Exchange Rate Theories

All pages references below refer to Hallwood and MacDonald, International Money and
Finance (Blackwell Publishing, ISBN 0631204628) unless otherwise stated.

The main exchange rate models or approaches are:

• Keynesian
o Elasticities (balance of trade on goods and services)
o Absorption
• Modern Asset View
o Flexible Price Monetary Model (FLMA) (PPP holds)
o Sticky Price Monetary Model (SPMA) (Overshooting)
o Currency Substitution
o Portfolio Balance (not a “monetary” model)

Traditional Flow View Modern Asset View

Keynesian Monetary
Elasticities Absorptio FLMA SPMA Currency Portfolio Balance
n Sub
Pages 24 52-56, 179 188 193-8 226, ST 115
156-9
Model 9.7 p p. 230 W =
181 M+B+SF
Author(s) Hicks Frenkel, Dornbusch, McKinno Branson,
Mussa, Frankel n McKinnon, etc
Bilson
Relevance LDCs
PPP Yes No No - SR, Yes – LR
holds?
Note: ST is Sarno and Taylor “Economics of Exchange Rates”
(http://www.cambridge.org/uk/catalogue/catalogue.asp?isbn=0521485843)

Keynesian models
Elasticities Approach (or Balance of Payments Approach), page 24.
“The exchange rate is determined by the flow of currency through the foreign exchange
market.” This approach focuses on the current capital and NOT the capital account. It is
more relevant in describing developing economies since they attract relatively little
international capital flows.

Model (p. 157)

B=X–M
B = current account balance (flow)
X = exports, M = imports

Some basic equations

 eP *

P
DC
e
FC
Y C  I G X M
A  C  I G
NX  X  M
  *
Foreign demand (for X): X  M  M   , Y 
* *

 
  

Domestic demand (for M): M  M   , Y 
 
Trade balance (TB) NX  M   , Y    M   , Y 
*

The first term represents the value of exports and the second term represetns the
value of imports (in domestic currency).
eP *
Recall:  M  M
P
Hence, NX  NX   , Y , Y 
*

NX NX NX

 0;  0; ?0
Y Y *

Note: TB can deteriorate if ρ increases (though it’s counter-intuitive).

M * 
Define: Price elasticity of foreign demand for X: *  0
 M *
M 
Price elasticity of domestic demand for M:     0
 M

Differentiating the TB with respect to ρ:

NX M * M  M* 
 M   M  *    1  M   *    1
    M 

Marshall-Lerner Condition
NX
0 if α*+α-1>0, or α*+a>1 (sum of elasticities is >1)


   *
If Marshall-Lerner holds, then NX  NX   , Y , Y 
 
Goods market equilibrium is given by:
      *
Y  A  Y , K  NX   , Y , Y 
   
Graph in Y, ρ space, there is an upward sloping YY line (since the M-L condition holds)
and a flatter, but upward sloping NX=0 line. The point of intersection indicates internal
balance.

Assuming the Marshall-Lerner condition holds, then a devaluation (depreciation) must

lead to an increase in B (improvement of balance of trade).

Interest Rates
The model can be used to address capital flows from disparities between the domestic
interest rate (i) and the world interest rate (i*). Note: these results are the opposite of the
results using the asset approach (monetary approach).
If i>i*, then there are capital inflows and the exchange rate appreciates.
If i<i*, then there are capital outflows and the exchange rate depreciates.

Weaknesses:
Assumes that income does not change. (55-56)

Absorption Approach
Model (basic Keynesian model)
Y= C + I + G + (X – M)
A= C+ I+G
B = X – M (same as above)
Y=A+B
Or, B =Y–A
B = current account balance (flow)
Y = income
A = (domestic) absorption
B = Y – A = - If
If = capital flows (<0 indicates an outflow)

Using the leakage-injection terminology

S+M+T=I+X+G
(S – I) + (T – G) = (X – M)
Net national savings is equal to the current account surplus. (Used for the “Twin Deficits
problem” p. 58-9)
B = Y – A = net national savings = - If

The trade balance can only improve when income is increased relative to absorption
(Y>A). This might require expenditure switching (devaluation) and expenditure-
reducing policies (p. 157).

Returning equilibrium when there is a balance of trade deficit.

Two methods, real balance effect (laissez-faire) or activist policy.
The real balance effect stipulates that price level movements are all that are required to
get the economy back into equilibrium, however these may can a long time.
Activist policies could be used to eliminate a trade deficit and avoid inflation.
“Expenditure switching switches demand toward home produced goods. Devaluation is
the best policy but import tariffs and quotas could also be used. Expenditure reduction
policies reduce the level of domestic adsorption...through higher interest rates and higher
taxes or lower government spending” (p. 54).

Monetary
Monetary models are based on the proposition that exchange rates are determined by the
supply and demand for the national money in each nation. Monetary models, unlike the
Mundell-Fleming model, ignore the flow implications. That is to say, overshooting
affects the real exchange rate and current account, but ignores the wealth implications.
Monetary approaches do not include the current account, but rather focus on the capital
account, thus they are inappropriate to analyze exchange changes from trade deficits (or
surpluses), except for the portfolio balance approach.

∆F = B + K
∆F = change in reserves
B = current account balance (flow)
K = capital account balance (flow)

Thus, the models are equivalent if K=0, as the Keynesian models assume.
∆F = B = X – M = Y – A = ∆M – ∆D
Where, ∆M = change in money stock, and ∆D = change in domestic credit expansion.

PPP
R=SP*/P
q=lnR, s=lnS, p=lnP, p*=lnP*
q=s-p+p*
or s = p – p*

Flexible Price Monetary Approach (FLMA)

Expanded PPP to include exchange rates and the quantity theory on money (Monetary
policy is inflationary). See also King, p. 245.

1. s = p – p*

Assume: monies are non-substitutable and bonds are perfect substitutes, portfolios are
adjusted instantly—capital is perfectly mobile, and UIRP holds.
2. UIRP ste1   i  i  
t

(If i>i*, then in the following period, the expected exchange rate will depreciate, s up).
Wealth constraint (on domestic residents)
W  M  B  B
3.
W  M V

M = money supply
B = domestic bonds
V = B + B*

Agents hold wealth in money, domestic bonds, and foreign bonds. Based on the
assumption, bonds are perfect substitutes, so they can be written as V.
Following Walras’ Law, if the money market is in equilibrium, then so is the bonds
market, thus the model only focuses on the money market.

Cagan money demand functions (p.180)

4. mt  pt  1 yt   2it
D

5. mt  pt  1 yt   2it
D   

α1 is an income elasticity and α2 is a semi-elasticity (since i is expressed as proportion,

not a log).

Money demand = money supply

mtD  mtS  mt
6. D
mt  mtS   mt

Substituting (6 into 4 and 5) and solving for prices

7. pt  pt  mt  mt  1  y  y    2  i  i 
   
t t

Substituting into the PPP equation (s=p-p*), we get the reduced-form equation of the
FPMM
8. s  mt  mt  1  y  y    2  i  i 
  
t t

Predictions:
If m increases, then s will increase (depreciate). [Because of the quantity theory, we
expect that inflation will increase from monetary expansion, leading to depreciation.]
dy>0, ds<0 the currency appreciates (unlike in the Keynesian models)
di>0, ds>0 the currency depreciates (unlike in the Keynesian models)
Why the difference?
First, the model is of money demand—the exchange rate is determined by money demand
(not demand for goods).
  
L  L Y,i  An increase in Y, increases L due to transactions demand.
 
  m
And L    the nominal money supply is fixed. An increase in L (because Y
 p
up) can only be balanced through a decrease in P.
Recall equation 1. s = p – p* Thus appreciation is needed for the domestic price to fall.
Concerning the interest rate
If the interest rate increases this reduces the demand for money (L) and thus P needs to
increase to maintain money market equilibrium. Since PPP holds, the domestic price
level can only rise if the exchange rate depreciates.
To make the link between interest rates and prices, one can substitute prices into the
equation for interest rates. Assume the real interest rates are the same between countries.
it  rt  pte1
9. Fisher Equations 
it  rt  pte1
8’. s  mt  mt  1  y  y  t   2  p  p  t 1
  e e

Sticky-Price Monetary Model (SPMM)

Dornbusch Overshooting Model
Sources: Lecture notes and handout: 2 February 2005, Obstfeld and Rogoff p. 609-618,
Hallwood and MacDonald p. 188-193, Sarno and Taylor p. 104-108

Note: the equation and page numbers reflect those in O&R, not the lecture notes.

Model (Mundell-Fleming with sticky prices)

Uncovered Interest Rate Parity must hold:
(1) it 1  i *   et 1  et 
Note on UIRP: if et 1  et  it 1  i *
Money demand equation in log-form
(2) mt  pt   it 1   yt
where η is the interest rate sensitivity of money demand and  is the income sensitivity
of money demand.

The IS curve
(3) yt  y    et  p *  pt  q 
d

Purchasing power parity (R=ep*/p) and lnR=q

(4) q  e  p *  p
q is the (long-run) equilibrium real exchange rate consistent with full employment,
where q =0

Expectation Augmented Phillips Curve (role of inflation)

(5) Pt 1  pt    yt  y    p%
t 1  pt 
%
d
Expected inflation: p% t  et  pt  q (price level if the output market cleared)
*

If PPP really holds, then e adjusts from a change in p expectations. “The first term on the
right-hand side of (5) embodies the price inflation caused by date t excess demand, while
the second term provides for the price-level adjustment needed to keep up with expected
inflation or productivity growth. That is, the second term captures the movement in
prices that would be needed to keep y  y if the output market were in equilibrium”
(O&R p 611-612).

Note that (5) implies:

(6) Pt 1  pt    yt  y   et 1  et
d

Dynamic Equations
To solve, insert (3) and (4) into (6)
(3) yt  y    et  p *  pt  q 
d

(4) p *  p  qt  et
(6)’ Pt 1  pt      et  p *  pt  q    et 1  et
(6)’’ qt  et      qt  et  et  q    et 1  et
(7) qt 1  qt 1  qt    qt  q 
assume  <1 (shocks to the real exchange rate damp out over time)

Substitute (1), (3), and (4) into (2) and let p*  y  i*  0

(2)’ mt   et  qt  p *    i *   et 1  et      qt  q 
(8) mt  et  qt    et 1  et     qt  q 
et  1    qt   q  mt 
or (9) et 1  et 1  et 
  
    
Notice that (7) and (9) constitute the two first-order differences of equations in q and e.
∆q =0 (or vertical on the graph) when q  q . Thus the speed of anticipated real
adjustment is independent of nominal factors. The ∆e=0 has a vertical-axis intercept of
 q  mt , and it is upward sloping if  <1 (the slope must be below 45 degrees).

Implications:
SR PPP is violated
An unanticipated increase in money supply, initially causes a more than proportional
exchange rate depreciation (e up). “The nominal depreciation of domestic currency
implies a real depreciation (since prices are sticky). This real depreciation raises
aggregate demand, so output rises temporarily above its steady state value” p. 616.

Short-comings:
While the real exchange rate changes and thus the current account balance and wealth do
not have an effect on aggregate demand.
Currency Substitution p. 196
Since corporations, investors, and speculators have incentives to hold a basket of
currencies to minimize risk, the previous assumption of agents holding no foreign
currency and monies are non-substitutable is no longer valid.

Note: currency substitution has been implicated as a factor reducing the stability of
money demand in the 1970s, thus reducing the effectiveness of monetary targets.
“For example, the Swiss and German monetary authorities set money supply targets of 5
and 8 percent, respectively, for the period 1977-9. The actual money supply outcome was
an increase of 16.2 in Switzerland and 11.4 percent in Germany. These overshoots of the
money supplies were blamed on a shift in foreign and domestic demand for financial
assets based in deutschmarks and Swiss francs (in particular a shift away from the US
dollar which was argued to be overvalued). Since the Swiss and German authorities were
unwilling to let the exchange rate take the adjustment (i.e. this would imply, on
assumption that prices are sticky, a real exchange rate change) by appreciating, they
intervened in the foreign exchange markets to supply Swiss francs and German marks.
Since the monetary consequences of this were not sterilized, increased money supplies
inevitably resulted. These monetary overshoots led to the non-announcement of
monetary targets by the Swiss authorities in 1979 and a more flexible target by German
authorities in 1979” (p. 195-6).

Portfolio Balance Approach

This models allows agents to hold domestic and foreign bonds and for the current account
(and capital account) to affect the exchange rate. Bonds are imperfect substitutes and
thus there is portfolio diversification in terms of bonds between countries.
‘International transactors are likely to hold a portfolio of currencies to minimize
exchange rate risk and risk-averse international investors will wish to hold a portfolio of
non-monetary assets—depending on risk-return factors.’ (p.228) Thus uncovered interest
rate parity is NOT expected to hold.
UIRP needs a risk premium attached to it to hold.
  i  i   s e where λ is the risk premium
If λ<0, then foreign assets are viewed as more risky and offer a relatively higher return.
If investors decide that the currency has also become riskier, then they will diversify
away form the currency—depreciation. [e.g. USD depreciated relative to DEM and JPY
in 1977-8 as Us assets were seen as more riskier.]

W = M+B+SF
Wealth comes from domestic money, domestic bonds, and foreign bonds.
Wealth could influence the exchange rate if...
 Consumption is a function of wealth (life-cycle theory) income and demand for
money will also change.
 Money demand is a function of wealth (not just Y and i as before), then it can
affect the exchange rate.
 Agents are risk-averse, they will hold a greater proportion of domestic bonds to
foreign (home country bias).