Exchange Rate “Fundamentals” FIN 40500: International Finance

Economic models represent an attempt to explain various phenomena with observable variables. Economic Model Exogenous Variables Endogenous Variables These variables are what we are trying to explain These variables are what we are taking as “given” An economic model is simply a set of assumptions Lets start with a simply one…

Demand is an economic model to explain consumer choices. Exogenous Variables Income Price Economic Model Endogenous Variable Consumers maximize utility ( Quantity demanded is a function of income and price)

Equilibrium models use supply and demand to explain price Exogenous Variables Income Costs Economic Model Endogenous Variable Price adjusts to clear the market ( Price is a function of income and costs)

Ultimately, the point is to use the economic model to pricing function that we can estimate empirically Parameters to be estimated (+) Once we have an estimated pricing function, we can use it to forecast Forecasts for income and costs

General Equilibrium Models try to explain multiple prices simultaneously using multiple markets

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 Any international general equilibrium must have at least 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

Purchasing Power Parity Currency Markets Uncovered Interest Parity The parity conditions can make things a lot simpler!

Foreign Bond Market Domestic Money Market Domestic Bond Market Foreign Money Market Currency Market The parity conditions eliminate the need for three markets!! Hence, this story is called “The Monetary Approach”

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) If prices are too high, there won’t be enough money available to buy all the goods and services available If prices are too low, there is excess money floating around

+- An increase in money supply raises the price level As the government makes more currency available, demand for goods and services increases. This allows suppliers to raise their prices. At the initial price, there is an excess supply of currency

An increase in interest rates lowers money demand – this raises the price level (holding money supply fixed) An increase in real income raises the demand for money – this lowers the price level (holding money supply fixed)

+- If we assign a particular functional form to money demand, we can solve for the equilibrium price level analytically. If we set money supply equal to money demand and solve for price, we get

Domestic Money Market Foreign Money Market PPP We can assume that the foreign money market is identical to the domestic money market. Using PPP and the two Money Market equilibrium conditions, we get the “fundamentals” for a currency Now, solve for the exchange rate

Relative Money Stocks Relative Outputs Relative Interest Rates Taking the previous expression and solving for the exchange rate, we get These are known as currency “fundamentals”

A regression using fundamentals would generally take the form: Percentage change in exchange rate (dollars per foreign currency) – an increase is a dollar depreciation Parameters to be estimated Estimated parameters of this regression are often statistically insignificant: Implied by the monetary framework

Note that while the “fundamentals” seem to track the general trend of the dollar, they don’t pick up the shorter term movements Fundamentals USD/JPY

The fact is that fundamentals just don’t exhibit enough variance to explain exchange rate movements in the short term Fundamentals USD/GBP

Real Exchange Rate Recall that PPP often fails in the short run. This is possibly due to trading friction or relative price changes Real exchange rate changes create a problem…they tend to follow random walks (i.e. unit root processes for you statistics buffs) and are, hence, unpredictable.

Real depreciation of the dollar relative to the Yen Does anybody remember why the dollar depreciated sharply in the mid-eighties?

Recall that UIP implies that the differences in nominal interest rates reflects expectations of currency price changes (countries with high interest rates should expect their currencies to depreciate Uncovered Interest Parity This incorporates an expectation of the future into the fundamentals

Suppose that expectations are stable (i.e. coincide with future fundamentals Continue the substitution process forward Today’s currency price depends on ALL future fundamentals!

Alternatively, its possible for expectations to be destabilizing (i.e. speculative bubbles) Continue the substitution process forward Some “non-fundamental” factor A “Bubble” Term!!

Why don’t trade deficits matter in the monetary approach? Remember, this framework assumes that PPP and UIP always hold Trade deficits aren’t a consequence of the price of foreign goods relative to US goods – PPP assures that these prices are the same Instead, trade deficits are motivated by real interest rates – low interest rates will lower domestic saving and increase domestic spending. This creates a trade deficit. But with globally integrated capital markets, every country takes the world interest rate as a constant.

Normally, we think of a country’s currency appreciating during an expansion while its trade deficit worsens. Trade deficits are determined in asset markets. Rising income tends to raise investment expenditures and lowers savings – the world interest rate remains unaffected, but the trade deficit worsens Meanwhile, in the domestic money market, an increase in income raises money demand and lowers prices A drop in the domestic price level causes the dollar to appreciate

If commodity prices are free to adjust, then commodity markets/money markets take center stage in currency price determination (PPP) There is no correlation between trade deficits and currency prices Volatility in currency markets is created by relative price changes (real exchange rate changes) or speculative behavior These relative price changes are passed onto nominal exchange rates The Bottom Line…