Chapter 15 International Economic Slides

International Economics

1. BCE 412 INTERNATIONAL ECONOMICS PART 3: BOP; FOREX; EXCHANGE RATE

2. Chapter 15 Exchange Rate Determination LEARNING OUTCOMES Examine the modern exchange rate theories: Understand the purchasing power parity theory Understand how the monetary and the portfolio balance models of the exchange rate work Understand the causes of exchange rate overshooting

3. Introduction International financial flows are now larger than trade flows, shifting the focus to monetary theories of exchange rates. Monetary exchange rate theories view the exchange rate as a purely financial phenomenon. They also seek to explain the short-run volatility of exchange rates and their tendency to overshoot their long-run equilibrium level, which have often been observed during the past four decades.

4. Introduction These theories are based on the monetary approach and the asset market or portfolio balance approach to the balance of payments They have been developed since the late 1960s These modern exchange rate theories may be distinguished from traditional exchange rate theories (discussed in Chapters 16 and 17), which are based on trade flows and help explain exchange rate movements only in the long run

5. Purchasing Power Parity Theory The purchasing-power parity (PPP) theory by the Swedish economist Gustav Cassel Is fundamental concept in economics that focuses on exchange rates and price levels between different countries The main idea of PPP is price levels changes determine the exchange rate change between two countries the rates of currency conversion that equalize the purchasing power of different currencies by eliminating the differences in price levels between countries.

6. Purchasing Power Parity Theory The purchasing-power parity (PPP) theory The exchange rate of two currencies is positively related to the price level in foreign country and negatively related to price level in home country. in the absence of transportation costs, identical goods should have the same price when expressed in a common currency. exchange rates should adjust over time to equalize the prices of an identical basket of goods in different countries. Critics argue that PPP doesn't always hold in the short term due to factors like market imperfections

7. Purchasing Power Parity Theory There is an absolute and a relative PPP theory. The “Law of One Price” as a basic of PPP theory and show its absolute and relative aspects. Absolute Purchasing Power Parity postulates: that the equilibrium exchange rate between two currencies is equal to the ratio of the price levels in the two nations. R = P/ P * Where R = exchange rate or spot rate P = general price level in home nation P* = general price level in foreign nation

8. Purchasing Power Parity Theory Absolute Purchasing Power Parity Example: If the price of a bushel of wheat is $1 in the United States and €1 in the European Monetary Union, then the exchange rate between the dollar and the euro should be R = $1/ €1 = 1. That is, according to the law of one price The law of one price states: A given commodity should have the same price (so that the purchasing power of the two currencies is at parity) in both countries when expressed in terms of the same currency. Caused by commodity arbitrage.

9. Purchasing Power Parity Theory Absolute PPP theory can be misleading because: 1st, it appears to give exchange rate that equilibrates trade in goods and services while ignoring capital account. At exchange rate that equilibrates trade in goods and services, capital inflows would produce surplus in balance of payments, while capital outflows would lead to deficits. Meaning a nation experiencing capital outflows would have a deficit in its BP, while nation receiving capital inflows would have a surplus if ER were the that equilibrated international trade in goods and services

10. Purchasing Power Parity Theory Absolute PPP theory can be misleading because: 2nd, this version will not even give exchange rate that equilibrates trade in goods and services because of existence of nontraded goods. International trade tends to equalize prices of traded goods and services, not nontraded goods. Furthermore, the absolute PPP theory fails to take into account transportation costs

11. Purchasing Power Parity Theory Relative Purchasing-Power Parity postulates: The change in the exchange rate over a period of time should be proportional to the relative change in the price levels in the two nations over the same time period Where R 1 and R = exchange rates in period 1 and base period Helps to explain how differences in inflation rates between two countries will result in an equal impact on their exchange rate R 1 = R P 1 / P P* 1 / P*

12. Purchasing Power Parity Theory Relative Purchasing-Power Parity: Example: If the general price level does not change in the foreign nation, from base period to period 1 (P*1/P*0 = 1), while the general price level in the home nation increases 50%, the relative PPP theory says the exchange rate should be 50% higher (home currency should depreciate 50%) in period 1 as compared to base period. Note that if the absolute PPP held, the relative PPP would also hold, but when the relative PPP holds, the absolute need no to hold.

13. Monetary Approach to the Balance of Payments and Exchange Rates This approach was started toward the end of the 1960s by Robert Mundell and Harry Johnson (1970s). Theoretical framework used in economics to understand the relationship between a country's money supply, exchange rates, and its balance of payments. Views both the balance of payments and exchange rate are purely monetary phenomenon.

14. Monetary Approach to the Balance of Payments and Exchange Rates Money plays crucial role in the long run as both a disturbance and as an adjustment in a nation balance of payments. The monetary approach assumes that exchange rates are primarily determined by changes in the money supply and the demand for money It suggests that when a country increases its money supply, its currency's value tends to depreciate, and vice versa

15. Monetary Approach to the Balance of Payments and Exchange Rates The approach relies on two key assumptions: a . Money supply is determined by the country's central bank. b. The demand for money is a function of income and interest rates . a country's balance of payments reflects its monetary policy decisions: A surplus or deficit in the balance of payments can be linked to changes in the money supply and exchange rate

16. Monetary Approach to the Balance of Payments and Exchange Rates Under Fixed Exchange Rates : Monetary approach states that the demand for nominal money balances is positively related to the level of nominal income and is stable in the long-run. Used the qty theory of money as the basis of function Thus, the equation for the demand for money can be written as: = quantity demanded of nominal money balances k = desired ratio of nominal money balances to nominal national income P = domestic price level and Y = real output  

17. Monetary Approach to the Balance of Payments and Exchange Rates Under Fixed Exchange Rates PY is the nominal national income or output (GDP). The parameter k measure the sensitivity of money demand to change in income; k= 1/V , where V is the velocity of circulation of money or the average number of times a currency change from one hand to another over in the economy during a year

18. Monetary Approach to the Balance of Payments and Exchange Rates The equation for the supply for money can be written as: Ms = the nation’s total money supply m = money multiplier (fixed) D = domestic component of the nation’s monetary base F = international or foreign component of the nation’s monetary base (D) is the domestic credit created by the nation’s monetary authorities or the domestic assets backing the nation’s money supply. (F) refers to the international reserves of the nation, which can be increased or decreased through balance-of-payments surpluses or deficits  

19. Monetary Approach to the Balance of Payments and Exchange Rates Starting with equilibrium wher e An increase in can satisfied by an increase in D or F And if the monetary authorities do not increase D, the excess demand for money can be satisfied by an increase in F An increase in D and money supply with an unchanged , money flows out of the country leading to a fall in F and a deficit in the BoP Meaning that surplus in BoP is a results from an excess in stock of money demanded that is not satisfied by the domestic monetary authorities BoP deficit and surplus are self-adjusting in long-run as country has not control over its money supply under fixed exchange rate in the LR  

20. Monetary Approach to the Balance of Payments and Exchange Rates Under Flexible Exchange Rates: Bop disequilibrium are corrected by automatic change in exchange rates Adjustment takes place as a results of the change in domestic prices and change in exchange rate Country has control over its money supply and monetary policy A deficit in the Bop resulting from an excess money supply leads to an automatic depreciation of the currency and causes the prices to rise

21. Monetary Approach to the Balance of Payments and Exchange Rates Under Flexible Exchange Rates: Demand for money will rise sufficiently to absorb the excess supply of money and automatically eliminate the deficit in BoP A surplus in the BoP resulting from an excess demand for money automatically leads to an appreciation of the currency and a reduction in domestic price, thus eliminating the excess demand for money and surplus So, under flexible exchange rate, equilibrium is return through with change in price level and corresponding change in exchange rate

22. Monetary Approach of Exchange Rate Determination The equation for demand for money in home country is given by: And the demand for money in the foreign country as: Equilibrium Exchange rate is determined by PPP: that is, R = P/P* In equilibrium, the quantity of money demanded is equal to the quantity of money supplied . That is, and  

23. Monetary Approach of Exchange Rate Determination Substituting for and for and dividing, we get: = Since, R = P/P* because of PPP, we can rewrite the above equation as: = Therefore, we can write the exchange rate equation as: R =  

24. Monetary Approach of Exchange Rate Determination That is: Exchange rate is determined by the relatively supply and demand for domestic money stock of the two countries An increase in domestic money stock relatively to foreign money stock will lead to a rise in exchange rate or depreciation of home currency An increase in the domestic income relatively to the foreign income leads to a fall in exchange rate or appreciation of home currency This is why the MA sees the BoP and exchange rate determination as a pure monetary phenomenon

25. Portfolio Balance Model and Exchange Rates The portfolio balance approach (also called the asset market approach ) Extension of the monetary approach as it included other financial assets besides money The portfolio balance approach was developed since the mid-1970s Pioneered by William Brason and Pennti Kouri and has been modified by various authors

26. Portfolio Balance Model and Exchange Rates The portfolio balance approach states that: The exchange rate is determined in the process of equilibrating or balancing the stock or total demand and supply of financial assets in each country Regard ed as a more realistic and comprehensive approach According to the portfolio balance approach, equilibrium in each financial market occurs when the quantity demanded of each financial asset equals its supply. Investors hold a diversified and balanced portfolio of financial assets This is why it is called portfolio balance approach

27. Portfolio Balance Model and Exchange Rates I ndividuals and firms hold their financial wealth in some combination of: Domestic money Domestic bond Foreign bond denominated in foreign currency Demand for financial assets are influence by: Domestic interest rate ( i ) Foreign interest rate ( i *) Expected Appreciation of foreign currency (EA) Risk Premium (RP) Real I ncome /Output (Y) Domestic Price Level (P) Wealth (W) of the Residents in the country

28. Portfolio Balance Model and Exchange Rates Let analyse the demand function for financial assets Home demand function for domestic money is given as: M = f ( i , i *, EA, RP, Y, P, W) + related to RP, Y, P, W - related to i , i *, EA Demand function for domestic bond is given as: M = f ( i , i *, EA, RP, Y, P, W) + related to i , RP and W - related to i *, EA, and P Demand function for foreign bond is given as: M = f ( i , i *, EA, RP, Y, P, W) + related to i *, EA, and W - related to i , RP, Y, and P

29. Portfolio Balance Model and Exchange Rates All three financial assets are substitutes of each Demand for the three assets will equal their respective supplies All Supplies of all assets are assumed to be exogenous. Let look at the Portfolio Adjustments and Exchange rates Given equilibrium, exogenous action will cause disturbances compelling investors to modify their portfolios assets As response, investors buy or sell their assets because of increase or reduction to foreign bonds stock

30. Portfolio Balance Model and Exchange Rates This will cause home currency to appreciate or depreciate or BoP surplus or deficit but only temporary It occurs only while the adjustment process to new equilibrium portfolios is taking place If investors demand more of a foreign asset, either because of higher relative foreign interest rates or increased wealth, demand for foreign currency will increase, depreciating domestic currency

31. Portfolio Balance Model and Exchange Rates If investors sell foreign assets, either because of lower relative foreign interest rates or decreased wealth, supply of foreign currency will increase, appreciating domestic currency. The exchange rate is determined in the process of reaching equilibrium in each financial market. Exchange rate changes are the result of portfolio adjustment. The PBM includes the real income or output of the nation (GDP), the price level (P), and the wealth (W) of the nation, as in the monetary approach

32. Exchange Rate Dynamics Exchange Rate Overshooting F irst introduced by economist Rudi Dornbusch. It refers to the temporary and excessive change in exchange rates in response to changes in monetary policy, particularly interest rates and money supply. Thus, exchange rate must overshoot or bypass its long run equilibrium level for equilibrium to be quickly reestablished in financial markets

33. Exchange Rate Dynamics Causes: Exchange Rate Overshooting : Monetary policy shocks : a significant raise in ( i ) can lead to rapid appreciation of domestic the currency Price Stickiness : prices of goods and services do not adjust immediately to changes in exchange rates. This lag in price adjustment causes the exchange rate to move more than what would be expected in the long run. Market Expectation and Dynamics : market participants' expectations of future economic conditions. If investors anticipate future changes in interest rates or inflation, they may react quickly, causing exchange rates to overshoot their long-term equilibrium values.

34. Exchange Rate Dynamics Causes: Exchange Rate Overshooting : Exchange rates are determined by supply and demand in the foreign exchange market. Temporary imbalances in supply and demand, often driven by speculative activities, can lead to overshooting. Speed of Adjustment Across Markets : differences in the speed at which various markets adjust to new information or shocks, leading to short-term fluctuations.

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