Mar 23 2004

Lesson 14

By

John Kennes

International Monetary Economics

Mar 23 2004

1. The coexistence of professional traders and inexperiened amateurs• Only a subset of traders are informed and have access to

information about the underlying value of assets• The remainder are noise traders who act on limited noisy

information• Noise traders can be either simply irrational or simply

misinformed. The result is they systematically lose money.• New noise traders continue to enter, stock prices diverge

from fundamental values, despite actions of professionals.• Andrei Shleifler (2000) Inefficient Markets, Oxford

University Press

2. The phenomenon of rational speculative bubbles

How and why might asset prices deviate from their fundamental values?

Mar 23 2004

– To see how bubbles arise, consider the valuation of a stock and assume that the real interest rate r is constant and the real dividend d is fixed forever.

– The fundamental value is q = (1/1+r)id = d/r summed over i = 0 until infinity

– It is constant and satisfies the no-profit condition since q=0

– The puzzling observation is that an infinite number of paths also satisfy the no-profit condition

– Consider the case where the stock price is higher than q. This is only possible if the share price is expected to rise tomorrow

– An overvalued share calls for a continuing increase in price

Speculative Bubbles (1)

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Speculative Bubbles (2)

Time

Asset Price

0

(1)

(2)

(3)

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– Only one of the paths does not explode, and it corresponds to its fundamental value

– The explosive paths are self-fullfilling: price rises because they are expected to.

– The apparent inexrable growth of the share price is called a speculative bubble

– There is a catch: Bubbles eventually burst. Why?– If the asset price grows indefinitely, it would

eventual exceed the world’s wealth, becoming too expensive for anyone.

– If there is a know date for this situation, the situation will unravel

Speculative Bubbles (3)

Mar 23 2004

– Bubbles may appear bizare because they have all the features of economic rationality and market efficiency, save the end

– Economists debate whether they exist or whether they can have subtle rational aspects

– Examples of claimed bubbles• Stock market crash of 1929, 87, and 89• Explosion of property prices in UK and Scandanavia in the

late 1980s, Ireland early 90s.• IT and the new economy in the late 90s and early 00s. See

behaviour of NASDAQ. Pattern very similar to the following:• Famous historical example: Tulipmania in Holland 1637

Speculative Bubbles (4)

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Tulipmania 1637

Guilders

1 Jan 10 Jan 20 Jan 30 Jan 10 Feb

.18

0

Mar 23 2004

– Only one of the paths does not explode, and it corresponds to its fundamental value

– The explosive paths are self-fullfilling: price rises because they are expected to.

– The apparent inexrable growth of the share price is called a speculative bubble

– There is a catch: Bubbles eventually burst. Why?– If the asset price grows indefinitely, it would

eventual exceed the world’s wealth, becoming too expensive for anyone.

– If there is a know date for this situation, the situation will unravel

Exchange Rate Determination in the Short Run

Mar 23 2004

– In 1979, Micheal Mussa made the following observations

1. On a dailybasis, changes in floating foreign exchange rates are largely unpredictable

2. On a month-to-month basis, over 90% of exchange rate movements are unexpected, and less than 10% are predictable

3. Countries with high inflation rates have depreciating currencies, and over the long run the rate of depreciation of the exchange rate between two countries is approximately equal to the difference in national inflation rates

Mussa’s Stylized Facts and the Asset Behaviour of Exchange Rates (1)

Mar 23 2004

4. Countries with rapidly expanding money supplies tend to have depreciating exchange rates vis-a-vis countries with slowly expanding money supplies. Countries with rapidly expanding money demands tend to have appreciating exchange rates vis-a-vis countries with slowly expanding money demands

5. In the longer run, the excess of domestic over foreign interest rates is roughly equal to the expected rate of appreciation of the foreign currency. On a day-to-day basis, however, the relationship is more tenuous

Mussa’s Stylized Facts and the Asset Behaviour of Exchange Rates (2)

Mar 23 2004

6. Actual changes in the spot exchange rate will tend to overshoot any smooth adjusting measure of the equilibrium exchange rate, the real exchange rate predicted by fundamentals.

7. The correlation between mon-to-month changes in exchange rates and monthly trade balances is low. On the other hand, in the longer run, countries with persistent trade deficits tend to have depreciating currencies, whereas those with trade surplus tend to have appreciating currencies.

Mussa’s Stylized Facts and the Asset Behaviour of Exchange Rates (3)

Mar 23 2004

– When a variable changes randomly from period to period, it is said to follow a random walk.

– In that case, the only change between its value today and its value tomorrow will be white noise

– Mussa’s first stylized fact– Can we understan the other stylized facts with a

simple economic model?

Unpredictable changes

Mar 23 2004

– Assume that economy can be collapsed into two periods – today (period 1) and the indefinite future when stationary equilibrium is reached (period 2)

– Assume output is constant Y– The LM curve describes money market equilibrium

in each periodMt / Pt = L (Y, it )

– The UIP conditon links the domestic and foreign interest rates, for period 1.

Mt / Pt = L (Y, i*- (S2– S1)/ S2)

Money Market Equilibrium (1)

Mar 23 2004

– Given S2 and i*, the money market imposes a positive relationship between the current exchange rate prices by an upward sloping MM schedule

– Why? Imagine the price level increases, this reduces real money supply so demand must also decrease.

– This occurs if the opportunity cost of holding domestic money, the nominal interest rate rises

– Since foreign rate is constant UIP implies the exchange rate must be expected to depreciate.

– Holding the future exchange rate S2 constant, the current exchange rate must appreciate.

Money Market Equilibrium (2)

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– Is this sensible?– Yes. The excess demand for money that follows a

price increase prompts domestic residents to borrow abroad

– The ensuing capital inflow leads to an appreciation

Money Market Equilibrium (3)

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– In the long run, goods market equilibrium is characterized by relative PPP

– i.e. A stable real exchange rate– If prices abroad are constant , the real exchange

rate remains unchanged as long as the exchange rate and the price level move in opposite directions

– i.e. An increase in the price level is met by an equiproportional depreciation

– The PPP schedule

Goods Market Equilibrium

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General Equilibrium

PPP (long run)

Nominal exchange rate

Price level

M

M

AC

B

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– The money market is always in equilibrium– The interest rate and exchange rate adjust

instantaneously to a level that guarantees equilibrium between money supply and demand

– As a result, the economy is always located on the MM schedule.

– On the other hand, PPP is expected to hold only in the long run, because of price stickiness

– In the short-run C corresponds to an undervalued exchange rate

Dynamic Adjustment (1)

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– Over time the price level must rise or the exchange rate must appreciate.

– The long-run equilibrium is restored as the economy moves up the MM curve

Dynamic Adjustment (2)

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– If prices are flexible, the gods market is always in equilibrium

– Starting from long run equilibrium at A (so that S2

=S1 and i=i*), we can consider a 5% increase in the money supply

– Long run neutrality implies the price level must increase and the exchange rate must decrease by 5%

– This causes a shift down of the MM curve to M’M’ and a long run equilibrium at C

– With fully flexible prices, neutrality occurs in the short run and the economy immediately jumps from A to C

– Predicts stylized fact 3: Countries with high inflation rates have depreciating currencies

Exchange rates with flexible prices

Mar 23 2004

General Equilibrium

PPP (long run)

Nominal exchange rate

Price level

M

AC

BM

M’

M’

P1 P2

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– In the short-run (period 1) it is more realistic to think of the price level as rigid, moving only slowly to eliminate goods market imbalances and deviations from the equilibrium real exchange rate.

– In the long run prices recover flexibility and increase 5%

– In period 1, however, the price remains unchanged at P1.

– At the same time, money market equilibrium requires the economy to jump to M’M’

– Overtime the price level adusts and moves from B to C

– A key feature is that B is below C. The short run nominal exchange rate overshoots its long run level. (Stylized Fact 6)

Exchange rates with sticky prices: Overshooting

Mar 23 2004

Overshooting over time

Time

S0

S1

M

P

i

S