EC4100: Exchange Rate Economics III
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1 EC4100: Exchange Rate Economics III Philip R. Lane, TCD February 2010 Philip R. Lane, TCD () EC4100: Exchange Rate Economics III February / 10
2 The Asset Approach in the Short Run Exchange rates highly volatile PPP does not operate in short run Currencies are assets Asset pricing: forward-looking; current and future fundamentals Philip R. Lane, TCD () EC4100: Exchange Rate Economics III February / 10
3 Uncovered Interest Parity (UIP) What determines expectations? What determines interest rates? i $ = i e + E e $/e E $/e Philip R. Lane, TCD () EC4100: Exchange Rate Economics III February / 10
4 Figure 15.1 Building Block: Uncovered Interest Parity The Fundamental Equation of the Asset Approach
5 Table 15.1 Interest Rates, Exchange Rates, Expected Returns, and FX Market Equilibrium: A Numerical Example
6 Figure 15.2 FX Market Equilibrium: A Numerical Example
7 Figure 15.3 A Change in the Home Interest Rate
8 down Figure 15.3 A Change in the Foreign Interest Rate
9 Figure 15.3 A Change in the Expected Future Exchange Rate
10 Short-Run Money Market Equilibrium M US P US = L(i $ )Y US M EUR P EUR = L(i e )Y EUR Short-run price stickiness Interest rate clears the market Philip R. Lane, TCD () EC4100: Exchange Rate Economics III February / 10
11 Figure 15.4 Equilibrium in the Home Money Market
12 Figure 15.5 Building Block: The Money Market Equilibrium in the Short Run
13 Figure 15.6 Home Money Market with Changes in Money Supply and Money Demand
14 Figure 15.7 Equilibrium in the Money Market and the FX Market
15 Figure 15.8 Temporary Expansion of the Home Money Supply
16 Figure 15.9 Temporary Expansion of the Foreign Money Supply
17 Figure U.S.-Eurozone Interest Rates and Exchange Rates,
18 The Monetary Model: Short Run versus Long Run Temporary monetary expansion: decline in interest rate, currency depreciation Permanent monetary expansion: increase in interest rate [higher expected in ation], currency depreciation [Short-run: expected future value of exchange rate unchanged] Philip R. Lane, TCD () EC4100: Exchange Rate Economics III February / 10
19 Unifying the Monetary and Asset Approaches Asset approach (short-run) P US = P EUR = M US L(i $ )Y US M EUR L(i e )Y EUR Monetary approach (long-run) i $ = i e + E e $/e E $/e P e US = P e EUR = M e US L(i e $ )Y e US M e EUR L(i e e )Y e EUR E e $/e = Pe US P e EUR Philip R. Lane, TCD () EC4100: Exchange Rate Economics III February / 10
20 Figure A Complete Theory of Floating Exchange Rates: All the Building Blocks Together
21 Figure Permanent Expansion of the Home Money Supply Short-Run Impact
22 Figure Permanent Expansion of the Home Money Supply Long-Run Adjustment
23 Overshooting Permanent money expansion Reduction in short-run interest rate Expected future currency depreciation, higher long-run interest rate Short-run depreciation in excess of long-run depreciation Helps to explain currency volatility in excess of fundamentals volatility Philip R. Lane, TCD () EC4100: Exchange Rate Economics III February / 10
24 Figure Responses to a Permanent Expansion of the Home Money Supply
25 Figure Exchange Rates for Major Currencies before and after 1973
26 Figure A Complete Theory of Fixed Exchange Rates: Same Building Blocks, Different Known and Unknown Variables
27 Fixed Exchange Rates and the Trilemma Only two of these three conditions can hold: Monetary policy autonomy A xed exchange rate International capital mobility Philip R. Lane, TCD () EC4100: Exchange Rate Economics III February / 10
28 Figure The Trilemma
29 Figure The Trilemma in Europe
30 The Trilemma: Denmark Short run Long run i DKr = i e M DEN = P DEN L(i DKr )Y DEN = P DEN L(i e )Y DEN P DEN = Ē DKr /e P EUR M DEN = P DEN L(i DKr )Y DEN = Ē DKr /e P EUR L(i e )Y DEN [Currency Union versus Fixed Exchange Rate] Philip R. Lane, TCD () EC4100: Exchange Rate Economics III February / 10
31 News and Exchange Rates Currency markets respond to news about current and future fundamentals War: in ationary nance; currency abolition risk Applications: US civil war; Iraq war (Kurdish [Swiss] dinar vs Saddam dinar) Philip R. Lane, TCD () EC4100: Exchange Rate Economics III February / 10
32 Figure Exchange Rates and News in the U.S. Civil War
33 Figure Exchange Rates and News in the Iraq War
34 Figure Exchange Rates and News in the Iraq War
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