Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 17-1 Chapter 17 Models of the exchange rate

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 17-2 Learning objectives Examine models of the exchange rate — the purchasing power parity approach, asset market (or portfolio balance) approach and monetary approach Explain the Fisher and international Fisher equations and their importance in linking short -run and long-run exchange-rate behaviour Integrate long-run and short-run descriptions of exchange-rate behaviour into simple model of overshooting exchange rates

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 17-3 Purchasing power parity (PPP) Purchasing power parity models suggest that the purchasing power of different currencies should be the same when converted to a common currency through the exchange rate

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 17-4 Absolute PPP PPP models assume that the law of one price holds: –When converted to a common currency value through the exchange rate, the price of identical goods should be the same across countries P d = E × P o/s Where P d = domestic price P o/s = foreign price

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 17-5 Absolute PPP (cont.) Changes in the exchange rate simply reflect changes in price levels in each of the two associated countries

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 17-6 Problems with absolute PPP The presence of non-traded goods Product differentiation Differences in consumption patterns and preferences across countries Transportation costs Tariffs and other forms of industry assistance distort relative prices between countries

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 17-7 Problems with absolute PPP (cont.) The possibility of relative price changes of goods and services in each country because of differences in market structure and the growth of productivity across different industry The model neglects the non-goods factors that might lead to changes in the exchange rates, like differences in interest rates The model is to simplistic to explain exchange rate movements

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 17-8 Relative PPP Model focuses on the importance of relative inflation rates as a determinant of the exchange rate

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 17-9 Relative PPP (cont.) The relative inflation rates explains movements in the exchange rates (appreciation or depreciation) If the rate of inflation in the domestic economy exceeds that of the foreign country the currency will depreciate and conversely

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal Australian & US inflation rates & the value of the Australian dollar 1975/76 – 2004/5

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal Asset market models Exchange rate risk and returns on foreign investment Asset Market Approach (AMA), also called Portfolio Balance Approach (PBA), looks at the changes in the exchange rates resulting from shifts in investors’ holding of assets Shifts occur in response to changes in relative real returns on assets in each country

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal Interest arbitrage Interest arbitrage is the relationship between returns in asset markets and the exchange rate Differences in the rates of return on assets will be reflected in the differences in value between the future and the current exchange rate r d *  r o/s –  E*/E Where: r d * = expected return from holding domestic asset r o/s = expected return from holding foreign asset  E*/E = expected changes in the value of the exchange rate

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal Interest arbitrage (cont.) Role of expectations –Expectations play a central role in the PBA models Various factors associated with the asset market determines the value of the future exchange rate –Relative inflation rates –Relative growth rates –Expected changes in interest rates –Expected government intervention in the foreign exchange market –Other risks associated with the currency

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal Interest arbitrage (cont.) Role of interest rate changes Interest rates affect the current and future exchange rate and consequently the returns from foreign and domestic assets since: r d *  r o/s -  E*/E

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal Evaluating interest arbitrage Adjustment to the expected future exchange rate Interest arbitrage and specific risk Other problems

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal Australian & US short-term interest rates & the value of AUD 1980–2005

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal The monetary approach Looks at the relationship between the domestic money supply, the domestic demand for money, and the exchange rate Money supply: M = R + D Money demand: L = k × P d × Y The addition of PPP

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal The monetary approach (cont.) Results of the monetary approach –If foreign prices are increased, holding domestic prices constant, then the exchange rate appreciates –If domestic income grows, assuming incomes in the rest of the world stay constant, the exchange rate appreciates –If domestic credit is increased, then the exchange rate depreciates

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal Models of exchange rate behaviour Fisher equation Where: ri = real interest rate i = nominal interest rate  P*/P = expected inflation rate

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal Models of exchange rate behaviour (cont.) International Fisher equation

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal Models of exchange rate behaviour (cont.) Impact of an easing of monetary policy Short-run impact Long-run impact –Exchange rate overshooting: the process by which adjustments in the exchange rate in the short term exceed those consistent with longer -term equilibrium, due to differences in the speed of adjustment between asset market prices and product market prices

Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal Exchange rate models Implications for Australia –The value of currency may reflect relative returns on assets, or expectations, and not current account problems –Monetary policy cannot be conducted independently of the exchange rate –Severe problems in adjusting to difficulties with the external balance