Transcript Chapter 6

International Financial Markets
Prices and Policies
Second Edition ©2001
Richard M. Levich
6

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Spot Exchange Rate Determination
6-2
Overview
 News and Foreign Exchange Rates: An
Introduction
Exchange Rates and News Stories: Three
Illustrations
 News and Foreign Exchange Rates: A Summary

 Flow vs. Stock Models of the Exchange Rate
An Overview of the Flow Approach
 An Overview of the Stock Approach
 Combining Flow and Stock Concepts of the
Exchange Rate

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6-3
Overview
 Asset Models of the Spot Exchange Rate
The Monetary Approach
 The Portfolio-Balance Approach

 Empirical Evidence on Exchange Rate Models
In-Sample Results
 Post-Sample Results
 The Role of News

 Policy Matters - Private Enterprises
 Policy Matters - Public Policymakers
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News and Foreign Exchange Rates:
An Introduction
6-4
 Financial markets are preoccupied with news.
 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.
 While two news announcements may seem similar,
their underlying aspects may be in fact different.

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Exchange Rates and News Stories:
6-5
Three Illustrations
 Story 1: At time t1, 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.
 Case b: The US$ strengthens as the market believes
that the Federal Reserve will take corrective actions.
 Case c: The US$ weakens and then steadily
depreciates as the market feels that the change in the
growth rate is permanent.

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Story 1: An Increase in the U.S. Money Supply
c
a
Nominal exchange
rate ($ /FC)
b
c
a
b
U.S. price level
c
b
$ interest rate
a
c
a
U.S.
money supply
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b
t1
t2
Time
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Exchange Rates and News Stories:
6-7
Three Illustrations
 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.
 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.

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Exchange Rates and News Stories:
6-8
Three Illustrations
 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.
 Case g: The change is due to greater private sector
investments, and the US$ strengthens as foreign
capital flows in to finance the investments.

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News and Foreign Exchange Rates:
6-9
A Summary
 Only unanticipated events cause exchange rates
to deviate from their expected path of
movement.
 Factors that increase the demand for a currency
tend to raise the price of that currency.
 The “character” and the “context” of the
economic news item will greatly influence the
“nature” of the exchange rate response that
follows.
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Flow versus Stock Models
6 - 10
of the Exchange Rate
 An exchange rate determination model requires
the specification of demand and supply curves,
the intersection of which determines the price.
 Until the early 1970s, 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.
 Most modeling attempts thus concentrated on
currency flows, and suggested a sluggish pattern
of exchange rate behavior.
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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
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Flow versus Stock Models
6 - 12
of the Exchange Rate
 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.
 The asset approach gained favor in the late
1960s and early 1970s, in part because financial
market transactions became more important as
capital flow restrictions and currency
convertibility rules were removed.
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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
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Flow versus Stock Models
6 - 14
of the Exchange Rate
 The asset approach is inherently “forward
looking” and predicts quick movements in the
exchange rate to reflect new information.
 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.
 This idea is developed in the International
Fisher Effect:
1  i  ~
St 
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£
1  i$ 
 
 E St 1
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Combining Flow and Stock Concepts
6 - 15
of the Exchange Rate
 An overall equilibrium requires a balance in
both flow and stock aspects of the market.
 Stock concepts are of primary importance for
determining exchange rates in the short run.
 Flow imbalances can be maintained over the
short run, but not in the long run.
 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.
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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
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Portfolio-Balance Approach
imperfect capital substitutability
Small Country Model
Preferred Local
Habitat Model
Uniform Preference
Model
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Asset Models
6 - 17
of the Spot Exchange Rate
 In asset models, the interrelationship between
the demand and supply of the specified assets
determines the price of foreign exchange.
 The only assets in the monetary approach are
domestic and foreign money, M and M*, which
are assumed to display perfect substitutability.
 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.
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The Monetary Approach
 The monetary approach is a direct outgrowth of
purchasing power parity and the quantity theory
of money.
 It suggests that the spot exchange rate is the
relative price of two monies.
 Within the monetary approach, there are two
models - the flexible-price model and the
sticky-price (overshooting) model.
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6 - 19
Flexible-Price Monetary Model
 Domestic good prices are assumed to be fully
flexible, implying that PPP holds continuously
and that the real exchange rate never changes.
 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
 For the foreign country, P* = M* / L(Y*,i*)
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Flexible-Price Monetary Model
 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
 By PPP, S home/foreign

 ln St  m  m
*
P
MK *Y * e i
 *  *   i*
P
M KY e
   y
t
*
 


 y t  k  k t  i i
*
*

t
where m  ln M , k  ln K , y  ln Y
t is a time subscript
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Flexible-Price Monetary Model
 The flexible-price model predicts that:
If the domestic money supply M increases, the
domestic currency will depreciate proportionately.
 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.

• 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..
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Sticky-Price (Overshooting) Monetary Model
 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.
 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.)

 Perfect capital mobility (IRP) and perfect
certainty are also assumed.
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Sticky-Price (Overshooting) Monetary Model
When a monetary shock occurs at time t1 ...
S1
Nominal exchange
rate ($/FC)
SN
S0
PN
US price level P0
$ Interest rate
M1
US money supply
M0
t1
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tN
Time
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6 - 24
Sticky-Price (Overshooting) Monetary Model
 Both the nominal and real exchange rates
follow an overshooting path. (The immediate,
short-run change exceeds the long-run change.)
 The path of the exchange rate is given by:
1
*
*
*
st   m  m  t    y  y  t   i  i  t

where  is the rate at which the exchange rate adjusts
toward its long-run equilibrium.
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6 - 25
The Portfolio-Balance Approach
 The portfolio-balance model has two financial
assets (money and bonds) and two countries
(home and foreign).
 In the model, the exchange rate establishes an
equilibrium in investor portfolios comprised of
domestic money and domestic and foreign
bonds.
 home country wealth W = M + B + SF
where M - domestic money, B - domestic bonds
SF - value of foreign bonds F
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The Portfolio-Balance Approach
 The balance between domestic and foreign
bonds in a portfolio is positively related to the
expected excess return on domestic bonds over
foreign bonds,  .
  = i - i* - E(s)
The domestic demand for domestic bonds is
positively related to the domestic interest rate i.
 The domestic demand for foreign bonds is positively
related to the foreign interest rate i* augmented by
the expected exchange rate change E(s).

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The Portfolio-Balance Approach
 The portfolio-balance approach allows
imperfect substitutability between domestic and
foreign bonds, with risk premium   0.
 As W increases, individuals hold more of each
asset (M, B, and F) in their portfolios.
 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).
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The Portfolio-Balance Approach
Effects of Macroeconomic Shocks on the Exchange Rate
Model
all
preferred
local
habitat
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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
Impact on
home currency
+ depreciates
- appreciates
- appreciates
+ depreciates
+ depreciates
- appreciates
- appreciates
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Empirical Evidence on
6 - 29
Exchange Rate Models
 In-sample results can measure how well actual
exchange rates conform to the predictions and
specifications of an estimated model.
 Post-sample results can measure how accurately
a model forecast exchange rates once the
model’s coefficients have been estimated.
 News can measure the relationship between
unanticipated exchange rate movements and
unanticipated macroeconomic events.
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Empirical Evidence on
6 - 30
Exchange Rate Models
 The initial analysis of the monetary approach
produced generally favorable results.
 But by the late 1970s, the predictions failed,
probably in relation to the turbulent structural
changes that occurred at the same time.
 More recent studies have offered more
encouraging results.
 Studies on the impact of news have been
consistently encouraging too.
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Policy Matters - Private Enterprises
 For business managers, portfolio managers, and
individual investors, the foreign exchange rate
is a key variable in all aspects of international
financial decision making.
 Can these managers and investors use
fundamentals to forecast better than the random
walk?
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Policy Matters - Public Policymakers
 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?
 Is the exchange rate variability excessive? Do
speculative bubbles exist?
 Normative economics: How will prospective policy
changes affect the level and variability of exchange
rates?

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