FIN 40500: International Finance Nominal Rigidities and Exchange Rate Volatility

So far, we have taken two approaches to exchange rate determination The trade balance approach equates the supply and demand for US dollars as derived from the trade balance The monetary approach approach equates the supply and demand for domestic and foreign currencies in money markets

Both of these approaches assume that commodity markets have enough time to adjust so that the prices of commodities are equalized across countries – this makes both approaches useful for a long run prediction However, there is one key difference between these two frameworks Trade Balance Approach Perfect correlation between exchange rate and trade balance (too much weight on current account) Monetary Approach Zero correlation between exchange rate and trade balance (too much weight on capital account)

The real issue at hand is the Balance of Payments, which measures the total flow of funds in and out of a country A balance of payments deficit would imply that dollars are leaving the US and flowing into the rest of the world. This excess supply of dollars should cause the international value of the dollar (aka the exchange rate) to depreciate Likewise, a BOP surplus (dollars flowing from the rest of the world to the US) should cause the dollar to appreciate due to lack of international supply

Change in US owned Assets Abroad US Official Reserve Assets US Government Assets US Private Assets Foreign Direct Investment Securities Change in Foreign Ownership of US Assets Foreign Official Assets Private Foreign Assets Foreign Direct Investment Currency Securities Merchandise Services Income Unilateral Transfers Current AccountCapital & Financial Account By definition, the actual balance of payments for the US (or any other country) is zero – that’s because cash is counted in the financial account

If we remove cash from the capital & financial accounts, we can develop a framework to think about commodity markets, currency markets, and asset markets Currency Markets Current Account Capital Account Trade balances are determined largely from changes in income Capital accounts are determined largely from changes in interest rates Exchange Rates determined by international supply of dollars

Suppose trade is initially balanced. An increase in income will create a trade deficit (spending increases, savings decreases) Without a change in the KFA, we would have a balance of payments deficit and the dollar would be forced to depreciate. To create an offsetting KFA surplus, the return on US assets would need to rise to attract foreign capital.

The degree of international capital mobility will dictate the rise in domestic interest rates necessary to offset a trade imbalance. BOP Deficit - Currency Depreciates BOP Surplus - Currency appreciates BOP Deficit - Currency Depreciates With high capital mobility, there is plenty of capital looking for higher returns – financing a trade deficit requires a small interest rate increase With low capital mobility, there is a shortage of capital looking for higher returns – financing a trade deficit requires a large interest rate increase

The trade balance approach assumes that it is impossible to finance a trade deficit with asset sales - a trade deficit requires a currency depreciation! (no capital mobility) The monetary approach assumes that any trade deficit can be financed without a rise in interest rates (perfect capital mobility) The trade balance approach and monetary approach are two special cases

Home Currency (M) Pays no interest, but needed to buy goods Domestic Bonds (B) Pays interest rate (i) Foreign Bonds (B*) Pays interest rate (i*), payable in foreign currency Foreign Currency (M*) Pays no interest, but needed to buy foreign goods As in the previous case, we begin with four commodities

Foreign Bond Market Domestic Money Market Domestic Bond Market Households choose a combination of the four assets for their portfolios Foreign Money Market Currency Market Benny Fluffy

Foreign Bond Market Domestic Money Market Domestic Bond Market We need five prices to clear all five markets Foreign Money Market Currency Market

For example, a 10% increase in the domestic money supply results is a long run 10% depreciation of the domestic currency. Over a long time horizon, all prices have a chance to adjust - currency prices return to their fundamental values and real returns are equalized across countries However, it’s now assumed that commodity prices are fixed in the short run (P is constant) – this causes PPP to fail! With fixed prices, the real and nominal exchange rates have a correlation of one! Further, real returns can vary across countries!

Instead, let’s assume that foreign variables (i* and P*) are constant. That way, we can ignore the foreign markets! P* and i* are fixed Without PPP, we need to explicitly analyze currency markets – this complicates matters a bit!

Foreign Bond Market Domestic Money Market Domestic Bond Market This leaves three markets and three prices Foreign Money Market Currency Market

Our money market model hasn’t changed. Cash is used to buy goods (transaction motive), but pays no interest -+ Money Demand Higher interest rates lower money demand Higher real income raises money demand Higher prices raises money demand + Money supply is assumed to be purely exogenous (a policy variable of the government)

+ - An equilibrium price level clears the money market (i.e. supply equals demand) Now, consider this price fixed over short time horizons With the price level fixed, the market will need to find a new way to adjust to changes in supply/demand

+ - Suppose that real income increases. This will raise the demand for money and put downward pressure on the price level Assuming that the Fed keeps the money supply constant, we need something else to adjust to return demand to its original position A rise in interest rates will return demand to its original position and maintain the constant price level. Excess Demand for Money

This positive relationship between interest rates and income in the money market is represented by the LM curve. At every point on the LM curve, For a fixed price level Note: The LM curve represents the set of equilibria in the money market for a fixed level of real (inflation adjusted) money supply.

Suppose that the Fed increases the money supply. This will put upward pressure on prices. To maintain a constant price level, money demand must increase. This is accomplished by a drop in interest rates and a rise in income This can be represented by the LM curve shifting to the right

Next, what is the relationship between the interest rate and income in the bond market Lower interest rates raise demand – this higher demand generates higher income The IS curve represents the negative relationship between interest rates and income in equilibrium

Suppose that an increase in government deficits forces interest rates up The upward pressure on interest rates is represented by a shift to the right of the IS curve

Now we can put everything together to see all three markets (currency, bonds, money) in a short run equilibrium. The LM curve gives us the interest rate/income combination that clears the money market The BOP curve gives us the interest rate/income combination that clears the currency market The LM curve gives us the interest rate/income combination that clears the bond market

Suppose that the Federal reserve increases the supply of money by 10% The monetary approach describes the long run reaction of currency markets – the dollar depreciates by 10% Increases by 10% Short Run 10% What happens in the short run?

Now we can put everything together to see all three markets (currency, bonds, money) in a short run equilibrium. The increase in the domestic money supply forces down interest rates in the short run while prices are fixed The lower interest rate stimulates consumption expenditures and worsens the trade deficit.

lower interest rates decreases the demand for domestic assets – dollar demand drops Increased trade deficit increases supply of dollars Dollar Depreciates We have a new short run (temporary) equilibrium.

10% Here’s what we know…. 1.The dollar will eventually depreciate by 10% (long run) 2.An immediate depreciation is also required to equalize the balance of payments 3.Interest rates in the US have dropped If US interest rates fall relative to foreign rates, the dollar must appreciate at some point to equalize the returns

10% What happens to the real exchange rate? Nominal Real In the short run, with fixed prices, the real exchange rate mimics the nominal rate – in the long run, PPP holds and the real exchange rate is constant

Suppose that the experiences a 10% increase in income Again, we know that long run impact will be a 10% dollar appreciation Short Run What happens in the short run? Increases by 10% 10%

This increase in income is due to increases in US government spending financed by borrowing higher interest rates increases the demand for domestic assets – dollar demand rises Increased trade deficit increases supply of dollars What happens to the value of the dollar?

If capital is very mobile globally, then the rise in interest rates domestically will be more than enough to finance the trade deficit The balance of payments surplus forces the dollar to appreciate in the short run.

10% Here’s what we know…. 1.The dollar will eventually appreciate by 10% (long run) 2.An immediate appreciation is also required to equalize the balance of payments 3.Interest rates in the US have risen If US interest rates rise relative to foreign rates, the dollar must depreciate at some point to equalize the returns

If capital has very low mobility, then the rise in interest rates domestically will not be enough to finance the trade deficit The balance of payments deficit forces the dollar to depreciate in the short run.

10% Here’s what we know…. 1.The dollar will eventually appreciate by 10% (long run) 2.An immediate depreciation is also required to equalize the balance of payments 3.Interest rates in the US have risen Note that uncovered interest parity fails (US interest rates rise and the dollar appreciates) – that’s because of the low capital mobility

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 asset markets creates excessive short run volatility Real exchange rate changes are due to fixed commodity prices