Exchange Rates II: The Asset Approach in the Short Run

Question 1

When will the forex market be in equilibrium as predicted by the concept of risky arbitrage?

Answer 1

When there is no expected difference in the rates of return on each type of currency investment in the two countries or locations.

return on home investment =

expected rate of depreciation of home currency

Question 2

Why does the demand for real money balances decrease as home nominal interest rates rise?

Answer 2

When nominal interest rates rise, the opportunity cost of holding money increases. Instead of holding money which earns a negative return (inflation), investors will demand less real money and will instead invest in non monetary assets, such as gov. bond to take advantage of the higher yields.

Question 3

What happens to nominal interest rates if the demand for real money balances is less then real money supply?

Answer 3

The interest rate will be driven down as eager lenders compete to attract scarce borrowers.

How?

1. The central bank has put more money in the public’s hand then the public wants to hold.
2. The public will want to reduce its cash holdings by exchanging money for interest-bearing assets such as bonds, savings accounts, and so on.
3. That is, they will save more and seek to lend their money to borrowers. But borrowers will not want to borrow unless the cost of borrowing falls.

Question 4

What happens to nominal interest rates when there is an excess demand for money and not enough supply?

Answer 4

Interest rates will be driven up by the increased demand for funds.

How?

1. The public will turn their interest-bearing assets into cash.
2. The supply of loanable funds will not be enough to meet the demand of investors.
3. Borrowers will bid up interest rates as they compete for the scare funds available.

Question 5

What happens to nominal interest rates when the central bank increases the money supply and the real money demand curve is unchanged?

Answer 5

Interest rates will fall.

• Think of the ECB announcing quantitative easing.
  So far, the result has been a weaker euro and falling treasury rates across the eurozone, with a few exceptions.

Question 6

What happens to nominal interest rates when the real money demand curve shifts out (real money demand increases)?

Answer 6

Interest rates will rise.

Question 7

In the crises, with interest rates at the floor, the Fed engaged in a number of extraordinary policy actions to push more money out into the economy. What were these extraordinary measures?

Answer 7

1. It expanded the range of credit securities it would accept as collateral to include lower-grade, private sector bonds.
2. It expanded the range of securities that it would buy outright to include private-sector credit instruments such as commercial paper and mortgage_backed securities.
3. It expanded the range of counter parties from which it would buy securities to include some nonblank institutions such as primary dealers and money market funds.

Question 8

In the short run, all else equal, an increase in a country’s real income will ___________ the country’s nominal interest rate.

Answer 8

Raise the country’s nominal interest rate

Question 9

In the short run, all else equal, a decrease in a country’s real income will ____________the country’s nominal interest rate.

Answer 9

Lower the country’s nominal interest rate

Question 10

The central bank announces it will initiate expansionary policy.

Money supply will grow at a rate of 5%

Annual expansions are expected to be a permanent policy in the long-run.

Answer 10

The long-run monetary approach and Fisher effect will predict the result of the policy.

a 5% increase in the rate of home money growth causes:

• a 5% point increase in the rate of home inflation
• a 5% point increase in the home nominal interest rate
• the home interest rate will then rise in the long run when prices are flexible.

Question 11

The central bank announces it will initiate expansionary policy.

Money supply will grow at a rate of 5%

Expansion is expected to be temporary.

Answer 11

The immediate effect is an excess supply of real money balances.

The home interest rate will then fall in the short run when prices are sticky.

Question 12

Suppose the Home money supply is increased temporarily.

What happens in the short-run.

Answer 12

In the short-run prices will be sticky, so the money supply will shift from M1/P1 to M2/P1. Since real money demand is not affected by an increase in the money supply, nominal interest rates will fall.

Since an increase in home’s money supply leaves foreign money supply and foreign interest rates unchanged, the FR curve is unchanged. A home monetary expansion lowers the home nominal interest rate, which is also the domestic return in the forex market. This makes foreign deposits look more attractive and makes traders wish to sell home deposits and buy foreign deposits.

Since an increase in home’s money supply leaves foreign interest rates unchanged, the home currency must fall to match the fall in home interest rates so that domestic and foreign returns are equal. (foreign interest rates + expected depreciation of home exchange rate)

Question 13

Suppose the Foreign money supply is increased temporarily.

What happens in the short-term.

Answer 13

An increase in foreign money supply, with foreign real money demand unchanged, will cause interest rates to fall. This fall in interest rates will lower the FR curve.

This causes the home exchange rate to fall, and the home currency to strengthen.

Question 14

What are the two key mechanisms that operate in a variety of ways to determine exchange rates in both the short run and the long run?

Answer 14

Expectations and arbitrage.

Question 15

If monetary authorities make a permanent policy change, what assumption changes?

Answer 15

The assumption of unchanged expectations is no longer appropriate.

Under such a change, the authorities would cause an enduring change in all nominal variables

Question 16

The monetary approach tells us that, in the long run, price and exchange rates will move _________ to changes in the money supply.

Answer 16

Proportional

Question 17

Permanent expansion of the home money supply.

Short-run impact.

Answer 17

Money Market:

1. Permanent rise in the home money supply.
2. Lowers the home nominal interest rate.

FX Market:

3. Domestic return falls (lower interest rate).
4. At the same time foreign return rises (there is a permanent rise in expected future exchange rates, which causes a permanent increase in the foreign return)
5. This causes a large short-run depreciation of the home currency.

Question 18

Permanent expansion of the home money supply.

Long-run adjustment.

Answer 18

Money Market:

1. Prices rise in the long-run, and real money supply returns to its old level.
2. The nominal interest rate will return to its old level.

FX Market:

3. Foreign return remains higher (expected future exchange rate is permanently higher).
4. Domestic return rise back to its original level.
5. The dollar appreciates to its new long run level.

Question 19

Suppose you are told that, all else equal:

1. the home money supply permanently increases by 5% today;
2. prices are sticky in the short run, so this also causes an increase in real money supply that lowers domestic interest rates by four percentage points from 6% to 2%;
3. prices will fully adjust in one year’s time to todays monetary expansion and PPP will hold again

Predict what will happen to prices and the exchange rate today and in a year’s time.

Answer 19

A permanent increase in the home money supply will cause a permanent increase in the expected future home exchange rate.

In the short run, prices will remain sticky, and the real money supply will increase. This will drive down home nominal interest rates, which is also the domestic return.

The fall in the domestic return will be matched by a depreciation of the home currency, which is exacerbated by a permanent increase in the expected future home exchange rate.

As we move into the long run, prices will adjust to the money supply, which will bring the real money supply back to its original level. This bring home nominal interest rates back to their original levels as well.

The permanent increase in the home money supply will cause a permanent increase in the expected future home exchange rate, meaning that the FR curve will remain where it was in the short run, but domestic returns will return to their original levels, leading to an appreciation of the home currency.

In the end, the home currency in the short run will depreciate by more than in the long run, before prices are able to adjust.

Question 20

What is meant by a peg?

Answer 20

A peg is another name for an exchange rate that is fixed somehow to another currency.

Question 21

How do governments intervene in the forex market?

Answer 21

Exchange rate intervention takes the form of the central bank buying and selling foreign currency at a fixed price, thus holding down the market exchange rathe at a fixed level.

Question 22

Under a Peg, what is the expected rate of depreciation of the home exchange rate?

Answer 22

zero.