1. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 18-1 Chapter 18 Models of the Exchange Rate

2. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 18-2 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.

3. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 18-3 Learning Objectives (cont.) Integrate long-run and short-run descriptions of exchange rate behaviour into simple model of overshooting exchange rates.

4. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 18-4 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

5. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 18-5 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

6. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 18-6 Absolute PPP (cont.) Changes in the exchange rate simply reflect changes in price levels in each of the two associated countries

7. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 18-7 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

8. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 18-8 Australian and US Inflation Rates

9. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 18-9 Relative PPP Model focuses on the importance of relative inflation rates as a determinant of the exchange rate

10. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 18-10 Asset Market Models Exchange rate risk and returns on foreign investment Asset Market Approach, also called Portfolio Balance Approach, 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

11. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 18-11 Interest Arbitrage Interest arbitrage is the relationship between returns in asset markets and exchange rates Role of expectations Role of interest rate changes

12. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 18-12 Evaluating Interest Arbitrage Adjustment to the expected future exchange rate Interest arbitrage and specific risk Other problems

13. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 18-13 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

14. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 18-14 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

15. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 18-15 Models of Exchange Rate Behaviour Fisher equation Where: ri = real interest rate i = nominal interest rate

16. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 18-16 Models of Exchange Rate Behaviour (cont.) International Fisher equation

17. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 18-17 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

18. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 18-18 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

19. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 18-19 Next Chapter: The International Monetary System