via exchange rate changesManaged floatBoth international money flows and exchange rate changes(2)Monetary Approach and Exchange Rate Determined1)money plays the crucial role in the long run: both as a disturbance and as an adjustment in a nations BP2)The exchange rate is determined by flow of f

20、unds, in the process of balancing the total demand and supply of the national currency in each country.3)money supply and demand: The supply of monetary determined by the monetary authorities, the demand for monetary depending on the level of real income, general price level and the interest rate.Th

21、e 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.The higher of interest, the greater is the opportunity cost of holding money.the higher the rate of interest ,the smaller is the quantity

22、of money demanded.For a given level of real income and prices, the equilibrium interest rate determined at the intersection of demand and supply curves of money.(2)Monetary Approach and Exchange Rate Determined(MAER)Suppose the FX market being equilibrium or at IRP, suppose that monetary authorities

23、 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. But it leads to decline of interest and affect financial markets and exchange rates immediately, resulting in increased financial

24、investment flows to the foreign countries. (2)Monetary Approach and Exchange Rate Determined(2)MAERUnder flexible exchange rate Backgrounds : elasticity supply ; stable demand; markets are competitive and no tariffs, no obstructions to trade; PPPIncome and interest are not relative to money supply.

25、Supply only leads to the changes of the price.(2)MAERElasticity supply:(2)MAEREquilibrium : (2)MAERSince so(2)MAERConclusionChanges in R are proportional to changes in inversely.It depends on PPP and the law of one priceNot include interest rate (UIRP)Exchange rate to adjustmentEA is the expected pe

26、rcentage appreciation per year of the foreign currency to the home currency.UIA formulation3.Asset Market model and Exchange Rates(1)Asset market model(2)Extended asset market model (3) Portfolio Balance Approach (1)Asset market modelAsset market model(PB) differs from the monetary approach(MA)Perfe

27、ct capital flow(MA, PB)Perfect substitutes(uncovered interest arbitrage and no foreign exchange risk premium(MA) (1)Asset market modelW=M+D+FM:domestic currency (transactions)D:domestic bonds (return it yields)F:foreign bonds (return and spreading risks)A change in any of underlying factors will ach

28、ieves a new portfolio; An increase in wealth increases the demand for these three assets.(1)Asset market modelAccording to asset market approach ,equilibrium in each financial market occurs when the quantity demanded of each financial asset equals its supply.The exchange rate is determined in the pr

29、ocess of reaching equilibrium in each financial market.(2) Extended asset market modelBook , p.522 models(2) Extended asset market model Domestic currency equilibrium iRMincreaseDFMRi(2) Extended asset market model foreign bondsDomestic bondsRiDincreaseincreaseFRi(3) Portfolio Balance Approach open

30、market purchase EERiM increases,Enew equilibriumDomestic currency depreciatesInterest decreasesMFMDF(3) Portfolio Balance Approach (BCA surplus) MDFFDMERiEDomestic currency appreciates Save foreign currency to change MMore foreign currency supplyF depreciates i* increasesIf i unchanged, wealth uncha

31、nged4.Exchange Rate DynamicsExchange Rate Overshooting (sticky price)4.Exchange Rate Overshooting1)conceptStock adjustments in financial assets are much larger and quicker to occur than in trade flows.in the short run ,changes in R are likely to reflect the effect of stock adjustments in financial a

32、ssets and expectations.but in the long run ,adjustments in trade flows occurs.The immediate flows of financial investment leads to an immediate depreciation of home currency which exceeds or overshoots the expected in the long run according to PPP.2)Sequence : the money supply increases,the interest

33、 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.4.Exchange Rate Overshooting3)modelRegarding a higher trade deficit for the domestic country, the spot exchange rate

34、 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. 4.Exchange Rate OvershootingtRPPP doesnt hold well under flexible exchange rate. Exchange rates exhibit much more volatile behavior

35、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 rates and prices.4.Excha

36、nge Rate OvershootingAt 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”

37、exchange 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.4.Exchange Rate OvershootingFor equilibrium, money demand must equal

38、 supply. If the money supply increases, 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+biMd,the real stock of money demandedY, incomeI, interest rateand i, or b is negati

39、ve.4.Exchange Rate OvershootingAs y increases, tend to demand more things including money. Interest rate is the opportunity cost of holding money, there is an inverse relation between money demand.In the short run, both income and the price level are relatively constant.Result :interest rate must dr

40、op to equate money demand to supply.4.Exchange Rate OvershootingBring into analysis a second country:IRP: i=i*+EAi 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 hi

41、gher future exchange rate to achieve PPP, a long run value of exchange rate RLR=P/P*P expected to rise over time, given P*, R will rise. 4.Exchange Rate Overshooting overshooting RR0 t0 i0 t0 t0RLRP05.Forecasting Exchange RatesForecasting is difficult, especially with regard to the future. Two reaso

42、ns , p.530As a whole, forecasters cannot do a better job of forecasting future exchange rates than the forward rate.The founder of Forbes Magazine once said: “You can make more money selling advice than following it.”MA Money supply and P Perfect substitutesPPP alwaysUIAP, EAMs elastic, Md stableCur

43、rency depreciates PB Financial assetsImperfect substitutesPPP longCIAP, EA-RPW=M+D+FIn short, depreciatesIn long, BCA and rate affects each other till BCA=0OvershootingDifferent adjustment speed and iPerfect substitutesPPP longUIAP, EAP sticky Md stableIn short, depreciates over RLRIn long, RLR(same

44、 as MA) Rate determined Ms increasessequencesupposeKey WordsArbitrage Covered and uncovered interest arbitrage parityPurchasing power parityNominal and real incomeMoney supply and demandBase moneyMABPMAPBOvershooting Stock and flow1.While you were visiting London, you purchased a Jaguar for 35,00, p

45、ayable in three months.you have enough cash at your bank in New York City, which pays 0.35% interest per month, 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% fo

46、r a three-month investment. Two alternative ways of paying for your Jaguar.1)Keep the funds at your bank in the U.S and buy 35,000 forward.2)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. Which method would

47、 you prefer? Why?2.Currently ,the spot exchange rate is $1.50/ and the three-month forward exchange rate is $1.50/. The three-month interest 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 1,000,000.1)Determine whether IRP is holding?2)If IRP holding ,how would you carry out covered interest arbitrage? Show all the steps and determine the arbitrage profit.Explain how IRP will be restore as a result of covered arbitrage activities.True, false