1. Reinert/Windows on the World Economy, 2005 Flexible Exchange Rates CHAPTER 14

2. Reinert/Windows on the World Economy, 2005 2 Introduction Forces of supply and demand in currency markets determine exchange rate An example of a flexible or floating exchange rate regime  Canadian dollar began the 1990s at 1.651 per US dollar  By 1998, it was trading at 2.155 per US dollar A fall from 61 US cents to 46 US cents What makes a flexible exchange rate move one way or another?  This chapter develops a model of how the nominal exchange rate is determined in currency markets Will consider a trade-based model  Nominal exchange rate is determined by currency transactions arising from imports and exports  Will extend model to account for exchange of assets

3. Reinert/Windows on the World Economy, 2005 3 A Trade-Based Model Part of fundamental accounting equations  Foreign Savings = Trade Deficit Rewrite this relationship using symbols  S F (foreign savings) = Z (imports) - E (exports) or S F = (Z - E) Use Mexico as home country and United States as foreign country S F is foreign savings  Savings supplied by US residents who buy Mexican assets  S F is a demand for pesos (supply of dollars) by US Demand is invariant with respect to value of peso Gives us the perfectly inelastic demand for pesos curve

4. Reinert/Windows on the World Economy, 2005 4 Figure 14.1 The Demand for Pesos

5. Reinert/Windows on the World Economy, 2005 5 A Trade-Based Model Z - E is the trade deficit  Net demand for US goods by Mexico  A supply of pesos (demand for dollars) by Mexico Z has a positive relationship to value of peso E has a negative relationship to value of peso  Thus Z-E has a positive relationship to value of peso

6. Reinert/Windows on the World Economy, 2005 6 Figure 14.2. The Value of the Peso and Mexico’s Imports

7. Reinert/Windows on the World Economy, 2005 7 Figure 14.3 The Value of the Peso and Mexico’s Exports

8. Reinert/Windows on the World Economy, 2005 8 Figure 14.4 The Supply of Pesos

9. Reinert/Windows on the World Economy, 2005 9 Figure 14.5 The Peso Market

10. Reinert/Windows on the World Economy, 2005 10 A Trade-Based Model We are considering the case of a flexible exchange rate regime  e can vary in response to excess supply of or excess demand for pesos  Increase in e or a fall in value of peso Depreciation of peso  Decrease in e or a rise in value of peso Appreciation of peso

11. Reinert/Windows on the World Economy, 2005 11 A Trade-Based Model Consider three alternative values of the peso  1 ÷ e 1 —supply of pesos exceeds demand for pesos Reduces value of peso  Trade deficit falls—brings the supply and demand of pesos into equality  1 ÷ e 2 —demand for pesos exceeds the supply of pesos Increases value of peso  As peso appreciates, trade deficit rises—brings supply and demand of pesos into equality  1 ÷ e 0 —demand for and supply of pesos are exactly the same Represents equilibrium value of peso, and e 0 is the equilibrium nominal exchange rate Model is trade-based in the sense that only trade flows respond to a change in value of peso

12. Reinert/Windows on the World Economy, 2005 12 Table 14.1. Exchange Rate Terminology

13. Reinert/Windows on the World Economy, 2005 13 An Assets-Based Model Views foreign currency transactions as arising from the buying and selling of foreign-currency- denominated assets, rather than from trade flows  Focuses on foreign savings rather than on trade deficit in the S F = Z - E relationship Pretend you are a Mexican investor, deciding upon the allocation of your wealth portfolio between two assets  A peso-denominated asset  A dollar-denominated asset For simplicity, assume both assets to be open-ended mutual funds with fixed domestic-currency prices  You will allocate your portfolio with an eye to rates of return of alternative assets

14. Reinert/Windows on the World Economy, 2005 14 An Assets-Based Model In the case of peso-denominated assets, return you obtain is the interest rate, or r M Total expected return on the peso-denominated asset is Since you are a Mexican investor, dollar-denominated assets are a bit more complicated—you must consider  Interest payment on the dollar-denominated assets, or r US  Exchange rate Suppose initial exchange rate is e 0 = 1  At this exchange rate, you purchase a dollar-denominated asset worth $1,000 which is worth 1,000 pesos  Suppose peso depreciates and the new exchange rate is e 1 = 1.1  $1,000 asset has increased in value to 1,100 pesos

15. Reinert/Windows on the World Economy, 2005 15 An Assets-Based Model At any point in time, current exchange rate is at a value e Also, at any point in time, you have your expectation of what exchange rate will be in the future, or e e Your expected rate of depreciation of the peso is Your expected total rate of return on dollar-denominated assets is the sum of the interest rate and the expected rate of depreciation of the peso

16. Reinert/Windows on the World Economy, 2005 16 An Assets-Based Model— Portfolio Allocation How will you allocate your portfolio between these two asset types? Possibilities include  If expected total rate of return on peso-denominated assets exceeds expected total rate of return on dollar-denominated assets Since peso-denominated assets offer a higher expected rate of return, reallocate your portfolio towards these assets, selling dollars and buying pesos  If expected total rate of return on dollar-denominated assets exceeds expected total rate of return on peso-denominated assets Reallocate your portfolio towards dollar-denominated assets, buying dollars and selling pesos  If expected total rate of return on dollar-denominated assets equals expected total rate of return on peso-denominated assets No reason or incentive to reallocate your portfolio

17. Reinert/Windows on the World Economy, 2005 17 Interest Rate Parity Reallocations cause buying of one currency and selling of another  Equilibrium in foreign exchange market requires that  Known as interest rate parity condition  Equilibrium in foreign exchange market requires that interest rate on peso deposits equals interest rate on dollar deposits plus expected rate of peso depreciation

18. Reinert/Windows on the World Economy, 2005 18 Interest Rate Parity Role of the value of the peso in the interest rate parity condition  Suppose initially equilibrium exists  Next suppose value of peso increases or e falls For a given expected future exchange rate the total expected rate of return on the dollar-denominated asset increases because as e falls You (along with other investors from all other countries) would sell peso-denominated assets and buy dollar-denominated assets  S F (asset-based demand for pesos) declines increases in value

19. Reinert/Windows on the World Economy, 2005 19 Interest Rate Parity To understand adjustment process, consider three alternative values of the peso  At 1/e 1 supply of pesos exceeds demand for pesos resulting in a fall in value of peso Trade deficit falls as Z decreases and E increases—decreases supply of pesos Foreign saving rises  Expected total rate of return on dollar-denominated assets falls  Investors move into peso-denominated assets—increases demand for pesos Both of these changes bring the peso market towards equilibrium

20. Reinert/Windows on the World Economy, 2005 20 Interest Rate Parity  At 1/e 2 demand for pesos exceeds supply of pesos leading to a rise in value of peso Trade deficit rises as Z increases and E decreases— increases supply of pesos Foreign savings falls  Expected total rate of return on dollar-denominated assets rises  Investors move out of peso-denominated assets into dollar-denominated assets—decreases demand for pesos  At e 0 demand for and supply of pesos are equal—peso market is in equilibrium

21. Reinert/Windows on the World Economy, 2005 21 Figure 14.6 An Assets-Based View of the Peso Market

22. Reinert/Windows on the World Economy, 2005 22 Interest Rates, Expectations, and Exchange Rates Interest rate parity condition An increase in r M increases total expected rate of return on peso-denominated assets  Results in an increase in demand for pesos Shifts demand curve to right and raises value of peso to 1/e 1 An increase in Mexican (home-country) interest rate causes an appreciation of the Mexican (home-country) currency in a flexible exchange rate regime

23. Reinert/Windows on the World Economy, 2005 23 Interest Rates, Expectations, and Exchange Rates An increase in r US increases total expected rate of return on dollar-denominated assets  Results in a decrease in demand for pesos, which shifts the demand curve to left and lowers value of peso to 1/e 2  An increase in US (foreign-country) interest rate causes a depreciation of the Mexican (home- country) currency in a flexible exchange rate regime

24. Reinert/Windows on the World Economy, 2005 24 Figure 14.7. Interest Rates and the Peso Market

25. Reinert/Windows on the World Economy, 2005 25 Interest Rates, Expectations, and Exchange Rates Interest rate parity condition involves expectations about future exchange rates  Expectations are formed in the minds of investors and are subjective  Suppose, for example, expected future exchange rate, e e, were to increase in the minds of investors Would increase total expected rate of return on dollar- denominated assets  Results in a decreased demand for pesos  Shifts demand curve to left which lowers value of peso to 1/e 2  An increase in expected future exchange rate for Mexico’s (home-country’s) currency causes a depreciation of Mexico’s (home-country’s) currency in a flexible exchange rate regime

26. Reinert/Windows on the World Economy, 2005 26 Table 14.2. Changes in Currency Markets