International Financial Markets Prices and Policies Second Edition

International Financial Markets Prices and Policies Second Edition © 2001 Richard M. Levich 6 Mc. Graw Hill / Irwin Spot Exchange Rate Determination

6 -2 Overview w News and Foreign Exchange Rates: An Introduction Exchange Rates and News Stories: Three Illustrations è News and Foreign Exchange Rates: A Summary è w Flow vs. Stock Models of the Exchange Rate An Overview of the Flow Approach è An Overview of the Stock Approach è Combining Flow and Stock Concepts of the Exchange Rate è Mc. Graw Hill / Irwin 2001 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

6 -3 Overview w Asset Models of the Spot Exchange Rate The Monetary Approach è The Portfolio-Balance Approach è w Empirical Evidence on Exchange Rate Models In-Sample Results è Post-Sample Results è The Role of News è w Policy Matters - Private Enterprises w Policy Matters - Public Policymakers Mc. Graw Hill / Irwin 2001 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

News and Foreign Exchange Rates: An Introduction 6 -4 w Financial markets are preoccupied with news. w However, we usually cannot find a simple unambiguous link between a news announcement and an exchange rate reaction. The market is forward-looking, and permanent changes versus transitory phenomena are viewed differently. è While two news announcements may seem similar, their underlying aspects may be in fact different. è Mc. Graw Hill / Irwin 2001 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Exchange Rates and News Stories: 6 -5 Three Illustrations w Story 1: At time t 1, it is announced that the U. S. money supply grew by $3 billion in the most recent week. (The consensus market forecast was $2 billion. ) Case a: The US$ weakens as the market feels that the higher money supply will be maintained. è Case b: The US$ strengthens as the market believes that the Federal Reserve will take corrective actions. è Case c: The US$ weakens and then steadily depreciates as the market feels that the change in the growth rate is permanent. è Mc. Graw Hill / Irwin 2001 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

6 -6 Story 1: An Increase in the U. S. Money Supply c a b Nominal exchange rate ($ / FC) U. S. price level c b $ interest rate a c a U. S. money supply Mc. Graw Hill / Irwin b t 1 t 2 Time 2001 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Exchange Rates and News Stories: 6 -7 Three Illustrations w Story 2: U. S. interest rates at all maturities have risen by 0. 10% or 10 basis points. (The market consensus was for no change in rates. ) Case d: The US$ weakens as the market feels that the rise stems from inflationary concerns, and is therefore a rise in the nominal interest rate. è Case e: The US$ strengthens as the market believes that inflation is under control, such that the higher rate corresponds to an increase in the real interest rate. è Mc. Graw Hill / Irwin 2001 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Exchange Rates and News Stories: 6 -8 Three Illustrations w Story 3: It is announced that the U. S. current account deficit will reach an annual rate of $250 billion. ( The consensus was $200 billion. ) current = exports – imports + unilateral transfers account = government (tax collections – expenditures) + private (savings – investments) Case f: The shortfall in exports or increase in imports is viewed as permanent and the US$ weakens. è Case g: The change is due to greater private sector investments, and the US$ strengthens as foreign flows in to finance the 2001 investments. by The Mc. Graw-Hill Companies, Inc. All rights reserved. Mc. Graw Hill /capital Irwin è

News and Foreign Exchange Rates: 6 -9 A Summary w Only unanticipated events cause exchange rates to deviate from their expected path of movement. w Factors that increase the demand for a currency tend to raise the price of that currency. w The “character” and the “context” of the economic news item will greatly influence the “nature” of the exchange rate response that follows. Mc. Graw Hill / Irwin 2001 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Flow versus Stock Models 6 - 10 of the Exchange Rate w An exchange rate determination model requires the specification of demand supply curves, the intersection of which determines the price. w Until the early 1970 s, foreign exchange was thought to be in demand or supply largely as a result of its being a medium of exchange for international trade transactions. w Most modeling attempts thus concentrated on currency flows, and suggested a sluggish pattern of exchange rate behavior. Mc. Graw Hill / Irwin 2001 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Flow versus Stock Models 6 - 11 of the Exchange Rate The Flow Approach D Price of Sterling S a S D Quantity of Sterling/Time Mc. Graw Hill / Irwin 2001 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Flow versus Stock Models 6 - 12 of the Exchange Rate w The stock or asset approach focuses on the total quantity of currency outstanding at a moment in time. Currency is treated as an asset, or store of value. w The asset approach gained favor in the late 1960 s and early 1970 s, in part because financial market transactions became more important as capital flow restrictions and currency convertibility rules were removed. Mc. Graw Hill / Irwin 2001 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Flow versus Stock Models 6 - 13 of the Exchange Rate The Stock Approach Price of Sterling D S a D Quantity of Sterling at a Moment in Time Mc. Graw Hill / Irwin 2001 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Flow versus Stock Models 6 - 14 of the Exchange Rate w The asset approach is inherently “forward looking” and predicts quick movements in the exchange rate to reflect new information. w Another aspect of the asset approach is that the current exchange rate is set to equilibrate the (risk-adjusted) expected rate of return on assets denominated in different currencies. w This idea is developed in the International Fisher Effect: Mc. Graw Hill / Irwin 2001 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Combining Flow and Stock Concepts 6 - 15 of the Exchange Rate w An overall equilibrium requires a balance in both flow and stock aspects of the market. w Stock concepts are of primary importance for determining exchange rates in the short run. w Flow imbalances can be maintained over the short run, but not in the long run. w Elements of the flow and stock models are related. For example, transfers of wealth through the current account may tilt the demand for currencies in the foreign exchange market. Mc. Graw Hill / Irwin 2001 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Asset Models 6 - 16 of the Spot Exchange Rate Asset Model Approach perfect capital mobility Monetary Approach perfect capital substitutability Monetarist Model completely flexible commodity prices Overshooting Model sticky commodity prices Mc. Graw Hill / Irwin Portfolio-Balance Approach imperfect capital substitutability Small Country Model Preferred Local Habitat Model Uniform Preference Model 2001 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Asset Models 6 - 17 of the Spot Exchange Rate w In asset models, the interrelationship between the demand supply of the specified assets determines the price of foreign exchange. w The only assets in the monetary approach are domestic and foreign money, M and M*, which are assumed to display perfect substitutability. w In the portfolio-balance approach, the menu of assets is expanded to include domestic and foreign bonds, B and F, which are assumed to display imperfect substitutability. Mc. Graw Hill / Irwin 2001 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

6 - 18 The Monetary Approach w The monetary approach is a direct outgrowth of purchasing power parity and the quantity theory of money. w It suggests that the spot exchange rate is the relative price of two monies. w Within the monetary approach, there are two models - the flexible-price model and the sticky -price (overshooting) model. Mc. Graw Hill / Irwin 2001 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

6 - 19 Flexible-Price Monetary Model w Domestic good prices are assumed to be fully flexible, implying that PPP holds continuously and that the real exchange rate never changes. w For the home country, P = M / L (Y, i ) where P - price level M - money supply L - money demand Y - real income i - interest rate w For the foreign country, P* = M* / L (Y*, i* ) Mc. Graw Hill / Irwin 2001 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

6 - 20 Flexible-Price Monetary Model w A common specification of L (Y, i ) is K Y e– i K - constant (the inverse of the velocity of money) - income elasticity of the demand for money - interest rate semielasticity of the demand for money w By PPP, Mc. Graw Hill / Irwin 2001 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

6 - 21 Flexible-Price Monetary Model w The flexible-price model predicts that: If the domestic money supply M increases, the domestic currency will depreciate proportionately. è If domestic real income Y rises or domestic interest rate i falls, the domestic currency will appreciate as the demand for domestic money is increased. è • Notably, these predictions are contrary to those from traditional theories! • Monetary theory considers capital flows in addition to trade balances. It also emphasizes the change in nominal interest rates rather than real interest rates. . Mc. Graw Hill / Irwin 2001 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

6 - 22 Sticky-Price (Overshooting) Monetary Model w Goods prices are assumed to be sticky (slow to adjust) relative to asset prices. As such, asset prices have to move by more than in the flexible price case, in order for markets to reach a temporary equilibrium. è The exchange rate follows a dynamic adjustment path. (The real exchange rate changes in the short run, but reverts to its original level in the long run. ) è w Perfect capital mobility (IRP) and perfect certainty are also assumed. Mc. Graw Hill / Irwin 2001 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

6 - 23 Sticky-Price (Overshooting) Monetary Model When a monetary shock occurs at time t 1. . . S 1 Nominal exchange rate ($/FC) US price level SN S 0 PN P 0 $ Interest rate M 1 US money supply M 0 t 1 Mc. Graw Hill / Irwin t. N Time 2001 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

6 - 24 Sticky-Price (Overshooting) Monetary Model w Both the nominal and real exchange rates follow an overshooting path. (The immediate, shortrun change exceeds the long-run change. ) w The path of the exchange rate is given by: where is the rate at which the exchange rate adjusts toward its long-run equilibrium. Mc. Graw Hill / Irwin 2001 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

6 - 25 The Portfolio-Balance Approach w The portfolio-balance model has two financial assets (money and bonds) and two countries (home and foreign). w In the model, the exchange rate establishes an equilibrium in investor portfolios comprised of domestic money and domestic and foreign bonds. w home country wealth W = M + B + SF where M - domestic money, B - domestic bonds SF - value of foreign bonds F Mc. Graw Hill / Irwin 2001 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

6 - 26 The Portfolio-Balance Approach w The balance between domestic and foreign bonds in a portfolio is positively related to the expected excess return on domestic bonds over foreign bonds, . w = i - i* - E(s) The domestic demand for domestic bonds is positively related to the domestic interest rate i. è The domestic demand foreign bonds is positively related to the foreign interest rate i * augmented by the expected exchange rate change E(s). 2001 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Mc. Graw Hill / Irwin è

6 - 27 The Portfolio-Balance Approach w The portfolio-balance approach allows imperfect substitutability between domestic and foreign bonds, with risk premium 0. w As W increases, individuals hold more of each asset (M, B, and F) in their portfolios. w The investors’ asset preferences may be similar across countries (uniform preference model), or the investors may prefer the assets of their home country (preferred local habitat model). Mc. Graw Hill / Irwin 2001 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

6 - 28 The Portfolio-Balance Approach Effects of Macroeconomic Shocks on the Exchange Rate Model all preferred local habitat Mc. Graw Hill / Irwin Impact on home currency Increase in B F i i* E(s) supply of home country bonds supply of foreign country bonds domestic interest rates foreign interest rate expected rate of home currency depreciation W home country wealth CA home country current account surplus + depreciates - appreciates 2001 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Empirical Evidence on 6 - 29 Exchange Rate Models w In-sample results can measure how well actual exchange rates conform to the predictions and specifications of an estimated model. w Post-sample results can measure how accurately a model forecast exchange rates once the model’s coefficients have been estimated. w News can measure the relationship between unanticipated exchange rate movements and unanticipated macroeconomic events. Mc. Graw Hill / Irwin 2001 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Empirical Evidence on 6 - 30 Exchange Rate Models w The initial analysis of the monetary approach produced generally favorable results. w But by the late 1970 s, the predictions failed, probably in relation to the turbulent structural changes that occurred at the same time. w More recent studies have offered more encouraging results. w Studies on the impact of news have been consistently encouraging too. Mc. Graw Hill / Irwin 2001 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

6 - 31 Policy Matters - Private Enterprises w For business managers, portfolio managers, and individual investors, the foreign exchange rate is a key variable in all aspects of international financial decision making. w Can these managers and investors use fundamentals to forecast better than the random walk? Mc. Graw Hill / Irwin 2001 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

6 - 32 Policy Matters - Public Policymakers w If the level and volatility of the exchange rate create competitive problems for local businesses, this is a public policy concern. Is the exchange rate level a fair reflection of economic fundamentals? è Is the exchange rate variability excessive? Do speculative bubbles exist? è Normative economics: How will prospective policy changes affect the level and variability of exchange rates? è Mc. Graw Hill / Irwin 2001 by The Mc. Graw-Hill Companies, Inc. All rights reserved.