Exchange Rate Models With Nominal Rigidities

1
Exchange Rate Models With Nominal Rigidities
2
Available Assets
Foreign Currency (M) Pays no
interest, but needed to buy foreign goods
Home Currency (M) Pays
no interest, but needed to buy goods
Foreign Bonds (B) Pays interest rate (i),
payable in foreign currency
Domestic Bonds (B) Pays interest rate (i)
3
Five Markets
Foreign Bond Market
Domestic Bond Market
Households choose a combination of the four
assets for their portfolios
Domestic Money Market
Currency Market
Foreign Money Market
4
General Equilibrium
Foreign Bond Market
We need five prices (P,P, i , i,e ) to clear
the five markets!!
Domestic Bond Market
Domestic Money Market
Foreign Money Market
Currency Market
5
Lets simplify things!!
Lets assume that foreign variables (i and
P) are constant. That way, we can ignore the
foreign markets!
P and i are fixed
6
Down to three!!!
Foreign Bond Market
Domestic Bond Market
Now we only need three prices (P, i ,and e) to
clear the two remaining markets!!
Domestic Money Market
Foreign Money Market
Currency Market
7
The Domestic Money Market
Cash is used to buy goods (transaction motive),
but pays no interest
-


d
M
L ( P, i, Y )

Higher real income raises transaction motive for
holding cash
Higher prices raises money demand
Real Money Demand
Higher interest rates lower money demand
8
Fixed Prices

• Its assumed that prices in commodity markets are
  fixed in the short run (P is constant)

Real Exchange Rate changes
Nominal exchange rate changes
1)
(PPP fails)
eP
RER
P
Real Interest rates can vary across countries
2)
Real incomes are no longer constant
3)
9
The Domestic Money Market
Cash is Supplied by the Federal Reserve
Now, assume that the price level is fixed at P 1
S

P
M
-
L (i, Y )
1
M
10
Money Supply Changes
Suppose the Fed increases the money supply by 10
S

P
M
-
L (i, Y )
1
Because prices cant adjust, the interest rate
drops. This encourages people to hold the extra
money thats now available
M
11
The Domestic Bond Market
Lower interest rates promote both domestic
consumption spending as well as investment
spending
i
Savings
Higher demand for goods and services raises real
incomes
Investment
S,I
S lt I
(A Trade Deficit is created or worsened)
12
The Domestic Money Market
The Fed increases the money supply
S

P
M
-
L (i, Y )
1
Higher incomes increase money demand even more
until the money market clears
M
13
Currency Markets
Asset Demand
Trade Balance
lower interest rates decreases the demand for
domestic assets currency demand drops
Increased trade deficit increases supply of
currency
Currency Markets
Dollar Depreciates
14
Currency Fundamentals (long Run)

• It is always assumed that a currency will
  eventually return to its fundamental value

(1i)
M
Y

e
Y
M
(1i)
A 10 increase in the money supply results is a
long run 10 depreciation of the currency.
15
Short run dynamics

• While commodity prices are fixed, we need to rely
  on currency markets and asset markets.

A 10 increase in the money supply results is a
long run 10 depreciation of the currency.
(Long Run)
Currency markets generate a short run
depreciation (Trade deficit plus low interest
rates)
(Short Run)
Bond markets suggest that if US interest rates
are low, then the dollar should appreciate at
some point (Uncovered Interest Parity)
16
Short Run Dynamics
Appreciation back to long run level
e (/F)
Eventual 10 depreciation (long run)
Time
Money Shock occurs here
Short Run Overreaction
17
Income Changes
Again, assume that the price level is fixed at P
1
S

P
M
-
L (i, Y )
A 10 increase in domestic income raises money
demand
1
Excess demand for money pushes interest rates up
(this returns money demand to its original
position)
M
18
The Domestic Bond Market
Interest rates are pushed up, but savings drops
and investment rises (due to higher income)
i
Savings
Investment
S,I
S lt I
(A Trade Deficit is created or worsened)
19
Currency Markets
Asset Demand
Trade Balance
Higher interest rates increase the demand for
domestic assets currency demand increases
Increased trade deficit increases supply of
currency
Currency Markets
?????
20
Two Cases

• Capital is relatively immobile between countries

• Capital is very mobile between countries

Trade deficit effect wins out (currency
depreciates) UIP does not hold
Capital inflow wins out (Currency
appreciates) UIP holds
21
High Capital Mobility

• It is always assumed that a currency will
  eventually return to its fundamental value

(1i)
M
Y

e
Y
M
(1i)
A 10 increase in income results is a long run
10 appreciation of the currency.
22
High Capital Mobility

• While commodity prices are fixed, we need to rely
  on currency markets and asset markets.

A 10 increase in income results is a long run
10 appreciation of the currency.
(Long Run)
Currency markets generate a short run
appreciation (Trade deficit is more than financed
by capital inflows)
(Short Run)
Bond markets suggest that if US interest rates
are high, then the dollar should depreciate at
some point (Uncovered Interest Parity)
23
Short Run Dynamics (High Mobility)
e (/F)
Income Shock occurs here
Eventual 10 appreciation (long run)
Time
Short Run Overreaction
depreciation back to long run level
24
Low Capital Mobility

• While commodity prices are fixed, we need to rely
  on currency markets and asset markets.

A 10 increase in income results is a long run
10 appreciation of the currency.
(Long Run)
Currency markets generate a short run
depreciation (Trade deficit dominates)
(Short Run)
UIP does not hold
25
Short Run Dynamics (Low Mobility)
e (/F)
Short Run Overreaction (UIP fails in this region)
Eventual 10 appreciation (long run)
Time
Income Shock occurs here
26
Bottom Line

• When commodity prices are not allowed to adjust,
  asset/currency markets take over to determine
  exchange rates
• This interplay between currency markets and
  commodity markets creates excessive short run
  volatility
• Real exchange rate changes are due to fixed
  commodity prices