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20ECC003 - International Money and Finance > WEEK 6 - Economic Models of Exchange Rate Determination and Volatility > Flashcards

WEEK 6 - Economic Models of Exchange Rate Determination and Volatility Flashcards

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1
Q

Where does the Flexible Monetary Model originate from and what does it view?

A
  • > Hume’s theory of Price-Specie Flow
  • > Links exchange rate movement to BoP equilibrium
  • > Hume’s analysis strict monetary approach to prices and BoP
  • > Basically, Exchange rate is relative price of money supply in dif countries
  • > Capital ignored so interest rates not considered
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2
Q

What are the three assumptions of the flexible monetary model?

A
  1. Aggregate Supply is Vertical
  2. Demand for real money balances is stable function of only few domestic maceoecon variables
  3. PPP obtains at all times
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3
Q

What is meant by Demand for real money is a stable function domestic macroecon variables?

A
  1. No capital considered, so no interest rates
  2. Ms = Md
    Where:
    Md = kPy k>0

Showing Md is a function of income

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4
Q

What is meant by the PPP obtains at all times?

A

Well Absolute PPP holds at all times so exchange rate always right

Anything above is an overvaluation and anything below is an undervaluation

SEE GRAPH AND CALCULATION IN NOTES

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5
Q

What does the Domestic Money Supply consist of?

A 
Ms = D + R 
Where:
Ms = Domestic Money Base
D = Domestic bond holdings
R = Foreign Reserves of Foreign Currency

-> Authorities can conduct OMO or foreign exchange operations (FXO)
Resulting in:
dMs = dD + dR

SEE GRAPH IN NOTES

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6
Q

What does the equilibrium look like in the Flexible Monetary Model look like?

A

EQUILIBRIUM IN ALL 3 MKTS

SEE GRAPH IN NOTES

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7
Q

What are the effects of a devaluation in the Flexible Monetary Model?

A
  • > Due to a devaluation -> S1 to S2
  • > Devaluation means currency underappreciated.
  • > Which means more exports -> AD1 to AD2
  • > Higher exports means more reserves not domestic credit (so MS increases)
  • > Due to inflation from more exports, new equilibrium from P1 to P2

SEE GRAPH IN NOTES

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8
Q

What do we see with monetary expansion under fixed rates in the Flexible Model?

A

D1 rise to D2
So, MS1 -> MS2
Affects inflation -> Price lvls up (P1 to p2)
Currency now overvalued ->Now has to intervene in mkt -> Reserves drop and Ms drops back to Ms1 again

SEE GRAPH IN NOTES

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9
Q

What do we see with monetary expansion under floating rates in the Flexible Model?

A
  1. D1 to D2
  2. PPP up
  3. AD1 to AD2
  4. No intervention so R stays the same, depreciation from S1 to S2

SEE GRAPH IN NOTES

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10
Q

What do we see with an increase in income under fixed rates in the Flexible Model?

A

AS1 to AS2 (More supply as incomes increase increase (Productivity))
So, P1 to P2 -> Means exchange should appreciate -> So intervene to buy foreign currency and sell domestic -> So R1 to R2 -> So, M1 to M2 -> So P1 to P2

SEE GRAPH IN NOTES

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11
Q

What do we see with an increase in income under floating rates in the Flexible Model?

A

AS1 to AS2 -> Prices go down ->Exchange appreciates (No change in money mkt)

SEE GRAPH IN NOTES

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12
Q

What do we see with an increase in foreign prices under fixed rates in the Flexible Model?

A

New change in PPP needed as the P* now changing -> So from PPP1 to PPP2

  • > Currency now overvalued
  • > Technically appreciating so intervention to increase prices to P2 -> Buying up foreign reserves (R1 to R2) to increase Md
  • > Prices increasing to P2

SEE GRAPH IN NOTES

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13
Q

What do we see with an increase in foreign prices under floating rates in the Flexible Model?

A

No change in any other mkt except appreciation
-> Because floating rates act as shock absorber

SEE GRAPH IN NOTES

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14
Q

What is the alternative flexible price monetary model?

A
  • > Developed by Frankel, Mussa and Bilson
  • > Also assumes PPP holds continuously
  • > In addition to existing variables also adds in interest rate parity conecpt
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15
Q

What is the differing MD Functions?

A

Md =
m-p = ηy - σr

Foreign Md=
m-p = ηy* - σr*

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16
Q

What is the PPP and the uncovered interest rate parity denoted as? Why does UIRP also hold in this model?

A

PPP:
s = p - p*

UIP holds since the model assumes that domestic and foreign bonds are perfect substitutes
UIP:
Es = r - r*

17
Q

How do we get the domestic and foreign prices and what is it denoted as?

A 
p = m - ηy + σr
p* = m* - ηy* - σr*

By combining the Md function together

18
Q

What are the domestic and foreign prices denotations also showing?

A

An exchange rate equation, where the spot exchange

is determined by the right hand variables

19
Q

What does the exchange rate equation predict? AND WHAT IS ITS DERIVATION

A

p* = m* - ηy* - σr*

1 Relative money supplies affect exchange rates;
2 Relative levels of national income influence exchange rates and;
3 Relative interest rates affect exchange rates

20
Q

What were some of the failures of the flexible price monetary model?

A
  • > Assumption in PPP holding constantly
  • > Prices both upward and downward flexible

_. Model not useful in explaining observed exchange rate departures from PPP

21
Q

What is the underlying principles in the Dornbusch Model?

A
  • > that prices in the goods market and wages in labour markets are sticky
  • > exchange rate is determined in “flex-price” market.
  • > UIP hold continuously
  • > Instant adjustment due to perfect capital mobility and asset substitutability
  • > So continuous equilibrium in money mkt
22
Q

What is meant by an ‘overshooting’ as used in the Dornbusch model?

A

> short-run excessive movement in exchange rates

  • > As a result of speed of adjustment across mkts
  • > Goods mkt prices are sticky but price adjust instantly in fin mkts

-> So in SR, mass depreciation or appreciation but in LR slowly comes back to equilibrium (or goes back to PPP)

23
Q

How do you derive the goods mkt (GG slope) in the sticky (Dornbusch) model?

A

The goods-market equilibrium schedule represents the equality of demand and supply

Positively sloping (Maths not really needed tbf)

SEE SLOPE IN NOTES

24
Q

How do you derive the money mkt schedule (MM slope) in the sticky (Dornbusch) model?

A

Equilibrium supply and demand of money

dp/ ds = -σΘ

Where:
dp = (log) demanded domestic price inflation
ds = (log) demanded spot rate
Θ = Expected rate of depreciation of currency

SEE SLOPE IN NOTES

25
Q

What is the formal explanation to the Dornbusch model?

A

SEE EXPLANATION IN NOTES

REAL USEFUL TO UNDERSTAND

26
Q

What does the equilibrium to the Dornbusch model look like?

A

SEE GRAPH IN NOTES

27
Q

What is a representation of a diagrammitical change in the Dornbusch model? (OVERSHOOTING)

A

Suppose equlibrium is in point A and unexpected expansionary monetary policy that shift M1M1 to M2M2

  • > As a result, exchange rate depreciate, moving from S1 to S2 passing LR point of Sbar (OVERSHOOTING)
  • > SR equilibrium is at B
  • > Since PPP holds in LR, prices rises gradually shifting the GG schedule upward and to new equilibrium to Sbar

SEE GRAPH IN NOTES

28
Q

What are the dif factors which suggest non-money assets are unlikely to be viewed as perfect substitution?

A 
1 Differential tax risk,
2 Liquidity considerations,
3 Political risk,
4 Default risk, and
5 Exchange risk

Therefore, international transactors likely to hold portfolio of currencies to minimise exchange risk

29
Q

What are the general features of the Portfolio Balance Model?

A

-> Demand for money generalised to demand for assets (i.e Proportions of wealth allocated to):
Money (M/W)
Domestic Currency Bonds (B/W)
Foreign Currency Bonds
(SF/W)
-> Imperfect capital mobility so risk aversion prevents UIRP
-> Sticky prices so BoP in temporary disequilibrium

30
Q

What are the other assumptions of the Portfolio Balance Model?

A
  1. Domestic Investors hold foreign assets BUT not vice versa (Foreigners hold no domestic assets)
  2. Other forms of wealth can be ignored: All wealth allocated money, domestic or foreign bonds
  3. Bonds -> Short term -> So capital gains/losses resulting from interest rate negligible
31
Q

What are the differing elements of Portfolio Balance Model?

A

-> Risk averse agents will take account of both risk and return, diversifying their asset portfolio to attain best (i.e utility-maximizing) risk-return combination.
-> Equilibrium in asset markets involves different (expected) rates of
return to compensate for risk differences between assets
->Given risks associated with each asset class, small increase in return
on asset j (relative to competing assets) increases demand for j
->Given wealth in short run, increase in demand for j implies fall in demand for other assets.

UK nominal wealth (in pounds) consists of:

W = Mbar + Bbar + SF
Where bars denote exogenous variables

32
Q

What do the equilibrium’s in each financial market defined as?

A

->Mbar/W = m (r,r*bar + Δ Se (Exchange rate)),
m1 < 0 m2 <0

->Bbar/W = b (r,r*bar + Δ Se)

b1 > 0 b2<0
If b2 negative, then foreign interest rate causes bonds to go down

->SF/W = f (r,r*bar + ΔSe)

f1< 0 f2>0

33
Q

How does the operation of the porfolio balance model work?

A

SEE SYSTEM IN NOTES

34
Q

What does the equilibrium of the model look like?

A

Equilibrium between F,M and B

SEE GRAPH IN NOTES

35
Q

What are the effect of a foreign exchange operation in the Portfolio Balance model?

A
  • > Due to forex operation -> F1 to F2
  • > Leads to Domestic Interest falling
  • > Leads to depreciation -> S1 to S2
  • > The selling of pounds leads to greater money supply (M1 to M2)
  • > New equilibrium at B

SEE GRAPH IN NOTES

36
Q

What are the effects of an open mkt operation in the Portfolio Balance Model?

A
  • > Central bank decides to sell bonds -> So B1 to B2
  • > At B2 interest falls since as a result of selling bonds more money supply in economy (MS Increase)
  • > Interest falling leads to depreciation
  • > New equilibrium at B

SEE GRAPH IN NOTES

37
Q

What do the dynamics of the portfolio balance model look like?

A

SEE GRAPH IN NOTES

38
Q

What are the effects of foreign bonds become more risky in the portfolio balance model?

A
  • > Foreign bonds more risky -> Sell off so F1 to F2
  • > Selling off = More money in domestic economy (M1 to M2)
  • > So interest down since more money in economy (R1 to R2)
  • > More money in economy = Appreciation (S1 to S2)
  • > Due to appreciation Domestic bonds now more expensive -> People sell of for a profit
  • > New equilibrium at B

SEE GRAPH IN NOTES -> You get the idea

39
Q

What are the effects of Perfect Substitutability in the portfolio balance model?

A

SEE GRAPH IN NOTES

20ECC003 - International Money and Finance (11 decks)

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