Week 3 Flashcards
Why does the Purchasing Power Parity (PPP) theory fail to explain large short-term exchange rate fluctuations?
PPP assumes exchange rates are driven solely by goods price differences across countries. However, in reality, short-term fluctuations can result from financial market dynamics, capital flows, or speculative activities unrelated to goods prices.
How do money and capital flows challenge the validity of PPP in modern economies?
PPP focuses only on goods prices, neglecting the impact of money and capital flows such as investments in bonds, stocks, and other financial instruments. These flows often play a larger role in driving exchange rates than goods price differences.
Explain how exchange rate expectations undermine the PPP framework using an example.
Exchange rate expectations can lead to immediate currency movements. For instance, if investors expect a currency to depreciate in the future, it may depreciate now as they act on their expectations. PPP does not account for such forward-looking behaviors.
What was the impact of Mario Draghi’s quantitative easing (QE) announcement on the euro, and why does this example highlight the limitations of PPP?
Draghi’s QE announcement increased expectations of future money supply, leading to an immediate depreciation of the euro against the dollar despite the current money supply remaining constant. This demonstrates that expectations, not just goods prices, significantly influence exchange rates.
Discuss how incorporating asset markets into exchange rate models provides a more realistic approach than PPP.
Asset markets incorporate the role of expectations, money supply, and financial instruments in determining exchange rates. Unlike PPP, this approach accounts for the dynamic interactions between currency values and future returns on assets, making it more flexible and realistic.
Why is the carry trade strategy not explained by PPP?
The carry trade exploits interest rate differentials between countries, borrowing in low-interest rate currencies and investing in high-interest rate ones. PPP does not address financial flows or interest rate dynamics, which are central to this strategy.
Provide an example of how capital flows can lead to currency appreciation or depreciation, bypassing the principles of PPP.
If a country experiences a surge in foreign investment due to attractive stock market returns, its currency may appreciate due to higher demand. This appreciation can occur independently of goods price differences, which PPP focuses on.
Why does PPP struggle to explain currency movements in the presence of speculative trading?
Speculative trading is driven by market sentiment and future expectations rather than goods prices. Speculators might buy or sell a currency in anticipation of future policy changes or economic events, causing volatility that PPP cannot account for.
Explain how an increase in the expected future money supply can affect current exchange rates, using the asset approach.
An increase in the expected future money supply can lead to a depreciation of the currency today. Investors anticipate lower future returns on the currency, sell it in the present, and drive its value down, consistent with the asset approach but not PPP.
What are the limitations of using PPP as a long-term exchange rate model when compared to asset-based models?
While PPP might explain long-term trends based on relative price levels, it ignores factors like capital flows, monetary policy, speculative behavior, and expectations, which are crucial in the short to medium term. Asset-based models incorporate these dynamics, providing a more comprehensive explanation.
Why does Uncovered Interest Parity (UIP) require that investors do not hedge exchange rate risk?
UIP assumes that investors rely on their expectations of future exchange rates without using forward contracts or other hedging tools. The lack of hedging introduces exchange rate risk, which is inherent in the “uncovered” nature of foreign investments.
How does speculation in the foreign exchange market help restore UIP when the foreign interest rate exceeds the domestic interest rate (r*>r)?
If r* > r, foreign investments are more attractive. Investors sell domestic currency to buy foreign currency, increasing the supply of the domestic currency in the forex market. This causes the domestic currency to depreciate, reducing the expected future depreciation (Et[s˙]) until UIP is restored.
What are the main conditions required for UIP to hold, and why are they important?
Perfect capital mobility: Investors must freely move capital across borders to exploit interest rate differentials.
Equal currency risk or risk neutrality: Investors must perceive currencies as equally risky or disregard risk entirely. These conditions ensure that interest rate differentials reflect expected exchange rate movements without distortions.
Why might UIP fail in the presence of a risk premium, and how does this affect the formula?
If investors perceive one currency as riskier, they demand a higher return, creating a risk premium. This alters the UIP formula to
r -r* = Et[s˙] + riskpremium, meaning the interest rate differential no longer solely reflects expected exchange rate movements.
Illustrate how UIP explains currency depreciation when a central bank raises foreign interest rates (r*)
When r* increases, foreign investments become more attractive. Investors convert domestic currency into foreign currency, causing the domestic currency to depreciate. This depreciation adjusts Et[s˙] until the interest rate differential matches the expected depreciation, restoring UIP.
Why is perfect capital mobility critical for UIP, and what happens if this condition is not met?
Perfect capital mobility ensures that investors can freely move funds to exploit interest rate differentials. Without it, barriers like capital controls or transaction costs prevent arbitrage, allowing interest rate differences to persist independently of expected exchange rate changes.
How does speculation in the foreign exchange market help restore UIP when r* - r?
When r*-r, foreign investments appear more attractive. Speculators convert domestic currency into foreign currency, increasing the supply of the domestic currency in the forex market. This causes the domestic currency to depreciate (St increases). The expected future depreciation (Et[s˙]) decreases until the interest rate differential matches the adjusted expectation, restoring UIP.
Explain the role of exchange rate expectations (Et[s˙]) in ensuring UIP is restored during speculative activity.
Speculative activity adjusts the current spot exchange rate (St) based on expectations of future exchange rates (Et[St+1]). If investors expect too high a depreciation (Et[s˙]), speculation causes the domestic currency to depreciate until Et[s˙] aligns with the interest rate differential, restoring UIP.
Why does UIP require the condition
r - r* = Et[s˙] to hold, and how does speculation ensure this?
UIP states that the interest rate differential
(r - r*) must equal the expected rate of currency depreciation (Et[s˙]). Speculation drives adjustments in St by increasing or decreasing demand for currencies, ensuring that the spot rate reflects these expectations and satisfies UIP.
What happens to the domestic currency if the expected depreciation (Et[s˙]) is too high compared to the interest rate differential
(r - r*)
If Et[s˙] is too high, foreign investment becomes more attractive, leading to an outflow of capital from the domestic economy. This increases the supply of the domestic currency in the forex market, causing it to depreciate (St rises). As depreciation occurs, Et[s˙] decreases until it aligns with r - r*
How does UIP form the basis of exchange rate theory?
UIP establishes a relationship between interest rate differentials (r - r*) and exchange rate expectations (Et [s˙]). It suggests that the current spot exchange rate (St) depends on the domestic interest rate (r) and market expectations of future spot rates. However, full exchange rate theory requires modeling both r and Et[s˙].
If r* is fixed, what factors primarily determine the current spot exchange rate (St ) under UIP?
If r*is exogenous, St is determined by:
The domestic interest rate (r): Higher r makes domestic currency more attractive, causing appreciation.
Expectations of future exchange rates (Et[s˙]): If depreciation is expected, St adjusts to reflect those expectations.
Describe how UIP explains the depreciation of the domestic currency when domestic interest rates (r) are lowered.
Lower domestic interest rates (r) reduce the return on domestic investments relative to foreign investments (r*). This prompts investors to move capital abroad, increasing the supply of domestic currency in the forex market. As a result, the domestic currency depreciates until UIP is restored.
What role does risk neutrality play in the validity of UIP, and what happens if investors are risk-averse?
UIP assumes investors are risk-neutral, treating all currencies as equally risky. If investors are risk-averse, they may demand a risk premium for holding certain currencies. This risk premium disrupts the equality
r - r* = Et[s˙], meaning UIP may not hold strictly in such cases.
Why does UIP provide only a partial explanation of exchange rate dynamics, and what components must be added for a complete theory?
UIP focuses on the relationship between interest rate differentials and exchange rate expectations but does not model how domestic interest rates (r) or expectations (Et[s˙]) are formed. A complete theory must include models of monetary policy, inflation expectations, and market sentiment to fully explain exchange rate dynamics.
What happens to the forward exchange rate (f) when both CIP and UIP hold, and why?
When both CIP and UIP hold, the forward exchange rate f equals the expected future spot exchange rate (Es). This is because the forward rate reflects market expectations of the future spot rate, and arbitrage ensures that discrepancies are eliminated.
Explain the mechanism by which arbitrage eliminates differences when f > Es.
If f > Es, arbitrageurs sell forward contracts since the forward rate offers a higher return than the expected spot rate. This increases the supply of forward contracts, pushing f down until it equals Es.
What arbitrage action occurs if f < Es, and what is the result?
If f < Es, arbitrageurs buy forward contracts because the expected spot rate offers a higher return. This increases the demand for forward contracts, driving f up until it equals Es.
Why is the forward exchange rate f considered a reflection of market expectations about the future spot exchange rate Es?
The forward rate f reflects market expectations because it incorporates all available information about future economic conditions. Investors’ expectations about the future spot rate Es drive their actions in the forward market, aligning f with Es.
How does CIP ensure no arbitrage when forward contracts are used?
CIP ensures no arbitrage by equating the return on a domestic investment with the return on a hedged foreign investment. This condition links the forward exchange rate f to interest rate differentials, ensuring that investors cannot profit from differences in forward and spot markets.
Explain how UIP and CIP together imply that the forward rate is determined by expectations of the future spot rate.
UIP links interest rate differentials to expected changes in the spot rate, while CIP equates the forward rate to these differentials. Together, they imply that f reflects Es, as any deviation would create arbitrage opportunities and adjust f to align with Es.
If the domestic interest rate (r) is 5% and the foreign interest rate (r*) is 6%, what does UIP predict about the expected rate of currency appreciation or depreciation (Es)?
UIP predicts that Es = r – r*. Substituting the values, Es = 5 – 6 = –1%. This means the domestic currency is expected to appreciate by 1% relative to the foreign currency.
What happens to Es immediately after a shock where r* increases from 6% to 9%, while r remains at 5%?
Immediately after the shock, UIP does not hold because the market is in disequilibrium. Es = r – r* = 5 – 9 = –4%, but this is not valid until the exchange rate adjusts. The spot rate (st) must increase (domestic currency depreciates) to restore equilibrium.
Explain the adjustment process when r* unexpectedly increases, making foreign investments more attractive.
Capital outflow: Higher r* prompts investors to move capital abroad.
Currency depreciation: Capital outflow increases the supply of the domestic currency, causing it to depreciate (st rises).
Restoring equilibrium: Depreciation continues until the domestic currency becomes so weak that investors expect it to appreciate in the future, offsetting the interest differential. Equilibrium is restored when r – r* = Es.
After adjustment, if r = 5% and r* = 9%, and the UIP equilibrium holds, what does Es = –4% signify?
Es = –4% signifies that the market expects the domestic currency to appreciate by 4% in the future. This expected appreciation offsets the 4% interest rate differential, restoring UIP equilibrium.
Why does a change in the spot rate (st) not necessarily change Es?
Es depends on both the spot rate (st) and the future expected spot rate (Et[st+1]). If st rises and Et[st+1] rises by the same amount, Es remains unchanged. If Et[st+1] rises by less or more than st, Es could increase or decrease.
Describe a scenario where st rises but Es decreases.
If the spot rate st rises but the expected future spot rate Et[st+1] rises by less than st, the difference Et[st+1] – st (which defines Es) decreases. For example, if st rises by 3% but Et[st+1] rises only by 1%, Es decreases.
What mistake do people commonly make when observing a rise in st, and why is it incorrect?
People often assume that a rise in st automatically decreases Es. This is incorrect because Es = Et[st+1] – st. If Et[st+1] rises along with st, Es may remain unchanged or even increase, depending on the relative magnitudes of their changes.
How does the market’s expectation of future depreciation change during the adjustment process after an interest rate shock?
During the adjustment, the depreciation of the domestic currency increases the spot rate (st), causing the expected future depreciation (Es) to adjust. Once the domestic currency is weak enough, the market begins to expect future appreciation, restoring UIP equilibrium.
Why does the actual depreciation of the domestic currency during adjustment differ from the new expected depreciation (Es) in equilibrium?
During adjustment, the domestic currency depreciates significantly to correct the disequilibrium caused by the interest rate shock. However, in the new equilibrium, Es reflects the market’s expectation of future appreciation rather than the magnitude of the past depreciation. This ensures that r – r* = Es holds.
What role does purchasing power parity (PPP) play in the flexprice monetary model?
PPP is assumed in the flexprice monetary model because it focuses on the long run, where the relationship between prices and exchange rates stabilizes. PPP provides a link between domestic and foreign price levels and exchange rates, with the assumption that exchange rate adjustments restore competitiveness when domestic prices rise relative to foreign prices.
Why do prices (p) adjust to clear the money market in this model rather than interest rates (r)?
This model is a long-run theory where changes in the money supply directly impact the price level. If the money supply doubles, the price level doubles in the long run to restore equilibrium in the money market. Interest rates are determined by other factors, such as UIP and inflation expectations.
What determines the long-run domestic interest rate (r) in the flexprice monetary model?
The long-run domestic interest rate is determined by:
The foreign interest rate (r*)
The difference between expected domestic inflation (E[p˙]) and expected foreign inflation (E[p*˙])
This relationship is derived from combining UIP and the Fisher effect.
Explain the Fisher effect in the context of the flexprice monetary model.
The Fisher effect states that in the long run, higher expected inflation (E[p˙]) leads to a proportional rise in the nominal interest rate (i). Since the real interest rate adjusts for inflation, this increase in expected inflation also raises r and expected exchange rate depreciation (E[s˙]).
How does a one-time increase in the money supply affect long-run expected inflation and the domestic interest rate?
A one-time increase in the money supply causes a temporary rise in prices but does not affect the long-run expected inflation rate (E[p˙]). Consequently, the domestic interest rate (r) remains unchanged in the long run.
What happens to the long-run domestic interest rate (r) when there is a sustained increase in the money growth rate?
A sustained increase in the money growth rate raises the long-run expected inflation rate (E[p˙]). As a result, the domestic interest rate (r) also increases to reflect the higher inflation expectations.
What is the relationship between exchange rate depreciation (s˙), domestic inflation (p˙), and foreign inflation (p*˙) in the flexprice monetary model?
The relationship is given by relative PPP: s˙ = p˙ – p*˙. This means that the exchange rate depreciation equals the difference between the domestic and foreign inflation rates.
How does an increase in domestic inflation (p˙) affect the expected exchange rate depreciation (E[s˙]) in the long run?
An increase in domestic inflation (p˙) relative to foreign inflation (p*˙) raises the expected exchange rate depreciation (E[s˙]). This is because higher domestic inflation makes domestic goods less competitive, leading to a weaker domestic currency over time.
Why doesn’t a temporary price increase due to higher money supply affect long-run inflation expectations?
A temporary price increase from a one-time change in money supply is not sustained and does not impact the long-run growth rate of prices (inflation). Inflation expectations depend on ongoing trends, not single events.
What happens to the competitiveness of domestic goods when the domestic price level (p) rises relative to foreign prices (p*)?
When domestic prices (p) rise relative to foreign prices (p*), domestic goods become less competitive in international markets. The exchange rate (s) must adjust (depreciate) to restore competitiveness, consistent with PPP.
How does the flexprice monetary model incorporate the endogeneity of prices compared to simpler PPP theories?
In the flexprice monetary model, prices (p and p*) are determined within the model by the interaction of money supply and demand, whereas simpler PPP theories treat prices as exogenous and focus only on their relationship with exchange rates.
Describe the adjustment process in the exchange rate when there is a sustained increase in domestic money growth.
A sustained increase in domestic money growth raises inflation expectations (E[p˙]), leading to higher domestic interest rates (r) and expected exchange rate depreciation (E[s˙]). The currency depreciates over time to maintain PPP as higher prices reduce competitiveness.
What misconception might arise from observing a rising spot exchange rate (s) and its impact on Es˙?
A common misconception is assuming that a rising spot rate (s) always reduces Es˙. In reality, both the spot rate (s) and expected future spot rate (E[st+1]) matter. If E[st+1] rises by more than s, Es˙ could increase.
Why is the flexprice monetary model considered a long-run theory, and how does this impact its assumptions?
The flexprice monetary model is a long-run theory because it assumes that markets, especially the money market, fully adjust to changes over time. This justifies assumptions like PPP and the proportional relationship between money supply and price levels. Short-term deviations are not accounted for.
Explain the relationship between real interest parity (RIP), uncovered interest parity (UIP), and purchasing power parity (PPP).
RIP is derived from combining UIP and PPP. UIP ensures that interest rate differentials are offset by expected currency depreciation, while PPP links exchange rates and inflation. RIP merges these principles to state that real interest rates between two open economies equalize in the long run after adjusting for inflation expectations.
How does RIP reflect the openness of an economy?
RIP depends on the ability to invest and borrow freely across borders. In a perfectly open economy, capital flows freely, ensuring that differences in real interest rates are arbitraged away. This equalization reflects the openness and integration of financial markets.
What is the impact of a restrictive monetary policy on real interest rates (r) in the short run and long run?
Short run: Restrictive monetary policy, interpreted as a reduction in money supply, creates a scarcity of money, pushing nominal interest rates and real interest rates (r) higher.
Long run: Restrictive monetary policy, interpreted as a lower money growth rate, reduces expected inflation (E[p˙]). With lower inflation expectations, real interest rates (r) decrease over time.
Why has the European Central Bank’s (ECB) restrictive monetary policy contributed to low real interest rates in the eurozone over the years?
The ECB’s low money growth policy aims to curb inflation, which has successfully reduced expected inflation (E[p˙]) in the long run. Since real interest rates (r) depend inversely on inflation expectations, this policy has kept long-term real interest rates low.
If real interest rates are lower in one country than another, what might this indicate about inflation expectations or monetary policy?
Lower real interest rates could indicate:
Higher expected inflation (E[p˙]) in the country with lower real rates.
Expansionary monetary policy aimed at stimulating growth.
This difference often triggers capital outflows to countries with higher real interest rates until parity is restored.
How does a sudden increase in inflation expectations (E[p˙]) affect real interest rates and RIP equilibrium?
An increase in domestic inflation expectations (E[p˙]) reduces the real interest rate (r = i – E[p˙]). This disrupts RIP equilibrium as the real interest rate differential widens. Capital flows will then adjust exchange rates or nominal rates until real interest parity is restored.
Explain why a country with consistently higher inflation might have difficulty maintaining RIP with other countries.
Higher inflation increases E[p˙], lowering real interest rates and creating persistent deviations from RIP. For RIP to hold, either the nominal interest rates must increase proportionally (unlikely in cases of weak monetary policy), or capital outflows must continuously adjust the exchange rate.
What role do capital flows play in restoring RIP when real interest rates differ across countries?
Capital flows exploit real interest rate differentials. For example:
If real interest rates are higher abroad, domestic investors move capital overseas, increasing the supply of domestic currency.
This causes domestic currency depreciation, raising E[s˙], until RIP (r – E[p˙] = r* – E[p*˙]) is restored.
A central bank unexpectedly tightens monetary policy by lowering the money growth rate. Explain the short-term and long-term effects on RIP.
Short-term: The restrictive policy may cause real interest rates to rise temporarily due to capital inflows and tight liquidity. RIP may be disrupted as domestic rates exceed foreign rates.
Long-term: The lower money growth rate reduces inflation expectations (E[p˙]), lowering real interest rates. RIP equilibrium is restored as real rates equalize across countries.
Why does RIP assume perfect capital mobility, and what happens if this assumption does not hold?
RIP assumes perfect capital mobility because unrestricted capital flows ensure real interest rate equalization. If capital mobility is limited (e.g., through capital controls), real interest rate differentials can persist due to a lack of arbitrage opportunities.
What are the implications of RIP for monetary policy coordination among open economies?
RIP implies that monetary policies in open economies are interconnected. A country’s real interest rate policies affect global capital flows and exchange rates, forcing other countries to consider these spillover effects when designing their policies.
If a country maintains higher nominal interest rates than its trading partners but also has higher inflation expectations, how does this affect RIP?
Higher nominal interest rates combined with higher inflation expectations could keep the real interest rate similar to trading partners, ensuring RIP holds. However, if inflation expectations rise disproportionately, the real interest rate may fall below parity, causing capital outflows.
Explain why the price level (p) adjusts to clear the money market in this model, rather than the real interest rate (r).
In this model, the money market clears through price adjustments because it operates as a long-run theory. The price level (p) adjusts to align money demand with a fixed money supply (ms). Real interest rates (r) are determined by international bond market equilibrium (UIP), so they are not the adjustment mechanism for the money market.
Using the equilibrium condition
m = p + ηy − σr, explain the effect of an increase in money supply m on price levels p.
An increase in the money supply (m) leads to an increase in the price level (p) to maintain equilibrium in the money market. Since ηy (income effect) and σr (interest rate effect) are fixed, the price level must rise proportionally to balance the equation.
How does a relative increase in domestic money supply (m > m*) affect the exchange rate (s) in the long run?
A relative increase in domestic money supply (m > m) causes the domestic price level (p) to rise, reducing the value of the domestic currency. Using the exchange rate equation
s = (m − m) − η(y − y) + σ(r − r), this leads to an increase in s (currency depreciation).
Describe the role of elasticity (η) in the money demand equation when there is a shock to real income (y).
The elasticity of money demand with respect to income (η) determines how sensitive money demand is to changes in y. A higher η means that a shock to y has a larger impact on money demand, requiring greater adjustments in the price level (p) to restore equilibrium.
Suppose the central bank increases the interest rate (r) in response to inflationary pressures. What is the immediate effect on money demand and price levels?
An increase in r decreases money demand (md) because of the negative relationship (−σr). To restore equilibrium, the price level (p) must decrease to match the reduced money demand with the fixed money supply (m).
How does an increase in foreign income (y*) relative to domestic income (y) affect the exchange rate (s)?
An increase in foreign income (y* > y) makes foreign goods relatively more competitive, leading to an appreciation of the foreign currency. From the exchange rate equation
s = (m − m) − η(y − y) + σ(r − r), the term −η(y − y) becomes negative, decreasing s (domestic currency appreciates).
A country experiences a simultaneous increase in money supply (m) and income (y). How do these changes interact to influence the price level (p)?
An increase in m raises p (price level), while an increase in y also increases money demand, which offsets some of the upward pressure on p. The net effect on p depends on the relative magnitudes of the changes in m and ηy (income elasticity of money demand).