FIN 40500: International FinanceNominal Rigidities and Exchange Rate Volatility
So far, we have taken two approaches to exchange rate determinationThe trade balance approach equates the supply and demand for US dollars as derived from the trade balanceThe monetary approach approach equates the supply and demand for domestic and foreign currencies in money markets
Both of these approaches assume that commodity markets have enough time to adjust so that the prices of commodities are equalized across countries this makes both approaches useful for a long run predictionHowever, there is one key difference between these two frameworksTrade Balance ApproachPerfect correlation between exchange rate and trade balance (too much weight on current account) Monetary ApproachZero correlation between exchange rate and trade balance (too much weight on capital account)
The real issue at hand is the Balance of Payments, which measures the total flow of funds in and out of a country A balance of payments deficit would imply that dollars are leaving the US and flowing into the rest of the world. This excess supply of dollars should cause the international value of the dollar (aka the exchange rate) to depreciateLikewise, a BOP surplus (dollars flowing from the rest of the world to the US) should cause the dollar to appreciate due to lack of international supply
Current AccountCapital & Financial AccountBy definition, the actual balance of payments for the US (or any other country) is zero thats because cash is counted in the financial account
Change in US owned Assets Abroad US Official Reserve Assets US Government Assets US Private Assets Foreign Direct Investment SecuritiesChange in Foreign Ownership of US Assets Foreign Official Assets Private Foreign Assets Foreign Direct Investment Currency Securities
If we remove cash from the capital & financial accounts, we can develop a framework to think about commodity markets, currency markets, and asset marketsCurrency MarketsCurrent AccountCapital AccountTrade balances are determined largely from changes in incomeCapital accounts are determined largely from changes in interest ratesExchange Rates determined by international supply of dollars
Suppose trade is initially balanced. An increase in income will create a trade deficit (spending increases, savings decreases)Without a change in the KFA, we would have a balance of payments deficit and the dollar would be forced to depreciate.To create an offsetting KFA surplus, the return on US assets would need to rise to attract foreign capital.
The degree of international capital mobility will dictate the rise in domestic interest rates necessary to offset a trade imbalance.BOP Deficit - Currency DepreciatesBOP Surplus - Currency appreciatesBOP Surplus - Currency appreciatesBOP Deficit - Currency DepreciatesWith high capital mobility, there is plenty of capital looking for higher returns financing a trade deficit requires a small interest rate increaseWith low capital mobility, there is a shortage of capital looking for higher returns financing a trade deficit requires a large interest rate increase
The trade balance approach assumes that it is impossible to finance a trade deficit with asset sales - a trade deficit requires a currency depreciation! (no capital mobility)The monetary approach assumes that any trade deficit can be financed without a rise in interest rates (perfect capital mobility)The trade balance approach and monetary approach are two special cases
Home Currency (M) Pays no interest, but needed to buy goodsDomestic Bonds (B) Pays interest rate (i)Foreign Bonds (B*) Pays interest rate (i*), payable in foreign currencyForeign Currency (M*) Pays no interest, but needed to buy foreign goodsAs in the previous case, we begin with four commodities
Foreign Bond MarketDomestic Money MarketDomestic Bond MarketHouseholds choose a combination of the four assets for their portfoliosForeign Money MarketCurrency MarketBennyFluffy
Foreign Bond MarketDomestic Money MarketDomestic Bond MarketWe need five prices to clear all five marketsForeign Money MarketCurrency Market
For example, a 10% increase in the domestic money supply results is a long run 10% depreciation of the domestic currency.Over a long time horizon, all prices have a chance to adjust - currency prices return to their fundamental values and real returns are equalized across countriesHowever, its now assumed that commodity prices are fixed in the short run (P is constant) this causes PPP to fail!With fixed prices, the real and nominal exchange rates have a correlation of one!Further, real returns can vary across countries!
Instead, lets assume that foreign variables (i* and P*) are constant. That way, we can ignore the foreign markets!P* and i* are fixedWithout PPP, we need to explicitly analyze currency markets this complicates matters a bit!
Foreign Bond MarketDomestic Money MarketDomestic Bond MarketThis leaves three markets and three pricesForeign Money MarketCurrency Market
Our money market model hasnt changed. Cash is used to buy goods (transaction motive), but pays no interest- + Money DemandHigher interest rates lower money demandHigher real income raises money demandHigher prices raises money demand+ Money supply is assumed to be purely exogenous (a policy variable of the government)
+ -An equilibrium price level clears the money market (i.e. supply equals demand)Now, consider this price fixed over short time horizonsWith the price level fixed, the market will need to find a new way to adjust to changes in supply/demand
+ -Suppose that real income increases. This will raise the demand for money and put downward pressure on the price levelAssuming that the Fed keeps the money supply constant, we need something else to adjust to return demand to its original positionA rise in interest rates will return demand to its original position and maintain the constant price level.Excess Demand for Money
This positive relationship between interest rates and income in the money market is represented by the LM curve.At every point on the LM curve, For a fixed price levelNote: The LM curve represents the set of equilibria in the money market for a fixed level of real (inflation adjusted) money supply.
Suppose that the Fed increases the money supply. This will put upward pressure on prices. To maintain a constant price level, money demand must increase.This is accomplished by a drop in interest rates and a rise in incomeThis can be represented by the LM curve shifting to the right
Next, what is the relationship between the interest rate and income in the bond marketLower interest rates raise demand this higher demand generates higher incomeThe IS curve represents the negative relationship between interest rates and income in equilibrium
Suppose that an increase in government deficits forces interest rates upThe upward pressure on interest rates is represented by a shift to the right of the IS curve
Now we can put everything together to see all three markets (currency, bonds, money) in a short run equilibrium.The LM curve gives us the interest rate/income combination that clears the money marketThe BOP curve gives us the interest rate/income combination that clears the currency marketThe LM curve gives us the interest rate/income combination that clears the bond market
Suppose that the Federal reserve increases the supply of money by 10% The monetary approach describes the long run reaction of currency markets the dollar depreciates by 10%
Increases by 10%Short Run10%What happens in the short run?
Now we can put everything together to see all three markets (currency, bonds, money) in a short run equilibrium.The increase in the domestic money supply forces down interest rates in the short run while prices are fixedThe lower interest rate stimulates consumption expenditures and worsens the trade deficit.
lower interest rates decreases the demand for domestic assets dollar demand dropsIncreased trade deficit increases supply of dollarsDollar DepreciatesWe have a new short run (temporary) equilibrium.
10%Heres what we know.The dollar will eventually depreciate by 10% (long run)An immediate depreciation is also required to equalize the balance of paymentsInterest rates in the US have droppedIf US interest rates fall relative to foreign rates, the dollar must appreciate at some point to equalize the returns
10%What happens to the real exchange rate?NominalRealIn the short run, with fixed prices, the real exchange rate mimics the nominal rate in the long run, PPP holds and the real exchange rate is constant
Suppose that the experiences a 10% increase in incomeAgain, we know that long run impact will be a 10% dollar appreciationShort RunWhat happens in the short run?Increases by 10%10%
This increase in income is due to increases in US government spending financed by borrowinghigher interest rates increases the demand for domestic assets dollar demand risesIncreased trade deficit increases supply of dollarsWhat happens to the value of the dollar?
If capital is very mobile globally, then the rise in interest rates domestically will be more than enough to finance the trade deficitThe balance of payments surplus forces the dollar to appreciate in the short run.
10%Heres what we know.The dollar will eventually appreciate by 10% (long run)A