Chapter 18
Exchange
Rate Theories
Topics to be Covered
• The Asset Approach
• The Monetary Approach to the Exchange Rate
• The Portfolio Balance Approach
• Sterilization
• Exchange Rates and the Trade Balance
• Overshooting Exchange Rates
• Currency Substitution
• Role of News
• Foreign Exchange Market Microstructure
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The Asset Approach
• The exchange rate is viewed as
adjusting to equilibrate global trade in
financial assets.
• An implication of this approach is that
exchange rates are more variable than
goods prices. See Table 18.1.
• The asset approach assumes perfect
capital mobility, that is, there are no
barriers to international capital flows.
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Types of Asset Approach Models
• Monetary Approach to the Exchange
Rate—the exchange rate is determined by
relative money demand and money supply
between two countries (see Chapter 17).
• Portfolio Balance Approach—a theory
of exchange rate determination which
argues that the exchange rate is a function
of the relative supplies of domestic and
foreign bonds.
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Monetary Approach vs. Portfolio
Balance Approach
• The main difference between the two
groups of asset approach models is that
the monetary approach model assumes
domestic and foreign bonds to be
perfect substitutes, while the portfolio
balance model assumes they are not.
• See Table 18.2
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Monetary Approach
to the Exchange Rate (MAER)
• Following the discussion from Chapter
17, the monetary approach equation
is (in percentage terms):
where R is international reserves, E is
exchange rate (domestic currency units
per unit of the foreign currency), PF the
foreign price level, Y domestic income,
and D domestic credit.
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MAER (cont.)
• With flexible exchange rates, reserves are
zero, and the MAER equation becomes:
–E = PF + Y – D
or, after multiplying both sides by (-1), we get:
• An increase in domestic credit, other things
constant, will result in E increasing (i.e.,
depreciating at a faster rate), while changes
in inflation and income growth will cause
changes in E in the opposite direction.
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Portfolio Balance Approach
• The PB approach assumes that financial assets
are imperfect substitutes because investors perceive
foreign exchange risk to be linked to foreign
currency-denominated bonds.
• It modifies the MAER equation by adding the
percentage changes in the supplies of foreign bonds
BF and domestic bonds B:
• An increase in supply of foreign bonds causes E to
fall (domestic currency appreciates faster) while an
increase in domestic bond supply raises E, other
things constant.
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Sterilization
• Sterilization refers to central banks offsetting
international reserve flows in order to follow
an independent monetary policy.
• Suppose the central bank is following some
money supply growth path and then money
demand increases, leading to reserve inflows.
The central bank will sterilize these reserve
inflows by decreasing domestic credit, thus
keeping base money and the money supply
constant or at desired levels.
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Sterilization (cont.)
• If sterilization occurs, then the causality
implied in the basic monetary approach
equation no longer holds. This is because
sterilization implies that there is also a
causality running from reserve changes to
domestic credit, as in:
where β is the sterilization coefficient,
ranging from 0 (no sterilization) to 1
(complete sterilization).
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Sterilized Intervention
• Sterilized Intervention—refers to a
foreign exchange market intervention
that leaves the domestic money
supply unchanged.
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Exchange Rates
and the Trade Balance
• It is useful to incorporate trade flows into the
asset approach models because trade flows
have implications for financial asset flows.
• If the exchange rate adjusts so that the stocks
of domestic and foreign money are willingly
held, then the country with a trade surplus
will be accumulating foreign currency. As
holdings of foreign money increase relative to
domestic money, then the foreign currency
will depreciate.
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Exchange Rates
and the Trade Balance (cont.)
• Refer to Figure 18.1
• An unexpected event causes a trade
deficit. The resulting outflow of money
leads to depreciation of the domestic
currency and to a new exchange
rate equilibrium.
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Overshooting Exchange Rates
• Since exchange rates are more volatile
and adjust more quickly than goods
prices, this differential speed of
adjustment can lead to a situation
where it appears that spot exchange
rates move too much for a given
disturbance. This is called
overshooting exchange rates.
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Overshooting Exchange Rate Model
• Money demand (L) is positively related
to income Y and negatively to interest
rate i:
• In the short run, as money supply
increases, income and price level are
constant. Consequently, interest rates
must fall to equate money demand and
money supply.
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Overshooting XR Model (cont.)
• The drop in interest rate will have a direct
effect on the exchange rate via the interest
rate parity relation:
• With the increase in money supply in country
A, prices will be expected to rise. This higher
future price will imply a higher long run
exchange rate to achieve PPP:
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Overshooting XR (cont.)
• The spot exchange rate will increase
above the long run equilibrium
exchange rate due to a need to maintain
interest parity. Over time, as prices
increase, the interest rate rises, and the
exchange rate converges to its new
equilibrium level.
• Refer to Figure 18.2
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Currency Substitution
• An advantage of flexible exchange rates is that
countries can pursue independent monetary policy.
This advantage is reduced if there is an international
demand for currencies.
• Currency substitution deals with the substitutability
of currencies on the demand side of the market.
• So long as people believe that the exchange value
between two currencies will never change, then
money demanders will be indifferent between holding
the two currencies.
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Currency Substitution (cont.)
• If money demanders are no longer
indifferent between two currencies, then
currency substitution becomes another
source of exchange rate variability.
• Regions with a high degree of
currency substitution may benefit from
currency unions where countries
coordinate monetary policies and fix
exchange rates.
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The Role of News
• The real world is characterized by
unpredictable shocks or surprises. As
such, predicting future spot rates is
difficult because the exchange rate is
partly determined by unforeseen events.
• Exchange rates are more sensitive,
and respond more quickly, to
expectations and new information (e.g.,
unemployment rates).
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Foreign Exchange
Market Microstructure
• At the micro level, exchange rates
can be determined by interactions
among traders.
• A foreign exchange trader may be
influenced to change his exchange rate
quotes even in the absence of news
regarding exchange rate fundamentals.
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FEM Microstructure Effects
• Inventory control effect—traders will
want to have no inventory at the end
of the day, so that their quotes reflect
this desire.
• Asymmetric information effect—
traders fear that they are trading with
agents who have better information than
they do.
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