Keywords

Currency substitution; equilibrium approach to exchange rates; exchange rate; macroeconomics; MAER model; monetary approach to exchange rates; monetary model; New International Macroeconomics; overshooting exchange rate model; portfolio balance; trade balance

The Role of News

The failure of the MAER to predict a high volatility of the exchange rate has led to extensions and challenges of the MAER approach. However, the high volatility is not difficult to explain. The real world is characterized by unpredictable shocks or surprises. When some unexpected event takes place, we refer to this as news. Since interest rates, prices, and incomes are often affected by news, it follows that exchange rates will also be affected by news. By definition, the exchange rate changes linked to news will be unexpected. Thus, we find great difficulty in predicting future spot rates, because we know the exchange rate will be determined in part by events that cannot be foreseen.

The fact that the predicted change in the spot rate, as measured by the MAER approach, varies less over time than does the actual change indicates how much of the change in spot rates is unexpected. Periods dominated by unexpected announcements or realizations of economic policy changes will have great fluctuations in spot and forward exchange rates as expectations are revised subject to the news. Volatile exchange rates simply reflect turbulent times. Even with a good knowledge of the determinants of exchange rates (as discussed in this chapter), without perfect foresight exchange rates will always prove to be difficult to forecast in a dynamic world full of surprises.

The fact that the expected volatility of the exchange rate using the monetary model is less than the actual volatility has led to many extensions of the monetary approach. We discuss these extensions in the rest of the chapter.

The PB Approach

If domestic and foreign bonds are perfect substitutes, then the basic monetary approach, presented in the last chapter, is a useful description of exchange rate determination. However, if domestic and foreign bonds are not perfect substitutes then the MAER has to be modified. The PB approach assumes that assets are imperfect substitutes internationally because investors perceive foreign exchange risk to be attached to foreign-currency-denominated bonds. As the supply of domestic bonds rises relative to foreign bonds, there will be an increased risk premium on the domestic bonds that will cause the domestic currency to depreciate in the spot market. If the spot exchange rate depreciates today, and if the expected future spot rate is unchanged, the expected rate of appreciation over the future will increase.

If the spot exchange rate is a function of relative asset supplies, then the monetary approach Eq. (14.10) should be modified to include the percentage change in the supply of domestic bonds $(\widehat{B})$ and the percentage change in the supply of foreign bonds $({\widehat{B}}^F)$:

$\text{−}\widehat{E}\text{=−}\widehat{D}\text{−}\widehat{B}+{\widehat{B}}^F+{\widehat{P}}^F+\widehat{Y}$ (15.1)

(15.1)

For instance, if the dollar/pound spot rate is initially E_$/£ = 2.00, and the expected spot rate from the MAER approach in 1 year is E_$/£ = 1.90, then the expected rate of dollar appreciation is 5% [(1.90−2.00)/2.00]. Now suppose that an increase in the outstanding stock of dollar-denominated bonds results in a depreciation of the spot rate today to E_$/£ = 2.05. The expected rate of dollar appreciation is now approximately 7.3% [(1.90 − 2.05)/2.05]. Thus, the addition of the imperfect substitution between the domestic and foreign bond portfolio can explain higher variability in the foreign exchange rate.

Recall in the last chapter that we discussed the sterilized intervention. It is difficult to explain in terms of the basic monetary approach model why a country would pursue sterilized intervention. However, in terms of the PB approach in Eq. (15.1), sterilization makes more sense. Suppose the Japanese yen is appreciating against the dollar, and the Bank of Japan decides to intervene in the foreign exchange market to increase the value of the dollar and stop the yen appreciation. The Bank of Japan increases domestic credit in order to purchase US dollar-denominated bonds. This should cause the yen to depreciate. This effect is reinforced by the open market sale of yen securities by the Bank of Japan. Thus, the yen can depreciate even with a sterilized intervention.

This broader PB view might be expected to explain exchange rate changes better than the simple MAER equation. However, the empirical evidence is not at all clear on this matter.

The Trade Balance Approach

The introduction to this chapter discussed the modern shift in emphasis away from exchange rate models that rely on international trade in goods to exchange rate models based on financial assets. However, there is still a useful role for trade flows in asset approach models, since trade flows have implications for financial asset flows.

If balance of trade deficits are financed by depleting domestic stocks of foreign currency, and trade surpluses are associated with increases in domestic holdings of foreign money, we can see the role for the trade account. If the exchange rate adjusts so that the stocks of domestic and foreign money are willingly held, then the country with a trade surplus will be accumulating foreign currency. As holdings of foreign money increase relative to domestic, the relative value of foreign money will fall or the foreign currency will depreciate.

Although realized trade flows and the consequent changes in currency holdings will affect the current spot exchange rate, the expected future change in the spot rate will be affected by expectations regarding the future balance of trade and its implied currency holdings. An important aspect of this analysis is that changes in the future expected value of a currency can have an immediate impact on current spot rates. For instance, suppose there is a sudden change in the world economy that leads to expectations of a larger trade deficit in the future, say, an international oil cartel develops and there is an expectation that the domestic economy will have to pay much more for oil imports. In this case forward-looking individuals will anticipate a decrease in domestic holdings of foreign money over time. This, in turn, will cause expectations of a higher rate of appreciation in the value of foreign currency, or a faster expected depreciation of the domestic currency. This higher expected rate of depreciation of the domestic currency leads to an immediate attempt by individuals and firms to shift from domestic into foreign money. Because, at this moment, the total stocks of foreign and domestic money are constant, the attempt to exchange domestic for foreign money will cause an immediate appreciation of the foreign currency to maintain equilibrium, and so the existing supplies of domestic and foreign money are willingly held.

We note that current spot exchange rates are affected by changes in expectations concerning future trade flows, as well as by current international trade flows. As is often the case in economic phenomena, the short run effect of some new event determining the balance of trade can differ from the long-run result. Suppose the long-run equilibrium under floating exchange rates is balanced trade, where exports equal imports. If we are initially in equilibrium and then experience a disturbance like an oil cartel formation, in the short run we expect large balance of trade deficits, but in the long run, as all prices and quantities adjust to the situation, we return to the long-run equilibrium of balanced trade. The new long-run equilibrium exchange rate will be higher than the old rate, since, as a result of the period of the trade deficit, foreigners will have larger stocks of domestic currency while domestic residents hold less foreign currency. The exchange rate need not move to the new equilibrium immediately. In the short run during which trade deficits are experienced, the exchange rate will tend to be below the new equilibrium rate. Thus, as the outflow of money from the domestic economy proceeds with the deficits, there is a steady depreciation of the domestic currency to maintain the short-run equilibrium where quantities of monies demanded and supplied are equal.

Fig. 15.1 illustrates the effects just discussed. Some unexpected event occurs at time t₀ that causes a balance of trade deficit. The initial exchange rate is E₀. With the deficit, and the consequent outflow of money from home to abroad, the domestic currency will depreciate. Eventually, as prices and quantities adjust to the changes in the structure of trade, a new long-run equilibrium is reached at E₁, where the trade balance is restored. This move to the new long-run exchange rate, E₁, does not have to come instantaneously, because the deficit will persist for some time. However, the forward rate could jump to E₁ at time t₀ as the market now expects E₁ to be the long-run equilibrium exchange rate. The dashed line in Fig. 15.1 represents the path taken by the spot exchange rate in the short run. At t₀, there is an instantaneous jump in the exchange rate even before any trade deficits are realized, because individuals try to exchange domestic money for foreign in anticipation of the domestic currency depreciation. Over time, as the trade deficits occur, there is a steady depreciation of the domestic currency, with the exchange rate approaching its new long-run steady-state value, E₁, as the trade deficit approaches zero.

The inclusion of the balance of trade as a determinant of exchange rates is particularly useful since the popular press often emphasizes the trade account in explanations of exchange rate behavior. As previously shown, it is possible to make sense of balance of trade flows in a model where the exchange rate is determined by desired and actual financial asset flows, so that the role of trade flows in exchange rate determination may be consistent with the modern asset approach to the exchange rate.

The Overshooting Approach

Fig. 15.1 indicates that with news regarding a higher trade deficit for the domestic country, the spot exchange rate will jump immediately above E₀ and will then rise steadily until the new long-run equilibrium, E₁, is reached. It is possible that the exchange rate may not always move in such an orderly fashion to the new long-run equilibrium following a disturbance.

We know that purchasing power parity does not hold well under flexible exchange rates. Exchange rates exhibit much more volatile behavior than do prices. We might expect that in the short run, following some disturbance to equilibrium, prices will adjust slowly to the new equilibrium level, whereas exchange rates and interest rates adjust quickly. Dornbusch (1976) shows that the different speed of adjustment to equilibrium allows for some interesting behavior regarding exchange rates and prices.

At times it appears that spot exchange rates move too much, given some economic disturbance. Moreover, we have observed instances when country A has a higher inflation rate than country B, yet A’s currency appreciates relative to B’s. Such anomalies can be explained in the context of an “overshooting” exchange rate model. We assume that financial markets adjust instantaneously to an exogenous shock, whereas goods markets adjust slowly over time. With this setting, we analyze what happens when country A increases its money supply.

For equilibrium in the money market, money demand must equal money supply. Thus, if the money supply increases, something must happen to increase money demand. We assume money demand depends on income and the interest rate, so we can write a money demand function like

$M^d=aY+bi$ (15.2)

(15.2)

where M^d is the real stock of money demanded (the nominal stock of money divided by the price level), Y is income, and i is the interest rate. Money demand is positively related to income, so a exceeds zero. As Y increases, people tend to demand more of everything, including money. Since the interest rate is the opportunity cost of holding money, there is an inverse relationship between money demand and i, or b is negative. It is commonly believed that in the short run following an increase in the money supply, both income and the price level are relatively constant. As a result, interest rates must drop to equate money demand to money supply.

The interest rate parity relation for countries A and B may be written as

$i_{\text{A}}=i_{\text{B}}+(F\text{−}E)/E$ (15.3)

(15.3)

Thus, if i_A falls, for a given foreign interest rate i_B, the expected change in the currency value, (F−E)/E, must be negative. However, when the money supply in country A increases, we expect that eventually prices there will rise, since we have more A currency chasing the limited quantity of goods available for purchase. This higher future price in A will imply a higher future exchange rate to achieve purchasing power parity:

$E=P_{\text{A}}\text{}/\text{}{P}_{\text{B}}$

Since P_A is expected to rise over time, given P_B, E will also rise. This higher expected future spot rate will be reflected in a higher forward rate now. But if F rises, while at the same time (F–E)/E falls to maintain interest rate parity, E will have to increase more than F. Then, once prices start rising, real money balances fall and the domestic interest rate rises. Over time, as the interest rate increases, E will fall to maintain interest rate parity. Therefore, the initial rise in E will be in excess of the long-run E, or E will overshoot its long-run value.

If the discussion seems overwhelming at this point, the reader will be relieved to know that a concise summary can be given graphically. Fig. 15.2 summarizes the discussion thus far. The initial equilibrium is given by E₀, F₀, P₀, and i₀. When the money supply increases at time t₀, the domestic interest rate falls, and the spot and forward exchange rates increase while the price level remains fixed. The eventual equilibrium price and exchange rate will rise in proportion to the increase in the money supply. Although the forward rate will move immediately to its new equilibrium, F₁, the spot rate will increase above the eventual equilibrium, E₁, because of the need to maintain interest parity (remember i has fallen in the short run). Over time, as prices start rising, the interest rate increases and the exchange rate converges to the new equilibrium, E₁.

As a result of the overshooting E, we observe a period where country A has rising prices relative to the fixed price of country B, yet A’s currency appreciates along the solid line converging to E₁. We might explain this period as one in which prices increase, lowering real money balances and raising interest rates. Country A experiences capital inflows in response to the higher interest rates, so that A’s currency appreciates steadily at the same rate as the interest rate increase in order to maintain interest rate parity.

The Currency Substitution Approach

Economists have long argued that one of the advantages of flexible exchange rates is that countries become independent in terms of their ability to formulate domestic monetary policy. This is obviously not true when exchange rates are fixed. If country A must maintain a fixed exchange rate with country B, then A must follow a monetary policy similar to B’s. Should A follow an inflationary policy in which prices are rising 20% per year while B follows a policy aimed at price stability, then a fixed rate of exchange between the money of A and B will prove very difficult to maintain. Yet with flexible exchange rates, A and B can each choose any monetary policy they like, and the exchange rate will simply change over time to adjust for the inflation differentials.

This independence of domestic policy under flexible exchange rates may be reduced if there is an international demand for monies. Suppose country B residents desire to hold currency A to use for future transactions or simply to hold as part of their investment portfolio. As demand for money shifts between currencies A and B, the exchange rate will shift as well. In a region with substitutable currencies, shifts in money demand between currencies will add an additional element of exchange rate variability.

With fixed exchange rates, central banks make currencies perfect substitutes on the supply side. They alter the supplies of currency to maintain the exchange rate peg. The issue of currency substitution deals with the substitutability among currencies on the demand side of the market. If currencies were perfect substitutes to money demanders, then all currencies would have to have the same inflation rates, or demand for the high-inflation currency would fall to zero (since the inflation rate determines the loss of purchasing power of a money). Perfectly substitutable monies indicate that demanders are indifferent between the use of one currency and another. If the cost of holding currency A rises relative to the cost of holding B, say because of a higher inflation rate for currency A, then demand will shift away from A to B, when A and B are substitutes. This would cause the A currency to depreciate even more than was initially called for by the inflation differential between A and B.

For instance, suppose Canada has a 10% annual inflation rate while the United States has a 5% rate. With no currency substitution, we would expect the US dollar to appreciate against the Canadian dollar on purchasing power parity grounds. Now suppose that Canadian citizens hold stocks of US dollar currency, and these US dollars are good substitutes for Canadian dollars. The higher inflation rate on the Canadian dollar means that stocks of Canadian dollars held will lose value more rapidly than US dollars, so there is an increased demand for US dollar currency. This attempt to exchange Canadian dollar currency for US dollars results in a further depreciation of the Canadian dollar. Such shifts in demand between currencies can result in volatile exchange rates and can be very unsettling to central banks desiring exchange rate stability.

Although central banks may attempt to follow independent monetary policies, they will not be able to do so with high currency substitution. Money demanders will adjust their portfolio holdings away from high-inflation currencies to low-inflation currencies. This currency substitution leads to more volatile exchange rates, since not only does the exchange rate adjust to compensate for the original inflation differential, but it also adjusts as currency portfolios are altered. Therefore, one implication of a high degree of currency substitution is a need for international coordination of monetary policy. If money demanders substitute between currencies to force each currency to follow a similar inflation rate, then the supposed independence of monetary policy under flexible exchange rates is largely illusory.

We should expect currency substitution to be most important in a regional setting where there is a relatively high degree of mobility of resources between countries. For instance, the use of the euro by countries in Western Europe may be evidence of a high degree of currency substitution that once existed among the former European currencies. Alternatively, there is evidence of a high degree of currency substitution existing between the US dollar and Latin American currencies. In many Latin American countries, dollars serve as an important substitute currency, both as a store of value (the dollar being more stable than the typical Latin American currency) and as a medium of exchange used for transactions. This latter effect is particularly pronounced in border areas. Aside from regional settings, it is not clear that currency substitution should be a potentially important source of exchange rate variability. At this point it is probably safe to treat currency substitution as a potentially important source of exchange rate variability, but one that may not be relevant to all country pairs.

Recent Innovations to Open-Economy Macroeconomics

The recent advances in open-economy macroeconomics come in two general types. The first assumes that the economy responds quickly so that an equilibrium is reached quickly, whereas the other type of models have some short-run restriction to prevent an equilibrium in the short run.

The so-called equilibrium approach to exchange rates assumes that prices, interest rates, and exchange rates are always at their market clearing equilibrium levels. In this approach, changes in exchange rates occur because of changes in tastes or technology and are part of the adjustment to a shock to the world economy. For instance, suppose an improvement in technology in Switzerland increases Swiss output, and at the higher level of productivity the price of Swiss goods relative to other countries’ goods falls through a depreciation of the franc. The lower relative price of Swiss output is associated with rising Swiss exports. In this scenario, the franc did not depreciate in order to make Swiss goods more competitive on world markets; instead it depreciated because the higher level of Swiss productivity made the relative price of Swiss goods fall.

According to the equilibrium approach, changes in exchange rates are caused by changes in tastes or technology, so the franc depreciation did not cause the increase in Swiss exports and output but instead was a result of these changes. Similarly, if tastes had changed so that Swiss goods were now more favored by consumers, this would increase the relative price of Swiss goods and would be associated with a franc appreciation. In this view of the world, exchange rate changes can never be viewed as good or bad—they simply occur in response to some other event and are part of the adjustment to a new equilibrium.

Another recent approach to explaining exchange rates assumes that in the long run the equilibrium approach is reached, but in the short run restrictions to price movements result in temporary disequilibria that result in large exchange rate variability. Essentially these models combine elements of the IS-LM-BP framework from Chapter 13, The IS-LM-BP Approach with the monetary approach. While these new models are too complex to be covered in detail here, we should realize where economic thought is moving and the implications of this new thinking. The New International Macroeconomics carefully considers the details of the economy to the level of individual firms and households and how their actions aggregate to macroeconomic phenomena.

The IS-LM-BP model focused on one country and abstracted from the rest of the world, which is in the background. The New International Macroeconomics typically examines two countries (you might think of one as the rest of the world) and the determination of key macroeconomic variables like incomes, prices, and the exchange rate. The predictions of this type of model would include the following effects of a surprising increase in the domestic money supply: consumer spending increases at home and abroad; domestic income increases by more than foreign income; the domestic currency depreciates and purchasing power parity is maintained continuously.

The IS-LM-BP model was developed holding the price level constant. In many New International Macroeconomic models the price level is held fixed for a short run and then allowed to change in the long run as in the monetary approach. So the short-run fixed price is like the old model, but the long run allows for a dynamic adjustment of prices over time that is missing from the static models of the IS-LM-BP type. In many New International Macroeconomic models, if prices were perfectly flexible, then money supply shocks would have no effects on real variables like income or consumption due to the assumption of purchasing power parity. In this case, prices would change in proportion to changes in the money supply and the exchange rate would change to leave relative prices at home and abroad unchanged (the “law of one price”) so that there is no inducement for changes in consumption or production. So the assumption of “sticky prices” is important to generate changes in spending and output.

Since there is much evidence against the law of one price, some research has focused on a modified version of a New International Macroeconomic model that allows for pricing to market. This occurs when local currency pricing reflects local market conditions in each country and allows for price discrimination across countries. In this case, purchasing power parity does not hold and so changes in the money supply of one country may result in bigger exchange rate changes due to the relative lack of responsiveness of price levels across countries. This is an important change since we observe real-world exchange rates having much greater volatility than relative prices across countries.

Summary

Exercises