Exchange Rates and Open-Economy
Macroeconomics
Szabolcs Sebestyén
[email protected]
Master Programmes
I NTERNATIONAL F INANCE
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Outline
PART 1:
PART 2:
PART 3:
Money, Bond and Foreign Exchange Markets
Money, Interest and Exchange Rates
Price Levels and the Exchange Rate in the Long Run
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Outline
Part I: Money, Bond and Foreign Exchange Markets
Outline of Part I
1
Determinants of Asset Demand
2
The Money Market
Money Demand
A Model of the Money Market
3
The Bond Market
Supply and Demand in the Bond Market
Changes in Equilibrium Interest Rates
4
The Foreign Exchange Market
The Demand for Foreign Currency Assets
Equilibrium in the FX Market
Interest Rates, Expectations and Equilibrium
Case Study: Carry Trade
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Outline
Part II: Money, Interest and Exchange Rates
Outline of Part II
5
The Money Supply and the Exchange Rate in the Short Run
6
Money, the Price Level and the Exchange Rate in the Long Run
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Outline
Part III: Price Levels and the Exchange Rate in the Long Run
Outline of Part III
7
The Law of One Price
8
Purchasing Power Parity
9
The Fisher Effect
10
Empirical Evidence on PPP
11
Explaining the Failure of PPP
12
Case Study: Why Are Poor Countries Cheaper?
13
The Real Exchange Rate
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Part I
Money, Bond and Foreign Exchange
Markets
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Determinants of Asset Demand
Outline
1
Determinants of Asset Demand
2
The Money Market
Money Demand
A Model of the Money Market
3
The Bond Market
Supply and Demand in the Bond Market
Changes in Equilibrium Interest Rates
4
The Foreign Exchange Market
The Demand for Foreign Currency Assets
Equilibrium in the FX Market
Interest Rates, Expectations and Equilibrium
Case Study: Carry Trade
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Determinants of Asset Demand
Determining the Quantity Demanded of an Asset
Wealth: the total resources owned by the individual, including all
assets
I
Ceteris paribus, the quantity demanded of an asset is positively
related to wealth
Expected return: the return expected over the next period on one
asset relative to alternative assets
I
The quantity demanded of an asset is positively related to its
expected return relative to alternative assets
Risk: the degree of uncertainty associated with the return on one
asset relative to alternative assets
I
The quantity demanded of an asset is negatively related to the risk
of its returns relative to alternative assets
Liquidity: the ease and speed with which an asset can be turned
into cash relative to alternative assets
I
The quantity demanded of an asset is positively related to its
liquidity relative to alternative assets
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Determinants of Asset Demand
Response of the Quantity of an Asset Demanded to
Changes in Wealth, Expected Returns, Risk, and
Liquidity
Source: Mishkin (2010), Table 5.1
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The Money Market
Outline
1
Determinants of Asset Demand
2
The Money Market
Money Demand
A Model of the Money Market
3
The Bond Market
Supply and Demand in the Bond Market
Changes in Equilibrium Interest Rates
4
The Foreign Exchange Market
The Demand for Foreign Currency Assets
Equilibrium in the FX Market
Interest Rates, Expectations and Equilibrium
Case Study: Carry Trade
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The Money Market
Money Demand
Outline
1
Determinants of Asset Demand
2
The Money Market
Money Demand
A Model of the Money Market
3
The Bond Market
Supply and Demand in the Bond Market
Changes in Equilibrium Interest Rates
4
The Foreign Exchange Market
The Demand for Foreign Currency Assets
Equilibrium in the FX Market
Interest Rates, Expectations and Equilibrium
Case Study: Carry Trade
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The Money Market
Money Demand
Determinants of Money Demand by Individuals
What influences demand of money for individuals and
institutions?
1
Interest rates/expected rates of return on monetary assets relative
to the expected rates of returns on non-monetary assets
A rise in the interest rate/expected return causes the demand for
money to fall
2
Risk: the risk of holding monetary assets principally comes from
unexpected inflation, which reduces the purchasing power of
money
But many other assets have this risk too, so this risk is not very
important in defining the demand of monetary assets versus
non-monetary assets
3
Liquidity: a need for greater liquidity occurs when the price of
transactions increases or the quantity of goods bought in
transactions increases
A rise in the average value of transactions of a household or firm
causes its demand for money to rise
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The Money Market
Money Demand
Determinants of Aggregate Money Demand
What influences aggregate demand of money?
1
Interest rates/expected rates of return: monetary assets pay little or
no interest, so the interest rate on non-monetary assets like bonds,
loans, and deposits is the opportunity cost of holding monetary
assets
A higher interest rate/expected return means a higher opportunity
cost of holding monetary assets =⇒ lower demand of money
2
Price level: the prices of goods and services bought in transactions
will influence the willingness to hold money to conduct those
transactions
A higher level of average prices means a greater need for liquidity to
buy the same amount of goods and services =⇒ higher demand of
money
3
Real national income: greater income implies more goods and
services can be bought, so that more money is needed to conduct
transactions
A higher real national income (GNP) means more goods and services
are being produced and bought in transactions, increasing the need
for liquidity =⇒ higher demand of money
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The Money Market
Money Demand
A Model of Aggregate Money Demand
The aggregate demand of money can be expressed as
Md = P × L (R, Y)
where
I
I
I
I
P is the price level
Y is real national income
R is a measure of interest rates on non-monetary assets
L (R, Y) is the aggregate demand of real monetary assets
Alternatively,
Md
= L (R, Y)
P
Aggregate demand of real monetary assets is a function of
national income and interest rates
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The Money Market
Money Demand
Aggregate Real Money Demand and the Interest Rate
Source: Krugman, Obstfeld and Melitz (2012), Figure 15.1.
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The Money Market
Money Demand
Effect on the Aggregate Real Money Demand
Schedule of a Rise in Real Income
Source: Krugman, Obstfeld and Melitz (2012), Figure 15.2.
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The Money Market
A Model of the Money Market
Outline
1
Determinants of Asset Demand
2
The Money Market
Money Demand
A Model of the Money Market
3
The Bond Market
Supply and Demand in the Bond Market
Changes in Equilibrium Interest Rates
4
The Foreign Exchange Market
The Demand for Foreign Currency Assets
Equilibrium in the FX Market
Interest Rates, Expectations and Equilibrium
Case Study: Carry Trade
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The Money Market
A Model of the Money Market
Equilibrium in the Money Market
The money market is where monetary or liquid assets, which are
loosely called “money”, are lent and borrowed
When no shortages (excess demand) or surpluses (excess supply)
of monetary assets exist, the model achieves an equilibrium:
Ms = Md
Alternatively, when the quantity of real monetary assets supplied
matches the quantity of real monetary assets demanded, the
model achieves an equilibrium:
Ms
= L (R, Y)
P
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The Money Market
A Model of the Money Market
Determination of the Equilibrium Interest Rate
Source: Krugman, Obstfeld and Melitz (2012), Figure 15.3.
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The Money Market
A Model of the Money Market
Excess Supply and Demand of Monetary Assets
When there is an excess supply of monetary assets, there is an
excess demand for interest-bearing assets like bonds, loans, and
deposits
I
I
People with an excess supply of monetary assets are willing to offer
or accept interest-bearing assets (by giving up their money) at
lower interest rates
Others are more willing to hold additional monetary assets as
interest rates fall
When there is an excess demand of monetary assets, there is an
excess supply of interest- bearing assets like bonds, loans, and
deposits
I
I
People who desire monetary assets but do not have access to them
are willing to sell non-monetary assets in return for the monetary
assets that they desire
Those with monetary assets are more willing to give them up in
return for interest-bearing assets as interest rates rise
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The Money Market
A Model of the Money Market
Effect of an Increase in the Money Supply on the
Interest Rate
Source: Krugman, Obstfeld and Melitz (2012), Figure 15.4.
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The Money Market
A Model of the Money Market
Effect on the Interest Rate of a Rise in Real Income
Source: Krugman, Obstfeld and Melitz (2012), Figure 15.5.
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The Bond Market
Outline
1
Determinants of Asset Demand
2
The Money Market
Money Demand
A Model of the Money Market
3
The Bond Market
Supply and Demand in the Bond Market
Changes in Equilibrium Interest Rates
4
The Foreign Exchange Market
The Demand for Foreign Currency Assets
Equilibrium in the FX Market
Interest Rates, Expectations and Equilibrium
Case Study: Carry Trade
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The Bond Market
Supply and Demand in the Bond Market
Outline
1
Determinants of Asset Demand
2
The Money Market
Money Demand
A Model of the Money Market
3
The Bond Market
Supply and Demand in the Bond Market
Changes in Equilibrium Interest Rates
4
The Foreign Exchange Market
The Demand for Foreign Currency Assets
Equilibrium in the FX Market
Interest Rates, Expectations and Equilibrium
Case Study: Carry Trade
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The Bond Market
Supply and Demand in the Bond Market
Supply and Demand for Bonds
An alternative way to determine the equilibrium interest rate
At lower prices (higher interest rates), ceteris paribus, the quantity
demanded of bonds is higher: an inverse relationship
At lower prices (higher interest rates), ceteris paribus, the quantity
supplied of bonds is lower: a positive relationship
Market equilibrium occurs when the amount that people are
willing to buy (demand) equals the amount that people are
willing to sell (supply) at a given price
Bd = Bs defines the equilibrium (or market clearing) price and
interest rate
When Bd > Bs , there is excess demand, price will rise and interest
rate will fall
When Bd < Bs , there is excess supply, price will fall and interest
rate will rise
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The Bond Market
Supply and Demand in the Bond Market
Supply and Demand for Bonds
Source: Mishkin (2010), Figure 5.1.
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The Bond Market
Changes in Equilibrium Interest Rates
Outline
1
Determinants of Asset Demand
2
The Money Market
Money Demand
A Model of the Money Market
3
The Bond Market
Supply and Demand in the Bond Market
Changes in Equilibrium Interest Rates
4
The Foreign Exchange Market
The Demand for Foreign Currency Assets
Equilibrium in the FX Market
Interest Rates, Expectations and Equilibrium
Case Study: Carry Trade
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The Bond Market
Changes in Equilibrium Interest Rates
Shifts in the Demand for Bonds
Wealth: in an expansion with growing wealth, the demand curve
for bonds shifts to the right
Expected returns: higher expected interest rates in the future
lower the expected return for long-term bonds, shifting the
demand curve to the left
I
Expected inflation: an increase in the expected rate of inflation
lowers the expected return for bonds, causing the demand curve to
shift to the left
Risk: an increase in the riskiness of bonds causes the demand
curve to shift to the left
Liquidity: increased liquidity of bonds results in the demand
curve shifting right
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The Bond Market
Changes in Equilibrium Interest Rates
Factors That Shift the Demand Curve for Bonds
Source: Mishkin (2010), Table 5.2.
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The Bond Market
Changes in Equilibrium Interest Rates
Shifts in the Supply for Bonds
Expected profitability of investment opportunities: in an
expansion, the supply curve shifts to the right
Expected inflation: an increase in expected inflation shifts the
supply curve for bonds to the right
Government budget: increased budget deficits shift the supply
curve to the right
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The Bond Market
Changes in Equilibrium Interest Rates
Factors That Shift the Supply of Bonds
Source: Mishkin (2010), Table 5.3.
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The Bond Market
Changes in Equilibrium Interest Rates
Application: Response to a Change in Expected
Inflation (Fisher effect)
Source: Mishkin (2010), Figure 5.4.
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The Bond Market
Changes in Equilibrium Interest Rates
Expected Inflation and Interest Rates (3-Month
Treasury Bills), 1953–2008
Source: Mishkin (2010), Figure 5.5. Expected inflation calculated using procedures outlined in Mishkin,
“The Real Interest Rate: An Empirical Investigation”, Carnegie-Rochester Conference Series on Public
Policy 15 (1981): 151–200. These procedures involve estimating expected inflation as a function of past
interest rates, inflation, and time trends.
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The Bond Market
Changes in Equilibrium Interest Rates
Application: Response to a Business Cycle Expansion
Source: Mishkin (2010), Figure 5.6.
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The Bond Market
Changes in Equilibrium Interest Rates
Business Cycle and Interest Rates (3-Month Treasury
Bills), 1951–2008
Source: Mishkin (2010), Figure 5.7. Data source is Federal Reserve.
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The Bond Market
Changes in Equilibrium Interest Rates
Everything Else Remaining Equal?
The money market framework leads to the conclusion that an
increase in the money supply will lower interest rates: the
liquidity effect
Income effect finds interest rates rising because increasing the
money supply is an expansionary influence on the economy (the
demand curve shifts to the right)
Price-level effect predicts an increase in the money supply leads
to a rise in interest rates in response to the rise in the price level
(the demand curve shifts to the right)
Expected-inflation effect shows an increase in interest rates
because an increase in the money supply may lead people to
expect a higher price level in the future (the demand curve shifts
to the right)
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The Bond Market
Changes in Equilibrium Interest Rates
Price-Level Effect vs Expected-Inflation Effect
A one-time increase in the money supply will cause prices to rise
to a permanently higher level by the end of the year =⇒ the
interest rate will rise via the increased prices
Price-level effect remains even after prices have stopped rising
A rising price level will raise interest rates because people will
expect inflation to be higher over the course of the year
When the price level stops rising, expectations of inflation will
return to zero
Expected-inflation effect persists only as long as the price level
continues to rise
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The Bond Market
Changes in Equilibrium Interest Rates
Response to an Increase in Money Supply Growth
Source: Mishkin (2010), Figure 5.11.
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The Bond Market
Changes in Equilibrium Interest Rates
Money Growth (M2, Annual Rate) and Interest Rates
(3-Month Treasury Bills), 1950–2008
Source: Mishkin (2010), Figure 5.12. Data source is Federal Reserve.
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The Foreign Exchange Market
Outline
1
Determinants of Asset Demand
2
The Money Market
Money Demand
A Model of the Money Market
3
The Bond Market
Supply and Demand in the Bond Market
Changes in Equilibrium Interest Rates
4
The Foreign Exchange Market
The Demand for Foreign Currency Assets
Equilibrium in the FX Market
Interest Rates, Expectations and Equilibrium
Case Study: Carry Trade
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The Foreign Exchange Market
The Demand for Foreign Currency Assets
Outline
1
Determinants of Asset Demand
2
The Money Market
Money Demand
A Model of the Money Market
3
The Bond Market
Supply and Demand in the Bond Market
Changes in Equilibrium Interest Rates
4
The Foreign Exchange Market
The Demand for Foreign Currency Assets
Equilibrium in the FX Market
Interest Rates, Expectations and Equilibrium
Case Study: Carry Trade
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The Foreign Exchange Market
The Demand for Foreign Currency Assets
Basic Question
What influences the demand of (willingness to buy) deposits
denominated in domestic or foreign currency?
The main issue is what the deposit will be worth in the future
The future value depends on two factors:
I
I
the interest rate it offers
the expected change in the currency’s exchange rate against other
currencies
Factors that influence the return on assets determine the demand
of those assets
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The Foreign Exchange Market
The Demand for Foreign Currency Assets
Risk and Liquidity
Ceteris paribus, individuals prefer to hold those assets offering
the highest expected real rate of return
Savers typically care about two main characteristics of an asset
other than its return:
I
I
Risk: the variability it contributes to savers’ wealth
Liquidity: the ease with which the asset can be sold or exchanged
for goods
An asset with a high expected return may be undesirable if its
realised return fluctuates widely =⇒ risky asset
Savers also prefer to hold some liquid assets as a precaution
against unexpected expenses that might force them to sell less
liquid assets at a loss
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The Foreign Exchange Market
The Demand for Foreign Currency Assets
Interest Rates
To compare returns on deposits in different currencies, two pieces
of information are needed:
I
I
How the money values of the deposits will change
How exchange rates will change
The first is the currency’s interest rate: the amount of that
currency one can earn by lending one unit of the currency for a
year
It is also the amount that must be paid to borrow one unit of the
currency for a year
Interest rates play an important role in the FX market because the
large deposits traded there pay interest, each at a rate reflecting its
currency of denomination
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The Foreign Exchange Market
The Demand for Foreign Currency Assets
Interest Rates on $ and ¥ Deposits, 1978–2011
Source: Krugman, Obstfeld and Melitz (2012), Figure 14.2.; the data source is Datastream. Three-month
interest rates are shown.
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The Foreign Exchange Market
The Demand for Foreign Currency Assets
Changes in Exchange Rates
A euro or a dollar deposit offers a higher expected rate of return?
Example
Suppose that today’s exchange rate is $1.10/e, but you expect it to be
$1.165/e in a year. The $ interest rate is 10% per annum while the e
interest rate is 5%. Which of these deposits offers a higher return?
Step 1 The dollar price of a e 1 deposit is $1.10
Step 2 At the end of the year, the e 1 deposit will be worth e 1.05
Step 3 Calculating with the expected exchange rate, the dollar
value of the euro deposit after a year is
$1.165/e × e1.05 = $1.223
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The Foreign Exchange Market
The Demand for Foreign Currency Assets
Changes in Exchange Rates
Example (cont.)
Step 4 The expected dollar rate of return on a euro deposit is
RR$/e =
$1.223 − $1.10
= 0.11 or 11% per annum
$1.10
Step 5 Since the expected dollar rate of return on a euro deposit
(11%) is greater than the dollar rate of return on a dollar
deposit (10%) =⇒ hold you wealth in euro deposits
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The Foreign Exchange Market
The Demand for Foreign Currency Assets
A Simple Rule
Rate of depreciation: the percentage increase in the exchange rate
In the last example the dollar’s expected depreciation rate is
$1.165 − $1.10
= 0.059 ≈ 6%
$1.10
Rule: the dollar RR on euro deposits is approximately the euro
interest rate plus the rate of depreciation of the dollar:
RRe$/e = Re +
Ee$/e − E$/e
E$/e
The expected RR difference between dollar and euro deposits is
R$ − Re −
Ee$/e − E$/e
E$/e
If it is positive, dollar deposits are more attractive, while if it is
negative, euro deposits become more attractive
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The Foreign Exchange Market
The Demand for Foreign Currency Assets
Comparing Dollar Rates of Return on Dollar and Euro
Deposits
Source: Krugman, Obstfeld and Melitz (2012), Table 14.3.
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The Foreign Exchange Market
Equilibrium in the FX Market
Outline
1
Determinants of Asset Demand
2
The Money Market
Money Demand
A Model of the Money Market
3
The Bond Market
Supply and Demand in the Bond Market
Changes in Equilibrium Interest Rates
4
The Foreign Exchange Market
The Demand for Foreign Currency Assets
Equilibrium in the FX Market
Interest Rates, Expectations and Equilibrium
Case Study: Carry Trade
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The Foreign Exchange Market
Equilibrium in the FX Market
Interest Parity
Interest Parity: the FX market is in equilibrium when deposits of
all currencies offer the same expected rate of return
In this case deposits in all currencies are equally desirable assets
and no type of deposit is in excess demand or excess supply
Interest parity also implies that
R$ = Re +
Ee$/e − E$/e
E$/e
If it does not hold, arbitrage opportunities adjust the exchange
rate until the equality is achieved
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The Foreign Exchange Market
Equilibrium in the FX Market
Changes in Current Exchange Rates
Ceteris paribus, depreciation (appreciation) of a country’s
currency today lowers (raises) the expected domestic currency
return on foreign currency deposits
For example, suppose that today’s exchange rate is $1.00/e and
the expected exchange rate a year from now is $1.05/e
With 5% euro interest rate this gives a 5% “bonus” in terms of
dollars
If today’s exchange rate suddenly jumps up to $1.03/e, then the
expected rate of dollar depreciation is
$1.05 − $1.03
= 0.019
$1.03
Hence the dollar return on euro deposits has fallen by 3.1
percentage points (5% − 1.9%)
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The Foreign Exchange Market
Equilibrium in the FX Market
Today’s $/e Exchange Rate and the Expected Dollar
Return on Euro Deposits When Ee$/e = $1.05/e
Source: Krugman, Obstfeld and Melitz (2012), Table 14.4.
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The Foreign Exchange Market
Equilibrium in the FX Market
Current $/e Exchange Rate vs the Expected Dollar
Return on Euro Deposits
Source: Krugman, Obstfeld and Melitz (2012), Figure 14.3.
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The Foreign Exchange Market
Equilibrium in the FX Market
The Equilibium Exchange Rate
Exchange rates always adjust to maintain interest parity
Assume that the dollar interest rate (R$ ), the euro interest rate
(Re ), and the expected future dollar/euro exchange rate (Ee$/e ) are
all given
The equilibrium exchange rate is given by
R$ = Re +
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E$/e
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The Foreign Exchange Market
Equilibrium in the FX Market
Equilibrium $/e Exchange Rate
Source: Krugman, Obstfeld and Melitz (2012), Figure 14.4.
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The Foreign Exchange Market
Interest Rates, Expectations and Equilibrium
Outline
1
Determinants of Asset Demand
2
The Money Market
Money Demand
A Model of the Money Market
3
The Bond Market
Supply and Demand in the Bond Market
Changes in Equilibrium Interest Rates
4
The Foreign Exchange Market
The Demand for Foreign Currency Assets
Equilibrium in the FX Market
Interest Rates, Expectations and Equilibrium
Case Study: Carry Trade
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The Foreign Exchange Market
Interest Rates, Expectations and Equilibrium
Effect of a Rise in the Dollar Interest Rate
Source: Krugman, Obstfeld and Melitz (2012), Figure 14.5.
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The Foreign Exchange Market
Interest Rates, Expectations and Equilibrium
Effect of a Rise in the Euro Interest Rate
Source: Krugman, Obstfeld and Melitz (2012), Figure 14.6.
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The Foreign Exchange Market
Interest Rates, Expectations and Equilibrium
The Effect of Changing Interest Rates
Ceteris paribus, an increase in the interest paid on deposits of a
currency causes that currency to appreciate against foreign
currencies
The assumption of a constant expected future exchange rate is
unrealistic
Hence in reality we cannot predict how a given interest rate
change will alter exchange rates unless we know why the interest
rate is changing
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The Foreign Exchange Market
Interest Rates, Expectations and Equilibrium
The Effect of Changing Expectations
Ceteris paribus, a rise in the expected future exchange rate causes
a rise in the current exchange rate
Similarly, a fall in the expected future exchange rate causes a fall
in the current exchange rate
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The Foreign Exchange Market
Case Study: Carry Trade
Outline
1
Determinants of Asset Demand
2
The Money Market
Money Demand
A Model of the Money Market
3
The Bond Market
Supply and Demand in the Bond Market
Changes in Equilibrium Interest Rates
4
The Foreign Exchange Market
The Demand for Foreign Currency Assets
Equilibrium in the FX Market
Interest Rates, Expectations and Equilibrium
Case Study: Carry Trade
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The Foreign Exchange Market
Case Study: Carry Trade
What is the Carry Trade
Over much of the 2000s, Japanese yen interest rates were close to
zero, while Australian interest rates were clearly positive
What not borrow yen and invest the proceeds in AUD?
According to interest parity, such a strategy should not be
systematically profitable: the yen should appreciate
Carry trade: investors borrow low-interest currencies (funding
currencies) and buy high-interest currencies (investment
currencies)
Interest parity never holds exactly in practice (risk and liquidity
factors, among others), but there is still a debate about
explanations on carry trade
Research suggests that investment currencies are subject to abrupt
crashes and funding currencies to abrupt appreciations
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The Foreign Exchange Market
Case Study: Carry Trade
Cumulative Total Investment Return in AUD
Compared to ¥, 2003–2010
Source: Krugman, Obstfeld and Melitz (2012), Figure 14.7. Exchange rates and three-month treasury
yields from Global Financial Data.
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Part II
Money, Interest and Exchange Rates
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The Money Supply and the Exchange Rate in the Short Run
Outline
5
The Money Supply and the Exchange Rate in the Short Run
6
Money, the Price Level and the Exchange Rate in the Long Run
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The Money Supply and the Exchange Rate in the Short Run
Introduction
We take the price level (and output) as given =⇒ short-run
analysis
We know that in the short run, an increase (fall) in the money
supply (Ms ) lowers (raises) the interest rate
We will show that an increase (reduction) in a country’s money
supply causes its currency to depreciate (appreciate) in the FX
market
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The Money Supply and the Exchange Rate in the Short Run
Linking Money, Interest Rate and Exchange Rate
Source: Krugman, Obstfeld and Melitz (2012), Figure 15.6.
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The Money Supply and the Exchange Rate in the Short Run
Money Market/Exchange Rate Linkages
Source: Krugman, Obstfeld and Melitz (2012), Figure 15.7.
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The Money Supply and the Exchange Rate in the Short Run
US Money Supply and the $/e Exchange Rate
Source: Krugman, Obstfeld and Melitz (2012), Figure 15.8.
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The Money Supply and the Exchange Rate in the Short Run
Euro Money Supply and the $/e Exchange Rate
Source: Krugman, Obstfeld and Melitz (2012), Figure 15.9.
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The Money Supply and the Exchange Rate in the Short Run
US Money Supply and the $/e Exchange Rate
How does the $/e exchange rate change when the Federal
Reserve changes the US money supply?
I
I
An increase in a country’s money supply causes interest rates to
fall, rates of return on domestic currency deposits to fall, and the
domestic currency to depreciate
A decrease in a country’s money supply causes interest rates to rise,
rates of return on domestic currency deposits to rise, and the
domestic currency to appreciate
How would a change in the supply of euros affect the US money
market and foreign exchange markets?
I
I
An increase in the supply of euros causes a depreciation of the euro
(an appreciation of the dollar)
A decrease in the supply of euros causes an appreciation of the euro
(a depreciation of the dollar)
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Money, the Price Level and the Exchange Rate in the Long Run
Outline
5
The Money Supply and the Exchange Rate in the Short Run
6
Money, the Price Level and the Exchange Rate in the Long Run
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Money, the Price Level and the Exchange Rate in the Long Run
Short vs Long Run
So far we have assumed that price levels and exchange rate
expectations were given =⇒ short run view
An economy’s long-run equilibrium is the position it would
eventually reach if no new economic shocks occurred during the
adjustment to full employment
It is the equilibrium that would be maintained after all wages and
prices had had enough time to adjust to their market-clearing level
In the long run, ceteris paribus, an increase in a country’s money
supply causes a proportional increase in its price level
Long-run neutrality of money: a change in the money supply has
no effect on the long-run values of the interest rate or real output
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Money, the Price Level and the Exchange Rate in the Long Run
Average Money Growth and Inflation in Western
Hemisphere Developing Countries, 1987-2007
Source: Krugman, Obstfeld and Melitz (2012), Figure 15.10. The data is from IMF, World Economic Outlook, and various issues. Regional
aggregates are weighted by shares of dollar GDP in total regional dollar GDP.
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Money, the Price Level and the Exchange Rate in the Long Run
Short-Run and Long-Run Effects of an Increase in the
US Money Supply
Source: Krugman, Obstfeld and Melitz (2012), Figure 15.12.
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Money, the Price Level and the Exchange Rate in the Long Run
Time Paths of US Economic Variables After a
Permanent Increase in the US Money Supply
Source: Krugman, Obstfeld and Melitz (2012), Figure 15.13.
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Money, the Price Level and the Exchange Rate in the Long Run
Permanent Money Supply Changes and the Exchange
Rate
A permanent increase in a country’s money supply causes a
proportional long-run depreciation of its currency
However, the dynamics of the model predict a large depreciation
first and a smaller subsequent appreciation
A permanent decrease in a country’s money supply causes a
proportional long-run appreciation of its currency
However, the dynamics of the model predict a large appreciation
first and a smaller subsequent depreciation
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Money, the Price Level and the Exchange Rate in the Long Run
Exchange Rate Overshooting
The exchange rate is said to overshoot when its immediate
response to a change is greater than its long-run response
Overshooting helps explain why exchange rates are so volatile
Overshooting is predicted to occur when monetary policy has an
immediate effect on interest rates, but not on prices and
(expected) inflation
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Part III
Price Levels and the Exchange Rate in the
Long Run
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The Law of One Price
Outline
7
The Law of One Price
8
Purchasing Power Parity
9
The Fisher Effect
10
Empirical Evidence on PPP
11
Explaining the Failure of PPP
12
Case Study: Why Are Poor Countries Cheaper?
13
The Real Exchange Rate
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The Law of One Price
Definition of the Law of One Price
Law of One Price (LOP): in competitive markets free of
transportation costs and official barriers to trade, identical goods
sold in different countries must sell for the same price when their
prices are expressed in terms of the same currency
For example, if the $/e exchange rate is $1.20/e, a bottle of
Portuguese wine that sells for e 1,000 in Lisbon must sell for
$1,200 in New York
If the exchange rate were $1.30/e, the dollar price of the wine in
New York would be $1,300, a hundred dollar more than in Lisbon
=⇒ wine would be shipped from Lisbon to New York until the
price adjusts
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The Law of One Price
Formal Definition
For any good i,
Dollar price of good i = Euro price of good i × Dollar per euro
Formally,
PiUS = PiEU × E$/e
or
E$/e =
PiUS
PiEU
Application: the Big Mac Index
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Purchasing Power Parity
Outline
7
The Law of One Price
8
Purchasing Power Parity
9
The Fisher Effect
10
Empirical Evidence on PPP
11
Explaining the Failure of PPP
12
Case Study: Why Are Poor Countries Cheaper?
13
The Real Exchange Rate
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Purchasing Power Parity
Definition of PPP
Purchasing power parity (PPP): one dollar will buy the same
basket of goods and services anywhere in the world, i.e.,
Dollar price of basket in the US = Dollar price of basket in the EU
Rearranging yields
Dollar price of basket in the US
=1
Dollar price of basket in the EU
We can rewrite this as
Dollar price of basket in the US
=1
Euro price of basket in the EU × Dollar per euro
Therefore,
Dollar price of basket in the US
= Dollar per euro
Euro price of basket in the EU
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Purchasing Power Parity
Formal Definition and Implications
Formally,
E$/e =
PUS
PEU
where PUS and PEU refer to the same basket of goods in the US
and Europe
The PPP theory predicts that a fall (increase) in a currency’s
domestic purchasing power (i.e., higher (lower) domestic price
level) will be associated with a proportional currency depreciation
(appreciation)
While the LOP applies to individual commodities, PPP applies to
the general price level
If LOP holds for every commodity =⇒ PPP must hold
However, the validity of PPP does not require the LOP to hold
exactly
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Purchasing Power Parity
Absolute and Relative PPP (1)
Relative PPP: the percentage change in the exchange rate between
two currencies over any period equals the difference between the
percentage changes in national price levels
Relative PPP translates absolute PPP from a statement about
levels into one about changes
If the US price level rises by 10% over a year while Europe’s rises
by 5%, relative PPP predicts a 5% depreciation of the dollar
against the euro
Formally,
E$/e,t − E$/e,t−1
= πUS,t − πEU,t
E$/e,t−1
where
πt =
Pt − Pt−1
Pt−1
is the inflation rate
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Purchasing Power Parity
Absolute and Relative PPP (2)
Relative PPP can only be defined with respect to the time interval
over which price levels and the exchange rate changes
Relative PPP is also computationally easier due to the difficulties
of computing price level indices
Relative PPP may be valid even when absolute PPP is not
Provided the factors causing deviations from absolute PPP are
more or less stable over time, percentage changes in relative price
levels can still approximate percentage changes in exchange rates
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The Fisher Effect
Outline
7
The Law of One Price
8
Purchasing Power Parity
9
The Fisher Effect
10
Empirical Evidence on PPP
11
Explaining the Failure of PPP
12
Case Study: Why Are Poor Countries Cheaper?
13
The Real Exchange Rate
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The Fisher Effect
Monetary Approach to the Exchange Rate
Monetary approach to the exchange rate: factors that do not
influence money supply or demand play no explicit role
It is a long-run approach as it does not allow for price rigidities
=⇒ prices adjust immediately to maintain full employment and
PPP
PPP states that E$/e = PUS /PEU
Prices are determined in the money markets as
PUS =
MsUS
L (R$ , YUS )
and PEU =
MsEU
L (Re , YEU )
Hence, the exchange rate is fully determined in the long run by the
relative supplies of monies and the relative real demands for them
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The Fisher Effect
Predictions of the Monetary Approach
1
Money supplies
I
2
Interest rates
I
3
An increase in the US money supply causes a proportional
long-run depreciation of the dollar against the euro
A rise in the US interest rate lowers the real US money demand, so
the long-run US price level rises, and the dollar must depreciate in
proportion to the price level increase
Output levels
I
A rise in US output raises real US money demand, so the long-run
US price level falls, leading to an appreciation of the dollar
Prediction 2 has the opposite conclusion we have seen earlier
Recall that what matters is exactly why interest rates have
changed
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The Fisher Effect
Ongoing Inflation and Interest Rates
Central banks typically choose a growth rate for the money
supply, and then allow money to grow smoothly
Ceteris paribus, money supply growth at a constant rate
eventually results in ongoing inflation at the same rate, with no
effect on the (full-employment) output level or on the long-run
relative prices
While the long-run interest rate does not depend on the absolute
level of the money supply, continuing growth in the money
supply eventually will affect the interest rate
If Pe is expected price level in a country for a year from today, the
expected inflation rate π e is π e = (Pe − P) /P
If relative PPP holds, investors will also expect relative PPP to
hold, yielding
Ee$/e − E$/e
e
e
= πUS
− πEU
E$/e
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The Fisher Effect
The Fisher Effect
Combine this with the interest parity condition
R$ = Re +
Ee$/e − E$/e
E$/e
We obtain that
e
e
R$ − Re = πUS
− πEU
Fisher effect: ceteris paribus, a rise (fall) in a country’s expected
inflation rate will eventually cause an equal rise (fall) in the
interest rate that deposits of its currency offer
It also implies that the real rate of return on the country’s assets
remains unchanged
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The Fisher Effect
Solving the Paradox
In the long-run equilibrium (monetary approach), a rise in the
difference between home and foreign interest rates occurs only
when expected home inflation rises relative to expected foreign
inflation
Short-run approach: the interest rate can rise when the domestic
money supply falls due to sticky prices
In the monetary approach the price level would fall right away,
leaving the real money supply unchanged and thus making the
interest rate change unnecessary
Suppose that the Fed unexpectedly increases the growth rate of
the money supply at time t0 from π to π + ∆π
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The Fisher Effect
Long-Run Time Paths of US Economic Variables After
a Permanent Increase in the Growth Rate of the US
Money Supply
Source: Krugman, Obstfeld and Melitz (2012), Figure 16.1.
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The Fisher Effect
Long-Run Time Paths of US Economic Variables After
a Permanent Increase in the Growth Rate of the US
Money Supply
Source: Krugman, Obstfeld and Melitz (2012), Figure 16.1.
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The Fisher Effect
The Functioning of the Monetary Approach
Source: Krugman, Obstfeld and Melitz (2012), Figure 16A.1.
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The Fisher Effect
Monetary Approach to Exchange Rates
Under PPP, acceleration in money supply growth generates
expectations of more rapid dollar depreciation in the future
Interest parity requires the dollar interest to rise
The increase in nominal interest rates decreases the real money
demand
In order for the money market to maintain equilibrium in the long
run, prices must jump so that
PUS =
MsUS
L (R$ , YUS )
In order to maintain PPP, the exchange rate must jump (the dollar
must depreciate) so that E$/e = PUS /PEU
Thereafter, the money supply and prices are predicted to grow at
rate π + ∆π and the domestic currency is predicted to depreciate
at the same rate
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The Fisher Effect
Long-Run vs Short-Run Approaches
The contrasting predictions about how exchange and interest rate
interact are explained by the different assumptions about the
speed of price level adjustment
Sticky prices
I
I
After a fall in the money supply an interest rate rise is needed to
preserve money market equilibrium, given that the price level
cannot drop immediately
An interest rate rise is associated with lower expected inflation and
a long-run appreciation =⇒ the currency appreciates immediately
Monetary approach
I
A rise in the money supply growth induces an interest rate
increase, which is associated with higher expected inflation and a
future depreciation =⇒ the currency depreciates immediately
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Empirical Evidence on PPP
Outline
7
The Law of One Price
8
Purchasing Power Parity
9
The Fisher Effect
10
Empirical Evidence on PPP
11
Explaining the Failure of PPP
12
Case Study: Why Are Poor Countries Cheaper?
13
The Real Exchange Rate
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Empirical Evidence on PPP
Little Empirical Support
All versions of the PPP theory do badly in explaining the facts
Changes in national price levels often tell us relatively little about
exchange rate movements
However, PPP is a key building block of more realistic exchange
rate models than the monetary approach
The empirical failures of PPP give us important clues how more
realistic models should be set up
Absolute PPP is clearly rejected by the data
Relative PPP is sometimes a reasonable approximation to the data,
but it, too, usually performs poorly
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Empirical Evidence on PPP
PPP, US/UK, 1973-2008 (March 1973 = 100)
Source: Mishkin (2010), Figure 20.2. The data source is Bureau of Labor Statistics.
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Empirical Evidence on PPP
PPP, US/EU, 1999–2015 (January 1999 = 100)
Source: FRED.
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Empirical Evidence on PPP
Exchange Rate Movements and Inflation Differentials,
1980–2010
Source: Cecchetti and Schoenholtz (2015), “Money, Banking, and Financial Markets”, McGraw Hill,
Figure 10.4. The data source is the IMF.
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Explaining the Failure of PPP
Outline
7
The Law of One Price
8
Purchasing Power Parity
9
The Fisher Effect
10
Empirical Evidence on PPP
11
Explaining the Failure of PPP
12
Case Study: Why Are Poor Countries Cheaper?
13
The Real Exchange Rate
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Explaining the Failure of PPP
Main Reasons
The law of one price may not hold because of
1
Trade barriers and non-tradable products
2
Imperfect competition
3
Differences in measures of average prices for baskets of goods and
services
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Explaining the Failure of PPP
Trade Barriers and Non-tradable Products
Transport costs and governmental trade restrictions make trade
expensive and in some cases create non-tradable goods or services
Services are often not tradable: services are generally offered
within a limited geographic region (for example, haircuts)
The price of a non-tradable is determined entirely by its domestic
supply and demand =⇒ a rise in the price of a non-tradable will
rise the country’s price level relative to foreign price levels
The greater the transport costs, the greater the range over which
the exchange rate can deviate from its PPP value
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Explaining the Failure of PPP
Imperfect Competition
Pricing to market: a firm sells the same product for different
prices in different markets to maximise profits, based on
expectations about what consumers are willing to pay
For example, in 2012 a Ford C-Max cost almost e 12,000 more in
Portugal than in Spain despite the common currencies and the
lack of trade barriers
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Explaining the Failure of PPP
Differences in Consumption Patterns and Price
Measurement
People living in different countries spend their incomes in
different ways =⇒ government measures of the price level differ
from country to country
Since relative PPP makes predictions about price changes rather
than price levels, it is a sensible concept regardless of the baskets
used
Change in the relative prices of basket components can cause
relative PPP to fail tests that are based on official price indices
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Explaining the Failure of PPP
PPP in the Short and the Long Run
The explaining factors can cause national price levels to diverge
even in the long run, after all prices have had time to adjust to
their market-clearing level
However, due to sticky prices, departures from PPP may be even
greater in the short run than in the long run
Short-run price stickiness and exchange rate volatility seem to
help explain the fact the violations of relative PPP have been much
more flagrant over periods when exchange rates have floated
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Case Study: Why Are Poor Countries Cheaper?
Outline
7
The Law of One Price
8
Purchasing Power Parity
9
The Fisher Effect
10
Empirical Evidence on PPP
11
Explaining the Failure of PPP
12
Case Study: Why Are Poor Countries Cheaper?
13
The Real Exchange Rate
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Case Study: Why Are Poor Countries Cheaper?
Price Levels and Real Incomes, 2007
Source: Krugman, Obstfeld and Melitz (2012), Figure 16.3. The data source is Penn World Table, version
6.3.
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Case Study: Why Are Poor Countries Cheaper?
The Balassa-Samuelson Effect
The labour forces of poor countries are less productive than those
of rich countries in the tradables sector, but international
productivity differences in non-tradables are negligible
If the prices of traded goods are roughly equal in all countries,
lower labour productivity in the tradables sectors of poor
countries implies lower wages than abroad =⇒ lower production
costs in non-tradables =⇒ lower price of non-tradables
Rich counties with higher labour productivity in the tradables
sector will tend to have higher non-tradable prices and higher
price levels
Productivity statistics give some empirical support to the
Balassa-Samuelson effect
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The Real Exchange Rate
Outline
7
The Law of One Price
8
Purchasing Power Parity
9
The Fisher Effect
10
Empirical Evidence on PPP
11
Explaining the Failure of PPP
12
Case Study: Why Are Poor Countries Cheaper?
13
The Real Exchange Rate
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The Real Exchange Rate
Definition
Because of the shortcomings of PPP, economists have tried to
generalise the monetary approach to PPP to make a better theory
Real exchange rate: the rate at which one can exchange the goods
and services from one country for the goods and services from
another country
It is the cost of basket of goods in one country relative to the cost
of the same basket of goods in another country
Assume that the Starbucks in New York charges $1.95 for an
espresso, in Florence an espresso costs e 1.00, and the nominal
$/e exchange rate is $1.30 per euro
Then, the real coffee exchange rate is
Dollar price of espresso in Italy e 1.00 × $1.30/e
= 2/3
Dollar price of espresso in the US $1.95
Hence, one cup of Italian espresso buys 2/3 cups of Starbucks
espresso
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The Real Exchange Rate
General Formula
We can compute the real exchange rates to compare baskets of
goods between countries
Then the real exchange rate is
q$/e =
Dollar price of domestic goods
E
× PEU
= $/e
Dollar price of foreign goods
PUS
If q$/e > 1, then foreign products will seem cheap
The real exchange rate is much more important than the nominal
because it tells us where things are cheap and where they are
expensive
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The Real Exchange Rate
Real Depreciation/Appreciation
Real depreciation: the dollar prices of European goods
(E$/e × PEU ) rise relative to those of US goods (PUS ) =⇒
America’s goods and services become cheaper relative to Europe’s
A real appreciation of the dollar against the euro is a fall in q$/e
It indicates a decrease in the relative price of products purchased
in Europe, or a rise in the dollar’s European purchasing power
compared with that in the US
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The Real Exchange Rate
Real Dollar-Euro Exchange Rate, 1999–2015
Source: FRED.
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The Real Exchange Rate
What Influences the Real Exchange Rate?
A change in relative demand for US products
I
I
I
I
An increase in relative demand for US products causes the price of
US goods relative to the price of foreign goods to rise
Real appreciation of the value of US goods: PUS rises relative to
E$/e × PEU =⇒ lower q$/e
The real appreciation of the value of US goods makes US exports
more expensive and imports less expensive
A decrease in relative demand of US products causes a real
depreciation of the value of US goods
A change in relative supply of US products
I
I
I
I
An increase in relative supply of US products causes the price of US
goods relative to the price of foreign goods to fall
Real depreciation of the value of US goods: PUS falls relative to
E$/e × PEU =⇒ higher q$/e
The real depreciation of the value of US goods makes US exports
less expensive and imports more expensive
A decrease in relative supply of US products causes a real
appreciation of the value of US goods
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The Real Exchange Rate
Nominal and Real Exchange Rates in the Long-Run
Changes in national money supplies and demands give rise to the
proportional long-run movements in nominal exchange rates and
price level ratios predicted by relative PPP
Demand and supply shifts in national output markets cause
nominal exchange rate movements that do not conform to PPP
Rearranging the definition of the real exchange rate yields
E$/e = q$/e ×
PUS
PEU
Comparing this with E$/e = PUS /PEU , the former accounts for
possible deviations from PPP by adding the real exchange rate as
an additional determinant of the nominal exchange rate
The theory now includes the valid elements of the monetary
approach, but in addition it corrects the monetary approach by
allowing for non-monetary factors that can cause sustained
deviations from PPP
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The Real Exchange Rate
Determinants of Long-Run Nominal Exchange Rates
(1)
A shift in relative money supply levels
I
A permanent, one-time increase in a country’s money supply rises
the country’s price level and nominal exchange rate in the long run,
while leaving the real exchange rate unchanged =⇒ consistent
with relative PPP
A shift in relative money supply growth rates
I
A permanent increase in the growth rate of a country’s money
supply leads to persistent inflation and a proportional depreciation
of the country’s currency, leaving q$/e unaffected =⇒ consistent
with relative PPP
A change in relative output demand
I
I
Since long-run national price levels do not change, the long-run
nominal exchange rate will change only insofar as q$/e changes
Higher relative demand for domestic products implies a real
appreciation =⇒ nominal appreciation
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The Real Exchange Rate
Determinants of Long-Run Nominal Exchange Rates
(2)
A change in relative output supply
I
I
I
An increase in relative domestic output supply leads to the real
depreciation of the country’s currency
It also raises real money demand, thereby pushing the long-run
price level down
The net effect on the nominal exchange rate is ambiguous
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The Real Exchange Rate
Conclusions
When all disturbances are monetary in nature,
I
I
exchange rates obey relative PPP in the long run
in the long run, a monetary disturbance affects only the general
purchasing power of a currency and no change in the real exchange
rate occurs
When disturbances occur in output markets,
I
I
the exchange rate is unlikely to obey relative PPP, even in the long
run
the real exchange rate changes
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The Real Exchange Rate
Effects of Money Market and Output Market Changes
on the Long-Run Nominal $/e Exchange Rate
Source: Krugman, Obstfeld and Melitz (2012), Table 16.1.
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The Real Exchange Rate
Interest Rate Differences and the Real Exchange Rate
Recall that the change in q$/e is the deviation from relative PPP,
Ee − E$/e
qe$/e − q$/e
e
e
= $/e
− (πUS
− πEU
)
q$/e
E$/e
Using the interest parity condition yields
R $ − Re =
qe$/e − q$/e
e
e
+ (πUS
− πEU
)
q$/e
The difference in nominal interest rates across two countries is the
sum of
I
I
the expected rate of depreciation in the value of domestic goods
relative to foreign goods; and
the difference in expected inflation rates between the domestic
economy and the foreign economy
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The Real Exchange Rate
Real Interest Parity
For investment decisions, real interest rates are more relevant
Recall that re = R − π e
Then the difference in expected real interest rates between the US
and Europe is
e
e
reUS − reEU = R$ − πUS
− Re − πEU
Combining this with the modified Fisher effect we obtain the real
interest parity condition:
reUS − reEU =
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qe$/e − q$/e
q$/e
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