EC4100: Exchange Rate Economics III Philip R. Lane, TCD February 2010 Philip R. Lane, TCD () EC4100: Exchange Rate Economics III February 2010 1 / 10
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 2010 2 / 10
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 2010 3 / 10
Figure 15.1 Building Block: Uncovered Interest Parity The Fundamental Equation of the Asset Approach
Table 15.1 Interest Rates, Exchange Rates, Expected Returns, and FX Market Equilibrium: A Numerical Example
Figure 15.2 FX Market Equilibrium: A Numerical Example
Figure 15.3 A Change in the Home Interest Rate
down Figure 15.3 A Change in the Foreign Interest Rate
Figure 15.3 A Change in the Expected Future Exchange Rate
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 2010 4 / 10
Figure 15.4 Equilibrium in the Home Money Market
Figure 15.5 Building Block: The Money Market Equilibrium in the Short Run
Figure 15.6 Home Money Market with Changes in Money Supply and Money Demand
Figure 15.7 Equilibrium in the Money Market and the FX Market
Figure 15.8 Temporary Expansion of the Home Money Supply
Figure 15.9 Temporary Expansion of the Foreign Money Supply
Figure 15.10 U.S.-Eurozone Interest Rates and Exchange Rates, 1999 2004
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 2010 5 / 10
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 2010 6 / 10
Figure 15.11 A Complete Theory of Floating Exchange Rates: All the Building Blocks Together
Figure 15.12 Permanent Expansion of the Home Money Supply Short-Run Impact
Figure 15.12 Permanent Expansion of the Home Money Supply Long-Run Adjustment
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 2010 7 / 10
Figure 15.13 Responses to a Permanent Expansion of the Home Money Supply
Figure 15.14 Exchange Rates for Major Currencies before and after 1973
Figure 15.15 A Complete Theory of Fixed Exchange Rates: Same Building Blocks, Different Known and Unknown Variables
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 2010 8 / 10
Figure 15.16 The Trilemma
Figure 15.17 The Trilemma in Europe
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 2010 9 / 10
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 2010 10 / 10
Figure 15.18 Exchange Rates and News in the U.S. Civil War
Figure 15.19 Exchange Rates and News in the Iraq War
Figure 15.19 Exchange Rates and News in the Iraq War