Issues in International Finance Exchange rates review UW Madison // Fall 2018
Administrative things PS #2 solutions posted this afternoon Last set of marked up slides posted this afternoon Practice exam and solutions posted Office hours (7444 Soc Sci): Today (10/2) 2:30PM 3:30PM Tomorrow (10/3) 5:30PM 6:30PM Thursday (10/4) 9:00AM 10:00AM Next week: Start Ch. 16 National and International Accounts 1
Exam I: Thursday 10/4 Exam duration is 75 minutes We will start on time; arrive early Bring Calculator One page of notes (8.5"x11") No wireless devices or other materials Show your work! 2
Big picture Exam information Introduction to exchange rates Definitions: appreciate, depreciate, multilateral fx rates Exchange rate regimes: fixed, floating, somewhere in between Types of fx contracts Triangle arbitrage Covered interest parity Uncovered interest parity 3
Big picture Exchange rates in the long run: Monetary approach Key assumption: Flexible prices Law of one price Purchasing power parity: Absolute and relative Quantity theory of money: Prices depend on money supply Hyperinflations Real and nominal interest rates (the Fisher effect) Real interest rate parity Nominal anchors Big idea: long-run exchange rates determined by money supply Big idea: nominal interest rates determined by expected inflation 4
Big picture Exchange rates in the short run: Asset approach Key assumption: Sticky prices Long-run model (PPP) pins down expected exchange rate UIP pins down short-run exchange rate Sticky prices: Change in money change M/P, i Temporary shocks vs. permanent shocks Overshooting Big idea: short-run exchange rates determined by UIP Big idea: nominal interest rates determined in money market 5
Introduction to fx rates: Key equations Triangle no-arbitrage E = E E e $ e $ Covered interest parity Uncovered interest parity F $/e = 1 + i $ 1 + i e E $/e E $/e,t = 1 + i e 1 + i $ E e $/e,t+1 d e $/e + i e = i $ Where the expected depreciation rate of the dollar is d e $/e = Ee $/e,t+1 E $/e,t 6
Long-run monetary approach: Key equations Purchasing power parity P us = P eu E $ e π us π eu = d $ e Money market equilibrium price level P = Expressed in changes inflation rate M L(i)Y π us = µ us g us λ us 7
Long-run monetary approach: Relationships Assumptions: flexible prices, no-arbitrage Fx rate Levels E H/F = P H P F Expected change d e H/F = πe H πe F Price P H = M H L(i H )Y H d e H/F = µe H ge H λ H Nominal interest rate i H = r + π e H Similar equations hold for foreign country Shocks: changes in M H, M F, Y H, Y F, µ H, µ F, g H, g F 8
Long-run monetary approach: Expectations Flexible prices: real variables are unaffected by changes in money Unstable expectations create unstable exchange rates and interest rates Expectation management is important for policy makers Nominal anchors help to coordinate expectations Exchange rate target: π H = d H/F + π F Money supply target: π H = µ H g H λ H Inflation target: πh e = i H r 9
Short-run asset approach: Key equations Bring together long-run and short-run models Long run: Purchasing power parity E e H/F = Pe H P e F Long run: Quantity theory with flexible prices (in expected value) M e F P e F = L F (if e)y F e M e F P e F = L F (if e)y F e 10
Short-run asset approach: Key equations Bring together long-run and short-run models Short run: UIP i H = i F + Ee H/F E H/F 1 Short run: Quantity theory with fixed prices M F P F = L F (i F )Y F M F P F = L F (i F )Y F 11
Short-run approach: Relationships Assumption: Long run = monetary approach in levels Assumption: Prices are sticky, but expectations adjust instantly Assumption: Over time, prices gradually adjust to long-run level Short run Long run Fx rate E H/F = Ee H/F 1+i H i F E H/F = P H P F Price fixed P H = M H Y H L(i H ) Nominal interest rate M H P H = Y H L(i H ) Similar equations hold for foreign country Shocks: changes in M H, M F, Y H, Y F both temporary and permanent 12
Short-run approach Sticky prices: fx rates more volatile than prices Permanent shocks create fx rate overshooting 13