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FIN 40500: International Finance Nominal Rigidities and Exchange Rate Volatility

FIN 40500: International Finance

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FIN 40500: International Finance. Nominal Rigidities and Exchange Rate Volatility. So far, we have taken two approaches to exchange rate determination. The trade balance approach equates the supply and demand for US dollars as derived from the trade balance. - PowerPoint PPT Presentation

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Page 1: FIN 40500: International Finance

FIN 40500: International Finance

Nominal Rigidities and Exchange Rate Volatility

Page 2: FIN 40500: International Finance

So far, we have taken two approaches to exchange rate determination

ttt NXe %

e

$D

S The trade balance approach equates the supply and demand for US dollars as derived from the trade balance

yiL ,M

M

P The monetary approach approach equates the supply and demand for domestic and foreign currencies in money markets

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*

* 11ii

YY

MMe

Page 3: FIN 40500: International Finance

*ePP

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 prediction

However, there is one key difference between these two frameworks

Trade Balance Approach

Perfect correlation between exchange rate and trade balance (too much weight on current account) Monetary Approach

Zero correlation between exchange rate and trade balance (too much weight on capital account)

Page 4: FIN 40500: International Finance

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 depreciate

Likewise, 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

Page 5: FIN 40500: International Finance

Change in US owned Assets Abroad

US Official Reserve Assets

US Government Assets

US Private Assets Foreign Direct Investment

Securities

Change in Foreign Ownership of US Assets

Foreign Official Assets

Private Foreign Assets

Foreign Direct Investment

Currency

Securities

Merchandise

Services

Income

Unilateral Transfers

Current Account Capital & Financial Account

By definition, the actual balance of payments for the US (or any other country) is zero – that’s because cash is counted in the financial account

KFACABOP

Page 6: FIN 40500: International Finance

If we remove cash from the capital & financial accounts, we can develop a framework to think about commodity markets, currency markets, and asset markets

Currency Markets

Current Account Capital AccountTrade balances are determined largely from changes in income

Capital accounts are determined largely from changes in interest rates

Exchange Rates determined by international supply of dollars

Page 7: FIN 40500: International Finance

r

r

TGI

S Suppose trade is initially balanced. An increase in income will create a trade deficit (spending increases, savings decreases)

SI ,

KFACABOP 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.

Page 8: FIN 40500: International Finance

The degree of international capital mobility will dictate the rise in domestic interest rates necessary to offset a trade imbalance.

r

y

r

yBOP Deficit - Currency Depreciates

BOP Surplus - Currency appreciates

BOP Surplus - Currency appreciates

BOP Deficit - Currency Depreciates

With high capital mobility, there is plenty of capital looking for higher returns – financing a trade deficit requires a small interest rate increase

With low capital mobility, there is a shortage of capital looking for higher returns – financing a trade deficit requires a large interest rate increase

0BOP0BOP

Page 9: FIN 40500: International Finance

r

y

r

y

0BOP

0BOP

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

wr

Page 10: FIN 40500: International Finance

Home Currency (M) Pays no interest, but needed to buy goods

Domestic Bonds (B) Pays interest rate (i)

Foreign Bonds (B*) Pays interest rate (i*), payable in foreign currency

Foreign Currency (M*) Pays no interest, but needed to buy foreign goods

As in the previous case, we begin with four commodities

Page 11: FIN 40500: International Finance

Foreign Bond Market

Domestic Money Market

Domestic Bond Market

Households choose a combination of the four assets for their portfolios

Foreign Money Market

Currency Market

BennyFluffy

Page 12: FIN 40500: International Finance

Foreign Bond Market

Domestic Money Market

Domestic Bond Market

We need five prices to clear all five markets

Foreign Money Market

Currency Market

eiiPP ,,,, **

Page 13: FIN 40500: International Finance

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 countries

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MMe

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However, it’s now assumed that commodity prices are fixed in the short run (P is constant) – this causes PPP to fail!

PePRER

*

With fixed prices, the real and nominal exchange rates have a correlation of one!

Further, real returns can vary across countries!

Page 14: FIN 40500: International Finance

Instead, let’s assume that foreign variables (i* and P*) are constant. That way, we can ignore the foreign markets!

P* and i* are fixed

Without PPP, we need to explicitly analyze currency markets – this complicates matters a bit!

Page 15: FIN 40500: International Finance

Foreign Bond Market

Domestic Money Market

Domestic Bond Market

This leaves three markets and three prices

Foreign Money Market

Currency Market

eiP ,,

Page 16: FIN 40500: International Finance

Our money market model hasn’t changed. Cash is used to buy goods (transaction motive), but pays no interest

- +

Money Demand Higher interest

rates lower money demand

Higher real income raises money demand

Higher prices raises money demand

+ yiPLM d ,,

Money supply is assumed to be purely exogenous (a policy variable of the government)

MM s

Page 17: FIN 40500: International Finance

++ - yiL ,

M

M

P

P

An equilibrium price level clears the money market (i.e. supply equals demand)

yiMPP ,,

Now, consider this price fixed over short time horizons

With the price level fixed, the market will need to find a new way to adjust to changes in supply/demand

Page 18: FIN 40500: International Finance

++ - yiL ,

M

M

P

P

Suppose that real income increases. This will raise the demand for money and put downward pressure on the price level

Assuming that the Fed keeps the money supply constant, we need something else to adjust to return demand to its original position

A rise in interest rates will return demand to its original position and maintain the constant price level.

Excess Demand for Money

Page 19: FIN 40500: International Finance

y

iLM

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,

yiLMM ds ,

For a fixed price level

Note: The LM curve represents the set of equilibria in the money market for a fixed level of real (inflation adjusted) money supply.

Page 20: FIN 40500: International Finance

yiL ,M

M

P

P

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 income

y

iLM

This can be represented by the LM curve shifting to the right

Page 21: FIN 40500: International Finance

i

IS ,

S

TGI

i

Next, what is the relationship between the interest rate and income in the bond market

i

yIS

Lower interest rates raise demand – this higher demand generates higher income

The IS curve represents the negative relationship between interest rates and income in equilibrium

Page 22: FIN 40500: International Finance

i

IS ,

S

TGI

i

Suppose that an increase in government deficits forces interest rates up

i

yIS

The upward pressure on interest rates is represented by a shift to the right of the IS curve

Page 23: FIN 40500: International Finance

i

i

yIS

LM

0BOP

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 market

The BOP curve gives us the interest rate/income combination that clears the currency market

The LM curve gives us the interest rate/income combination that clears the bond market

Page 24: FIN 40500: International Finance

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%

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MMe

Increases by 10%

e

timeShort Run

10%What happens in the short run?

Page 25: FIN 40500: International Finance

i

i

yIS

LM

0BOP

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 fixed

The lower interest rate stimulates consumption expenditures and worsens the trade deficit.

Page 26: FIN 40500: International Finance

lower interest rates decreases the demand for domestic assets – dollar demand drops

Increased trade deficit increases supply of dollars

Dollar Depreciates

i

i

yIS

LM

0BOP

We have a new short run (temporary) equilibrium.

Page 27: FIN 40500: International Finance

e

time

10%

*% iieE t

Here’s what we know….

1. The dollar will eventually depreciate by 10% (long run)

2. An immediate depreciation is also required to equalize the balance of payments

3. Interest rates in the US have dropped

If US interest rates fall relative to foreign rates, the dollar must appreciate at some point to equalize the returns

Page 28: FIN 40500: International Finance

e

time

10%

What happens to the real exchange rate?

PePRER

*

Nominal

Real

In 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

Page 29: FIN 40500: International Finance

Suppose that the experiences a 10% increase in income

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YY

MMe

Again, we know that long run impact will be a 10% dollar appreciation

e

timeShort Run

What happens in the short run?

Increases by 10%

10%

Page 30: FIN 40500: International Finance

i

i

yIS

LM

This increase in income is due to increases in US government spending financed by borrowing

higher interest rates increases the demand for domestic assets – dollar demand rises

Increased trade deficit increases supply of dollars

What happens to the value of the dollar?

Page 31: FIN 40500: International Finance

i

i

yIS

LM

If capital is very mobile globally, then the rise in interest rates domestically will be more than enough to finance the trade deficit

KFACABOP

0BOP

The balance of payments surplus forces the dollar to appreciate in the short run.

Page 32: FIN 40500: International Finance

e

time

10%

*% iieE t

Here’s what we know….

1. The dollar will eventually appreciate by 10% (long run)

2. An immediate appreciation is also required to equalize the balance of payments

3. Interest rates in the US have risen

If US interest rates rise relative to foreign rates, the dollar must depreciate at some point to equalize the returns

Page 33: FIN 40500: International Finance

i

i

yIS

LM

If capital has very low mobility, then the rise in interest rates domestically will not be enough to finance the trade deficit

KFACABOP

0BOP

The balance of payments deficit forces the dollar to depreciate in the short run.

Page 34: FIN 40500: International Finance

e

time

10%

Here’s what we know….

1. The dollar will eventually appreciate by 10% (long run)

2. An immediate depreciation is also required to equalize the balance of payments

3. Interest rates in the US have risen

Note that uncovered interest parity fails (US interest rates rise and the dollar appreciates) – that’s because of the low capital mobility

Page 35: FIN 40500: International Finance

Bottom Line When commodity prices are not allowed to

adjust, asset/currency markets take over to determine exchange rates

This interplay between currency markets and asset markets creates excessive short run volatility

Real exchange rate changes are due to fixed commodity prices