Transcript Slide 1
Economic Modelling
Lecture 18 Exchange Rate: Purchasing Power Parity Uncovered Interest Parity Fixed or Flexible ER?
1
$ £ λ 1 Why is not appreciation of domestic currency not good for Foreign Investment?
.
85 Real 2004 Exchange Rate Net capital outflow
S
I
T
G
S-I
X
M
Net Cap Flow
X
M
Cap Flow
0 Current A/C bal +capital A/C bal =0 $ 1 .
45 £ 2001 Net capital inflow NX(λ) Net export When £ appreciate you get more $ per £.
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Exchange Rate and the Demand and Supply of Foreign Currency 2001: £ $ 0 .
69 E1 Depreciation Excess supply of FC Exports: X(E,Y*) E 0.66
A e NX Appreciation E2 2004: £ $ 0 .
53 Excess Demand for FC Imports: M(E,Y) 0 F Demand and supply of Foreign Currency [($) in UK] Dollar depreciated 23 percent between 2002 and 2004 3
Exchange Rate and the Demand and Supply of Foreign Currency 2003: £ $ 0 .
63 E1 Depreciation Excess supply of FC Exports: X(E,Y*) E 0.66
A e NX Appreciation E2 2004: £ $ 0 .
53 Excess Demand for FC Imports: M(E,Y) 0 F Demand and supply of Foreign Currency [($) in UK] Dollar depreciated 23 percent between 2002 and 2004 4
Musa (1979) ’s seven stylised facts on exchange rates ( from p.486 of the Burda and Wyplosz) • • • • • • • On daily basis changes in foreign are largely unpredictable.
On month to month basis over 90% are unpredictable, only 10% predictable.
Countries with high inflation have depreciating currencies. And the rate of deprecation approximately is equals the differences in the national inflation rates Countries with rapidly expanding money supply have depreciation exchange rates and countries with expanding money demand have appreciating currencies In the long run, excess of domestic interest rate over foreign interest rate equals the expected appreciation of the foreign currency.
Spot exchange rate tends to overshoot any smoothly adjusting measure of equilibrium exchange rate Countries with persistent trade deficits have depreciating currencies and countries with trade surplus have appreciating currencies in the long run. This relation is not obvious in the short run. 5
Purchasing Power Parity Theory of the Exchange Rate: Long Run Real Exchange Rate: Change in the real exchange rate:
EP
*
P
t
t
e
e t t
t
*
P t
*
P t t
Stable real exchange rate implies: PPP-hypothesis:
t t
0
e
e t t
*
g
* *
g
* 6
Purchasing Power Parity Theory : Notations P* is foreign price level, P is the domestic price level,
e t
is the change in the nominal exchange rate
e t
is the nominal exchange rate * = foreign inflation, * = growth rate of money supply abroad,
g
* = growth rate of economy abroad; = domestic inflation, = growth rate of money supply at home,
g
= growth rate of income at home 7
Fundamentals of A Stable Exchange Rate according to the PPP Theory Change in the exchange rate must equal the inflation deferential between home and foreign countries.
e e
t t
*
g
* * Inflation both at home and abroad equals
g
* differences in the growth rate of money supply and growth in money demand due to income growth. Liberal economies have free capital mobility: there is no control in inflow and outflow of capital; exchange rate is determined endogenously weaker economies cannot commit to free capital mobility and have controls in the mobility of capital. They fix the exchange rate arbitrarily to ration the foreign exchange. 8
Covered and Uncovered interest parity Covered Interest Parity (no risk)
i
i
*
F
E E
where F is forward exchange rate, i = domestic interest rate i* = foreign interest rate, E = actual exchange rate. Uncovered interest parity condition (interest differences are due to expected appreciation or depreciation): 1
i
1
i
* 1
E t e
1
E t
E t
i
i
*
E t e
1
E t
E t
Compare CIP and UIP
F t
E t e
1 is the forward Exchange rate 9
i i2 i1 Impact of Fiscal Policy on the Exchange Rate, Interest Rate and Output: ISLM Model IS2 UIP LM i i IS Y1 Y2 Fiscal expansion raises output and Appreciation Interest rate and an appreciation E2 E1 Depreciation 10
Purchasing Power Parity:
t e t
t
*
t
(1) Uncovered Interest Parity:
i t
i t
*
e t t
(2) Using the Fisher equation (2) becomes
t
r t
t
*
r t
*
e
t e t
Slight rearrangement:
t
t
*
e
t e t
r t
r t
* (3) (4) From PPP
t
t
*
t e t t
0
r t
r t
* When both PPP and UIP hold exactly the domestic and foreign real interest rates are equal. 11
Depreciation of Dollar or Appreciation of Pounds Between December 2001 and February 2004 Sterling Pound Appreciated
AR
£
E t
1
E t
E t
100 =
AR
£ 0 .
53 0 .
69 100 0 .
69 23 % Euro also appreciated
AR
E t
1
E t
E t
100 =
AR
0 .
78 1 .
11 100 1 .
11 29 .
7 % Yen also appreciated
AR Y
E t
1
E t E t
100 =
AR Y
105 128 100 128 18 % 12
Triangular Exchange Rates and Appreciation and Depreciation with respect to the Third Currency
Initial exchange rates End of 2002
1.11
0.98
0.78 £0.69 $1 £0.63 $1 £0.53 $1 2001 2002 2004
0 .
53
In 2004 one dollar in terms of pound and Euro is
0 .
78 0 .
63
In 2002 one dollar in terms of pound and Euro is
0 .
98 0 .
68 0 .
64 0 .
69
In 2001 one dollar in terms of pound and Euro is
1 .
11
Appreciation of
against £ (2001-04) =
0 .
68 0 .
62 0 .
62 0 .
621 0 .
0968 9 .
7 % 13
The Problems of Flexible Exchange Rates
The exchange rate can move for many other reasons than changes in the domestic interest rate. Expectations play a large role in the determination of the exchange rate. Flexible exchange rate may be subject to large fluctuations which, in turn, require large movements in the interest rate which can make the economy unstable. Exchange rate may overshoot for a long time 14
Which countries should have fixed exchange rates?
Countries with poor reputation for controlling inflation It is better to fix exchange rate with a country with a heavy trade link Country which has relatively little involvement in the global capital market Coutries with high level of foreign reserves.
Countries with flexible labour market.
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Disadvantages of Fixed Exchange Rate System Giving up the powerful exchange rate tool for external stabilisation. Sacrifice of domestic stability for external balance. Gives up control of its interest rate, no independent monetary policy Widespread speculation of a devaluation or shift to a flexible exchange rate system particularly when Economy is with higher inflation Or the currency is overvalued Fear of Speculative attacks require an increase in the interest rate. Frequent devaluation creates uncertainty and overvalued currency causes BOP problem. 16
Benefits and cost of a Monetary Union and Optimal Liberalisation?
Which countries benefit from a monetary union? Criteria for an optimal currency area Higher Degree of Trade Link
Impossible trilogy: fixed exchange rate free capital mobility monetary independence
Common shocks Degree of labour mobility Degree of fiscal transfers.
Optimal Order of Liberalization 1 st goods market (subsidies) 2 nd Trade (Tariffs) Financial market (no control on r) Full convertibility
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• • • • • • • • • • •
References
Britain in Euro http://www.britainineurope.org.uk/home.phtml Blanchard (19,20) Mankiw (2) M&S (20) Dornbusch R. (1976) Expectations and Exchange Rate Dynamics, Journal of Political Economy, vol. 84, no.6.
Fleming J. Marcus (1962) Domestic financial policies under fixed and under floating exchange rates, IMF staff paper 9, November , 369-379.
Krugman Paul (1979) A Model of Balance of Payment Crisis, Journal of Money Credit and Banking, 11, Aug.
Mundell Robert (1961) A Theory of Optimal Currency Areas, American Economic Review, September.
Mundell R. A (1962) Capital mobility and stabilisation policy under fixed and flexible exchange rates, Canadian Journal of Economic and Political Science, 29, 475 85.
Mussa Micheal Empirical Regularities in the Behaviour of Exchange Rates and Rogoff, K (1999) "International institutions for reducing global financial instability", Journal of Economic Perspectives, 1999 or NBER WP 7265.
Rogoff K and M Obstfeld (1996) Foundation of International Macroeconomics, MIT Press.
Taylor Mark (1995) The Economics of Exchange Rates, Journal of Economic Literature, March, vol 33, No. 1, pp. 13-47. 18