Econ 352 Spring 2012 Determination of Exchange Rate (Ch. 17)

Transcription

1 Econ 352 Spring 2012 Determination of Exchange Rate (Ch. 17) Instructor: Kanda Naknoi April 17, Determination of Exchange Rate in the Long Run The theory of purchasing power parity (PPP) proposes that exchange rates are determined by the inflation rate in the long run. According to the PPP, in the long run: Hence, ɛ = 1. EP F/H = P (1) From equation (1), we can calculate the long-run exchange rate as follows. E F/H = P P Converting equation (2) into percentage change by taking the first difference of natural logarithm. (2) % E = π π (3) π = Inflation rate at home π = Inflation rate abroad Equation (3) predicts that the rate of appreciation of home currency is equal to foreign-domestic inflation differentials. π > π: We predict weak foreign currency and strong home currency in the long run. π < π: We predict strong foreign currency and weak home currency in the long run. Intuitively, the long-run determination of exchange rates emphasizes the role of currency or money as a medium of exchange and a unit of account. 1

2 2 Determination of Exchange Rate in the Short Run The short-run determination of exchange rates emphasizes the role of currency or money as a store of value. In the short run, exchange rates are driven by rates of return of currencies, like other assets. Demand for a currency in the currency market is downward sloping. Why? Given expected future exchange rate E e t+1, low E t today implies that the expected appreciation (E e t+1 E t ) is high. The higher the expectation, the higher is the rate of return from investing in a currency. Supply of a currency in the currency market is vertical. Why? We assume that banks supply fixed quantities of foreign-currency denominated accounts at any exchange rate. Figure 1: Equilibrium Exchange Rate in the Short Run E e/$ = Units of euro per one US dollar. 2

3 2.1 What Shifts Demand in the Currency Market? Changes in Domestic Real Interest Rate on Exchange Rate (r D ) Figure 2: Effects of a Rise in Domestic Real Interest Rate r D E. A rise in the domestic return increases demand for the US dollar in the currency market. As a result, the US dollar appreciates Changes in Foreign Real Interest Rate on Exchange Rate (r F ) Figure 3: Effects of a Rise in Foreign Real Interest Rate r F E. A rise in the foreign return decreases demand for the US dollar in the currency market. As a result, the US dollar depreciates. 3

4 2.1.3 Changes in Expected Future Exchange Rate (E e t+1) Figure 4: Effects of a Rise in Expected Future Exchange Rate or an Expected Appreciation E e t+1 E. A rise in the expected future rate increases the expected return, thus that increases demand for the US dollar in the currency market. As a result, the US dollar appreciates. 3 Intervention in Foreign Exchange Market All central banks around the world maintain the following central bank s balance sheet: B + DL + F = MB (4) B = Domestic government bonds DL = Discount loans F = Foreign exchange reserves, international reserves = foreign currencies + foreign government bonds + gold holdings There are two types of intervention. Sales of F = Purchases of domestic currency F MB M i d r d This intervention creates an appreciation pressure. Purchases of F = Sales of domestic currency F MB M i d r d This intervention creates a depreciation pressure. 4

5 4 Fixed Exchange Rate Regime Countries are free to choose their exchange rate policy. Various types of fixed exchange rate policy: currency board, basket peg, peg to an anchor currency. Various types of flexible exchange rate policy: free float, managed float/dirty float. 4.1 Overvaluation Figure 5: Intervention to Appreciate Currency Target exchange rate = Ē and Ē > E 1. Goal of policy = To appreciate currency. Purchase of domestic currency = sales F = increase in demand for domestic currency. 5

6 4.2 Undervaluation Figure 6: Intervention to Depreciate Currency Target exchange rate = Ē and Ē < E 1. Goal of policy = To depreciate currency. Intervention: Sales of domestic currency = purchases F = decrease in demand for domestic currency. 5 Fixed Exchange Rate and Capital Mobility: Policy Trilemma Central banks can choose only two things out of the following three policy options. (i) Fixed exchange rate (ii) Free capital mobility (iii) Monetary independence Figure 7: Effect of Capital Mobility and Fixed Exchange Rate Suppose r F rises. If the central attempts to fix exchange rate, then the central bank must raise r d too. Thus, fixed exchange rate and free capital mobility imply loss of monetary independence. 6