Lecture 2:

Monetary Models of the Exchange Rate

Prof. Menzie Chinn Kiel Institute for World Economics March 7-11, 2005

Lecture Outline
Flexible price monetary model PV model of flexible price monetary approach Sticky price formulation Dornbusch model An application: the USD/EUR rate

I The Flexible Price Monetary Model

Derivation of the Flex Price Model

Assume UIP and rational expectations

Invoke PPP:

Money demand functions in the two countries:

Combine with money market equilibrium:

II A PV model of the FPMA

A Rat-Ex/PV Formulation

Assuming perfectly flexible prices, the Fisherian model of interest rates should hold:

So it is assumed that real int. rate is constant

Derivation (I)
Recall UIP and ex ante rel. PPP:

Hence the FPMA can be re-expressed as:

Rearranging:

Imposing Rat-Ex:

substituting into the previous eqn:

But note:

substituting iteratively:

Conclusion: The current spot rate is the PDV of the future stream of fundamentals, where discount rate is the semi-elasticity of money demand.

Special Cases (I): AR(1)

Substituting into previous expression:

Note: The relationship between the current spot rate and current fundamentals will change if either 8 or D (the driving process for the fundamentals) change.

Consider no autocorrelation, D=0:

If the fundamentals are a white noise process around a mean, ::

Special Cases (II): Random Walk

The fundamentals:
Substitute D=1 into the PV equation

Current spot rate equals the current fundamentals as all future fundamentals

are expected to equal the current value. Or set all the EtMt+i's equal to Mt in the PV equation:

What if the fundamentals follow a random walk with drift?

Let:

re-arranging:

Let

and

subtracting this from the previous equation:

Magnification Effect:

Hold M constant, change growth rate:

News
What moves asset prices? News What is the actual exchange rate at time t?

What is the exchange rate expected at time t based on time t information?

What is the revision in the exchange rate?

What is News?
Revisions in expectations in ( ). For J=0, this is a surprise:

Example: EUR/USD & CB Res.

Application: USD/EUR bond yields

III The Sticky Price Monetary Model

The Flex Price Model as the Long Run

Recall:

Assume long run PPP:

Assume flex price model applies in long run:

"Overshooting":

2 is the rate of reversion. If 2 = 0.5, 0.10 (10%) undervaluation induces a 0.05 (5%) exchange rate appreciation in the next period.

 "Rational Expectations"

By UIP:

Solving for s:

Substitute in the long run s:

This expression can be rewritten as:

IV The Dornbusch Model

Consider UIP (where r is nominal, e is s):

(1)

Ad hoc model of expd depreciation:

(2)

(3)

Solving for (p-m) and substituting in (1):

substituting in for x from equation (2):

rearranging yields (4);

(4)

Solve for p - p , noting the LR version of (4) is:

(5)

solve for 8r

substitute this in for r* in (4):

solving for e yields:

(6)

The domestic macroeconomy is described as:

(7)

(8)

ln(D/Y) is log excess demand (e-p) is the real exchange rate (since p* = 1) u is a fiscal shift parameter One can solve for long run values of e and p by
. =0, r = r*, in equation (8): setting p

(10)

Notice that (1) and (2) imply:

but (6) implies a reln betw (e-e ) and (p-p ):

substituting into (8):

but equation (9) is an expression for e ,

where the last line is obtained by recalling from (1), (2) and (6) that:

Then one obtains (10) :

for the following expression (11) holding true:

(11)

Solving (10) yields:

(12)

Substituting (12) into (6) yields:

but since

and
(13)

This result implies (14):

(14)

Hence the ad hoc expression for exchange rate depreciation in (2) is equivalent to the perfect foresight expression if:

Using the quadratic formula, dropping the neg. root:

This yields (15):

(15)

Convergence is faster (2 larger): the larger *, F, B are the smaller 8 is Recall in (4):

(4)

implies for de = dm = dp , that:

but dp/dm = 0 in the short run, due to sticky prices:

(16)

substituting (15) into (16) yields (17):

(17)

Degree of overshooting depends on 8 and the rate of convergence to PPP. The more rapid the convergence rate, the less overshooting.

. The p dot=0 line (combined goods and money

market equilibrium), is given by:

Notice in (17) as:

 If output responds to AD/mon. shocks, overshooting may be dampened. If 1-N:* < 0 then the exchange rate will undershoot (where : = 1/(1-(), and ( is the income elasticity of demand for domestic goods).

Time series of macro variables in Dornbusch Model

Implications
Both the flex price and sticky price models try to explain the volatility in exchange rates. In both models, exchange rates will be more volatile than the fundamentals. The Dornbusch model illustrates one way to get volatility: hold one variable constant, so the other variable has to undertake all the

adjustment (p fixed, e very flexible). A general principle in models. E.g. current account and net foreign assets.

V An Application

Johansen Cointegration Results: 1991M08-1999M12 Panel 2.1: Long Run Coefficients [1] LR c.v. CRs 158.0 111.0[144.3] 2[1] [2] 136.8 103.2[134.2] 2[1] [3] 162.4 111.0[144.3] 3[1] [4] 133.4 103.2[134.1] 2[0]

mUS-meuro

0.396*** (0.086)

0.396*** (0.086) -2.217*** (0.480) 0.947 (0.556) 10.881*** (2.319) 2.070** (0.902) 13.626***

0.687*** (0.088) -0.754** (0.291) 0.129 (0.808) 13.542*** (3.181) 1.323 (1.132)

0.658*** (0.082) -0.703*** (0.278) -0.084 (0.791)

yUS-yeuro

-2.219*** (0.478)

iUS-ieuro

0.968 (1.195)

BUS-Beuro
~ T

10.797*** (2.302) 2.057** (0.898)

(3.044) 1.268 (1.082)

Tracking the Euro

.2 A c tu a l .1 E C M n o tr e n d 9 1 M 8 -9 8 M 1 2

.0

E C M n o tr e n d 9 1 M 8 -9 9 M 1 2

-.1

-.2 1997 S 1998 SSEQ EC M 9198 1999 2000 SSEQ EC M 9199