International Finance

Transcription

1 Inernaional Finance FINA 533 Lecure 3: Moneary Models of Exchange Raes William J. Crowder Ph.D.

2 The Moneary Models of Exchange Rae Deerminaion The Flexible-Price Model The Sicky-Price Model The Porfolio Balance Model

3 Moneary Models

4 Asse Models of he Spo Exchange Rae Asse Model Approach perfec capial mobiliy Moneary Approach perfec capial subsiuabiliy Monearis Model compleely flexible commodiy prices Overshooing Model sicky commodiy prices Porfolio-Balance Approach imperfec capial subsiuabiliy Small Counry Model Preferred Local Habia Model Uniform Preference Model

5 The Flexible-Price Model We sar wih he following assumpions:. PPP holds coninuously 2. Bonds denominaed in differen currencies are perfec subsiues UIP 3. Perfec capial mobiliy, 2 and 3 ogeher imply ha real ineres raes are equal inernaionally r = r

6 The Flexible-Price Model Ex-Ane PPP is implied by Absolue PPP UIP implies ha: % Δ s e e e + = π + π + % Δ s e + = i i Combined wih he Fisher equaion, i = r + π + e Gives Real Ineres Pariy r = r

7 The Flexible-Price Model Furher assume ha money demand in each counry is given by he liquidiy preference heory. where m p = δ y γ i m is he domesic money supply in logs p is he log of domesic price level y is he log of domesic real income i is he domesic nominal ineres rae

8 The Flexible-Price Model A similar money demand exiss for he foreign counry = m p δ y γ i Noe: The use of logarihms allows us o make an oherwise nonlinear relaionship linear. Linear models are much easier o work wih.

9 The Flexible-Price Model The assumpion of PPP implies: s = p p Combine he PPP relaionship wih he wo money demands: = s p p m p = δ y γ i m p = δ y γ i

10 The Flexible-Price Model Re-wrie he money demands as: p = m δ y + γ i = + p m δ y γ i

11 The Flexible-Price Model Using PPP o combine he wo money demands yields: = δ + δ + γ γ p p m m y y i i or = δ + δ + γ γ s m m y y i i

12 The Flexible-Price Model We can simplify his equaion furher by assuming ha he money demand elasiciies are he same in boh he foreign and domesic economies: δ = δ and γ = γ ( ) ( ) ( δ γ ) s = m m y y + i i

13 The Flexible-Price Model This las equaion represens he basic Flex-Price Model: ( ) ( ) ( δ γ ) s = m m y y + i i Using he UIP relaionship he Flex-Price model can be equivalenly wrien as: ( ) ( ) s % e = m m δ y y + γ Δs+ or ( ) ( ) ( e e δ γ π ) + π + s = m m y y +

14 Implicaions of he Flex-Price Model for Exchange Rae Behavior s i = γ s i = γ s y δ = s y δ = s m = s m = e s γ π + = e s γ π + = % e s s γ + = Δ

15 Sicky-Price Model One of he mos imporan facs abou he floaing exchange rae sysem is he huge increase in exchange rae volailiy observed since he demise of he Breon Woods regime. Wha can explain his large increase in volailiy? Remember ha PPP does no have srong empirical suppor in he shor run. PPP holds beer in he long run. If we assume ha price levels are sicky, i.e. hey do no adjus quickly in response o a changing economic environmen, hen PPP will no hold every period.

16 Sicky-Price Model Assume ha PPP only holds in he long run, such ha = s p p where a bar over a variable indicaes a long-run equilibrium value. In he long run PPP holds and hus he Flex-Price model is valid, bu only in he long run. ( ) ( ) ( δ γ ) s = m m y y + i i In he shor run, prices are sicky and PPP will no hold and neiher will he Flex-Price model.

17 Sicky-Price Model Mainain he assumpion of UIP Assume PPP only holds in he long run Deviaions of he exchange rae from is long-run equilibrium value, i.e. i s PPP value, will adjus in he following way: % Δ s = θ ( s s ) + π π e e e + + +

18 Sicky-Price Model Noing ha %Δs e = i-i implies, ( e e ) + ( + ) s s = θ i π i π or ( ) s s r r = θ Then subsiue from he earlier equaion o ge ( ) δ ( ) γ ( ) θ ( ) s = m m y y + i i r r

19 Sicky-Price Model This las equaion is he basic Sicky-Price model. I has he following equivalen represenaion: e e s = m m y y i i + + θ θ ( ) ( ) ( ) ( δ γ π ) + π +

20 Implicaions of he Sicky-Price Model for Exchange Rae Behavior s i θ = s i θ = s y δ = s y δ = s m = s m = e s γ π θ + = + e s γ π θ + = +

21 Overshooing Exchange Raes

22 The Porfolio Balance Model Now relax assumpion of risk neuraliy, i.e. asses denominaed in differen currencies are no longer perfec subsiues. The UIP relaion mus now be augmened wih a risk premium ha is a funcion of he relaive supplies of domesic o foreign asses expressed in a common currency. ( % e ) α + β i i Δ s + = b f s

23 The Porfolio Balance Model This yields he following adjusmen equaion for he exchange rae: b f s α s s = θ i π i π β e e ( + ( + ) ) and by subsiuion we obain he Porfolio Balance model α δ s = + ( m m ) y y i i θβ θ + β [ θβ ] [ θβ ] e e ( + + ) ( b f) ( ) ( ) γ + θ + π π + + [ θβ ] + θβ

24 Implicaions of he Porfolio Balance Model for Exchange Rae Behavior s = m + s m + = [ θβ ] [ θβ ] γ + s θ = e π [ ] θβ + + s = y + s = y + δ [ θβ ] δ [ θβ ] s = b + θβ γ + s θ = e π [ ] θβ + + s = i θ + β s = i θ + β s = f + θβ

25 Forecasing Exchange Raes Efficien Markes Approach Fundamenal Approach Technical Approach Performance of he Forecasers

26 Efficien Markes Approach Financial Markes are efficien if prices reflec all available and relevan informaion. If his is so, exchange raes will only change when new informaion arrives, hus: S = E[S + ] and F = E[S + I ] Predicing exchange raes using he efficien markes approach is affordable and is hard o bea.

27 Fundamenal Approach MV=PY P=MV/Y PPP S = P/P Combine so ha s = a 0 +a (m-m )+a 2 (i-i )+a 3 (y-y ) s s s = a > 0, = a2 > 0, = a3 < 0 m i y Involves economerics o develop models ha use a variey of explanaory variables. This involves hree seps: sep : Esimae he srucural model. sep 2: Esimae fuure parameer values. sep 3: Use he model o develop forecass. The downside is ha fundamenal models do no work any beer han he forward rae model or he random walk model.

28 Technical Approach Technical analysis looks for paerns in he pas behavior of exchange raes. Clearly i is based upon he premise ha hisory repeas iself. Thus i is a odds wih he EMH

29 Technical Analysis

30 Technical Analysis

31 Performance of he Forecasers Forecasing is difficul, especially wih regard o he fuure. As a whole, forecasers canno do a beer job of forecasing fuure exchange raes han he forward rae. The founder of Forbes Magazine once said: You can make more money selling financial advice han following i.

32 Forecasing Performance

33 Bank s Forecass

34 News and Foreign Exchange Raes Financial markes are preoccupied wih news. However, we usually canno find a simple unambiguous link beween a news announcemen and an exchange rae reacion. The marke is forward-looking, and permanen changes versus ransiory phenomena are viewed differenly. While wo news announcemens may seem similar, heir underlying aspecs may be in fac differen.

35 Exchange Raes and News Sories: Three Illusraions Sory : A ime, i is announced ha he U.S. money supply grew by $3 billion in he mos recen week. (The consensus marke forecas was $2 billion.) Case a: The US$ weakens as he marke feels ha he higher money supply will be mainained. Case b: The US$ srenghens as he marke believes ha he Federal Reserve will ake correcive acions. Case c: The US$ weakens and hen seadily depreciaes as he marke feels ha he change in he growh rae is permanen.

36 Sory : An Increase in he U.S. Money Supply c Nominal exchange rae ($ /FC) a b c U.S. price level a b $ ineres rae a b c c U.S. money supply a b 2 Time

37 Exchange Raes and News Sories: Three Illusraions Sory 2: U.S. ineres raes a all mauriies have risen by 0.0% or 0 basis poins. (The marke consensus was for no change in raes.) Case d: The US$ weakens as he marke feels ha he rise sems from inflaionary concerns, and is herefore a rise in he nominal ineres rae. Case e: The US$ srenghens as he marke believes ha inflaion is under conrol, such ha he higher rae corresponds o an increase in he real ineres rae.

38 Exchange Raes and News Sories: Three Illusraions Sory 3: I is announced ha he U.S. curren accoun defici will reach an annual rae of $250 billion. ( The consensus was $200 billion.) curren accoun = expors impors + unilaeral ransfers Case g: The change is due o greaer privae secor invesmens, and he US$ srenghens as foreign capial flows in o finance he invesmens. Case f: The shorfall in expors or increase in impors is viewed as permanen and he US$ weakens.

39 News and Foreign Exchange Raes: A Summary Only unanicipaed evens cause exchange raes o deviae from heir expeced pah of movemen. Facors ha increase he demand for a currency end o raise he price of ha currency. The characer and he conex of he economic news iem will grealy influence he naure of he exchange rae response ha follows.