The Monetary Models of Exchange Rate Determination

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The Monetary Models of Exchange Rate Determination

• The Flexible-Price Model
• The Sticky-Price Model
• The Portfolio Balance Model

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Monetary Models
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Asset Modelsof the Spot Exchange Rate
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The Flexible-Price Model

• We start with the following assumptions
• PPP holds continuously
• Bonds denominated in different currencies are
  perfect substitutes ? UIP
• Perfect capital mobility
• 1, 2 and 3 together imply that real interest
  rates are equal internationally ? r r

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The Flexible-Price Model
Ex-Ante PPP is implied by Absolute PPP
UIP implies that
Combined with the Fisher equation,
Gives Real Interest Parity
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The Flexible-Price Model
Further assume that money demand in each country
is given by the liquidity preference theory.

• where
• mt is the domestic money supply in logs
• pt is the log of domestic price level
• yt is the log of domestic real income
• it is the domestic nominal interest rate

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The Flexible-Price Model
A similar money demand exists for the foreign
country
Note The use of logarithms allows us to make an
otherwise non-linear relationship linear. Linear
models are much easier to work with.
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The Flexible-Price Model
The assumption of PPP implies
Combine the PPP relationship with the two money
demands
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The Flexible-Price Model
Re-write the money demands as
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The Flexible-Price Model
Using PPP to combine the two money demands yields
or
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The Flexible-Price Model
We can simplify this equation further by assuming
that the money demand elasticities are the same
in both the foreign and domestic economies
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The Flexible-Price Model
This last equation represents the basic
Flex-Price Model
Using the UIP relationship the Flex-Price model
can be equivalently written as
or
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Implications of the Flex-Price Model for Exchange
Rate Behavior
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Sticky-Price Model

• One of the most important facts about the
  floating exchange rate system is the huge
  increase in exchange rate volatility observed
  since the demise of the Bretton Woods regime.
  What can explain this large increase in
  volatility?
• Remember that PPP does not have strong empirical
  support in the short run.
• PPP holds better in the long run.
• If we assume that price levels are sticky, i.e.
  they do not adjust quickly in response to a
  changing economic environment, then PPP will not
  hold every period.

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Sticky-Price Model

• Assume that PPP only holds in the long run, such
  that
• where a bar over a variable indicates a long-run
  equilibrium value.
• In the long run PPP holds and thus the
  Flex-Price model is valid, but only in the long
  run.
• In the short run, prices are sticky and PPP will
  not hold and neither will the Flex-Price model.

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Sticky-Price Model

• Maintain the assumption of UIP
• Assume PPP only holds in the long run
• Deviations of the exchange rate from its long-run
  equilibrium value, i.e. its PPP value, will
  adjust in the following way

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Sticky-Price Model
Noting that ?se i-i implies,
or
Then substitute from the earlier equation to get
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Sticky-Price Model
This last equation is the basic Sticky-Price
model. It has the following equivalent
representation
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Implications of the Sticky-Price Model for
Exchange Rate Behavior
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Overshooting Exchange Rates
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The Portfolio Balance Model
Now relax assumption of risk neutrality, i.e.
assets denominated in different currencies are no
longer perfect substitutes. The UIP relation
must now be augmented with a risk premium that is
a function of the relative supplies of domestic
to foreign assets expressed in a common currency.
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The Portfolio Balance Model
This yields the following adjustment equation for
the exchange rate
and by substitution we obtain the Portfolio
Balance model
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Implications of the Portfolio Balance Model for
Exchange Rate Behavior
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Forecasting Exchange Rates

• Efficient Markets Approach
• Fundamental Approach
• Technical Approach
• Performance of the Forecasters

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Efficient Markets Approach

• Financial Markets are efficient if prices reflect
  all available and relevant information.
• If this is so, exchange rates will only change
  when new information arrives, thus
• St ESt1
• and
• Ft ESt1 It
• Predicting exchange rates using the efficient
  markets approach is affordable and is hard to
  beat.

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Fundamental Approach

• MVPY ? PMV/Y
• PPP ? S P/P
• Combine so that s a0a1(m-m)a2(i-i)a3(y-y)
• Involves econometrics to develop models that use
  a variety of explanatory variables. This involves
  three steps
• step 1 Estimate the structural model.
• step 2 Estimate future parameter values.
• step 3 Use the model to develop forecasts.
• The downside is that fundamental models do not
  work any better than the forward rate model or
  the random walk model.

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Technical Approach

• Technical analysis looks for patterns in the past
  behavior of exchange rates.
• Clearly it is based upon the premise that history
  repeats itself.
• Thus it is at odds with the EMH

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Technical Analysis
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Technical Analysis
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Performance of the Forecasters

• Forecasting is difficult, especially with regard
  to the future.
• As a whole, forecasters cannot do a better job of
  forecasting future exchange rates than the
  forward rate.
• The founder of Forbes Magazine once said
• You can make more money selling financial
  advice than following it.

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Forecasting Performance
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Banks Forecasts
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News and Foreign Exchange RatesAn Introduction

• 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 StoriesThree
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
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Exchange Rates and News StoriesThree
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 StoriesThree
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.)

• Case g The change is due to greater private
  sector investments, and the US strengthens as
  foreign capital flows in to finance the
  investments.
• Case f The shortfall in exports or increase in
  imports is viewed as permanent and the US
  weakens.

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News and Foreign Exchange RatesA 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.