THE ASSET MARKET APPROACH TO EXCHANGE RATE DETERMINATION

Observed Features of Post-Bretton Woods Exchange Rate Behaviour

1. NOMINAL EXCHANGE RATES ARE HIGHLY VOLATILE IN THE SHORT RUN. They display large changes on a day-to-day, week-to-week, month-to-month basis. These exchange rate movements are largely unpredictable in advance. 2. Because price levels are much less volatile, NOMINAL EXCHANGE RATE VOLATILITY AND UNPREDICTABILITY ARE REFLECTED IN REAL EXCHANGE RATE VOLATILITY AND UNPREDICTABILITY. 3. Both nominal and real exchange rate movements are often partly reversed at a later date a phenomenon known as OVERSHOOTING. 4. Real exchange rates display SUSTAINED DEPARTURES FROM THEIR PPP VALUES. 5. Notwithstanding 2, 3, and 4, in the longer run NOMINAL EXCHANGE RATES TEND TO MOVE IN THE GENERAL DIRECTION PREDICTED BY PPP. i.e. countries with relatively high inflation rates tend to have depreciating currencies, those with relatively low inflation rates tend to have appreciating currencies. 6. IN THE SHORT RUN, THE CURRENT ACCOUNT APPEARS TO HAVE LITTLE DIRECT EFFECT ON THE EXCHANGE RATE. However, in the long run there does appear to be an influence: e.g. countries with large current account deficits tend, on average, to have depreciating currencies.

Traditional Approaches to Explaining Exchange Rate Determination Under Floating Rates.

Purchasing Power Parity Sees exchange rates as determined by relative price levels between countries. The Flow View of Exchange Rate Determination Views exchange rates as determined by the flow of transactions in international currencies, reflecting trade in goods, services and financial assets. In the approach the current and capital accounts, though having different determinants, are treated symmetrically. Both PPP and the flow view would suggest gradual and predictable exchange rate movements. The perception that exchange rate adjustments would be smooth under floating rates was an argument central to the case for exchange rate flexibility put forward by proponents such as M. Friedman (contrasted with currency crises under Bretton Woods system). Actual exchange rate behaviour post-Bretton Woods required a new theoretical approach.

The Asset Market Approach to Exchange Rate Determination.

Exchange rates are viewed as being determined within asset markets, in much the same way as equity prices. The approach assumes instantaneous and continuous portfolio equilibrium. Exchange rates are modelled as being determined by the conditions for international asset market equilibrium. Different theories within the asset market approach are distinguished by the assumptions made with regards to: 1. 2. 3. 4. 1. 2. Which assets are traded internationally The risk characteristics of these assets The attitude towards risk of international investors. Different assumptions in respect of 1-3 generate different asset market equilibrium conditions. The behaviour of goods and labour markets. Asset market models fall into two broad groups: Monetary models Portfolio balance models

Monetary Models of Exchange Rate Determination

Monetary models assume international investors are risk-neutral. This implies that exchange risk is unimportant for investment choices. Consequently, domestic and foreign bonds which are identical in all respects other than currency of denomination are perfect substitutes from an investors viewpoint (contrast with portfolio balance models). Assets which are perfect substitutes must pay the same expected return. This idea is encapsulated in the characterisation of perfect capital mobility in the Mundell-Fleming model, in which international asset market equilibrium requires equality between interest rates on domestic and foreign bonds, i.e. r = r * . However, asset market models in general, and monetary models in particular, recognise the impact of expected exchange rate movements on expected returns to assets denominated in different national currencies. Exchange rate expectations and expected returns Let x = expected rate of depreciation of domestic currency. Expected returns in domestic currency terms: Domestic Asset Expected Return Foreign Asset
r * +x

Expected Differential
r (r * + x)

Expected returns in foreign currency terms:

Domestic Asset Expected Return
rx

Foreign Asset
r*

Expected Differential
r xr* = r (r * + x)

If domestic and foreign interest-bearing assets are perfect substitutes, as assumed by monetary models, then international asset market equilibrium requires the expected differential in returns to be zero. i.e. r (r * + x) = 0 or r = r *+x Uncovered interest parity (UIP) condition UIP represents one of the asset market equilibrium conditions of most monetary models and plays a central role in exchange rate determination in these models.

The Simple Monetary Model

Asset market equilibrium condition condition for money market equilibrium
Assumptions Money is the only financial asset held by residents of different countries. Money is not traded internationally, therefore there are no capital account transactions. The level of output is exogenously given at YF . The exchange rate and domestic and foreign prices are related through relative PPP. Prices are perfectly flexible. Key Relationships

Domestic demand for money

M d = m1PY

(1)

Domestic money supply

Ms =M

(2)

Domestic money market equilibrium

Md = Ms m1PY = M P = M m1Y (3)

Exogenously given full employment output

Y = YF

(3)

Substituting (4) into (3): M P= m1YF

(3')

Relative PPP
eP * = P where = a constant

(4)

e =

P
P*

(5')

Equilibrium nominal exchange rate Substitute (3') into (5')

e=

M
m1P * YF

(5)

Implications

1. Increase in M leads to proportionate depreciation of domestic currency

M > 0 ( MME ) P > 0 ( PPP) e > 0

2. Increase in YF causes appreciation of domestic currency

YF > 0 M d > ( MME ) P < 0 ( PPP) e < 0

3. Increase in P * leads to proportionate appreciation of domestic currency P* > 0 ( PPP) e < 0

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Extending the model to two countries assuming an identical form for the foreign demand for money function allows us to determine P*.
P* = M* m1YF *

substituting into (6):

e=

MYF *
M * YF

Given , the nominal exchange rate is determined by relative money supplies, and relative (full-employment) output levels. In log form the equation can be rewritten as:
m= e = m m * + ( yF yF *) LOG M etc.

(Note: e and now represent logs)

Equilibrium Rational Expectations Monetary Model

(Flexible price monetary approach Hallwood and MacDonald)
Asset market equilibrium conditions:

Condition for money market equilibrium Uncovered interest party.

Assumptions:

1. There are 4 financial assets : domestic and foreign monies, domestic and foreign bonds. 2. Domestic and foreign bonds are traded internationally, domestic money is held only by domestic residents, foreign money is held only by foreign residents. 3. International investors are risk neutral, implying domestic and foreign bonds are perfect substitutes. Therefore uncovered interest parity must hold. 4. Output is exogenously given, at full employment level. 5. Relative PPP holds. 6. Prices are perfectly flexible.
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7. Agents have rational exchange rate expectations.

Two country version of the model: Principal relationships

Domestic Demand for Money

The demand for nominal money balances is assumed to depend on the price level, income, and the interest rate. The demand for money function is specified to be linear when expressed in logs:
M d = PY exp( r ) income elasticity of M d

(1)

exp = exponential function

= interest semi-elasticity of M d
Domestic Money Supply
Ms =M

(2)

Domestic Money Market Equilibrium Md = Ms using (1) and (2) PY exp( r ) = M or

P= M exp( r ) Y

(3)

Taking logs:
p = m y + r (3')

p, m, y = LOGS of P, M , Y , (r remains a level)

Exogenously given full employment output

Y = YF

(4)

In LOGS:
y = yF
(4')

Substituting (4') into (3') :

p = m yF + r

(5)

Foreign Price Level

Assuming an identical form for the foreign M d function:
* p* = m * yF + r *

(6)

Relative PPP
eP * = P

(7)

e =

P P*

(7 ')

Taking logs and rearranging

e = + ( p p*)
(7 '')

(Note e and now represent logs)

Equilibrium nominal exchange rate

Substituting (5) and (6) into (7 '')
* e = m m * + ( yF yF ) + (r r*)

(8)

Equation (8) is often presented in its own right as an equation explaining exchange rate determination. It forms the basis of the most common empirical tests of the monetary model. It indicates that the nominal exchange rate is determined by relative money supplies, relative prices ( ), real income levels and relative interest rates. 8

Note the final term implies: r > 0 e This prediction is in apparent contrast to that of the Mundell-Fleming model. Explanation: r > 0 M d ( MME ) P > 0 ( PPP) e > 0 Note that the contrast is more apparent than real. Underlying (8) there is no representation of capital mobility. In (8) r is viewed as an exogenous variable which affects e via its effect on the demand for money. Equation (8) can be developed further by incorporating the assumption of UIP.

Uncovered Interest Parity

In log form:
Et (et +1 ) et = rt rt *

(9)

where Et (et +1 ) expectation of et +1 formed at time t

Et (et +1 ) et = expected rate of depreciation of domestic currency.

Expectation and the equilibrium exchange rate Substituting (9) into(8) with time subscripts added:
* et = mt mt * + t ( yFt yFt ) + [ Et (et +1 et )]

Collecting et on LHS and dividing by 1 +

et =
* mt mt* + t ( yFt yFt ) + Et (et +1 ) (1 + )

(10)

* ) Let: zt = mt mt* + t ( yFt yFt

i.e. zt represents the fundamental determinants of the exchange rate as viewed by the ERE monetary model
et = zt Et (et +1 ) + (1 + ) (1 + )
(10')

The current nominal exchange rate depends on: 1. Current economic fundamentals, zt 2. The expected future value of e Agents with rational expectations are assumed to understand the process of exchange rate determination and use this understanding in forming exchange rate expectations. Hence expectations of future exchange rates are formed using (10'') :
Et (et +1 ) = Et ( zt +1 ) + Et (et +1 ) (1 + ) (1 + )

Generally:
Et (et + j ) = Et ( zt + j )
(1 + )

(1 + )

Et (et + j +1 )

Continuous forward substitution into (10') yields:

et =
zt 1 + Et zt + j (1 + ) (1 + ) j =1 1 +

(11)

(11) indicates that the current exchange rate depends not only on the current values of economic fundamentals, but also on the expected future values of fundamentals into infinite future. This provides one possible explanation of exchange rate volatility i.e. volatile expectations. The equation also indicates that the precise effect of current changes in fundamentals, i.e. zt , will depend on whether, and how, these current changes affect expectations of future values of fundamentals.
The exchange rate and the money supply

The ERE monetary approach focuses on relative money supply changes as the principal determinant of exchange rate movements. Assume , yF , yF *and m * to be constant. Therefore current changes in z are purely the consequence of current changes in m.

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Effect of changes in mt on et depends on whether and how current changes in mt affect expectations of future values of m .
Alternative money supply processes

(i)

the money supply fluctuates randomly about its mean value m

ut + j WN (0, u2 )

mt + j = m + ut + j Et (mt + j ) = m

Effect of current change in mt on et :

et = mt (1 + )

i.e. rise in m produces less than proportionate depreciation

(ii)

the level of the money supply follows a random walk

mt + j = mt + j 1 + ut + j Et (mt + j ) = mt

i.e. the best forecast of any future value of m is its current value.

Effect of current change in mt on et

et = mt

i.e. increase in m leads to proportionate depreciation.

(iii)

The rate of growth of the money supply follows a random walk

mt + j = mt + j 1 + ut + j Et (mt + j ) = mt + jmt

Effect of current change in mt on et

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Assuming mt 1 = 0
et = (1 + )mt

i.e. rise in m leads to more than proportional depreciation

Explanation

Lies in different effects of current changes in m on expected future values of m (i) (ii) (iii) rise in m expected to be temporary rise in m expected to be permanent rise in m taken as a signal of a permanent increase in the rate of growth of m.

Each has different consequences for the demand for money: (i) (ii) (iii)

M d rises M d unchanged M d falls

Contributions of the ERE monetary model

1. It helps explain, via PPP, why high inflation countries tend to have depreciating currencies. 2. It identifies the importance of expectations for exchange rate determination. 3. It contributes to our understanding of exchange rate volatility via its emphasis on expectations.
Weaknesses

1. It assumes continuous PPP this is in direct contradiction of the facts of exchange rate behaviour. 2. It takes relative prices and real incomes to be given exogenously, rather than determined endogenously. 3. In assuming risk neutrality it: (a) identifies a limited range of assets whose relative supplies are important for exchange rate determination. (b) Precludes a role for the current account in exchange rate determination

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The Dornbusch Sticky-Price exchange rate overshooting model (JPE, 1976)

Asset market equilibrium conditions:
Condition for money market equilibrium Uncovered interest parity.
Assumptions

1. Four financial assets: domestic and foreign monies, domestic and foreign bonds. 2. Domestic and foreign bonds are traded internationally, money is not. 3. International investors are risk neutral, therefore UIP must hold. 4. Output is exogenously given, at full employment level (assumption is relaxed later in the paper). 5. Domestic output is an imperfect substitute for world output. 6. The price of domestic output is instantaneously fixed, but responds gradually to excess demand or supply in the goods market. 7. The country is small world variables are given exogenously. 8. Agents have rational exchange rate expectations. The model can be viewed as a dynamic AD-AS model. Prices are fixed in the (very) short run, and, in its variable output version, the framework generates short-run results very similar to those of the M-F model. However, in the long run, prices are flexible

The Demand for Money

md = p + y r

(1)

p = log of domestic prices y = log of domestic income/output r = domestic interest rate md = log of demand for money
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The money supply

ms = m

(2)

Money market equilibrium

ms = md

using (1) and (2):

m = p + y r

(3)
(3')

Rearranging

p = m y + r

output is assumed fixed at its full employment level:

y = yF

substituting into (3')

p = m yF + r (3'')

(in short run, with p fixed, r adjusts to clear money market)

Long-run equilibrium price level

In the long run, r = r * . Substituting into (3'')

p = m yF + r *

(4)

where p = LR equilibrium price level. In long run, with m, yF and r * given exogenously, adjustments in p ensure money market equilibrium.
Uncovered Interest Parity
r = r *+x

(5)

x = expected rate of depreciation of the domestic currency.

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Exchange Rate Expectations

x = ( e e) e= e=

(6)

current value of exchange rate long-run equilibrium value of exchange rate

(6) states that the domestic currency is expected to adjust towards its long-run equilibrium value, e , at a rate which is proportional to the difference between e and the current value of e. (Dornbusch demonstrates that this is consistent with rational expectations). Substituting (6) into (5):

r = r * + (e e)
r r * = ( e e) e < e x > 0:requires r > r * e > e x < 0:requires r < r *

(7)
(71)

or
r > r *requires x > 0, requires e < e r < r * requires x < 0, requires e > e

Relationship between e and p consistent with overall asset market equilibrium (money market equilibrium and UIP)

Subtract Equation (4) from ( 3'' )

p = m yF + r * p = m yF + r

p p = (r r*)

(8)

substituting from (7 ') for r-r*

p p = (e e )

( 8' )

or
ee =
1

( p p)

( 8'' )
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Interpretation:

p > p requires, for money market equilibrium, r>r*: for consistency with UIP this requires x>0 which, in turn, requires e < e
A: p > p r > r* e < e B: p < p r < r * e > e

Given p, the exchange rate adjusts to maintain overall asset market equilibrium, on the QQ schedule. The economy always lies on QQ.
Demand for Domestic Output

The demand for domestic output, d, is determined in the same way as in the MundellFleming model and depends on: Exogenous domestic expenditure: Domestic Competitiveness: Domestic Income/Output: The Domestic Interest Rate: (all variables other than r in logs) To simplify notation, p* (exogenously given and constant) is normalised at zero: p*=0 with output fixed at its full-employment level, i.e. y = yF , d is determined by:
d = u + (e p ) + y F r ; < 1

u e + p*p y r

(9)

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Price Adjustment

Goods market equilibrium is a feature only of long-run equilibrium. The price of domestic output is instantaneously fixed, but adjusts gradually in response to disequilibrium, i.e. excess demand or supply, in the goods market:
p = (d y ) p = dp / dt = rate of change of domestic prices

(10)

=
NB:

adjustment coefficient-determines speed of price adjustment

= 0 prices never adjust instantaneous price adjustment

With y=yF
p = (d yF )

(10' )

If d = yF there is goods market equilibrium and p = 0 . Substituting for d from (9) into (10' ):
p = [u + (e p ) (1 ) yF r ]

(10'' )

Goods market equilibrium, the long-run value of competitiveness, and the long-run relationship between e and p.

Goods market equilibrium, i.e. y = d , p = 0, is a feature of long-run equilibrium. Setting p = 0 in (10'' ) and noting that in the long run r=r*:
u + (e p ) (1 ) yF r* = 0

Rearranging this equation allows us to determine the long-run value of competitiveness, or the long run real exchange rate e p

ep=

[ r * + (1 ) yF u ]

(11)

(What are effects of m, r*, yF and u on L-R competitiveness?)

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The long-run relationship between e and p is implicit in (10) but can be written explicitly as:
1 e = p + [ r * + (1 ) yF u ]

(12)

Note: Equations (4) and (12) together allow us to determine the effects of changes in any exogenous variable on the long-run values of p and e.
Simultaneous goods and money market equilibrium Although goods market equilibrium is a feature only of long-run equilibrium, for the diagrammatic analysis combinations of e and p consistent with goods market (and money market) equilibrium in the short run need to be identified.

This allows us to determine whether, at any given point in time, there is excess demand, excess supply, or equilibrium in the goods market. Set yF = d in (9), and rearrange:

(e p) = r + (1 ) yF u

(13)

This equation represents the condition for goods market equilibrium in the short run but from the condition describing goods market equilibrium in the long run (i.e. (11)):

(e p ) = r * + (1 ) yF u
Subtracting from (13):

(e e ) ( p p ) = (r r*)
But from (8), relating to money market equilibrium:
p p

r r* =
(e e ) = ( p p ) + (e e ) = p p = ( + )

( p p)

(e e ) +

( p p) (14)

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This equation represents combinations of p and e consistent with simultaneous goods and money market equilibrium in the short run.

Slope = At A AB At B

<1 +
:

BC At C

: : : :

d=y e p d d>y e p AND r d d=y

Points to right of schedule : d > y p > 0 Points to left of schedule d < y p < 0 Summary of Key Relationships Long-run value of p p = m yF + r * Long-run value of e
e = p+ 1

(4)

[ r * + (1 ) yF u ]

(12)

Asset market equilibrium

ee = 1

( p p)

( 8'' )
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Goods market equilibrium p p = (e e ) ( + )

(14)

Diagrammatic representation of long-run equilibrium

Diagram drawn for case of r * + (1 ) yF u = 0, implying p = e

Increase in Domestic Money Stock

Long-Run Effects
Price Level: From (4) with yF , r * constant
p = m

(15)

i.e. there is a proportionate increase in the price level

Nominal Exchange Rate: From (12) with yF , r * and u constant
e = p = m

(16)

Domestic Competitiveness: From (15) and (16):

(e p ) = 0

(17)
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i.e. in the long-run domestic competitiveness is unchanged implying relative PPP is maintained in the long run following a monetary expansion

The economy cannot move directly to C because p is instantaneously fixed.

m > 0 (mme) r < 0

A fall in r is consistent with UIP only if x<0 i.e. the domestic currency is expected to appreciate given expectations formation x = (e e) , this requires e ' > e2 Hence the exchange rate overshoots its new L-R value.

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The gain in competitiveness and the reduction in r both increase demand for domestic output. Excess demand in the goods market causes p to rise gradually, increasing r, accompanied by an appreciation of the domestic currency, i.e. falling value of e. The economy moves up QQ, with excess demand falling, until the new long-run equilibrium is achieved.
Extent of Overshooting

From the equation of the QQ schedule:

ee =

( p p)
e = p = m

but p = 0 ;
e m =

1 e = 1 + m

( > m )

The extent of overshooting is greater (i) (ii) The smaller is (interest semi-elasticity of md) - increase in m requires larger fall in r for MME The smaller is (expectations coefficient) - a larger difference between e and e is needed to generate value of x consistent with UIP.

Rational Expectations

Dornbusch shows there is a unique value of consistent with RE, i.e. expectations which are correct .

Variable output Assume prices are sticky but y adjusts to clear the goods market. Price adjustment is given by:
p = ( y yF )

In this case, it is possible that overshooting does not occur. 22

Contributions of the Dornbusch Model

1. While consistent with relative PPP (following purely nominal shocks) in the long run, it provides an explanation of why real exchange rates might depart from their PPP values for sustained periods. 2. It identifies a possible reason for exchange rate overshooting. 3. It is a fully specified macroeconomic model which allows analysis of the interaction between the nominal exchange rate, prices and output.
Weaknesses

1. Relative supplies of assets other than money are irrelevant for exchange rate determination. 2. The current account plays no role in exchange rate determination.

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