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So far, we have taken two approaches to exchange rate determination
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$D
S The trade balance approach equates the supply and demand for US dollars as derived from the trade balance
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P The monetary approach approach equates the supply and demand for domestic and foreign currencies in money markets
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Both of these approaches assume that commodity markets have enough time to adjust so that the prices of commodities are equalized across countries – this makes both approaches useful for a long run prediction
However, there is one key difference between these two frameworks
Trade Balance Approach
Perfect correlation between exchange rate and trade balance (too much weight on current account) Monetary Approach
Zero correlation between exchange rate and trade balance (too much weight on capital account)
The real issue at hand is the Balance of Payments, which measures the total flow of funds in and out of a country
A balance of payments deficit would imply that dollars are leaving the US and flowing into the rest of the world. This excess supply of dollars should cause the international value of the dollar (aka the exchange rate) to depreciate
Likewise, a BOP surplus (dollars flowing from the rest of the world to the US) should cause the dollar to appreciate due to lack of international supply
Change in US owned Assets Abroad
US Official Reserve Assets
US Government Assets
US Private Assets
Foreign Direct Investment
Securities
Change in Foreign Ownership of US Assets
Foreign Official Assets
Private Foreign Assets
Foreign Direct Investment
Currency
Securities
Merchandise
Services
Income
Unilateral Transfers
Current Account Capital & Financial Account
By definition, the actual balance of payments for the US (or any other country) is zero – that’s because cash is counted in the financial account
KFACABOP
If we remove cash from the capital & financial accounts, we can develop a framework to think about commodity markets, currency markets, and asset markets
Currency Markets
Current Account Capital AccountTrade balances are determined largely from changes in income
Capital accounts are determined largely from changes in interest rates
Exchange Rates determined by international supply of dollars
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TGI
S Suppose trade is initially balanced. An increase in income will create a trade deficit (spending increases, savings decreases)
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KFACABOP Without a change in the KFA, we would have a balance of payments deficit and the dollar would be forced to depreciate.
To create an offsetting KFA surplus, the return on US assets would need to rise to attract foreign capital.
The degree of international capital mobility will dictate the rise in domestic interest rates necessary to offset a trade imbalance.
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yBOP Deficit - Currency Depreciates
BOP Surplus - Currency appreciates
BOP Surplus - Currency appreciates
BOP Deficit - Currency Depreciates
With high capital mobility, there is plenty of capital looking for higher returns – financing a trade deficit requires a small interest rate increase
With low capital mobility, there is a shortage of capital looking for higher returns – financing a trade deficit requires a large interest rate increase
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0BOP
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The trade balance approach assumes that it is impossible to finance a trade deficit with asset sales - a trade deficit requires a currency depreciation! (no capital mobility)
The monetary approach assumes that any trade deficit can be financed without a rise in interest rates (perfect capital mobility)
The trade balance approach and monetary approach are two special cases
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Home Currency (M) Pays no interest, but needed to buy goods
Domestic Bonds (B) Pays interest rate (i)
Foreign Bonds (B*) Pays interest rate (i*), payable in foreign currency
Foreign Currency (M*) Pays no interest, but needed to buy foreign goods
As in the previous case, we begin with four commodities
Foreign Bond Market
Domestic Money Market
Domestic Bond Market
Households choose a combination of the four assets for their portfolios
Foreign Money Market
Currency Market
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Foreign Bond Market
Domestic Money Market
Domestic Bond Market
We need five prices to clear all five markets
Foreign Money Market
Currency Market
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For example, a 10% increase in the domestic money supply results is a long run 10% depreciation of the domestic currency.
Over a long time horizon, all prices have a chance to adjust - currency prices return to their fundamental values and real returns are equalized across countries
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However, it’s now assumed that commodity prices are fixed in the short run (P is constant) – this causes PPP to fail!
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With fixed prices, the real and nominal exchange rates have a correlation of one!
Further, real returns can vary across countries!
Instead, let’s assume that foreign variables (i* and P*) are constant. That way, we can ignore the foreign markets!
P* and i* are fixed
Without PPP, we need to explicitly analyze currency markets – this complicates matters a bit!
Foreign Bond Market
Domestic Money Market
Domestic Bond Market
This leaves three markets and three prices
Foreign Money Market
Currency Market
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Our money market model hasn’t changed. Cash is used to buy goods (transaction motive), but pays no interest
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Money Demand Higher interest
rates lower money demand
Higher real income raises money demand
Higher prices raises money demand
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Money supply is assumed to be purely exogenous (a policy variable of the government)
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An equilibrium price level clears the money market (i.e. supply equals demand)
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Now, consider this price fixed over short time horizons
With the price level fixed, the market will need to find a new way to adjust to changes in supply/demand
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Suppose that real income increases. This will raise the demand for money and put downward pressure on the price level
Assuming that the Fed keeps the money supply constant, we need something else to adjust to return demand to its original position
A rise in interest rates will return demand to its original position and maintain the constant price level.
Excess Demand for Money
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This positive relationship between interest rates and income in the money market is represented by the LM curve.
At every point on the LM curve,
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For a fixed price level
Note: The LM curve represents the set of equilibria in the money market for a fixed level of real (inflation adjusted) money supply.
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P
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Suppose that the Fed increases the money supply. This will put upward pressure on prices. To maintain a constant price level, money demand must increase.
This is accomplished by a drop in interest rates and a rise in income
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This can be represented by the LM curve shifting to the right
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IS ,
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TGI
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Next, what is the relationship between the interest rate and income in the bond market
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Lower interest rates raise demand – this higher demand generates higher income
The IS curve represents the negative relationship between interest rates and income in equilibrium
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TGI
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Suppose that an increase in government deficits forces interest rates up
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The upward pressure on interest rates is represented by a shift to the right of the IS curve
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LM
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Now we can put everything together to see all three markets (currency, bonds, money) in a short run equilibrium.
The LM curve gives us the interest rate/income combination that clears the money market
The BOP curve gives us the interest rate/income combination that clears the currency market
The LM curve gives us the interest rate/income combination that clears the bond market
Suppose that the Federal reserve increases the supply of money by 10% The monetary approach describes the long run reaction of currency markets – the dollar depreciates by 10%
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Increases by 10%
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10%
What happens in the short run?
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LM
0BOP
Now we can put everything together to see all three markets (currency, bonds, money) in a short run equilibrium.
The increase in the domestic money supply forces down interest rates in the short run while prices are fixed
The lower interest rate stimulates consumption expenditures and worsens the trade deficit.
lower interest rates decreases the demand for domestic assets – dollar demand drops
Increased trade deficit increases supply of dollars
Dollar Depreciates
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LM
0BOP
We have a new short run (temporary) equilibrium.
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10%
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Here’s what we know….
1. The dollar will eventually depreciate by 10% (long run)
2. An immediate depreciation is also required to equalize the balance of payments
3. Interest rates in the US have dropped
If US interest rates fall relative to foreign rates, the dollar must appreciate at some point to equalize the returns
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time
10%
What happens to the real exchange rate?
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Nominal
Real
In the short run, with fixed prices, the real exchange rate mimics the nominal rate – in the long run, PPP holds and the real exchange rate is constant
Suppose that the experiences a 10% increase in income
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Again, we know that long run impact will be a 10% dollar appreciation
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What happens in the short run?
Increases by 10%
10%
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yIS
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This increase in income is due to increases in US government spending financed by borrowing
higher interest rates increases the demand for domestic assets – dollar demand rises
Increased trade deficit increases supply of dollars
What happens to the value of the dollar?
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yIS
LM
If capital is very mobile globally, then the rise in interest rates domestically will be more than enough to finance the trade deficit
KFACABOP
0BOP
The balance of payments surplus forces the dollar to appreciate in the short run.
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time
10%
*% iieE t
Here’s what we know….
1. The dollar will eventually appreciate by 10% (long run)
2. An immediate appreciation is also required to equalize the balance of payments
3. Interest rates in the US have risen
If US interest rates rise relative to foreign rates, the dollar must depreciate at some point to equalize the returns
i
i
yIS
LM
If capital has very low mobility, then the rise in interest rates domestically will not be enough to finance the trade deficit
KFACABOP
0BOP
The balance of payments deficit forces the dollar to depreciate in the short run.
e
time
10%
Here’s what we know….
1. The dollar will eventually appreciate by 10% (long run)
2. An immediate depreciation is also required to equalize the balance of payments
3. Interest rates in the US have risen
Note that uncovered interest parity fails (US interest rates rise and the dollar appreciates) – that’s because of the low capital mobility