International Monetary Relations
Lecture 1 c© Marc-Andreas Muendler
University of California, San Diego
April 1, 2014
Web page http://econ.ucsd.edu/muendler/teach/14s/103
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1. Introduction to Open-economy Macroeconomics Econ 103, c© M. Muendler
The Macroeconomic Perspective
• Economy-wide factor employment, production, and growth
• Business cycles, fiscal and monetary policies
• Key variables:
– Unemployment
– Consumption and savings
– Trade and current account balance
– Money, price level, exchange rate
1. Introduction to Open-economy Macroeconomics Econ 103, c© M. Muendler
Macroeconomic Accounting
• National Income Accounting (overall perspective)
– Gross National Income (GNI, Y ) Value of all goods and services produced by a country’s “nationals”
– National Income (NI) Net income earned by a country’s “nationals” after adjustments
• Balance of Payments Accounting (foreign exchange perspective)
– Current Account (CA)
– Financial Account and Capital Account
1. Introduction to Open-economy Macroeconomics Econ 103, c© M. Muendler
National Accounting
• GDP: Y GDP = C + I + G + EX − IM – Y : Gross Domestic Product
– C: (Private) Consumption
– I: (Private) Investment
– G: Government Purchases (consumption and investment)
– EX: Exports, IM: Imports
• GNI is GDP plus net transfers (net transfers: domestic factor income abroad less foreign factor income at home)
• GNI is related to National Income (NI) Adjustments: Depreciation (NNP), Unilateral transfers, Tax wedge in prices
1. Introduction to Open-economy Macroeconomics Econ 103, c© M. Muendler
Simplified GNI
• GNI ≈ GDP: Y GNI ≈ C + I + G + EX − IM – Y : Gross National Income
– C: (Private) Consumption
– I: (Private) Investment
– G: Government Purchases (consumption and investment)
– EX: Exports, IM: Imports
• GNI is roughly equal to GDP in most countries empirically
• GNI is conceptually different from GDP The conceptual difference matters for current account sustainability
1. Introduction to Open-economy Macroeconomics Econ 103, c© M. Muendler
The Current Account
• Simplified Definition of Current Account: CA ≡ EX − IM
• Domestic Production less Domestic Purchases equals Net Exports:
Y − (C + I + G) = EX − IM = CA.
• A positive CA means that US residents give up domestic consumption (or investment) for exports. What do they gain?
• US residents gain the promise of foreign debtors to pay back in the future. In financial parlor: Domestic residents receive foreign assets for net exports
1. Introduction to Open-economy Macroeconomics Econ 103, c© M. Muendler
US Gross National Product T
ri lli
o n
s o
f cu
rr e
n t
U S
D
−2
0
2
4
6
8
10
12
Gross National Product Consumption Investment Government Purchases Current Account
2001 2006
Source: Government Printing Office, Economic Indicators, 2008-02
1. Introduction to Open-economy Macroeconomics Econ 103, c© M. Muendler
Composition of US Output P
e rc
e n
ta g
e o
f G
D P
−5 0
20
40
60
80
100
Consumption/GDP Investment/GDP Government Purchases/GDP Current Account/GDP
1998 1999
2000 2001
2002 2003
2004 2005
2006 2007
Source: Government Printing Office, Economic Indicators, 2008-02
1. Introduction to Open-economy Macroeconomics Econ 103, c© M. Muendler
Balance of Payments
• Balance of Payments: Accounts (only concerned with flows)
– Current Account CA (cross-border commodity flows)
– Financial Account FA (purchase and sale of foreign assets)
– Capital Account (non-market financial flows)
• Double-entry book keeping
– Commodity flows are accompanied by reverse financial flows
– Financial transactions involve creditors and debtors
1. Introduction to Open-economy Macroeconomics Econ 103, c© M. Muendler
International Transactions: Movie Export
Export of movies to Japan Credit CA Debit FA US sale (services export) USD +10,000
Check to US bank (asset import) USD -10,000
(denoted in Yen at current exchange rate)
Purchase of Japanese government bonds Credit FA Debit FA US check to Japanese bank (asset export) USD +10,000
(redeemed in USD from US bank and deposited at Japanese bank in Yen)
US residents’ bond acquisition (asset import) USD -10,000
• CA = EX − IM > 0: A net exporter is a net foreign lender. CA = EX − IM < 0: A net importer is a net foreign borrower.
1. Introduction to Open-economy Macroeconomics Econ 103, c© M. Muendler
International Transactions: Foreign Investment
Investment in Californian biotech shares Credit FA Debit FA Japan’s share purchase (asset export) USD +10,000
Japanese check to US bank (asset import) USD -10,000
(redeemed in Yen from Japan and deposited at US bank in dollars)
Import of lab equipment Credit FA Debit CA US purchase (commodity import) USD -10,000
Check to Japanese bank (asset export) USD +10,000
(denoted in dollars at current exchange rate)
• CA = EX − IM > 0: A net exporter is a net foreign lender. CA = EX − IM < 0: A net importer is a net foreign borrower.
1. Introduction to Open-economy Macroeconomics Econ 103, c© M. Muendler
Savings in the Open Economy
• In a closed economy: S = I
• In an open economy: S = I + CA
• I is domestic investment, CA is net lending to the rest of the world
• Closed economy: All savings invested domestically Open economy: Savings partly invested abroad
• CA = EX − IM > 0: Net exports are net foreign lending. CA = EX − IM < 0: Net imports are net foreign borrowing.
1. Introduction to Open-economy Macroeconomics Econ 103, c© M. Muendler
The CA Flipside: Savings Invested Abroad
• In an open economy: S = I + CA So,
CA = S − I.
• CA = S − I = EX − IM is net lending to the rest of the world Net lending to foreigners is income from production not consumed or invested.
So, goods must be shipping abroad
• CA = EX − IM stresses the physical side of the current account CA = S − I stresses the financial side of the current account
1. Introduction to Open-economy Macroeconomics Econ 103, c© M. Muendler
Savings in the Open Economy: The Derivation
• S = I + CA: Derivation
Private Savings: SP = Y − T − C
Government Savings: SG = T − G
Economy-wide Savings:
S = SP + SG = Y − C − G =
= (C + I + G + EX − IM) − C − G = I + (EX − IM)
• CA = EX − IM > 0: Net exports are net foreign lending. CA = EX − IM < 0: Net imports are net foreign borrowing.
1. Introduction to Open-economy Macroeconomics Econ 103, c© M. Muendler
Net Foreign Wealth of US Residents per GDP S
h a
re
year
Foreign net wealth (cost)/GDP Foreign net wealth (mktval)/GDP
1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 20022004
−.25
−.2
−.15
−.1
−.05
0
.05
.1
.15
Source: Bureau of Economic Analysis. NIPA, July 2006
International Monetary Relations
Lecture 2 c© Marc-Andreas Muendler
University of California, San Diego
April 3, 2014
2. International Monetary Systems, Past and Present Econ 103, c© M. Muendler
Macroeconomic Policy Targets
• Long-term Growth
– Factor accumulation
– Total factor productivity (TFP) change
• Short-term Fluctuations
– Business cycle shocks
– For monetary impact on the real side: price stickiness
2. International Monetary Systems, Past and Present Econ 103, c© M. Muendler
U.S. Real GDP 1950-2010 2
4 8
1 6
01jan1950 01jan1970 01jan1990 01jan2010 day
Log Real GDP Trillion (2005 prices) Fitted values
L o
g R
e a
l G D
P (
2 0
0 5
= 1
)
Source: BEA NIPA, 2010
2. International Monetary Systems, Past and Present Econ 103, c© M. Muendler
International Macro Policy Concerns
• Internal Balance
– Full employment of resources, price level stability, steady growth
• External Balance
– Balanced current account
∗ Problems of excessive CA deficits: Low domestic savings, high consump- tion, loss of foreign investors’ confidence
∗ Problems of excessive CA surpluses: Low domestic investment in equip- ment and plants, excessive foreign lending at high risk
2. International Monetary Systems, Past and Present Econ 103, c© M. Muendler
Current Account Value and Trade Volumes
• The real exchange rate q is the relative price of foreign goods in terms of domestic goods.
The real exchange rate q affects trade volumes and current account values in different ways
• Trade volumes: Home exports EX, foreign exports EX∗
(think of volumes like physical quantities).
• Current account value in terms of home goods:
CA = EX − IM = EX − q · EX∗
because home import value IM = q · EX∗.
2. International Monetary Systems, Past and Present Econ 103, c© M. Muendler
International Money
• Money serves as medium of exchange, unit of account, store of value
• International money: System of national currencies
• The order of the system—the “rules of the game”—are the laws, con- ventions and regulations under which the system operates
• International monetary systems resolve conflicts of internal and ex- ternal balance in different ways. Over time, the systems’ suitability, political circumstances, and financial technologies change
2. International Monetary Systems, Past and Present Econ 103, c© M. Muendler
Currencies, Gold, and the Price Level
• Money and the price level (at a given supply of goods)
– Gold standard : Higher gold supply depresses the gold price and raises the price level of goods
– Fiat money : Higher money supply bids up the price level of goods
• Exchange of currencies
– Gold standard : Central banks pledge to exchange money for gold Guarantee applies to anyone at home or abroad, anchoring foreign exchange
– Fiat money : Currencies have intrinsic value where legal tender Foreign exchange markets clear demand and supply across countries
2. International Monetary Systems, Past and Present Econ 103, c© M. Muendler
Monetary Systems
• The International Gold Standard, 1880 to 1914 Convertibility of currencies into gold, no foreign exchange restrictions
• The Interwar Period, 1918 to 1939 Managed convertibility of currencies into gold, foreign exchange restrictions
• The Bretton Woods Order, 1945 to 1973 Convertibility of currencies into dollars at gold parity, IMF interventions
• The International Monetary System since 1973 Fixed, managed and freely floating currencies
2. International Monetary Systems, Past and Present Econ 103, c© M. Muendler
Gold Standard: External Balance
• Central banks’ duties
– Preserve fixed parity between domestic currency and gold . Permit free conversion of paper money into gold in unlimited amounts
– Preserve full international capital mobility
– Laissez-faire attitude toward current account
– Byproduct: Fixed exchange rates
– Limit function of lender of last resort (above-market interest rates, Bagehot)
• Price-Specie-Flow Mechanism (Hume 1752) World-wide equilibration of individual balances of payments
2. International Monetary Systems, Past and Present Econ 103, c© M. Muendler
Price-Specie-Flow Mechanism
• Price-Specie-Flow Mechanism
– Current account imbalances cause ensuing gold shipments and subsequent price adjustments
– The price adjustments prevent lasting current account imbalances
• Example. Autonomous reversion of a current account surplus A country in current account surplus accumulates gold. This raises the price of
all other commodities in the home country relative to gold. The higher domestic
price level makes domestic goods more costly both for domestic and foreign resi-
dents, while making foreign goods less expensive. This ultimately ends the trade
imbalance.
2. International Monetary Systems, Past and Present Econ 103, c© M. Muendler
Gold Standard: A Double-Standard?
• The “Rules of the Game” (Keynes): Expedite restoration of current account balance by preempting Price-Specie-Flow Mechanism Prevent gold outflows: CB sells assets to expedite deflation (monetary contraction)
Prevent gold inflows: CB buys assets to expedite inflation (monetary expansion)
• Central banks’ commitment to preempt gold flows made actual flows unnecessary
• Asymmetric burden on deficit countries to maintain gold convertibility Countries in CA surplus welcomed gold inflows and inflation, leaving the adjust-
ment to countries with incipient CA deficits
“Rules of the game” frequently violated before 1914
2. International Monetary Systems, Past and Present Econ 103, c© M. Muendler
Gold Standard and No Arbitrage
• In a credible monetary system, speculation has a stabilizing effect
• Example. Reversion of upward pressure on exchange rate Consider the Home country with an incipient current account surplus
– As real exchange rate appreciates (higher domestic than foreign price level), domestic money buys more foreign goods and currency than usual
• The nominal exchange rate must be fixed. There would otherwise be an arbitrage opportunity, which cannot last
– Buy foreign currency with domestic currency on foreign exchange market,
– Send foreign currency to foreign central bank and exchange it for gold,
– Ship gold back home,
– Get more of domestic currency.
2. International Monetary Systems, Past and Present Econ 103, c© M. Muendler
Gold Convertibility of the USD, 1800-1971
G o
ld B
u lli
o n
P ri ce
N e
w Y
o rk
, U
S D
/O u
n ce
01jan1800 06nov1860 25oct1929 15aug1971
0
10
20
30
40
50
Source: Global Financial Data, 2010
2. International Monetary Systems, Past and Present Econ 103, c© M. Muendler
Price Levels and Gold Supply
• Milton Friedman: “Inflation is always and everywhere a monetary phenomenon.” The Counter-Revolution in Monetary Theory (1970)
• If there is a constant peg to gold (gold parity), then inflation and de- flation are ultimately tied to gold reserves
• After collapse of Roman Empire (476), gold mining and minting ceased. Long-term economic decline ensued with lasting periods of deflation
• All gold today occupies 6,300m3 (a 18.5m cube): 2% produced prior to 1492, 8% 1492-1800, 20% 1801-1900, 70% since 1901
2. International Monetary Systems, Past and Present Econ 103, c© M. Muendler
Interwar Period
• A fleeting return to gold
1919 US returns to gold
1922 Agreed cooperation program between Britain, France, Italy, and Japan
1925 Britain returns to gold
1929 and thereafter Great Depression forces countries off gold
• Beggar-thy-neighbor policies: Devaluations to achieve current account surpluses
• Restrictions on foreign exchange harm trade and growth
2. International Monetary Systems, Past and Present Econ 103, c© M. Muendler
Bretton Woods System
• Central banks’ duties
– All countries but USA: Preserve fixed exchange rate with US dollar . Convertibility of domestic currency and dollar
– USA: Preserve fixed parity between dollar and gold (key-currency regime)
• Provide international liquidity by lending to countries with current ac- count deficits through the IMF
– Lending facilities under IMF conditionality (surveillance), adjustable parities
• Lesson from the Interwar Period: Allow countries to attain external balance without sacrificing internal balance
2. International Monetary Systems, Past and Present Econ 103, c© M. Muendler
Bretton Woods: Success and Failure
• “Fixed-Rate” Dollar Standard, 1950-1970 External balance achieved, dollar and gold shortages overcome
Exchange rate rigidity: Passive center country, private capital mobility, gold peg
• American monetary independence (Nth country)
• Confidence Problem (Triffin Dilemma) As long as US gold reserves sufficient, dollar holdings attractive to CBs.
However, volume of international transactions grew faster than US gold reserves.
Dilemma for the US: Go off gold or slow down world trade
Temporary solution: Special Drawing Rights (artificial reserve asset)
2. International Monetary Systems, Past and Present Econ 103, c© M. Muendler
International Monetary System since 1973
• Long-term solution: Abandonment of Bretton Woods System Among causes of collapse: High US inflation, “import” not accepted abroad
• Exchange rate regimes and central banks’ duties: A country’s choice
• Coexistence of freely floating, managed and fixed exchange rates
• Regional monetary integration Intervention accords (Plaza-Louvre 1985-1995)
• Frequent financial crises
2. International Monetary Systems, Past and Present Econ 103, c© M. Muendler
Gold Price in USD, 1971-2010
G o
ld B
u lli
o n
P ri ce
N e
w Y
o rk
, U
S D
/O u
n ce
01jan1971 01jan1981 01jan1991 01jan2001 31mar2010
0
100
200
300
400
500
600
700
800
900
1000
1100
1200
Source: Global Financial Data, 2010
International Monetary Relations
Lecture 3 c© Marc-Andreas Muendler
University of California, San Diego
April 8, 2014
3. Exchange Rates and Foreign Exchange Markets Econ 103, c© M. Muendler
The Role of Exchange Rates
• Exchange Rates translate different countries’ prices into comparable terms
• Financial assets and commodities are exchanged at the exchange rate
• Although there is more than one asset behind the exchange rate, the exchange rate is determined similar to other asset prices
• The no-arbitrage principle helps determine the equilibrium exchange rate
3. Exchange Rates and Foreign Exchange Markets Econ 103, c© M. Muendler
The Role of Exchange Rates
• Translation between domestic and foreign prices
– Example: A European car for EUR 20,000 costs USD 25,000 at an exchange rate of 1.25 USD/EUR
– Example: A British government bond for GBP 100 costs USD 160 at an ex- change rate of 1.60 USD/GBP
• Appreciation of USD: Less dollars needed to buy foreign currency
• Depreciation of USD: More dollars needed to buy foreign currency
3. Exchange Rates and Foreign Exchange Markets Econ 103, c© M. Muendler
Exchange Rate Changes
• Appreciation of USD
– Less dollars needed to buy foreign currency
– Lower relative price of imports, higher relative price of exports
– According adjustment of fixed exchange rate would be called revaluation
• Depreciation of USD
– More dollars needed to buy foreign currency
– Higher relative price of imports, lower relative price of exports
– According adjustment of fixed exchange rate would be called devaluation
3. Exchange Rates and Foreign Exchange Markets Econ 103, c© M. Muendler
Exchange Rate Quotes
Source: Wall Street Journal, April 6, 2010
3. Exchange Rates and Foreign Exchange Markets Econ 103, c© M. Muendler
Exchange Rate Quotes
• Direct (price notation, “American terms”)
– Example: USD 1.25 per EUR (pay 1.25 USD to receive one EUR)
– Throughout the class, we use direct quotes: E in units [
USD EUR
]
– A drop in the exchange rate quote is a USD appreciation
• Indirect (volume notation, “European terms”)
– Example: EUR .8 per USD (pay 1/.8 USD to receive one EUR)
– A rise in the exchange rate quote is a USD appreciation
3. Exchange Rates and Foreign Exchange Markets Econ 103, c© M. Muendler
Foreign Exchange Markets
• Exchange rates are determined in the foreign exchange market
• Substantial daily volume (typically more than USD 1 trillion)
• Actors In 2001: 2,772 dealer institutions reported to the BIS, 100-200 might be market makers, an even smaller number accounts for almost all transactions
– Commercial banks & nonbank financial institutions (Most currency trading is interbank trading)
– Central banks
– International corporations
3. Exchange Rates and Foreign Exchange Markets Econ 103, c© M. Muendler
Centers of Foreign Exchange Trading P
e rc
e n
t
0
10
20
30
40
UK USA Japan Singapore Germany Switzerland
1989 1992 1995 1998 2001 2004 2007
Source: Bank of International Settlements Basel, Triennial Central Bank Survey 2007
3. Exchange Rates and Foreign Exchange Markets Econ 103, c© M. Muendler
Vehicle Currencies P
e rc
e n
t
0
50
100
150
200
USD DEM EUR JPY GBP Other
1989 1992 1995 1998 2001 2004 2007
Source: Bank of International Settlements Basel, Triennial Central Bank Survey 2007
3. Exchange Rates and Foreign Exchange Markets Econ 103, c© M. Muendler
Key Notions in Foreign Exchange Markets
• Spot and forward exchange rates
– Spot exchange rate: for trade “on the spot” (at the same instant)
– Forward exchange rate: for future exchange at contracted date
• No arbitrage (due to international market integration)
– Example of an arbitrage: E (USD/GBP) is 1.60 in New York but 1.59 in London. Buy USD in N.Y., sell in London. Alternatively, buy GBP in London, sell in N.Y.
• The foreign exchange market is in equilibrium when deposits of all currencies offer the same return at all time horizons
3. Exchange Rates and Foreign Exchange Markets Econ 103, c© M. Muendler
No Arbitrage and Interest Parity Conditions
• No arbitrage: There cannot be a ‘free lunch’ in market equilibrium A free lunch would invite speculators (arbitrageurs). When all prices can adjust
freely, speculative activity (arbitrage) restores equilibrium at an equilibrium price
• Interest parity conditions
– Covered Interest Parity (must hold in absence of arbitrage)
– Uncovered Interest Parity (holds if markets efficient and agents risk neutral)
– Real Interest Parity (holds under additional conditions)
3. Exchange Rates and Foreign Exchange Markets Econ 103, c© M. Muendler
The Futures Exchange Market
• Forward contract: Individual contract to exchange one currency for another at a future date but at a rate determined now
– Determine that your contract partner pay 1 JPY to you (or to someone of your choice) on a specific day in the future (tomorrow, 30 days, 90 days, 1 year)
– To close the contract, agree to pay F dollars to your contract part- ner on that future day
• Standardized forward contracts publicly traded and called ‘Futures’ Examples. 30-, 60, 90-day future contracts for USD-EUR, USD-JPY, USD-GBP.
3. Exchange Rates and Foreign Exchange Markets Econ 103, c© M. Muendler
Covered Interest Parity
• Covered Interest Parity: (1 + R) = (1 + R∗)(1 + F−E E
)
• No arbitrage in the forward exchange market (futures market)
• Returns on USD and foreign deposits are related to (see note)
– Gross return on a USD deposit: 1 + R (R interest rate)
– Gross return on a JPY deposit: 1 + R∗ (R∗ foreign interest rate)
– Spot exchange rate: E (USD/JPY)
– Forward exchange rate: F (USD/JPY)
3. Exchange Rates and Foreign Exchange Markets Econ 103, c© M. Muendler
Covered Interest Parity
• Covered Interest Parity: (1 + R) = (1 + R∗)(1 + F−E E
)
• F−E E
: Forward premium of JPY against USD
– Negative forward premium, F < E: Anticipated USD appreciation against JPY
– Positive forward premium, F > E: Anticipated USD depreciation against JPY
• Covered Interest Parity is also said to mean
R = R∗ + F − E
E This is true for small R∗ and F−E
E (we will come to this next lecture)
3. Exchange Rates and Foreign Exchange Markets Econ 103, c© M. Muendler
Covered Interest Parity
• An arbitrage is a profit without investment and without risk
• There cannot be an arbitrage in equilibrium: If there is no investment and no risk, there cannot be a profit
• (1 + R) > (1 + R∗)(1 + F−E E
) means (1 + R) > (1 + R∗)F E
Claim: If this were true, then there would be an arbitrage opportunity
• Note: An American investor who lends 1 JPY to a Japanese investor for 30 days can exchange the JPY repayment that is due in 30 days at F and enter a contract over F USD with any other investor today.
3. Exchange Rates and Foreign Exchange Markets Econ 103, c© M. Muendler
Covered Interest Parity
• Consider the following arbitrage opportunity
1. Borrow 1 JPY in Japan for 30 days. In 30 days, pay back JPY 1 + R∗ (start )
2. Enter forward contract: Agree to pay USD F(1+R∗) in 30 days and have your contract partner pay JPY 1 + R∗ in 30 days (no future risk )
3. Exchange the borrowed 1 JPY for E USD on the spot market (no spot risk )
4. Lend out E USD on the US market for E(1 + R) in 30 days (no investment )
5. Receive E(1 + R), pay F(1 + R∗), and keep the rest (a profit )
• There is a rest, an arbitrage, if (1 + R) > (1 + R∗)F E
!
3. Exchange Rates and Foreign Exchange Markets Econ 103, c© M. Muendler
Covered Interest Parity
• Covered Interest Parity: (1 + R) = (1 + R∗)(1 + F−E E
)
Or,
R = R∗ + F − E
E
No arbitrage in the forward exchange market (futures market)
• Market participants trace E and F . Should Covered Interest Parity fail at any moment, arbitrageurs will reap the profit.
In our example where (1 + R) > (1 + R∗)F E
, arbitrageurs borrow JPY and invest in USD for the higher return. So, they bid for and appreciate the USD (reducing E) until equality is restored.
International Monetary Relations
Lecture 4 c© Marc-Andreas Muendler
University of California, San Diego
April 10, 2014
4. An Asset Approach to the Exchange Rate Econ 103, c© M. Muendler
Asset Returns, Risk and Liquidity
• Investors care about an asset’s return, its risk and its liquidity
• Asset Return: The percentage increase in the value of an asset over a given time period
• Risk : The variability of an asset’s return and a saver’s wealth
• Liquidity : The ease at which an asset can be sold or exchanged for goods
• Our focus lies on the Asset Return
4. An Asset Approach to the Exchange Rate Econ 103, c© M. Muendler
The Asset Return to Currency Deposits
• Interest Rate
– Currency deposits yield the going interest rate of securities in that currency: R∗
– Example: At a EUR interest rate of 5% per year, an investor receives EUR 1.05 after a year (1 + R∗ = 1 + .05)
• Changes in Currency Value
– Currencies fluctuate in value. They appreciate and depreciate
– The expected rate of depreciation of a USD over a given time period is
Ê e − E
E
4. An Asset Approach to the Exchange Rate Econ 103, c© M. Muendler
The Asset Return to Currency Deposits
• Changes in Currency Value: The Expected Rate of Depreciation
– The expected rate of depreciation of a USD is Ê e −E
E
– An investor with 1 EUR expects to hold EUR worth 1 + Ê e −E
E USD in a year
– Example: At its introduction, the EUR is calculated to be worth 1 USD.
If the USD is expected to depreciate from 1 USD/EUR to 1.10 USD/EUR, the expected return on holding 1 EUR in a year is 1.10 (1 + Ê
e −E
E = 1 + 1.10−1
1 )
4. An Asset Approach to the Exchange Rate Econ 103, c© M. Muendler
Recall: Covered Interest Parity
• Covered Interest Parity: (1 + R) = (1 + R∗)(1 + F−E E
)
Or,
R = R∗ + F − E
E
No arbitrage in the forward exchange market (futures market)
• Market participants trace E and F . Should Covered Interest Parity fail at any moment, arbitrageurs will reap the profit.
If (1 + R) > (1 + R∗)F E
, arbitrageurs borrow JPY and invest in USD for the higher return. So, they bid for and appreciate the USD (reducing E) until equality is restored.
4. An Asset Approach to the Exchange Rate Econ 103, c© M. Muendler
Uncovered Interest Parity (UIP)
• Uncovered Interest Parity: (1 + R) = (1 + R∗)(1 + Ê e −E
E )
• In an efficient financial market, a currency’s expected depreciation or appreciation should make up for differences in interest rates
• Returns on USD deposits and foreign deposits are related to
– Gross return on a USD deposit: 1 + R (R interest rate)
– Gross return on a EUR deposit: 1 + R∗ (R∗ foreign interest rate)
– Spot exchange rate: E (USD/EUR)
– Expected exchange rate: Êe (USD/EUR)
4. An Asset Approach to the Exchange Rate Econ 103, c© M. Muendler
Uncovered Interest Parity (UIP)
• Suppose (1 + R) > (1 + R∗)Ê e
E
– A USD deposit would yield more than a EUR deposit
– Investors would sell EUR for USD and bid up the spot rate E until (1 + R) = (1 + R∗)Ê
e
E
• This is not a strict no-arbitrage argument but it is closely related
• Ê e is not quoted anywhere, Êe is not a price to trade on (‘uncovered’)
• In contrast to Covered Interest Parity, UIP may fail
4. An Asset Approach to the Exchange Rate Econ 103, c© M. Muendler
Uncovered Interest Parity (UIP)
• Suppose (1 + R) > (1 + R∗)Ê e
E
– The spot rate E will be bid up until (1 + R) = (1 + R∗)Ê
e
E
• Key conditions for (1 + R) = (1 + R∗)Ê e
E (UIP) to be restored
– Financial markets are efficient so that everyone holds the same information about Êe
– Investors are risk neutral and only concerned with the level of Êe, not the risk (variance) around the expected level
4. An Asset Approach to the Exchange Rate Econ 103, c© M. Muendler
Uncovered Interest Parity (UIP)
• A simplified version of UIP is
R = R∗ + Ê
e − E
E Dollar (net) return = Foreign currency (net) return
• The two versions are approximately the same
(1 + R) = (1 + R∗)(1 + Ê
e − E
E )
1 + R = 1 + R∗ + Ê
e − E
E + R∗ ·
Ê e − E
E
R = R∗ + Ê
e − E
E
because R∗ · Ê e −E
E is a very small number
4. An Asset Approach to the Exchange Rate Econ 103, c© M. Muendler
Interest Parity and Exchange Rate Determination
• CIP mostly serves to price F , given R, R∗ and E. But what determines E?
• UIP: If we have a theory of R, R∗ and Êe, then we know E. Take R and R∗ as given.
• Consider Êe as the long-term anchor: widely shared exchange-rate expectations. Then,
R = R∗ + Ê
e − E
E
E = (R∗ − R) · E + Êe.
4. An Asset Approach to the Exchange Rate Econ 103, c© M. Muendler
Uncovered Interest Parity and the Spot Exchange Rate
Time
R<R* R>R*
N o m
in a l E x c h a n g e R
a te
4. An Asset Approach to the Exchange Rate Econ 103, c© M. Muendler
Spot Exchange Rate and Expected Currency Return
0
E
R +(E -E)/E * e
Expected currency return
S p o t
e x c h a n g e r
a te
.
..
.
4. An Asset Approach to the Exchange Rate Econ 103, c© M. Muendler
Uncovered Interest Parity
0
E
R +(E -E)/E * e
Expected currency return
S p o t
e x c h a n g e r
a te
.
..
.
4. An Asset Approach to the Exchange Rate Econ 103, c© M. Muendler
Increase of USD interest rate
0
E
R +(E -E)/E * e
Expected currency return
S p o t
e x c h a n g e r
a te
.
..
.
4. An Asset Approach to the Exchange Rate Econ 103, c© M. Muendler
Increase of foreign currency’s interest rate
0
E
R +(E -E)/E * e
Expected currency return
S p o t
e x c h a n g e r
a te
.
..
.
4. An Asset Approach to the Exchange Rate Econ 103, c© M. Muendler
Increase in expected future exchange rate
0
E
R +(E -E)/E * e
Expected currency return
S p o t
e x c h a n g e r
a te
.
..
.
4. An Asset Approach to the Exchange Rate Econ 103, c© M. Muendler
Empirical Results on Interest Parity
• Whereas CIP is confirmed in careful empirical studies, UIP is often shown to fail empirically.
• Why does UIP fail? (Why does technical analysis generate returns?)
– Information is not processed efficiently
– There is a risk premium in currency returns, beyond mere interest rates
– Exchange rates may contain bubbles or non-fundamental information (Menkhoff & Taylor 2007)
– If the spot exchange rate follows a random walk, tests don’t work
– Expectations may assign a small probability to a large devaluation, this can cause tests to go wrong (“peso problem”)
4. An Asset Approach to the Exchange Rate Econ 103, c© M. Muendler
How Efficient Are Currency Markets?
• Federal Reserve Chairman Alan Greenspan, November 2003: (21st Annual Monetary Conference Washington DC, November 20, 2003)
“My experience is that exchange markets have become so effi- cient that virtually all relevant information is embedded almost instantaneously in exchange rates to the point that anticipating movements in major currencies is rarely possible.”
• Deutsche Bank G10 Currency Future Harvest Index: Associated fund that replicates currency Carry Trade. Back-tests show noteworthy returns.
International Monetary Relations
Lecture 5 c© Marc-Andreas Muendler
University of California, San Diego
April 15, 2014
5. A Monetary Approach to the Exchange Rate Econ 103, c© M. Muendler
Monetary Conditions and Exchange Rates
• Objective: Combined model of money and foreign exchange markets Monetary conditions are important determinants of exchange rates
• Domestic monetary conditions affect R and therefore E through UIP UIP is taken to be satisfied
• Review: Three basic functions of money
– Medium of exchange
– Unit of account
– Store of value
5. A Monetary Approach to the Exchange Rate Econ 103, c© M. Muendler
The Value of Money Holdings
• Money is an asset
– Return: Small (and negative if inflation)
– Risk: Not different from inflation or deflation risk in other nominal assets
– Liquidity: High (except during hyper-inflation)
• Alternative assets determine the opportunity of cost of money
– Domestic bonds yield R
– Opportunity cost of money holding: R (R = re + πe) (positive opportunity cost is negative return)
– A rise in the nominal interest rate R tends to reduce money demand
5. A Monetary Approach to the Exchange Rate Econ 103, c© M. Muendler
Money Supply and Central Banks
• Money supply is controlled by the central bank
– CB directly regulates amount of currency in circulation
– CB indirectly affects other aggregates of money (M1, M2, M3)
• Policy instruments: The central bank can
– engage in open market transactions
– set the interest rate at which commercial banks refinance
– change deposit requirements for commercial banks
5. A Monetary Approach to the Exchange Rate Econ 103, c© M. Muendler
Central Bank Balance Sheet
Assets Liabilities
B CB
(domestic assets)
M S (monetary base)W
CB (foreign assets)
Other Assets (gold, SDRs)
Net Worth (asset price corrections)
5. A Monetary Approach to the Exchange Rate Econ 103, c© M. Muendler
Example: Open-market Intervention to Increase Monetary Base
Assets Liabilities
B CB
(domestic assets)
M S (monetary base)W
CB (foreign assets)
5. A Monetary Approach to the Exchange Rate Econ 103, c© M. Muendler
Real Money Demand
• Households’ nominal money demand is determined by
– Nominal interest rate R (bond yield)
– Real national income Y GNI
– Price level P
• Nominal money demand MD:
M D = P · L(R
(−)
, Y
(+)
)
• Real money demand (also ‘liquidity preference’): M D
P = L(R, Y )
5. A Monetary Approach to the Exchange Rate Econ 103, c© M. Muendler
Bond Yields and Monetary Policy
• Face value of a bond: A $1 bond has $1 face value (and return R̄)
• Bonds trade at discounts of their face value Example: At a 20% discount, a $1 bond costs 80 cents (80% of $1)
• Yield of a bond at 20% discount: 1+R = 1+R̄ .8
= 1.25(1+R̄)
• When the CB purchases bonds, it reduces the yield Reason: The CB bids up the bond price and reduces the discount Example: At 10% discount, the $1 bond yields only 1+R = 1+R̄
.9 ≈ 1.11(1+R̄)
5. A Monetary Approach to the Exchange Rate Econ 103, c© M. Muendler
Aggregate Real Money Demand
0
Real money holdings
N o m
in a l in
te re
s t
ra te
5. A Monetary Approach to the Exchange Rate Econ 103, c© M. Muendler
Money Market Equilibrium
0
Real money holdings
N o m
in a l in
te re
s t
ra te
5. A Monetary Approach to the Exchange Rate Econ 103, c© M. Muendler
Increase in real national income Y GNP
0
Real money holdings
N o m
in a l in
te re
s t
ra te
5. A Monetary Approach to the Exchange Rate Econ 103, c© M. Muendler
Short-term and Long-term Effects of Monetary Policy
• Short-term
– Prices are sticky
– Monetary policy has a real impact
• Long-term
– Prices are fully flexible, R is determined by real variables
– Monetary policy has no real impact
5. A Monetary Approach to the Exchange Rate Econ 103, c© M. Muendler
Increase in real money supply under sticky prices
0
Real money holdings
N o m
in a l in
te re
s t
ra te
5. A Monetary Approach to the Exchange Rate Econ 103, c© M. Muendler
Increase in real money supply under flexible prices
0
Real money holdings
N o m
in a l in
te re
s t
ra te
5. A Monetary Approach to the Exchange Rate Econ 103, c© M. Muendler
5. A Monetary Approach to the Exchange Rate Econ 103, c© M. Muendler
Background : Money Supply and Central Banks
• Seignorage
– The only persistent (and large-scale) arbitrage in an economy
– The central bank receives valuable assets for fiat money
• The monetary base and money supply are not quite the same
– Monetary aggregates such as M1, M2, M3 evolve on top of the monetary base
– Minimum deposit requirements for commercial banks limit their buildup Example:
A commercial bank receives USD 1,000 from CB and lends it out The borrower goes on to purchase a good for USD 1,000 The seller of that good deposits 1,000 USD with her bank, which that bank lends out, ... This infinite process can only be limited with minimum reserve requirements
International Monetary Relations
Lecture 6 c© Marc-Andreas Muendler
University of California, San Diego
April 17, 2014
6. Monetary Policy and Exchange Rate Determination Econ 103, c© M. Muendler
Money and Foreign Exchange Market Equilibrium
• Combined model of money and currency markets Monetary conditions are fundamental determinants of exchange rates
• Simultaneous money market and foreign exchange equilibrium
• Domestic monetary conditions affect R and therefore E through Uncovered Interest Parity UIP is taken to be satisfied
6. Monetary Policy and Exchange Rate Determination Econ 103, c© M. Muendler
Spot Exchange Rate and Expected Currency Return
0
Interest rate and expected currency return
E x c h a n g e r
a te
R e a l m
o n e y h
o ld
in g s
6. Monetary Policy and Exchange Rate Determination Econ 103, c© M. Muendler
Money and Foreign Exchange Market Equilibrium
• Model determines money and foreign exchange market equilibrium
• Emphasis on domestic money market Similar foreign money market in the background
• Domestic monetary conditions affect R and therefore E Foreign monetary conditions affect R∗ and therefore E
• Exchange rate response depends on degree of price flexibility
– Short-term: Sticky prices
– Long-term: Flexible prices
6. Monetary Policy and Exchange Rate Determination Econ 103, c© M. Muendler
Temporary increase in domestic money supply under sticky prices
0
Interest rate and expected currency return
E x c h a n g e r
a te
R e a l m
o n e y h
o ld
in g s
6. Monetary Policy and Exchange Rate Determination Econ 103, c© M. Muendler
Temporary increase in foreign money supply under sticky prices
0
Interest rate and expected currency return
E x c h a n g e r
a te
R e a l m
o n e y h
o ld
in g s
6. Monetary Policy and Exchange Rate Determination Econ 103, c© M. Muendler
Temporary Changes to the Money Supply
• Sticky prices and temporary changes With temporary changes, exchange rate expectations do not change
• A temporary increase in the domestic money supply causes a short-term USD depreciation because the domestic interest rate falls. A temporary increase in the foreign money supply causes a short-term USD appreciation because the foreign interest rate falls
• In the long term, temporary policies are reversed and have no impact
• Under flexible prices neither interest rates nor the exchange rate would change
6. Monetary Policy and Exchange Rate Determination Econ 103, c© M. Muendler
A Preview of the Long Term: E traces P
• A high domestic price level P causes a depreciated (high) nominal exchange rate E in the long term
Reason. Given any exchange rate E, a higher P makes exports rel- atively expensive for foreigners and imports relatively inexpensive for domestic residents. The ensuing trade flows cause the exchange rate E to depreciate until it makes up for the rise in P .
Lectures 8 and 9 on the real exchange rate will clarify this relationship.
• A higher foreign price level P ∗ or a lower domestic price level P cause the nominal exchange rate E to appreciate (lower E) in the long term
6. Monetary Policy and Exchange Rate Determination Econ 103, c© M. Muendler
Permanent Changes to the Money Supply
• Permanent changes have both short-term and long-term effects
• With permanent changes, exchange rate expectations do change
• In the long term, prices are flexible
• A permanent increase in the money supply causes a higher domestic price level in the long term
• A higher domestic price level causes the nominal exchange rate to depreciate in the long term (see lectures 8 and 9 on the real exchange rate)
6. Monetary Policy and Exchange Rate Determination Econ 103, c© M. Muendler
Permanent increase in domestic money supply under sticky prices
0
Interest rate and expected currency return
E x c h a n g e r
a te
R e a l m
o n e y h
o ld
in g s
6. Monetary Policy and Exchange Rate Determination Econ 103, c© M. Muendler
Permanent Changes and Overshooting
• Sticky prices and permanent changes With permanent changes, exchange rate expectations do change
• In the short term, a permanent increase in domestic money supply causes a USD depreciation because the domestic interest rate falls
• In the long term, a permanent increase in domestic money supply causes less USD deprecation because the domestic interest rate re- turns to its long-term level
• Under flexible prices neither interest nor exchange rates change
6. Monetary Policy and Exchange Rate Determination Econ 103, c© M. Muendler
Overshooting: The exchange rate does the job that sticky prices don’t do
0
R
Time
M S
0
0
E
P
0
t
tt
t
International Monetary Relations
Lecture 7 c© Marc-Andreas Muendler
University of California, San Diego
April 22, 2014
7. Purchasing Power Parity and the Monetary Approach Econ 103, c© M. Muendler
Short-term Exchange Rate Behavior
• Framework for determining spot exchange rates
• Expectations of long-term movements matter in the short term
• Key ingredients of short-term asset approach
– Uncovered Interest Parity R = R∗ + Ê e −E E
– Money market equilibrium M S
P = L (R, Y )
• Overshooting of exchange rate (Sticky prices cause short-term responses in interest rate and exchange rate)
7. Purchasing Power Parity and the Monetary Approach Econ 103, c© M. Muendler
Spot Exchange Rate Changes and Price Level Changes USD/DEM C
h a
n g
e s
in U
S D
/D E
M
End of Month
Monthly change in exchange rate Monthly change in CPI ratio
31jan1987 31jan1991 31jan1995 31jan1999 31dec2002
−.125
−.1
−.075
−.05
−.025
0
.025
.05
.075
.1
Source: www.globalfindata.com
7. Purchasing Power Parity and the Monetary Approach Econ 103, c© M. Muendler
Long-term Exchange Rate Behavior
• Framework for forecasting future exchange rates
• Expectations of long-term movements matter for the short term (Part of the short-term asset approach to the exchange rate)
• Purchasing Power Parity (PPP) theory allows for a Long-term Monetary Approach to the Exchange Rate
– A theory to explain movements in the nominal exchange rate with changes in the countries’ price levels
– Real Interest Rate Parity depends on Purchasing Power Parity (next lecture)
7. Purchasing Power Parity and the Monetary Approach Econ 103, c© M. Muendler
Nominal Exchange Rate Moves and Price Level Changes USD/DEM U
S D
/D E
M
End of Month
Exchange rate USD/DEM CPI USD / CPI DEM
31dec1971 31dec1979 31dec1987 31dec1995 31dec2002
0
.25
.5
.75
1
1.25
Source: www.globalfindata.com ()
7. Purchasing Power Parity and the Monetary Approach Econ 103, c© M. Muendler
The Exchange Rate in the Long Term
• Objective: Determine the long-term behavior of the exchange rate.
• Three no-arbitrage conditions for international goods markets
– The Law of One Price (most restrictive, implies both following conditions)
– Absolute Purchasing Power Parity (implies only the following condition)
– Relative Purchasing Power Parity (least restrictive, least likely to fail)
• These conditions relate the exchange rate to goods markets. However, overall price levels are driven by monetary conditions
7. Purchasing Power Parity and the Monetary Approach Econ 103, c© M. Muendler
Review : Domestic Price Level in the Long Term
• Quantity Theory of Money (with velocity of money v):
M S · v = P · Y GNI.
So, in the long term (for given national income Y GNI and v)
M S /P = const. or MS/P = L
(
R, Y GNI
)
• Statistical offices measure the overall price level P as
P = α1p1 + α2p2 + . . . + αipi + . . . + αNpN
with the consumption-basket weights α1, . . . , αN
7. Purchasing Power Parity and the Monetary Approach Econ 103, c© M. Muendler
Long-term Exchange Rate Behavior
• The real exchange rate q
– is defined as q ≡ EP ∗
P
– expresses the relative price of a foreign consumption basket in terms of a domestic consumption basket
– helps express the concept of Purchasing Power Parity (PPP)
– has no unit (expresses a ratio of ‘real’ quantities [1])
– depreciates when it increases, appreciates when it decreases
7. Purchasing Power Parity and the Monetary Approach Econ 103, c© M. Muendler
The Law of One Price
• Identical goods should sell at the same prices in different countries (when expressed in the same currency units)
– Formally, the Law of One Price states that, for every good i,
pi = Ep ∗
i .
Example: At a USD/GBP exchange rate of 1.50, a pair of jeans that costs GBP
20 in Great Britain should sell at USD 30 in the US.
• The Law of One Price is a no-arbitrage condition for goods markets.
However, arbitrage opportunities can persist when markets are not competitive, trade barriers exist or transport costs are high.
7. Purchasing Power Parity and the Monetary Approach Econ 103, c© M. Muendler
Absolute Purchasing Power Parity
• Identical consumption baskets should sell at the same price in all countries (when expressed in the same currency units)
• In other words, the real exchange rate q should be equal to unity (1)
– Formally, if q = 1, then P = EP ∗.
– Absolute PPP is a weaker statement than the Law of One Price because Absolute PPP only applies to an average of commodity prices, not to every individual price
– If the Law of One Price holds, Absolute PPP must be satisfied
7. Purchasing Power Parity and the Monetary Approach Econ 103, c© M. Muendler
Relative Purchasing Power Parity
• The relative price of identical consumption baskets in different coun- tries should remain constant (when expressed in same currency units)
• In other words, the real exchange rate q should be constant
– Formally, relative PPP holds if q e −q q
= 0.
– Relative PPP is a weaker statement than both the Law of One Price and Absolute PPP because Relative PPP only applies to price changes
– If the Law of One Price holds or Absolute PPP holds, Relative PPP must be satisfied
7. Purchasing Power Parity and the Monetary Approach Econ 103, c© M. Muendler
Aside: Calculating Changes in Variables
• Products and ratios of variables can be transformed into sums and differences of the (marginal) changes in these variables
• Rule: If XY = Z, then X e −X X
+ Y e −Y Y
= Z e −Z Z
• Alternate rule: If X/Y = Z, then X e −X X
− Y e−Y
Y = Z
e −Z Z
• Proof : XY = Z. So, log X + log Y = log Z. Differentiate w.r.t. time t. d log X
dt +
d log Y
dt =
d log Z
dt dX
X +
dY
Y =
dZ
Z
7. Purchasing Power Parity and the Monetary Approach Econ 103, c© M. Muendler
The Monetary Approach to the Exchange Rate
• The Monetary Approach to the Exchange Rate is an extension to the (short-term) Asset Approach
• The Monetary Approach relies on three fundamental ingredients
– Uncovered Interest Parity R − R∗ = Ê e −E E
– Money market equilibrium M S
P = L
(
R, Y GNI )
– Relative Purchasing Power Parity: q e −q q
= 0.
• UIP and money market equilibrium are the same as in the asset approach.
7. Purchasing Power Parity and the Monetary Approach Econ 103, c© M. Muendler
The Monetary Approach: UIP and Relative PPP
• Main Insight : Relative PPP implies the Long-term Condition
Êe − E
E = πe − π∗,e
where πe is the expected inflation rate at home, and π∗,e expected inflation abroad
• Proof : Apply the rule of changes to q ≡ EP ∗
P . So,
qe−q q
= Ê e −E E
+ P ∗,e
−P ∗
P ∗ −
P e−P P
= 0.
By UIP R − R∗ = Ê e −E E
, we have the Fisher effect R − R∗ = πe − π∗,e. The interest differential must equal the inflation differential
7. Purchasing Power Parity and the Monetary Approach Econ 103, c© M. Muendler
The Monetary Approach: Money Supply Growth
• Interpretation of the Long-term Condition: Ê e −E E
= πe − π∗,e
• The Money Market Equilibrium M S
P = L(·) implies P = MS/L(·),
πe = M S,e
−MS
MS −
Le−L L
and π∗,e = M S,∗,e
−MS,∗
MS,∗ −
L∗,e−L∗
L∗
• Together with Relative PPP, we obtain
Êe−E E
=
(
MS,e−MS
MS −
Le−L L
)
−
(
MS,∗,e−MS,∗
MS,∗ −
L∗,e−L∗
L∗
)
The expected nominal depreciation equals the difference in monetary tightness
7. Purchasing Power Parity and the Monetary Approach Econ 103, c© M. Muendler
Policy Change: Accelerated Money Supply Growth
• Money supply initially grows at a rate π = M S,next period
−MS
MS .
Now, supply growth is accelerated to π + ∆π. (Domestic GNI is constant, and so are foreign conditions.)
• By the Fisher effect: R′ = R + ∆π. (R − R∗ = πe − π∗,e)
• The price level P = MS/L(·) must jump up initially to accommodate the immediate fall in L (R, Y ). Recall that MS does not jump. Then P rises continuously at the rate π + ∆π.
• Long-term Condition: E subsequently traces the price level P .
7. Purchasing Power Parity and the Monetary Approach Econ 103, c© M. Muendler
Accelerated Money Growth: Inflation and Depreciation Responses
0
R
Time
M S
0
0
E
P
0
t
tt
t
P
7. Purchasing Power Parity and the Monetary Approach Econ 103, c© M. Muendler
Single Money Supply Shift: Price and Exchange Rate Responses
0
R
Time
M S
0
0
E
P
0
t
tt
t
7. Purchasing Power Parity and the Monetary Approach Econ 103, c© M. Muendler
Predictions of the Long-term Model
• Money supply: An increase in domestic money supply causes a pro- portional long-term depreciation of the USD
• Output and Income levels: A rise in US income (Y GNI) causes an appreciation of the USD
• Interest rates: A rise in the long-term interest rate of USD deposits is associated with a depreciation of the USD by the Fisher effect R − R∗ = πe − π∗,e. This is the opposite effect of a monetary supply shock in the short-term model.
UIP and PPP give rise to the Fisher effect, which ties the international interest rate
differential to an identical inflation differential: R − R∗ = Ê e −E E
= πe − π∗,e.
International Monetary Relations
Lecture 8 c© Marc-Andreas Muendler
University of California, San Diego
April 24, 2014
8. Purchasing Power Parity and the Real Exchange Rate Econ 103, c© M. Muendler
The Monetary Approach to the Exchange Rate
• The Monetary Approach relies on three fundamental ingredients
A. UIP holds: R − R∗ = Ê e −E E
B. Money market equilibrium: M S
P = L(R, Y )
C. Relative PPP holds: q e −q q
= Ê e −E E
+ π∗,e − πe = 0
• Condition C is a pillar of the long-term model and gives rise to the Long-term Condition (Êe − E)/E = πe − π∗,e.
Condition C is played down in the short-term model (it only enters through the back-door of expectations).
8. Purchasing Power Parity and the Real Exchange Rate Econ 103, c© M. Muendler
The Monetary Approach to the Exchange Rate
• The Monetary Approach provides three predictions for the long term
1. Using condition C, (Long-term Condition)
Êe − E
E = πe − π∗,e
2. Using condition B, (as in the short term)
P = MS
L(R, Y )
3. Using conditions A and C, (Fisher effect)
R − R ∗ = πe − π∗,e
8. Purchasing Power Parity and the Real Exchange Rate Econ 103, c© M. Muendler
Evidence on the Law of One Price and PPP
• Though intuitive, the Law of One Price and Purchasing Power Parity frequently fail in real data
• Burgernomics: Under the Law of One Price, McDonald’s burgers and Starbucks coffees should sell at one (exchange-rate adjusted) price everywhere
• Tests for a reversion of the Real Exchange Rate to a long-term level
– Measurement problems affect long-term data
– Up to 100 years of data may be needed to conduct powerful tests
8. Purchasing Power Parity and the Real Exchange Rate Econ 103, c© M. Muendler
Nominal Exchange Rate Moves and Price Level Changes USD/DEM U
S D
/D E
M
End of Month
Exchange rate USD/DEM CPI USD / CPI DEM
31dec1971 31dec1979 31dec1987 31dec1995 31dec2002
0
.25
.5
.75
1
1.25
Source: www.globalfindata.com (P DEM/P USD = 1 on Jan 29, 1999)
8. Purchasing Power Parity and the Real Exchange Rate Econ 103, c© M. Muendler
Nominal Exchange Rate Moves and Price Level Changes USD/DEM U
S D
/D E
M
End of Month
Exchange rate USD/DEM CPI USD / CPI DEM
31dec1923 31dec1939 31dec1955 31dec1971 31dec198731dec2002
0
.25
.5
.75
1
1.25
Source: www.globalfindata.com (P DEM/P USD = 1 on Jan 29, 1999)
8. Purchasing Power Parity and the Real Exchange Rate Econ 103, c© M. Muendler
How to Compare GNI?
• World Bank Atlas method for GNI comparisons
– Atlas method uses three-year moving average conversion
– GNI: GDP plus net flows of factor income
• PPP: account for relative prices of goods and services, particularly non-tradables
– Better overall measure of the real value of output
– PPP GNI: current international dollars equaling dollar spent in U.S. economy
– Basis for the World Bank’s calculations of poverty rates at $1.25 and $2.5 a day
8. Purchasing Power Parity and the Real Exchange Rate Econ 103, c© M. Muendler
GNI Per Capita 2008 Atlas method PPP method
Ranka Country GNI (US $) Rank Country GNI (Intl $) 1 Liechtenstein . . . 3 Norway 87,070 4 Norway 58,500 4 Luxembourg 84,890 2 Luxembourg 64,320 6 Switzerland 65,330 12 Switzerland 46,460 7 Denmark 59,130 25 Denmark 37,280 9 Sweden 50,940 22 Sweden 38,180
14 United States 47,580 11 United States 46,970 22 Germany 42,440 29 Germany 35,940 30 Japan 38,210 32 Japan 35,220 33 Singapore 34,760 10 Singapore 47,940 75 Russian Fed. 9,620 71 Russian Fed. 15,630 82 Brazil 7,350 95 Brazil 10,070
130 China 2,770 122 China 6,020 163 India 1,070 155 India 2,960
a Bermuda, Channel Islands (68,640) and Qatar are 2nd, 5th and 8th ranked but no PPP rank is available.
Source: World Bank Quick Reference Tables, 2010 (posted July 1, 2009)
8. Purchasing Power Parity and the Real Exchange Rate Econ 103, c© M. Muendler
Evidence on the Law of One Price and PPP
• Law of One Price also fails within countries
– US city-level data: Distance explains large part of price difference
– National data: Deviations due to highly responsive E and sticky Pi
• Relative PPP is satisfied in the long-term (among major industrialized countries)
• Reversion of the Real Exchange Rate to its long-term level is slow and jumpy There is a band of unexploited goods-market arbitrage around the long-term level
8. Purchasing Power Parity and the Real Exchange Rate Econ 103, c© M. Muendler
Explanations for the Failure of Absolute PPP
• Firms price to market if markets are not perfectly competitive Price-over-cost markups differ with market size
• Tariffs and non-tariff barriers Tariffs and voluntary or imposed quantity restrictions reduce trade and distort prices
• Transportation costs Empirical difference between FOB and CIF paid by shipper: Up to 10%
FOB: free on board, and CIF: cost freight insurance
• Nontraded goods and productivity shocks
8. Purchasing Power Parity and the Real Exchange Rate Econ 103, c© M. Muendler
Nontraded Goods and Productivity Change
• Productivity changes move the real exchange rate If productivity in the tradable goods sector improves faster than in the nontraded
goods sector, the real exchange rate appreciates
• Think of two types of goods: Cars and nontraded goods
• If productivity of car production improves, the price of nontraded com- modities increases
Reason: A worker in car production produces more cars in the same amount of time. When all production workers exchange the extra- output for nontraded goods, the nontraded goods’ price is bid up.
8. Purchasing Power Parity and the Real Exchange Rate Econ 103, c© M. Muendler
Examples: Productivity and Nontraded Goods
• The real estate example: If local industries in San Diego become more productive, the income level in San Diego increases. This bids up house prices.
• The barber example: During the same work time, a production worker puts out more cars. So, every worker can exchange his or her output for more haircuts. But all production workers can. This bids up prices of haircuts.
• In general : The same labor time to produce a nontraded good is now worth more to production workers.
8. Purchasing Power Parity and the Real Exchange Rate Econ 103, c© M. Muendler
Nontraded Goods and Productivity Change
• If productivity in the tradable goods sector improves faster than in the nontraded goods sector, the real exchange rate appreciates Reason: The domestic price of nontraded goods increases
• Real exchange rate: q = EP ∗
P =
E(a∗T P̄ ∗
T +a∗
NT P ∗ NT )
aT P̄T +aNT PNT
– P̄T = EP̄ ∗
T : World-wide price of tradable goods
– PNT : Domestic price of nontraded goods, P ∗ NT
: Foreign price of nontraded goods
– ai = a ∗
i : Weights of goods in commodity baskets
8. Purchasing Power Parity and the Real Exchange Rate Econ 103, c© M. Muendler
Real Exchange Rate USD/JPY R
e a
l E xc
h a
n g
e R
a te
U S
D /J
P Y
End of Month 31jan1950 31jan1958 31jan1966 31jan1974 31jan1982 31jan1990 31dec2002
.25
.5
.75
1
1.25
1.5
Source: www.globalfindata.com (qUSD/JPY = 1 on Jan 29, 1999)
8. Purchasing Power Parity and the Real Exchange Rate Econ 103, c© M. Muendler
The Balassa-Samuelson Effect
• Countries differ in their traded-goods sector productivity. This is an explanation of long-term deviations from PPP
• Empirically, countries with high per-capita incomes have higher price levels than low-income countries (Balassa and Samuelson 1964) Reason. Rich countries are relatively more productive in the tradable goods sector. Historically, agriculture and raw materials exhibit the fastest productivity growth,
followed by manufactures.
• Higher productivity in the traded-goods sector can stem from low capital-labor ratios in services or from low total factor productivity
8. Purchasing Power Parity and the Real Exchange Rate Econ 103, c© M. Muendler
The Monetary Approach Beyond PPP
• The Monetary Approach relies on three fundamental ingredients
A. UIP holds: R − R∗ = Ê e −E E
B. Money market equilibrium: M S
P = L(R, Y )
C′. Relative PPP fails: q e −q q
= Ê e −E E
+ π∗,e − πe 6= 0
• The modified condition C provides a version of the long-term model when PPP fails
8. Purchasing Power Parity and the Real Exchange Rate Econ 103, c© M. Muendler
Beyond PPP: Long-term Exchange Rate Models
• Nominal exchange rate: E = q P P ∗
Real exchange rate: q = EP ∗
P
– Monetary policy shocks only affect E and P P ∗
for q =const. Apply the Monetary Approach to the nominal exchange since PPP is satisfied
– Shocks to supply of US tradable goods production and to productivity affect q and P Higher productivity in US tradable goods production makes q appreciate
– Shocks to relative demand for US tradable goods affect q Higher demand for US export goods makes q appreciate (reduces q)
In particular, increased fiscal demand makes q appreciate (lecture 11)
8. Purchasing Power Parity and the Real Exchange Rate Econ 103, c© M. Muendler
Beyond PPP: Real Interest Parity
• Real Interest Parity
re − r∗,e = qe−q q
• In equilibrium, a real interest rate differential must be compensated by an expected real depreciation
• Derivation (R = re + πe)
– q = EP ∗
P . Apply rule of changes: q
e −q
q = Ê
e −E E
+ π∗,e − πe
– Use UIP: R − R∗ = Ê e −E E
. So, (re + πe) − (r∗,e + π∗,e) = q e −q
q − π∗,e + πe
8. Purchasing Power Parity and the Real Exchange Rate Econ 103, c© M. Muendler
The Long-term Monetary Approach
• The asset approach to exchange rates takes interest rates as given
• A monetary approach incorporates interest rates and can help ex- plain nominal exchange rate moves in the short term (overshooting)
• Combined with (relative) PPP, the monetary approach can help ex- plain nominal exchange rate trends in the long term
• Empirically, changes in real exchange rates invalidate PPP. However, at the very long horizon PPP seems to be satisfied when correcting for effects in the spirit of Balassa-Samuelson
8. Purchasing Power Parity and the Real Exchange Rate Econ 103, c© M. Muendler
Backup
8. Purchasing Power Parity and the Real Exchange Rate Econ 103, c© M. Muendler
The Terms of Trade and the Real Exchange Rate
• Barter Terms of Trade (ToT ): The average world-market price of a country’s exports goods divided by the average world-market price of its import goods
ToT = pEX
E · pEX∗ .
• Real Exchange Rate (q): The relative price of a foreign commodity basket in terms of a domestic commodity basket
q ≡ E · P ∗
P =
αXE p ∗
EX∗ + αME p ∗
EX + αNE p ∗
N
αX pEX + αM pEX∗ + αN pN .
8. Purchasing Power Parity and the Real Exchange Rate Econ 103, c© M. Muendler
Current Account Value and Trade Volumes
• Current account value in terms of home goods (precise definition):
CA = EX − IM = EX − (1/ToT) · EX∗.
because home import value IM = (1/ToT) · EX∗.
• In the short-term, when prices are sticky, a real appreciation (drop in q) and an improvement in the terms of trade (rise in ToT ) are qualita- tively the same.
• Current account value in terms of home goods (approximation):
CA = EX − IM = EX − q · EX∗.
International Monetary Relations
Lecture 9 c© Marc-Andreas Muendler
University of California, San Diego
May 1, 2014
9. Flexible Exchange Rates and Output in the Short Term Econ 103, c© M. Muendler
Macroeconomic Changes and Their Output Effect
• Nominal interest rates, exchange rates and price levels can affect output in the short term (Prices are slow to adjust and PPP breaks down in the short term)
• Effects of macroeconomic policies on output and the current account
• Non-financial view on the current account
– So far, CA = S − I has played the dominant role
– Now we consider the flip-side of the coin: CA ≈ EX − IM
9. Flexible Exchange Rates and Output in the Short Term Econ 103, c© M. Muendler
Aggregate Demand and the Exchange Rate
• A short-term model of aggregate demand and the exchange rate
• Objective: Investigate the simultaneous effect of policies on the ex- change rate and output. Building blocks:
(i) Stylized model of aggregate demand
(ii) Monetary approach to the real exchange rate q
• Similar to IS − LM framework, but one key difference in our model: Investment I taken as unaffected by short-term moves in R (Basic relationship between q and aggregate demand unchanged)
9. Flexible Exchange Rates and Output in the Short Term Econ 103, c© M. Muendler
Determinants of Aggregate Demand
• Aggregate demand: Amount of goods and services demanded by households and firms throughout the world
• Aggregate demand consists of four components
– Consumption C
– Investment demand I
– Government demand G
– Current account CA (net foreign demand)
9. Flexible Exchange Rates and Output in the Short Term Econ 103, c© M. Muendler
Determinants of C and Autonomy of I and G
• Consumption demand increases with disposable income
– Disposable income: Y d = Y GNI − T (T : taxes)
– Consumption: C = C (Y − T (+)
)
• The consumption response to tax changes is less than proportional because some disposable income is saved (C = c · (Y −T), c=.8)
• Investment is unaffected by short-term changes in R: I = Ī (In contrast IS − LM: I = I(R − πe)) Government spending G is autonomous
9. Flexible Exchange Rates and Output in the Short Term Econ 103, c© M. Muendler
Trade-related Determinants of the Current Account
• Current account is taken to be roughly equal to CA = EX − IM. CA, EX, IM are total values in domestic prices
• Two main determinants
– Real exchange rate q = EP ∗
P
– Domestic disposable income Y − T Higher domestic income results in higher spending on imports
So, CA = CA( q (?)
,Y − T (−)
)
9. Flexible Exchange Rates and Output in the Short Term Econ 103, c© M. Muendler
The Real Exchange Rate and the Current Account
• Since IM = q · EX∗, the current account is
CA = EX(q) − IM(q) = EX ( q (+)
) − q · EX∗ ( q (−)
)
• EX depends positively and EX∗ negatively on q When q depreciates, domestic goods become less expensive for foreigners
• The effect of a q-depreciation on CA through EX is positive
• The effect of a q-depreciation on CA through IM is ambiguous: Positive volume effect (EX∗(q)), negative value effect (q)
9. Flexible Exchange Rates and Output in the Short Term Econ 103, c© M. Muendler
The Real Exchange Rate and the Current Account
• Volume effect: As the real exchange rate depreciates, domestic products become relatively less
expensive, foreign products relatively more expensive for residents anywhere.
So, in the short-to-medium term the quantities (volume) of domestic exports in-
crease. Equivalently, the quantities (volume) of foreign exports decrease. For given
prices, EX rises, and IM and EX∗ fall.
• Value effect: (more on this in lecture 11) In the immediate short term, contracted quantities of exports do not respond.
As the real exchange rate depreciates, the relative value (price x quantity) of given
quantities of domestic exports EX decreases. Equivalently, for foreigners the rela-
tive value (price x quantity) of given quantities of their exports EX∗ increases.
9. Flexible Exchange Rates and Output in the Short Term Econ 103, c© M. Muendler
The Aggregate Demand Equation
• We assume: The positive volume effect of q on CA dominates the value effect
• Combining the four components, we find aggregate demand
D = C (Y − T (+)
) + Ī + G + CA( q (+)
, Y − T (−)
)
• We assume: The effect of disposable income on domestic consump- tion is greater than on imports. So,
D = D( Y − T (+)
, Ī (+)
, G (+)
, q (+)
)
9. Flexible Exchange Rates and Output in the Short Term Econ 103, c© M. Muendler
The Real Exchange Rate and Aggregate Demand
• An increase in q raises CA and D
– A depreciation of q makes domestic goods and services cheaper relative to foreign goods and services
– A depreciation of q shifts both domestic and foreign spending towards domestic goods
– A depreciation of q raises aggregate demand for home output (when the volume effect dominates)
• A decrease in q reduces CA and D
9. Flexible Exchange Rates and Output in the Short Term Econ 103, c© M. Muendler
Keynesian Cross
0
D,Y
Y
Output
A g g re
g a te
d e m
a n d a
n d o
u tp
u t
9. Flexible Exchange Rates and Output in the Short Term Econ 103, c© M. Muendler
The Real Exchange Rate and the DD Schedule
• In the short-term, P and P ∗ do not respond. So, PPP breaks down and E moves q = EP
∗
P
• An increase in q raises CA and D in the short term
– A depreciation of q makes domestic goods and services cheaper relative to foreign goods and services
– A depreciation of q shifts both domestic and foreign spending towards domestic goods
– A depreciation of q raises aggregate demand for home output (when the volume effect dominates)
9. Flexible Exchange Rates and Output in the Short Term Econ 103, c© M. Muendler
Depreciation of Real Exchange Rate from q to q′
0
D,Y
Y
Output
A g g re
g a te
d e m
a n d a
n d o
u tp
u t
9. Flexible Exchange Rates and Output in the Short Term Econ 103, c© M. Muendler
Depreciation of Real Exchange Rate from q to q′
0
D,Y
Y
Output
A g g re
g a te
d e m
a n d a
n d o
u tp
u t
Y
D Y-T I G q( , , , )
D Y-T I G q'( , , , )
Y0 Y'
9. Flexible Exchange Rates and Output in the Short Term Econ 103, c© M. Muendler
The DD Schedule
0
q
Y
Output
R e a l e x c h a n g e r
a te
Y=D Y-T I G q( , , , )
9. Flexible Exchange Rates and Output in the Short Term Econ 103, c© M. Muendler
The DD Schedule
0
q
Y
Output
R e a l e x c h a n g e r
a te
very low E
high E
very high E
low E
Y=D Y-T I G q( , , , )
9. Flexible Exchange Rates and Output in the Short Term Econ 103, c© M. Muendler
Short-term Asset Approach to the Exchange Rate
• Uncovered Interest Parity R = R∗ + Ê e
E − 1
By E = qP/P ∗, UIP is R = R∗ + Ê eP ∗
qP − 1
• Domestic Money Market Equilibrium: M S
P = L(R, Y )
• Asset approach therefore relates E to Y , and q to Y
• In the long term, Relative PPP applies and q = q̄ (for any Y )
9. Flexible Exchange Rates and Output in the Short Term Econ 103, c© M. Muendler
Asset Market Equilibrium after a Temporary Increase of Y to Y ′
0
E
R, R + E -E /E * e
( )
Interest rate and expected currency return
E x c h a n g e r
a te
R + E -E /E * e
( )
R
R0
E0
R e a l m
o n e y h
o ld
in g s
M /P, L R Y
S
( , )
M /P S
L R Y( , ) M /P
S
9. Flexible Exchange Rates and Output in the Short Term Econ 103, c© M. Muendler
The QQ Schedule
0
q
Y
Output
R e a l e x c h a n g e r
a te
M =P L R + E /q P /P ,Y S * e *
( )( )( ) -1
9. Flexible Exchange Rates and Output in the Short Term Econ 103, c© M. Muendler
The QQ Schedule
0
q
Y
Output
R e a l e x c h a n g e r
a te
M =P L R + E /q P /P ,Y S * e *
( )( )( ) -1
very high Y
low Y
very low Y
high Y
9. Flexible Exchange Rates and Output in the Short Term Econ 103, c© M. Muendler
Short-term Equilibrium: The QQ and DD Schedule
0
q
Y
Output
R e a l e x c h a n g e r
a te
9. Flexible Exchange Rates and Output in the Short Term Econ 103, c© M. Muendler
Short-term Equilibrium: The QQ and DD Schedule
0
q
Y
Output
R e a l e x c h a n g e r
a te
M =P L R + E /q P /P ,Y S * e *
( )( )( ) -1
Y=D Y-T I G q( , , , )
DD
DDQQ
Y0
q0
qA
qB
9. Flexible Exchange Rates and Output in the Short Term Econ 103, c© M. Muendler
Shifts of the DD and QQ Schedules
• DD schedule: Y = D(Y − T, I, G, q)
– Given q, an increase in I, G or CA(·) shifts DD schedule east
– Given q, an increase in T shifts DD schedule west
• QQ schedule: MS = P · L(R∗ + Ê e
q P ∗
P − 1, Y )
(q has a positive effect on L)
– Given Y , an increase in MS, R∗, Êe, P ∗ shifts QQ schedule north
– Given Y , an increase in P, L(·) shifts QQ schedule south
International Monetary Relations
Lecture 10 c© Marc-Andreas Muendler
University of California, San Diego
May 6, 2014
10. Policy under Floating Exchange Rates Econ 103, c© M. Muendler
Temporary Changes in Policy
• Monetary policy: Changes in the nominal money supply MS
• Fiscal policy: Changes in either government spending G or taxes T
• Temporary policies are expected to be reversed in the near future and do not affect the long-term expected exchange rate Êe
• We assume: Domestic policy shifts do not influence the foreign inter- est rate R∗ or the foreign price level P ∗
10. Policy under Floating Exchange Rates Econ 103, c© M. Muendler
Temporary Monetary Expansion
• Temporary increase in money supply raises the economy’s output in the short term
– Excess supply of money is only absorbed by private sector if interest rate in equilibrium reduced
– As a result, the nominal exchange rate must depreciate
– Since PPP fails in the short-term, the real exchange rate depreciates
– A depreciated real exchange rate makes domestic exports relatively cheaper and foreign imports relatively more expensive
10. Policy under Floating Exchange Rates Econ 103, c© M. Muendler
Short-term Effect of Temporary Monetary Expansion
0
q
Y
Output
R e a l e x c h a n g e r
a te
10. Policy under Floating Exchange Rates Econ 103, c© M. Muendler
Short-term Effect of Temporary Monetary Expansion
0
q
Y
Output
R e a l e x c h a n g e r
a te
DD
DDQQ
Y0
q0 QQ'
QQ'
q'
Y'
M =P L R + E /q P /P ,Y S * e *
( )( )( ) -1
Y=D Y-T I G q( , , , )
10. Policy under Floating Exchange Rates Econ 103, c© M. Muendler
Temporary Fiscal Expansion
• Temporary cut in taxes, given government spending, or temporary increase in government spending, given tax revenue (Deficit spending)
– A tax cut increases consumption (but also savings) and partially raises aggre- gate demand Increased government spending raises aggregate demand by the same pro- portion
– Increased money demand raises domestic interest rate
– Higher domestic interest rate makes nominal and real exchange rate appreci- ate (PPP fails). This partially offsets the output effect
10. Policy under Floating Exchange Rates Econ 103, c© M. Muendler
Short-term Effect of Temporary Fiscal Expansion
0
q
Y
Output
R e a l e x c h a n g e r
a te
10. Policy under Floating Exchange Rates Econ 103, c© M. Muendler
Short-term Effect of Temporary Fiscal Expansion
0
q
Y
Output
R e a l e x c h a n g e r
a te
DD
DDQQ
Y0
q0
DD'
q'
Y'
DD' { D DG -c Tor
M =P L R + E /q P /P ,Y S * e *
( )( )( ) -1
Y=D Y-T I G q( , , , )
10. Policy under Floating Exchange Rates Econ 103, c© M. Muendler
Temporary Economic Policy Interventions
• Temporary policy interventions can be used to stabilize the economy
• Under a floating exchange rate, disturbances that lead to output (and employment) fluctuations can be offset
– Monetary policy can offset output shocks effectively On the other hand, unanticipated monetary shocks have strong output effects
– Fiscal policy can offset output shocks but a resulting exchange rate appreciation reduces the effect On the other hand, unanticipated fiscal shocks have less strong output effects
10. Policy under Floating Exchange Rates Econ 103, c© M. Muendler
Problems with Economic Policy Interventions
• Interventions need to be timely and effective
• Problems with policy timeliness
– Time lags in the identification of shocks and their duration
– Time lags in the implementation of policies
• Problems with effectiveness
– Expansionary fiscal policy results in a budget deficit (government borrowing) and may crowd out investment
– Expansionary monetary (or fiscal) policy may result in inflation with no gain in output if fully anticipated (inflationary bias)
10. Policy under Floating Exchange Rates Econ 103, c© M. Muendler
Permanent Changes in Policy
• Permanent policies are not reversed in the near future and do affect the long-term expected exchange rate Êe
• Monetary policy: In the long term, a permanent monetary expansion results in a proportional depreciation
• Fiscal policy: In the long term, a permanent fiscal expansion results in an offsetting appreciation but has no effect on domestic prices P
• We assume: Domestic policies do not influence foreign interest rates R∗ or price levels P ∗
10. Policy under Floating Exchange Rates Econ 103, c© M. Muendler
Permanent Monetary Expansion
• Long-term effects of permanent increase in money supply
– In the long term, prices are flexible and fully offset the increase in nominal money supply
– Output returns to its long-term level and the exchange rates stabilizes at a less depreciated level (initial overshooting)
– PPP holds in the long term
• Short-term effects of permanent increase in money supply
– A permanent increase in money supply raises the economy’s output even if it starts in long-run equilibrium
– The effect is stronger than under a temporary increase because the expected depreciation causes a stronger immediate depreciation of the exchange rate
10. Policy under Floating Exchange Rates Econ 103, c© M. Muendler
Short-term Effect of Permanent Monetary Expansion
0
q
Y
Output
R e a l e x c h a n g e r
a te
10. Policy under Floating Exchange Rates Econ 103, c© M. Muendler
Short-term Effect of Permanent Monetary Expansion
0
q
Y
Output
R e a l e x c h a n g e r
a te
DD
DDQQ
Y0
QQ'
QQ'
q'
Y'
SR
q =q0
M =P L R + E /q P /P ,Y S * e *
( )( )( ) -1
Y=D Y-T I G q( , , , )
_
10. Policy under Floating Exchange Rates Econ 103, c© M. Muendler
Long-term Effect of Permanent Monetary Expansion
0
q
Y
Output
R e a l e x c h a n g e r
a te
10. Policy under Floating Exchange Rates Econ 103, c© M. Muendler
Long-term Effect of Permanent Monetary Expansion
0
q
Y
Output
R e a l e x c h a n g e r
a te
DD
DDQQ''
QQ''
Y =Y0
QQ'
QQ'
q'
Y'
SR
M =P L R + E /q P /P ,Y S * e *
( )( )( ) -1
Y=D Y-T I G q( , , , )
q =q0 _
LR
10. Policy under Floating Exchange Rates Econ 103, c© M. Muendler
Permanent Fiscal Expansion
• Long-term effects of permanent fiscal expansion
– A permanent fiscal expansion has no long-term output effect
– The real exchange rate and the expected nominal exchange rate appreciate PPP “fails” even in the long run (q appreciates due to government demand for domestic goods)
• Short-term effects of permanent fiscal expansion
– A permanent fiscal expansion leads to an expected exchange rate appreciation
– The expectation of an appreciated nominal exchange rate in the future causes an immediate appreciation of the spot nominal exchange rate
– A permanent fiscal expansion has little effect on short-term output (no effect if starting in long-term equilibrium) because the immediate exchange rate appre- ciation offsets the fiscal expansion
10. Policy under Floating Exchange Rates Econ 103, c© M. Muendler
Long-term Effect of Permanent Fiscal Expansion
0
q
Y
Output
R e a l e x c h a n g e r
a te
10. Policy under Floating Exchange Rates Econ 103, c© M. Muendler
Long-term Effect of Permanent Fiscal Expansion
0
q
Y
Output
R e a l e x c h a n g e r
a te
DD
DDQQ
DD'
DD' {
QQ'
QQ'
LR
Y =Y0
D DG -c Tor q =q0
_
q =q' ' _
M =P L R + E /q P /P ,Y S * e *
( )( )( ) -1
Y=D Y-T I G q( , , , )
10. Policy under Floating Exchange Rates Econ 103, c© M. Muendler
Permanent Fiscal Expansion
• Short-run output unchanged (if starting in long-term equilibrium).
Why does the real appreciation completely offset the fiscal expansion in the short run?
– Expectations of future nominal exchange rate change immediately
– Short-run response is therefore the same as the long-run response
– Note: Prices P and P ∗ only respond to monetary conditions
10. Policy under Floating Exchange Rates Econ 103, c© M. Muendler
Short-term Effect of Permanent Fiscal Expansion
0
q
Y
Output
R e a l e x c h a n g e r
a te
10. Policy under Floating Exchange Rates Econ 103, c© M. Muendler
Short-term Effect of Permanent Fiscal Expansion
0
q
Y
Output
R e a l e x c h a n g e r
a te
DD
DDQQ
DD'
DD' {
QQ'
QQ'
LR&SR
Y =Y0
D DG -c Tor q =q0
_
q =q' ' _
M =P L R + /q P /P ,Y S * *
( )( )( ) -1E e
Y=D Y-T I G q( , , , )
10. Policy under Floating Exchange Rates Econ 103, c© M. Muendler
Effectiveness of Economic Policy Interventions
Under Floating Exchange Rates:
• Temporary policy interventions can be used to stabilize the economy
– Temporary monetary interventions are highly effective because the exchange rate response amplifies the effect on output
– Temporary fiscal interventions are effective but the exchange rate response reduces the effect on output
• Temporary policy interventions only have a short-term but no long- term effect on output
10. Policy under Floating Exchange Rates Econ 103, c© M. Muendler
Effectiveness of Economic Policy Interventions
Under Floating Exchange Rates:
• Permanent monetary interventions can stabilize the economy However, permanent fiscal interventions are little effective
– Permanent monetary interventions are very effective because the expected exchange rate response amplifies the effect on output beyond the effect of a temporary intervention
– Permanent fiscal interventions are not effective because the ex- pected exchange rate response offsets the effect on output
• Permanent monetary interventions only have a short-run output effect
10. Policy under Floating Exchange Rates Econ 103, c© M. Muendler
10. Policy under Floating Exchange Rates Econ 103, c© M. Muendler
Background : The QQ-DD and the IS-LM Models
• Equilibrium conditions in the QQ-DD and IS-LM models
Equation (Condition) QQ-DD IS-LM
Money Mkt.: MS = P L(R, Y ) QQ LM
UIP: R = R∗ + Ê e −E E
(and q = EP ∗/P ) QQ IS
Agg. Demand: Y = D = C + I + G + CA C: C = C(Y − T) = cY − cT DD IS
I: I = I DD - I: I = I(R − πe) - IS
CA: CA = CA(q, Y − T) DD IS
10. Policy under Floating Exchange Rates Econ 103, c© M. Muendler
Background : The QQ-DD and the IS-LM Models
• Equilibrium derivation in the QQ-DD and IS-LM models
QQ-DD: q − Y perspective IS-LM: R − Y perspective
DD schedule IS curve
Y = D (
Y − T, I, G, EP ∗
P
)
Y = D (
Y − T, R − πe, G, ÊeP ∗
P(1+R−R∗)
)
since UIP is equivalent to
E = Ê e
1+R−R∗
QQ schedule LM curve
MS = P L (
R∗ + Ê e −E E
, Y
)
MS = P L (R, Y )
since UIP states that
R = R∗ + Ê e −E E
International Monetary Relations
Lecture 11 c© Marc-Andreas Muendler
University of California, San Diego
May 8, 2014
11. Managed and Fixed Exchange Rates Econ 103, c© M. Muendler
Managed and Fixed Exchange Rate Regimes
• Exchange rates are not completely flexible in practice
• Industrialized countries operate under a hybrid system of managed floating rates Objectives: To moderate exchange rate movements without keeping rigid pegs
• Several developing countries retain some form of government ex- change rate fixing Objectives: To lend credibility to domestic monetary policy by tying the central bank’s hands, to avoid large swings in the exchange rate, to influence the current account
11. Managed and Fixed Exchange Rates Econ 103, c© M. Muendler
Managed and Fixed Exchange Rate Regimes
• Exchange Arrangement with no Separate Legal Tender Currency unions or “dollarization” (another country’s currency is sole legal tender)
• Currency Board Arrangement Legal commitment to exchange domestic currency for a specified foreign currency
• Conventional Fixed Peg Arrangement Peg of currency to one single foreign currency or a basket of foreign currencies
• Pegged Exchange Rate Within Horizontal Bands Maintenance of currency within fixed margins around a central exchange rate
11. Managed and Fixed Exchange Rates Econ 103, c© M. Muendler
Managed and Fixed Exchange Rate Regimes
• Crawling Peg Periodically adjusted exchange rate to target preannounced exchange rate path
• Exchange Rate Within Crawling Bands Maintenance of currency within fixed margins around a crawling exchange rate
• Managed Floating with No Preannounced Path Active foreign exchange interventions without commitments of preannouncements
• Independent Floating Purely market-determined exchange rate
11. Managed and Fixed Exchange Rates Econ 103, c© M. Muendler
Exchange Rate Pass-Through
• The current account only responds to exchange rate changes fully if the prices to consumers and investors reflect changes one-for-one
• Exchange Rate Pass-Through: Exchange rate changes are com- pletely passed through to final consumers and investors Reasons for incomplete pass-through (a form of price stickiness)
– Pricing to market by wholesalers and retailers
– Domestic distribution costs
– Costs of price adjustments to sellers, possible loss of consumers
11. Managed and Fixed Exchange Rates Econ 103, c© M. Muendler
Current Account Targeting and External Balance
• Governments choose to target current account levels
• XX schedule: CAtarget = CA( q (+)
,Y − T (−)
)
– XX schedule: Shows all combinations of output and the nominal exchange rate for which current account attains target level
– Upward sloping because a depreciation of the nominal exchange rate causes a depreciation of the real exchange rate (if PPP fails). A depreciated real ex- change rate raises the current account (if the value effect is small)
– Slopes up less steeply than DD schedule because an increase in Y − T sets off a multiplier effect through consumption behind the DD curve. So, E must rise more strongly along DD schedule to guarantee Y = D(·)
11. Managed and Fixed Exchange Rates Econ 103, c© M. Muendler
Current Account Effects of Economic Policies
0
q
Y
Output
R e a l e x c h a n g e r
a te
DD
DDQQ
q0
Y =Y0
XX
XX
M =P L R + E /q P /P ,Y S * e *
( )( )( ) -1
Y=D Y-T I G q( , , , )
11. Managed and Fixed Exchange Rates Econ 103, c© M. Muendler
Volume and Value Effects and Marshall-Lerner
• Current account volume and value depend on q
CA = EX(q) − IM(q) = EX ( q (+)
) − q · EX∗ ( q (−)
).
• Define the elasticities of volume responses with respect to the real exchange rate
η ≡ dEX/dq
EX/q =
d log EX
d log q , η
∗ ≡
dEX∗/dq
EX∗/q =
d log EX∗
d log q .
• Marshall-Lerner Condition: Volume effect dominates value effect iff
η EX IM
+ η∗ > 1.
11. Managed and Fixed Exchange Rates Econ 103, c© M. Muendler
J-curve: Current Account Effects of a Real Exchange Rate Depreciation
0
CA
t
Time
C u rr
e n t
a c c o u n t
b a la
n c e
11. Managed and Fixed Exchange Rates Econ 103, c© M. Muendler
Sterilized Interventions
• Net effect: Change ratio of home-currency bonds to foreign-currency bonds held in private sector
• No effect of sterilized intervention on money supply (Full Sterilization)
• Similar intervention in the forward exchange market
– Forward contract: Central bank forward sells 1 + R USD for (1 + R)F JPY
– Under CIP , this reduces JPY holdings in private sector by E JPY today
– Same outcome as under sterilized intervention through money market
11. Managed and Fixed Exchange Rates Econ 103, c© M. Muendler
Central Bank Balance Sheet
Assets Liabilities
B CB
(domestic assets)
M S (monetary base)W
CB (foreign assets)
Other Assets (gold, SDRs)
Net Worth (asset price corrections)
11. Managed and Fixed Exchange Rates Econ 103, c© M. Muendler
Example: Open-market Purchase of Foreign Assets
Assets Liabilities
B CB
(domestic assets)
M S (monetary base)W
CB (foreign assets)
11. Managed and Fixed Exchange Rates Econ 103, c© M. Muendler
Example: Sterilized Open-market Purchase of Foreign Assets
Assets Liabilities
B CB
(domestic assets)
M S (monetary base)W
CB (foreign assets)
11. Managed and Fixed Exchange Rates Econ 103, c© M. Muendler
Managed Floating and Relative Risk Premia
• Uncovered Interest Parity (UIP) is based on the assumption of risk neutrality. However, deposits in different currencies carry different risks and investors are risk averse
• Imperfect Asset Substitutability: Relative risk premium ρ for domestic currency deposits compared to foreign deposits
• Adjusted UIP: R = R∗ + Ê e −E E
+ ρ
Returns on domestic currency deposits must reward investors for the relative risk they take (ρ > 0 if domestic assets relatively more risky, ρ < 0 if relatively less risky)
11. Managed and Fixed Exchange Rates Econ 103, c© M. Muendler
Imperfect Asset Substitutability and Adjusted UIP
• Private-sector holdings of domestic assets are: Bpriv = Btot − BCB
• The relative risk premium ρ increases if the private sector has to hold more domestic assets
ρ = ρ(Bpriv
(+)
) = ρ(Btot − BCB)
• Adjusted UIP: R = R∗ + Ê e −E E
+ ρ(Btot − BCB)
• A sterilized intervention in favor of foreign currency increases W CB, reduces BCB and causes an increase in ρ
11. Managed and Fixed Exchange Rates Econ 103, c© M. Muendler
Sterilized Purchase of Foreign Assets under Imperfect Substitutability
0
E
R, R + E -E /E+ * e
( ) r
Interest rate and expected currency return
E x c h a n g e r
a te
R e a l m
o n e y h
o ld
in g s
M /P, L R Y
S
( , )
11. Managed and Fixed Exchange Rates Econ 103, c© M. Muendler
11. Managed and Fixed Exchange Rates Econ 103, c© M. Muendler
Current Account Response to Real Depreciation
• Current account balance: CA(q) = EX(q) − q · EX∗(q)
• Total differentiation of CA with respect to q yields
dCA = ∂EX
∂q dq − q ·
∂EX∗
∂q dq − EX∗ · dq
or dCA
dq =
[
∂EX/∂q
q · EX∗/q −
∂EX∗/∂q
EX∗/q − 1
]
· EX ∗
= [
η · EX IM
+ η∗ − 1 ]
· EX ∗ .
• So, dCA/dq > 0 iff η · EX IM
+ η∗ > 1.
11. Managed and Fixed Exchange Rates Econ 103, c© M. Muendler
The Implicit Function Theorem
• Consider the equilibrium equation F(X, Y ) = 0.
• Implicit Function Theorem:
dY
dX
∣
∣
∣
∣
∣
F(X,Y) = 0
= − ∂F(X, Y )/∂X
∂F(X, Y )/∂Y .
(A useful tool derive the response of one variable Y to a change in another variable
X, requiring that the equilibrium relationship is being restored.)
• Taking the total differential of F(X, Y ) = 0 yields the statement of the theorem because
∂F(X, Y )
∂X dX +
∂F(X, Y )
∂Y dY = 0.
11. Managed and Fixed Exchange Rates Econ 103, c© M. Muendler
XX Schedule
• CAtarget restoration through dq after dY shock
• XX schedule: CAtarget = CA(q, Y ).
Total differentiation of XX equation with respect to q and Y yields
0 = ∂CA
∂Y dY +
∂CA
∂q dq
or dq
dY
∣
∣
∣
∣
∣
XX
= − ∂CA/∂Y
∂CA/∂q > 0.
• The derivation is an instance of the Implicit Function Theorem.
11. Managed and Fixed Exchange Rates Econ 103, c© M. Muendler
DD Schedule
• DD equilibrium restoration through dq after dY shock
• DD schedule: Y = C (Y − T) + Ī + G + CA(q , Y − T).
Total differentiation of DD equation with respect to q and Y yields
dY = ∂C
∂Y dY +
∂CA
∂Y dY +
∂CA
∂q dq
or dq
dY
∣
∣
∣
∣
∣
DD
= − −(1−∂C/∂Y ) + ∂CA/∂Y
∂CA/∂q >
dq
dY
∣
∣
∣
∣
∣
XX
> 0.
• The derivation is an instance of the Implicit Function Theorem.
11. Managed and Fixed Exchange Rates Econ 103, c© M. Muendler
QQ Schedule
• QQ equilibrium restoration through dq after dY shock
• QQ schedule: MS = P · L(R∗ + (Êe/q)(P ∗/P) − 1 , Y ).
Total differentiation of QQ equation with respect to q and Y yields
0 = −P ∂L
∂R
Êe
q2
P ∗
P dq + P
∂L
∂Y dY
or dq
dY
∣
∣
∣
∣
∣
= − ∂L/∂Y
−(∂L/∂R)(Êe/q2)(P ∗/P) < 0.
• The derivation is an instance of the Implicit Function Theorem.
11. Managed and Fixed Exchange Rates Econ 103, c© M. Muendler
Current Account Effects of Economic Policies
0
q
Y
Output
R e a l e x c h a n g e r
a te
DD
DDQQ
q0
SR
Y =Y0
XX
XX
SR
temporary fiscal
expansion
permanent fiscal
expansion
permanent monetary
expansion
temporary monetary
expansion
SR
SR
CA =CA Y-T EP P target
( , / ) *CA>CA
target
CA<CA target
M =P L R + E /q P /P ,Y S * e *
( )( )( ) -1
Y=D Y-T I G q( , , , )
International Monetary Relations
Lecture 12 c© Marc-Andreas Muendler
University of California, San Diego
May 13, 2014
12. Policy under Fixed Exchange Rates Econ 103, c© M. Muendler
Stabilization Policies with Fixed Exchange Rates
• Monetary policy must be used to keep the fixed exchange rate at its arranged level
• Fiscal policy benefits from the fact that the central bank will undo the otherwise countervailing exchange rate change
• Unless a country joins a currency union, exchange rate fixes can be reset: Devaluations and revaluations
• Mirage of fixed exchange rates? Fear of floating exchange rates?
12. Policy under Fixed Exchange Rates Econ 103, c© M. Muendler
Fixed Exchange Rate and Monetary Interventions
• Foreign exchange market equilibrium (UIP): R = R∗ + Ê e −E E
We assume: Foreign currency (W CB) interventions have no effect on ρ
• Under a credibly fixed exchange rate: Êe = E = E at all times So, no expected depreciation or appreciation and R = R∗
• The central bank must stand ready to immediately adjust money sup- ply and maintain MS = P L(R∗, Y )
• Example: Temporary positive output shock. Central bank must pur- chase assets instantly, increase money supply and maintain R = R∗
12. Policy under Fixed Exchange Rates Econ 103, c© M. Muendler
Intervention to Maintain Fixed Exchange Rate
• Example: Positive output shock. (Output shocks are temporary) If prices are sticky, the central bank must purchase assets instantly, increase money supply and maintain R = R∗
It is convenient to think of interventions with foreign reserves, in this case reserves acquisitions.
• After intervention under sticky prices, prices do not adjust over time. The deflation that would have occurred in the absence of an interven- tion is fully offset by the inflationary monetary intervention.
• If prices are fully flexible, a positive output shock will result in an im- mediate offsetting deflation. No monetary intervention needed
12. Policy under Fixed Exchange Rates Econ 103, c© M. Muendler
Temporary Positive Output Shock and Exchange Rate Fix
0
E
Interest rate and expected currency return
E x c h a n g e r
a te
R e a l m
o n e y h
o ld
in g s
M /P, L R Y
S
( , )
12. Policy under Fixed Exchange Rates Econ 103, c© M. Muendler
Response to Temporary Monetary Shock
• Temporary autonomous shortfall of domestic money demand would lower domestic interest rates. The demand shortfall needs to be offset by a sale of (foreign) assets to maintain the exchange rate peg.
– Incipient reduction in domestic nominal interest rate would cause an exchange rate depreciation
– Central bank needs to intervene in either domestic money or foreign exchange market and sell domestic or foreign assets
– Sale of domestic or foreign assets can only stop at a level so that domestic interest rate back to prior level R = R∗
– Resulting monetary contraction fully offsets temporary demand shortfall
12. Policy under Fixed Exchange Rates Econ 103, c© M. Muendler
Monetary Response to Temporary Money Demand Shortfall
0 Y
Output
R e a l e x c h a n g e r
a te
q
12. Policy under Fixed Exchange Rates Econ 103, c© M. Muendler
Temporary Fiscal Expansion
• Temporary fiscal expansion through tax cuts or increases in govern- ment spending Under a fixed exchange rate, the central bank stands ready to fully offset the incipient exchange rate appreciation
– In the absence of an exchange rate peg, a temporary fiscal expansion would result in an exchange rate appreciation and a moderate output increase
– To maintain the exchange rate peg, the central bank purchases foreign assets
– The acquisition of foreign assets increases money supply
– The central bank acquires an amount of foreign assets so that the incipient appreciation is fully offset
– The resulting expansion of output is completely effective: ∆G or −c∆T (or (1−c)∆G = (1−c)∆T under a balanced-budget rule)
12. Policy under Fixed Exchange Rates Econ 103, c© M. Muendler
Temporary Fiscal Expansion
0
q
Y
Output
R e a l e x c h a n g e r
a te
12. Policy under Fixed Exchange Rates Econ 103, c© M. Muendler
Stimulation through Currency Devaluation
• A nominal exchange rate devaluation can be used to stimulate output. A revaluation can be used to calm domestic economic activity For a devaluation, the central bank purchases (foreign) assets. For a revaluation, the central bank sells (foreign) assets (or reserves)
– Under sticky prices, the expectations change cause a strong output response to the monetary changes in the short run (strong shift in QQ schedule)
– In the long run, the output response is offset by increasing prices and a return of the real exchange rate to its long-term level (the exchange rate remains depreciated consistent with expectations)
– Under imperfectly substitutable assets, a revaluation is most successful if the central bank has sufficient reserves (foreign assets).
12. Policy under Fixed Exchange Rates Econ 103, c© M. Muendler
Permanent Nominal Exchange Rate Devaluation
0
q
Y
Output
R e a l e x c h a n g e r
a te
12. Policy under Fixed Exchange Rates Econ 103, c© M. Muendler
Announcement Effect of Currency Devaluation
• An announced future exchange rate devaluation causes an immedi- ate depreciation. If the announcement is credible, the central bank is expected to pur- chase (foreign) assets at the announced time of devaluation.
– The mere announcement of a de- or revaluation causes exchange rate expec- tations to move and puts severe pressure on the nominal spot exchange rate
– For no initial interest differential R = R∗ (under a fixed exchange rate), an expected future exchange rate depreciation (Êe − E)/E > 0 would yield an arbitrage. So, E must immediately depreciate or be immediately devalued to the announced future exchange rate level
– Irrespective of whether the central bank acquires domestic assets in defense against attacks on its initial exchange rate peg and thus raises money supply, or gives in to the pressure by immediately raising money supply, new monetary conditions lead to a devalued E
12. Policy under Fixed Exchange Rates Econ 103, c© M. Muendler
Announcement Effect of an Exchange Rate Devaluation
0
E
R, R + E -E /E * e
( )
Interest rate and expected currency return
E x c h a n g e r
a te
R e a l m
o n e y h
o ld
in g s
M /P, L R Y
S
( , )
12. Policy under Fixed Exchange Rates Econ 103, c© M. Muendler
Announcement Effect of Currency Devaluation
• Various possible market and central-bank responses lead to similar conclusions
– Scenario 1: The central bank tries an immediate defense by selling foreign reserves from its books to keep E0 appreciated compared to the future E′. This will not end the run on the home currency because investors still face a future capital loss, so foreign reserves will soon be depleted
– Scenario 2: Either after foreign reserve depletion or immediately, the central bank may purchase domestic assets to raise demand for the home currency on the spot market but increased money supply will ultimately result in a spot depreciation
– Scenario 3: By the QQ-DD analysis, an expected devaluation causes an im- mediate output stimulation, and the central bank must meet the resulting real money demand with a matching real money supply to keep the nominal interest rate fixed, ultimately causing a spot depreciation
12. Policy under Fixed Exchange Rates Econ 103, c© M. Muendler
Monetary Policy at the Zero Lower Bound
• Liquidity trap: Nominal interest rate is at zero lower bound (R = 0)
• In general, private sector does not accept negative nominal interest
• This means, monetary policy faces an ineffective range for high q
In general, R ≥ 0 and monetary policy becomes ineffective
By UIP: R = R∗ + E e −E E
≥ 0. So, E ≤ E e
1−R∗ (= in liquidity trap)
Therefore q = EP ∗
P ≤
Ee
1−R∗ P ∗
P (= at zero lower bound)
12. Policy under Fixed Exchange Rates Econ 103, c© M. Muendler
Fixed Exchange Rates as a Commitment Device
• To end periods of high inflations and hyperinflations, countries can choose fixed exchange rates in order to make their commitment to sound monetary policy more credible (Examples: Argentina’s currency board in 1991, Brazil’s crawling peg in 1994)
• At the other extreme, it has been recommended to Japan to adopt an exchange rate anchor and make Japan’s commitment to inflationary policy more credible (Svensson; Krugman, McKinnon made similar arguments)
In a liquidity trap, R = 0 and monetary policy becomes ineffective By UIP: R = 0 = R∗ + E
e −E E
. So, q = E e
1−R∗ P ∗
P in liquidity trap
12. Policy under Fixed Exchange Rates Econ 103, c© M. Muendler
Escape from Liquidity Trap through Exchange Rate Fix and Devaluation
0
q
Y
Output
R e a l e x c h a n g e r
a te
12. Policy under Fixed Exchange Rates Econ 103, c© M. Muendler
Escape from Liquidity Trap through Exchange Rate Fix and Devaluation
0
q
Y
Output
R e a l e x c h a n g e r
a te
DD
DD
Y0
q' QQ'
QQ'
Y''
q0
[ /(1 )]( )E ' -R P /P e * *
[ /(1 )]( )E -R P /P e * *
M =P L R + E /q P /P ,Y S * e *
( )( )( ) -1
Y=D Y-T I G q( , , , )
SR
International Monetary Relations
Lecture 14 c© Marc-Andreas Muendler
University of California, San Diego
May 22, 2014
14. Currency Crises Econ 103, c© M. Muendler
International Financial Crises
• International Financial Crises
– Currency Crises that end exchange rate pegs
– Banking and Financial Market Crises involving foreign investors
– Debt Crises that force borrowers to restructure debt or to default
• Currency Attacks
– An attack on domestic currency is the sale of domestic assets in exchange for
foreign assets. Under a pegged exchange rate, the central bank must sell its
foreign reserves to maintain the exchange rate peg.
14. Currency Crises Econ 103, c© M. Muendler
Definitions of Financial Crisis
• Definition by Threshold
– Inflation crisis: more than 20% annual inflation for 12 months
– Currency crash: exchange-rate devaluation of more than 15% per annum
– Currency debasement: reduction in metallic content of money
• Definition by Event
– Banking crisis: bank runs on deposits, deterioration in asset quality, real-sector bankruptcies (burst or pricked bubbles, U.S. and Europe 2007)
– External debt crisis: default on foreign-jurisdiction debt (Argentina 2001)
– Domestic debt crisis: default on domestic-jurisdiction debt (Mexico 1994)
14. Currency Crises Econ 103, c© M. Muendler
Fundamentals-Driven Currency Crises
• Central banks may be forced to pursue inconsistent policies for polit- ical reasons (“first-generation” attack model)
– Fixed exchange rates are not sustainable if domestic monetary fundamentals conflict with foreign monetary fundamentals
– Example: Some governments are tempted to finance their spend- ing by having the monetary authorities issue money for govern- ment debt (Seignorage)
• The Mexican Peso (Tequila) crisis 1994, the East Asian financial crisis 1997, and the Argentine crisis 2001 exhibit features of inconsistent government policies
14. Currency Crises Econ 103, c© M. Muendler
Self-fulfilling Currency Crises
• Central banks may come under self-fulfilling attacks despite sound monetary policies (“second-generation” attack model)
– Defenses of fixed exchange rates are generally feasible but may be very costly (causing recessions or unemployment)
– Anticipating the reluctance of central banks to take strong defense measures, investors may attack
• The crises in the European monetary system in 1992 and the Brazil- ian Real crisis 1999 exhibit self-fulfilling features
14. Currency Crises Econ 103, c© M. Muendler
Collapse of the European Monetary System 1993
• EMS: Currency bands, sustained by credits from strong- to weak- currency members
• Policy conflict between Germany and EMS partners in early 1990s Reunification boom in Germany and strong borrowing, Bundesbank adopts anti-
inflationary stance but France, Italy and the UK unwilling to risk recession.
• Fierce attacks starting September 1992. Self-fulfilling aspects in Britain, fundamental aspects in Italy
By August 1993, retreat to wider bands for all currencies except DEM- NLG (from ±2.25 to ±15)
14. Currency Crises Econ 103, c© M. Muendler
European Exchange Rate Mechanism (ERM) and the Euro N
o m
in a
l E xc
h a
n g
e R
a te
Day
France Franc / DEM (via USD) 100 Italy Lira / DEM (via USD) British Pound / 10 DEM (v. USD)
29jan1988 31may1991 31aug1994 30nov1997 28feb2001 21may2004
0
2
4
6
8
10
12
Source: Global Financial Data, 2004
14. Currency Crises Econ 103, c© M. Muendler
A Fundamentals-Driven Currency Crisis
• Monetary policies that are inconsistent with a fixed exchange rate regime must lead to a complete foreign reserve depletion (W CB = 0 ultimately)
• The attack will generally occur before reserves are depleted
• Reason: Complete foresight and no arbitrage
– Investors anticipate the fundamental value of the exchange rate after the attack (‘shadow exchange rate’)
– There cannot be an anticipated jump in the exchange rate. This would be an arbitrage opportunity
14. Currency Crises Econ 103, c© M. Muendler
A Fundamentals-Driven Currency Crisis
• Central bank balance sheet: M = BCB + W CB
BCB is domestic government debt held by the central bank and
W CB is net foreign wealth held by the central bank (foreign reserves)
• For fixed exchange rate E = Ē: Maintain M = M̄ at all times (E = P/P ∗ = (M/M∗)/(L/L∗) by Abs. PPP, and M∗, L, L∗ are given)
• However, the government forces the central bank to buy its debt BCB (“monetize” the debt). The debt increases at a constant rate π = ∆BCB/BCB every period. To keep the exchange rate fixed, the central bank must sell compen- sating amounts of foreign reserves W CB as long as it can
14. Currency Crises Econ 103, c© M. Muendler
Open-market Sale of Foreign Assets to Sterilize Domestic Asset Intake
Assets Liabilities
B CB
(domestic assets) M (monetary base)
W CB
(foreign assets)
14. Currency Crises Econ 103, c© M. Muendler
A Fundamentals-Driven Currency Crisis
• Investors anticipate what the exchange rate will be after complete foreign reserve depletion: E = P/P ∗ = (BCB/M∗)/(L/L∗) (M∗, L, L∗ given)
• Even before the attack, investors consider the shadow exchange rate
E shadow = P/P ∗ = (BCB/M∗)/(L/L∗)
Investors know that this exchange rate would prevail if the central bank were not
forced to sterilize the intake of foreign debt. It will ultimately prevail.
• There cannot be an anticipated arbitrage. So, there cannot be a jump from the fixed exchange rate Ē to the shadow exchange rate Eshadow.
14. Currency Crises Econ 103, c© M. Muendler
A Fundamentals-driven Currency Crisis
0
M
Time
B CB
0
0
E
0
t
tt
t
W CB
14. Currency Crises Econ 103, c© M. Muendler
A Fundamentals-driven Currency Crisis
0
M
Time
B CB
0
0
E
0
t
tt
t
W CB
E
B0 CB
p W0 CB
M =B +W0 0 0 CB CB
M0
M=B +W CB CB
-p
T depletion
T depletion
T depletion
T depletion
p
E =P/P = M/L /( ) ( ) shadow * * *
M /L
p
{ DW
CB
T attack
T attack
T attack
T attack
{DWCB
14. Currency Crises Econ 103, c© M. Muendler
A Fundamentals-Driven Currency Crisis
• The attack must occur at a time T attack when the shadow exchange rate Eshadow equals the fixed exchange rate Ē
• The attack time T attack can be much earlier than the time of complete reserve depletion
• If the attack occurred later, investors holding domestic currency would make an anticipated loss Ē − Eshadow < 0. Investors holding foreign currency would make an anticipated gain. This arbitrage opportunity cannot be an equilibrium.
• If the attack occurred earlier, investors holding domestic currency would make a
gain equal to Ē − Eshadow > 0. Investors holding foreign currency would make a
loss. That cannot be an equilibrium.
14. Currency Crises Econ 103, c© M. Muendler
European Exchange Rate Mechanism (ERM) and the Euro N
o m
in a
l E xc
h a
n g
e R
a te
Day
France Franc / DEM (via USD) 100 Italy Lira / DEM (via USD) British Pound / 10 DEM (v. USD)
29jan1988 31may1991 31aug1994 30nov1997 28feb2001 21may2004
0
2
4
6
8
10
12
Source: Global Financial Data, 2004
14. Currency Crises Econ 103, c© M. Muendler
Hong Kong Monetary Authority E
xc h
a n
g e
R a
te (
U S
D )
Day
Hong Kong Dollar Hong Kong Dollar Black Market
31jan1981 30sep1985 31may1990 31jan1995 30sep1999 21may2004
5
5.5
6
6.5
7
7.5
8
8.5
9
9.5
Source: Global Financial Data, 2004
14. Currency Crises Econ 103, c© M. Muendler
Argentina Currency Board E
xc h
a n
g e
R a
te (
U S
D )
Day
Argentina Peso Argentina Peso Black Market
31jan1992 31jul1994 31jan1997 30jun1999 31dec200121may2004
.5
1
1.5
2
2.5
3
3.5
4
Source: Global Financial Data, 2004
14. Currency Crises Econ 103, c© M. Muendler
Self-fulfilling Currency Crises
• Central banks do not pursue inconsistent policies in general but cur- rency attacks still occur
• Investors anticipate that central banks, although they have the means to defend their currency, may be reluctant to do so
• A large fraction of money M circ in circulation is backed with the central bank’s money base M. Instead of selling foreign reserves, the central bank can sell domestic assets and contract money supply
However, central bankers shy excessively high interest rates because they can reduce short-term output and may cause unemployment
14. Currency Crises Econ 103, c© M. Muendler
Self-fulfilling Currency Crises
• Defending the currency costs the central bank −R, due to foregone seignorage and a resulting short-term contraction of domestic output (R can also be viewed as the reserves that a CB is willing to use for a defense)
• Investors hold one unit of domestic currency (in total). If they attack, they incur a transaction cost of −c
• In the case of a devaluation, investors reap a capital gain of ∆E, the central bank suffers a net capital loss of −∆E BCB + ∆E W CB
• For low −R (large R > 0), self-fulfilling attacks can succeed
14. Currency Crises Econ 103, c© M. Muendler
An Attack Game
Central Bank (W CB <BCB)
Investors Defend (∆E =0) Devalue (∆E >0)
Attack −c ∆E − c
−R ∆E(W CB−BCB)
Hold 0 −∆E
0 ∆E(W CB−BCB)
• Analysis of best responses. Investors: Best response to anticipated Central Bank policy Central Bank: Best response to investor behavior Equilibrium: Mutually best responses (Nash equilibrium)
14. Currency Crises Econ 103, c© M. Muendler
An Attack Game
Central Bank (W CB <BCB)
Investors Defend (∆E =0) Devalue (∆E >0)
Attack −c ∆E − c
−R ∆E(W CB−BCB)
Hold 0 −∆E
0 ∆E(W CB−BCB)
• If investors anticipate devaluation: Attack (best response). If investors anticipate defense: Hold. If central bank anticipates no attack: Maintain ∆E =0 (Defend). If central bank anticipates attack: R matters (Devalue or Defend).
14. Currency Crises Econ 103, c© M. Muendler
An Attack Game
Central Bank (W CB <BCB)
Investors Defend (∆E =0) Devalue (∆E >0)
Attack −c ∆E − c
−R ∆E(W CB−BCB)
Hold 0 −∆E
0 ∆E(W CB−BCB)
• R matters for the central bank’s best response to an attack. If and only if R > ∆E(BCB−W CB), the central bank’s best response to an attack is devaluation and self-fulfilling attacks can succeed Two equilibria exist: No-Attack-No-Devaluation, Attack-Devaluation
14. Currency Crises Econ 103, c© M. Muendler
Self-fulfilling Currency Crises
• If the central bank is not committed to a defense at all cost, self- fulfilling attacks may succeed even if a country’s monetary fundamen- tals are sound
However, sufficiently large currency holdings need to be coordinated on an attack
• Fixed exchange rates may appear more stable than they are
• Financial crises can occur under floating exchange rates
Causes for international debt and banking crises are more similar in nature to domestic financial crises
International Monetary Relations
Lecture 15 c© Marc-Andreas Muendler
University of California, San Diego
May 27, 2014
15. Banking and Debt Crises Econ 103, c© M. Muendler
Features of International Financial Crises
• Exchange rate devaluations or sharp exchange rate depreciations
• Contractions of output or recessions, following credit crunches
• Substantial withdrawals of short-term investments, disrupting bank operations and production
• Triggers can be unexpected news or sudden changes in investors’ expectations
• Do crises happen despite sound policies and strong institutions?
15. Banking and Debt Crises Econ 103, c© M. Muendler
Third-Generation Models of Financial Crises
• Fragilities in the banking and financial system reduce the amount of credit available to firms and increase the likelihood of a crisis
• Features: High debt, low foreign reserves, expectations of a devalu- ation, domestic borrowing constraints Example. Firms are required to collateralize their debt with domestic assets. With
a looming devaluation, the collateral value in foreign currency falls. This can trigger
a lending stop, and cause a self-fulfilling crisis.
• Typically, restrictive monetary policy is recommended. However, in a third-generation crisis, low interest policies more suit- able to ease credit.
15. Banking and Debt Crises Econ 103, c© M. Muendler
Bank Runs
• Diamond & Dybvig (1983): Banks allow deposits that can be with- drawn but are vulnerable to self-fulfilling crises
• Illiquidity of long-term assets is rationale for existence of banks: Banks’ deposit contracts permit investors with sudden liquidity need to withdraw and still earn some interest
• Multiple equilibria exist: Bank runs can cause a self-fulfilling crisis
• Instruments that can prevent bank runs: Suspension of convertibility, deposit insurance, lender of last resort
15. Banking and Debt Crises Econ 103, c© M. Muendler
Fundamentals of the Economy
• Two basic technologies: Higher payoff for long-term investment (payoffs in gross interest rates)
• Three periods: 0,1,2
Period 0 1 2
Storage -1 1 . Long-term Project -1 . rgross > 1
Bank -1 r > 1 r̄ > r (but r̄ < rgross)
15. Banking and Debt Crises Econ 103, c© M. Muendler
Investors and Uncertain Liquidity Needs
• There are 3 investors. At date 0, investors do not know whether they will be needy (“impatient”) or greedy (“patient”)
• One investor will be needy (impatient) and withdraw in period 1
• Two investors will be greedy (patient) and hold deposits until period 2
• In the absence of banks, needy investors have to cancel their long- term investment and receive 1 whereas greedy investors receive rgross
15. Banking and Debt Crises Econ 103, c© M. Muendler
How Can the Bank Finance its Deposit Contract?
• Deposit contract: Return r > 1 in period 1, r̄ < rgross in period 2 (bank collects three deposits of 1, allows depositor one withdrawal)
• Keep r in storage, invest remaining deposits 3−r in long term project
• Then return to each greedy (patient) investor is: r̄ = (3 − r) rgross/2 Note: r̄ < rgross because r > 1
• Banks redistribute returns from the greedy to the needy. Banks exist if investors under uncertainty prefer this redistribution
15. Banking and Debt Crises Econ 103, c© M. Muendler
Bank Runs and Receivership
• In an equilibrium without bank run, only the needy investor withdraws and the two greedy investors hold to enjoy the return r̄
• Suppose one greedy investor decides to withdraw r early
– Then the bank has to cancel r long-term investments to honor its contract and pay out r to the second investor (date 1)
– If the third (greedy) investor holds, she gets (3−2r)rgross (date 2)
– If the third (greedy) investor also runs, the bank goes bankrupt because 3r > 3 and each investor gets (3 − r)rgross/2 (date 2)
15. Banking and Debt Crises Econ 103, c© M. Muendler
Game between the Patient Investors
Investor B
Investor A Withdraw Hold
Withdraw (3 − r)r∗/2 r
(3 − r)r∗/2 (3 − 2r)r∗
Hold (3 − 2r)r∗ r̄
r r̄
• If investor A anticipates B to hold: Hold (best response for r̄ > r).
If investor A anticipates B to withdraw: Withdraw (best response for (3 − r)r∗/2 > (3 − 2r)r∗ because 3r > 3).
15. Banking and Debt Crises Econ 103, c© M. Muendler
If Banks Exist, Then Bank Runs Exist
• If a greedy (patient) investor expects any other greedy (patient) in- vestor to withdraw early, then the greedy (patient) investor will run
• Suspension of convertibility (bank holiday): Bank suspends convert- ibility after an amount r has been withdrawn. Then only the needy investor will withdraw early in equilibrium
• Deposit insurance: Collect tax r − 1 from early withdrawals Then banks never become illiquid but gains from banking gone too
• Lender of last resort: Banks owe nominal assets, money creation
15. Banking and Debt Crises Econ 103, c© M. Muendler
The Great Recession
• A house price bubble in the United States bursts Slowly growing house prices in 2007 turn into a nationwide drop by 2008
• Erroneously highly rated mortgage-backed securities lose value as first wave of defaults on variable-interest mortgages rolls in (MBS are composite assets such as collateralized debt obligations)
• Some banks become insolvent, write-downs require refinancing Credit markets freeze in environment of uncertainty and distrust
• Real economic activity declines
15. Banking and Debt Crises Econ 103, c© M. Muendler
Fundamental Imbalances as Triggers
• Caballero, Farhi & Gourinchas (2008): Scarcity of sound financial assets, not macroeconomic imbalance
• Capital flows to United States result in asset bubbles
• Bursting bubbles aggravate asset scarcity: dot-com decline leads to mortgage bubble, mortgage decline leads to commodity bubble
• U.S. asset demand is flip side of excess liquidity in emerging markets
• Hotelling (1931): Price of exhaustible resource rises at interest rate
15. Banking and Debt Crises Econ 103, c© M. Muendler
Policy Imbalances as Triggers
• Greenspan (2010): Under-capitalization of financial intermediaries and underpricing of risk (conjecture of “a far more limited tail risk”)
• Securitized and toxic U.S. subprime mortgages a symptom of global excess savings from fast emerging-market growth
• Fannie Mae and Freddie Mac heavily purchase subprime assets
• Real interest rates depressed
• Contagion would not necessarily occur if assets more equity financed
15. Banking and Debt Crises Econ 103, c© M. Muendler
The Classic Trigger
• Fisher (Econometrica 1933): The Debt-Deflation Theory of Great Depressions
The over-indebtedness hitherto presupposed must have had its starters. It may be started by many causes, of which the most common appears to be new opportunities to invest at a big prospective profit, as compared with ordinary profits and interest, such as through new inventions, new industries, de- velopment of new resources, opening of new lands or new markets. Easy money is the great cause of overborrowing.
15. Banking and Debt Crises Econ 103, c© M. Muendler
There Is Debt in the Private Sector Too
• Private-sector debt growth widely differs across countries 1997-2007
• Within United States, household leverage by county early and pow- erful recession predictor (Mian & Sufi IMF WP 2009)
• Countries with more leverage suffered from bigger real-estate bubble
• Countries with no private-sector debt run-ups have faced a smaller slump and will arguably experience faster recovery
• Debt-deflation depression (Irving Fisher)
15. Banking and Debt Crises Econ 103, c© M. Muendler
Household Leverage: Debt to Disposable Income Ratios
Note: Japan 1997/2006, Spain 2000/2007, Ireland 2002/2007. Source: Glick & Lansing FRBSF Economic Letter 2010-01.
15. Banking and Debt Crises Econ 103, c© M. Muendler
Household Leverage and Real House Price Run-Up
Note: Line fits linear ordinary least squares. Source: Glick & Lansing FRBSF Economic Letter 2010-01.
15. Banking and Debt Crises Econ 103, c© M. Muendler
Household Leverage and Decline in Consumption
Note: Line fits linear ordinary least squares. Source: Glick & Lansing FRBSF Economic Letter 2010-01.
15. Banking and Debt Crises Econ 103, c© M. Muendler
Financial Disintermediation as Transmitter
• Duffie (2010): Runs on Dealer Banks (intermediaries for securities)
• Flight of short-term creditors: repurchase agreements (“repos”), at downpayment (“haircut”) of as little as two percent, not rolled over. “Fire sales” of assets below market value lead to “death spiral”
• Flight of prime brokerage clients: securities and cash in prime bro- kerage accounts can no longer be used for own business as usual
• Exit of derivatives counterparties: Borrowing from dealer, cashing out from dealer, or other measures reducing dealer bank’s cash
15. Banking and Debt Crises Econ 103, c© M. Muendler
Asset-Backed Securities and Credit Default Swaps
• Mortgage-Backed Securities: Mortgages placed in a pool for notes
– Originate-to-distribute raises capital but reduces monitoring
– Best “tranches” highly rated under assumption of idiosyncratic risk
• Credit Default Swaps: Insurance against default of underlying asset
– Can be “naked”: Insured party need not own underlying asset
– Even for senior tranches, default not a well defined event
– Web of exposures accelerates loss of trust and solvency in crisis
15. Banking and Debt Crises Econ 103, c© M. Muendler
The Great Debt Shift
• Attempted resolution to “Great Recession” is a “Great Debt Shift”
• Debt from private hands to sovereigns
– Private-company take-overs (GM, AIG)
– Bank bailouts and explicit or implicit savings guarantees
– Stimulus raising household after-tax incomes and facilitating pri- vate debt service
• Policy shifts from stimulus to austerity sooner rather than later?
15. Banking and Debt Crises Econ 103, c© M. Muendler
Debt Shift from Private to Public Sector
• IMF (Global Financial Stability Report 2010): “Key task ahead is to reduce sovereign vulnerabilities.”
• Sovereign Debt to GDP ratio in G-7 close to 120% (unmatched since 1950)
• World’s government deficits as a share of GDP at 6 percent now, up from just 0.3 percent before financial crisis
• If public debt not lowered back to pre-crisis levels, G-7 growth could be depressed by half a percentage point annually
15. Banking and Debt Crises Econ 103, c© M. Muendler
Change in Underlying Budget Balance, in per cent of potential GDP
Source: OECD Economic Outlook 88 (Economic Outlook November 18, 2010).
15. Banking and Debt Crises Econ 103, c© M. Muendler
Government Debt per GDP, in per cent
1. Cumulated deficit for 2008-12, debt-increasing equity participations and impact of GDP growth. 2. Cumulated deficit mainland only Source: OECD Economic Outlook 88 (Economic Outlook November 18, 2010).
15. Banking and Debt Crises Econ 103, c© M. Muendler
Expect: Fiscal Restraint
• Expected slowdown in growth across most OECD countries and sev- eral non-OECD countries
• Net stimulus to date in the United States possibly zero: Federal spend- ing offset by state cuts (Cogan & Taylor NBER 2010)
• Monetary models of U.S. economy widely differ in interest rate effects at longer horizons (Taylor & Wieland NBER 2009)
• Household leverage strong predictor for depth of crisis and arguably subsequent growth performance across countries
15. Banking and Debt Crises Econ 103, c© M. Muendler
Contributions to Global Growth, in per cent
Note: Contributions to annualized quarterly world real GDP growth, using moving nominal GDP weights based on national GDP at purchasing power parities. Source: OECD Economic Outlook 88 (Economic Outlook November 18, 2010).
International Monetary Relations
Lecture 16 c© Marc-Andreas Muendler
University of California, San Diego
May 29, 2014
16. International Capital Market Integration Econ 103, c© M. Muendler
The International Capital Market
• Capital markets allow to reap two further types of gains from trade, beyond gains from trade in commodity markets:
– Gains from intertemporal trade: trade between periods
– Gains from insurance opportunities: trade between possible states of nature in the future
• International banking and securities
• Performance of the international capital market
16. International Capital Market Integration Econ 103, c© M. Muendler
The International Capital Market
• International capital market: Group of markets where residents of dif- ferent countries write loan contracts and trade securities (currencies, stocks, bonds and other assets)
• How do international capital markets enhance a country’s welfare?
• How integrated are international capital markets?
• How can policy makers mitigate problems without reducing the ben- efits from capital mobility?
16. International Capital Market Integration Econ 103, c© M. Muendler
The Current Account Balance
• Current Account CA: Savings invested abroad (and not domestically) A current account surplus is used to build up foreign net wealth:
CA = ∆W = Wtomorrow − Wtoday
(to keep matters simpler, we will consider Wtoday = 0)
• Total savings Stottoday go to I or CA: S tot today = I + CA
• The current account balance is
CA = Stottoday − I = (Y GNP
today −Ctoday) − I
(neglecting government spending)
16. International Capital Market Integration Econ 103, c© M. Muendler
Current Account, Investment and Consumption
• Consumption today: Ctoday = Y GNPtoday − CA − I
• Consumption tomorrow:
Ctomorrow ≈ Y GNP
tomorrow = (1 + r e,∗) · Wtomorrow + Y
GDP tomorrow
and Y GDPtomorrow = F(I) is the production function for tomorrow’s output
• With international capital mobility: CA 6= 0 is possible and
Wtomorrow = (Y GNP
today −Ctoday) − I
16. International Capital Market Integration Econ 103, c© M. Muendler
Savings and Investment in a Closed Economy
0
Consumption and Income Today (MEX)
C o
n s u
m p
ti o
n a
n d
I n
c o
m e
T o
m o
rr o
w (
M E
X )
C ,
Y tomorrow
tomorrow
C ,Ytoday today
16. International Capital Market Integration Econ 103, c© M. Muendler
Savings, Investment and Capital
• In a closed economy, all savings are investment in domestic uses Domestic investment augments the country’s capital stock:
I = ∆K = Ktomorrow − Ktoday
(to keep matters simpler, we will consider Ktoday = 0)
• Total savings Stottoday go to I only: S tot today = I
• The remaining income is consumed
S tot today − I = (Y
GNI today−Ctoday) − I
(neglecting government spending)
16. International Capital Market Integration Econ 103, c© M. Muendler
The Current Account Balance
• Current Account CA: Savings invested abroad (and not domestically) A current account surplus is used to build up foreign net wealth:
CA = ∆W = Wtomorrow − Wtoday
(to keep matters simpler, we will consider Wtoday = 0)
• Total savings Stottoday go to I or CA: S tot today = I + CA
• The current account balance ‘unchains’ consumption from investment
CA = Stottoday − I = (Y GNI
today−Ctoday) − I
(neglecting government spending)
16. International Capital Market Integration Econ 103, c© M. Muendler
Savings and Investment in a Small Open Economy
0
Consumption and Income Today (MEX)
C o
n s u
m p
ti o
n a
n d
I n
c o
m e
T o
m o
rr o
w (
M E
X )
C ,
Y tomorrow
tomorrow
C ,Ytoday today
16. International Capital Market Integration Econ 103, c© M. Muendler
Savings and Investment in a Small Open Economy
0
Consumption and Income Today (MEX)
C o
n s u
m p
ti o
n a
n d
I n
c o
m e
T o
m o
rr o
w (
M E
X )
C ,
Y tomorrow
tomorrow
C ,Ytoday today
A
Ytoday
Ctoday
C =Ytomorrow tomorrow
16. International Capital Market Integration Econ 103, c© M. Muendler
Savings and Investment in a Small Open Economy
0
Consumption and Income Today (MEX)
C o
n s u
m p
ti o
n a
n d
I n
c o
m e
T o
m o
rr o
w (
M E
X )
C ,
Y tomorrow
tomorrow
C ,Ytoday today
PPF Ytoday 1+r* in world equilibrium
1
1+r*
Itoday
Ytomorrow
Ctoday
Ctomorrow
{ CA { (1 )+r* CA.
Gains from tradeA W
16. International Capital Market Integration Econ 103, c© M. Muendler
The Gains from Intertemporal Trade
• In the presence of an international capital market, a country’s resi- dents can choose investment and consumption independently
• Countries in need of large investments but insufficient savings rates can fund their investments by borrowing abroad
• Countries with temporarily less attractive investment opportunities can lend abroad and enjoy higher returns
• Foreign lending is risky because countries are sovereigns and no court system can ensure repayment
16. International Capital Market Integration Econ 103, c© M. Muendler
Does the International Capital Market Work?
• Obstfeld (1998): Historic |CA|/GDP ratios about a century ago larger than today’s
• Feldstein and Horioka (1980): Home Bias Puzzle. Most savings are invested in home country
In a regression of S/Y GDP on a constant and I/Y GDP, the coefficient on I/Y GDP is .89 (16 OECD countries, 1960-74)
• Obstfeld and Rogoff (2002): Home Bias Puzzle less severe but still present for 1990-97 period (57 OECD and non-OECD countries)
16. International Capital Market Integration Econ 103, c© M. Muendler
Historic Relative Current Account Balances Argentina Germany Japan UK USA Alla
(1) (2) (3) (4) (5) (6) 1870-89 18.7 1.7 .6 4.6 .7 3.7 1890-1913 6.2 1.5 2.4 4.6 1.0 3.3 1914-18 2.7 6.8 3.1 4.1 5.1 1919-26 4.9 2.4 2.1 2.7 1.7 3.1 1927-31 3.7 2.0 .6 1.9 .7 2.1 1932-39 1.6 .6 1.0 1.1 .4 1.2 1940-46 4.8 1.0 7.2 1.1 3.2 1947-59 3.1 2.0 1.3 1.2 .6 1.9 1960-73 1.0 1.0 1.0 .8 .5 1.3 1974-89 1.9 2.1 1.8 1.5 1.4 2.2 1990-96 2.2 1.9 2.2 2.0 1.0 2.3
|CA|/GDP ratios. Source: Obstfeld (1998) aSample of 12 countries.
16. International Capital Market Integration Econ 103, c© M. Muendler
Home Bias in Savings among OECD countries, 1990-07 In
ve st
m e
n t p
e r
G D
P
Savings per GDP
0 .1 .2 .3 .4 .5
0
.1
.2
.3
.4
.5
GB GR SE US
CA IS NZ
AU
DK
FI
MX
IT
ES TR FRIE
DE
BE
PT AT
NL NO CH
JP
Source: Obstfeld and Rogoff (2003)
16. International Capital Market Integration Econ 103, c© M. Muendler
Home Bias in Savings in a sample of 56 countries, 1990-97 In
ve st
m e
n t p
e r
G D
P
Savings per GDP
0 .1 .2 .3 .4 .5
0
.1
.2
.3
.4
.5
SV
JO
MW
GT
BF ZM
UY
PYDM
KE
LK
GB
ZWNA
SE GRUS
NZPK EC
IS CA
PH AU
HN
DK
TN
TT FI
CO MA
IT
MX TR ES
FRIE
DE
CR CL
BE VE
PT AT PA
MU
NL
IR
NO SA
CH
JP
MY TH
KR SG
Source: Obstfeld and Rogoff (2003)
16. International Capital Market Integration Econ 103, c© M. Muendler
Why Does Not More Capital Flow North to South?
• Reinhart & Rogoff (2004): Serial default is the rule, not the exception, and prevents North-South flows.
• Serial defaulters in history: Spain (13×), Ecuador and Venezuela (9×), Germany and France (8×), Argentina (5×)
• Weak debt contract enforcement, credit-market imperfections.
• Lucas (1990): Externalities in human-capital formation, physical cap- ital traces human capital
16. International Capital Market Integration Econ 103, c© M. Muendler
International Portfolio Choice
• Risk averse investors appreciate both high returns and low risk
• The prospect of little variation in future returns on investment is simi- lar to insurance
• Little variation in future returns guarantees a steady level of income and consumption
• A diversification of investments to different countries reduces the vari- ation in future returns in a portfolio
16. International Capital Market Integration Econ 103, c© M. Muendler
International Diversification of Investments
• Suppose there are only two possible states of nature tomorrow: A good-luck and a bad-luck state from the perspective of the home country. There is good luck with probability p
• There are two assets: A home-country stock and a foreign stock
• The expected payoffs are
States of Nature p 1−p
Home Stock 5 1 Foreign Stock 1 5
16. International Capital Market Integration Econ 103, c© M. Muendler
Optimal Portfolio Choice
• A risk-averse investor mixes the two assets
• If prices of the two assets are the same, the risk-averse investor holds a share λ of the foreign asset irrespective of p
Portfolio Income/ Home stock Foreign stock Consumption
1− λ λ
Good state of nature 5 1 5 − 4λ Bad state of nature 1 5 1 + 4λ
• A risk-averse investor chooses λ = 1 2
with a guaranteed income of 3
16. International Capital Market Integration Econ 103, c© M. Muendler
The Gains from Insurance Opportunities
• International capital market provide additional opportunities to diver- sify the portfolio
• If there were no world-wide (“aggregate”) risk, investors could guar- antee themselves a constant income (in the example 5 + 1 = 6 in all states of nature, so there is no aggregate risk)
• There is world-wide (“aggregate”) risk. Then investors world-wide can at least guarantee themselves a consumption level proportional to world income. Empirically, however, the fluctuations in consumption are not synchro- nized across countries. So, capital markets are not integrated.
16. International Capital Market Integration Econ 103, c© M. Muendler
Does International Portfolio Allocation Work?
• Under perfect insurance, consumption changes across the world would be perfectly correlated even in the presence of aggregate risk
Consumption and Output: Correlations of Home and World Growth Rates 1973-92
Country Corr(∆C C
, ∆CW
CW ) Corr(∆Y
Y , ∆Y W
Y W )
Japan .38 .46 United Kingdom .63 .62 United States .52 .68 OECD average .43 .52 Developing country avg. -.10 .05
Source: Obstfeld and Rogoff (1995)
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1 Capital Controls, Monetary Autonomy and
Exchange Rate Stability
this policy makes the Uncovered Interest Parity condition break down.
Uncovered interest rate parity (UIP) predicts that high interest rate currencies will depreciate relative to their low interest rate counterparts. This relationship between interest rate differentials and spot exchange rate depreciation is at the heart of many theoretical models in finance. A simple example can illustrate these dynamics. Suppose foreign interest rates were higher over a one week horizon than their domestic counterparts. Risk neutral investors with rational expectations (two key assumptions of the model) would buy the foreign currency to invest abroad at the one week maturity and capture these excess returns. This would continue up to the point that the foreign currency depreciates sufficiently to account for the initial interest rate differential. This simple uncovered arbitrage argument dictates that in equilibrium, there are zero attainable excess returns from such a strategy. If we are to believe that such a process holds for all currency pairs over all time horizons, UIP will hold. Given the depth of liquidity in markets for foreign exchange, efficiency of this type is not an unreasonable assumption.
2 Balance-of-Payments Crisis
Uncovered Interest Parity and Purchasing Power Parity to express the shadow exchange rate as a function of the monetary base.
an attack on the currency will occur when the shadow exchange rate hits the exchange rate peg
the government forces its monetary authorities to monetize new debt at an even faster rate
3 Self-fulfilling Currency Attack
4 Speculation against the European Monetary
System
"the British government's critics" have thought it possible to lower interest rates after taking Sterling out of the ER
The Economist think the opposite would occur soon after Britain exited the ER
British nominal interest rates relative to German rates have suggested an expectation of high future British ination.
purchase of the German stock is a debit in the U.S. financial account. There is a
corresponding credit in the U.S. financial account when the American pays with a
check on his Swiss bank account because his claims on Switzerland fall by the amount
of the check. This is a case in which an American trades one foreign asset for another.
there is a U.S. financial account debit as a result of the purchase of a German
stock by an American. The corresponding credit in this case occurs when the German
seller deposits the U.S. check in its German bank and that bank lends the money to a
German importer (in which case the credit will be in the U.S. current account) or to an
individual or corporation that purchases a U.S. asset (in which case the credit will be
in the U.S. financial account). Ultimately, there will be some action taken by the bank
which results in a credit in the U.S. balance of payments.
5 Bank Run
in the case of withdrawals by all investors, the central
bank serves as a lender of last resort, prints money and pays r in cash to every
investor. Of course, rational investors know that these 3r money units only buy
3 units of real goods under the storage technology so that the real payo_s in
this crisis case are 1 to each investor.
6 Debt Sustainability
This structure allows for heterogeneity, generates a yield curve and some interesting dynamics
and, at the same time, is quite tractable. If D is the measure of agents that holds debtor’s
bonds, then the amount of debt with maturity at this period is DλΔt, regardless of history –
it does not matter how we got to the present state.
Each lender can buy one bond that pays 1 (infinitesimal) unit at maturity (if there is no
default) and costs 1 − r when it is bought – bonds will be offered with several different
maturities and interest rates, r is the main endogenous variable of the model.
The outside option of the lender is a safe technology that yields zero return for sure. Lenders
have to pay a small transaction cost every time they have to make a decision and invest.
The debtor at a given period has own resources equal to θ. In addition, it can borrow from the
lenders by issuing bonds (i.e., promises to pay 1 at a given maturity date) that cost 1 − r. At
a given period, the debtor has debt D and its available resources are θ + D. The debtor goes
bankrupt if its own resources plus the debt become negative (that is, if it runs out of money).
The amout of its own resources, θ, follows a random walk and is also affected by the total
amount of interest paid (R(t)). Thus:
1. At the beginning of each period, the debtor has debt D, and own resources θ and so,
D + θ resources available.
2. The debtor repays the lenders that are leaving the economy and may issue debt. The
lenders that are just arriving choose whether they buy one bond or not.
3. The random term ΔX is revealed.
The debtor may go bankrupt at either step 2 or 3. If that doesn’t happen, another period
starts.
with maturity in 1 period for (λΔt) (λΔt) lenders with discount factor r = Φ(Δt),
• with maturity in 2 periods for (λΔt) (λΔt) (1 − λΔt) lenders with discount factor r =
Φ (2Δt),
• with maturity in 3 periods for (λΔt) (λΔt) (1 − λΔt)2 lenders with discount factor r =
Φ (3Δt),
m
CBCB
WB
<
(
)
(
)
*
*
*
*
1
1
3
32
2
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rr
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Economics 103 — Spring 2014
International Monetary Relations
Problem Set 3 May 20, 2014
Due: Thu, June 5, before 9:30am Instructor: Marc-Andreas Muendler E-mail: [email protected]
1 Capital Controls, Monetary Autonomy and Exchange Rate Stability
Suppose a country has strict capital controls in place and restricts capital flows unless approved by the government. Explain why this policy makes the Uncov- ered Interest Parity condition break down. Use a diagram showing the exchange rate, expected currency returns and real money holdings to verify that the cen- tral bank can reduce the domestic interest R to a level of its choice without an effect on the exchange rate.
Now suppose that capital is completely free to flow in and out of the country. However, investors assess the risk of the country’s securities as different from other countries’ assets. Show how the central bank can reduce the interest rate R without affecting the exchange rate level. [Hint: Engineer a partly sterilized intervention that moves the risk premium to the right extent.]
2 Balance-of-Payments Crisis
A small open economy pegs its exchange rate to a foreign currency at the level Ē. The government expands its debt steadily and forces its monetary authorities to buy (monetize) the new debt at a rate µ. The government also requires the monetary authorities to maintain the exchange rate peg as long as they have foreign reserves. Once foreign reserves are depleted, monetary authorities float the exchange rate freely.
• In this scenario, government debt and therefore the monetary base expand at a rate µ. Depict the time path of foreign reserves of the monetary authorities. Is the peg sustainable indefinitely?
• Define the shadow exchange rate. Use Uncovered Interest Parity and Pur- chasing Power Parity to express the shadow exchange rate as a function of the monetary base. Depict the time path of the shadow exchange rate.
• Explain why an attack on the currency will occur when the shadow ex- change rate hits the exchange rate peg Ē. Depict the immediate response of the domestic interest rate and the domestic price level to the attack.
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• Suppose the government forces its monetary authorities to monetize new debt at an even faster rate µ′. How is the timing of attack affected? Infer the new shadow exchange rate and position it, given anticipated money supply growth after foreign reserve depletion or after the attack.
3 Self-fulfilling Currency Attack
Consider the following attack game (with foreign and domestic asset holdings such that W CB <BCB). There is a number J of small investors who all own one unit of currency, and one big investor who owns K units of currency. In the case of a defense, the central bank incurs losses of R per unit of foreign reserves that it has to use for the intervention.
Central Bank
Investor i Defend (∆E = 0) Devalue (∆E >0)
Attack −c ∆E − c
−R(J + K) ∆E(W CB−BCB)
Hold 0 −∆E
0 ∆E(W CB−BCB)
• State the condition for a self-fulfilling attack to be an equilibrium.
• Explain under what condition a successful attack becomes a best response for any small investor (among the J investors) when he or she observes the big investor in a fire sale of K units of the currency but the J − 1 other small investors holding on to the currency.
• Suppose K = 0. Investor i and the central bank anticipate that J − 1 other investors will attempt to attack. Show that a successful attack is an equilibrium for every investor i if there is a large number J of other at- tacking investors. Also show that a no-attack-no-devaluation equilibrium exists.
• Why is a discrete foreseeable devaluation ∆E > 0 possible in a self- fulfilling crisis but not in a fundamentals-driven crisis?
• Evaluate the following statement.
One way to reduce the chance of a self-fulfilling attack is to raise the transaction cost c so that investors are more reluctant to run.
Is this statement correct in the strategic framework above? Why or why not?
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4 Speculation against the European Monetary System
Short before the British government gave in to speculative pressure on the British Pound against the German Deutschmark and abandoned the European Exchange Rate Mechanism (ERM) in September 1992, The Economist magazine wrote (“Crisis? What Crisis?”, in The Economist, August 29, 1992):
The [British] government’s critics want lower interest rates, and think this would be possible if Britain devalued Sterling, leaving the ERM if necessary. They are wrong. Quitting the ERM would soon lead to higher, not lower, interest rates, as British economic management lost the degree of credibility already won through ERM membership. Two years ago British government bonds yielded three percentage points more than German ones. Today the gap is half a point, reflecting investors’ belief that British inflation is on its way down—permanently.
Evaluate this statement.
• Why might “the British government’s critics” have thought it possible to lower interest rates after taking Sterling out of the ERM? Britain’s economy was in a recession in fall 1992.
• Why did The Economist think the opposite would occur soon after Britain exited the ERM? In what way might ERM membership have lent cred- ibility to British economic policy makers? Britain entered the ERM in 1990.
• Why would elevated British nominal interest rates relative to German rates have suggested an expectation of high future British inflation? Can you think of alternative explanations? Suggest two reasons why British interest rates might have exceeded German rates at the time of the writing of the article, despite the alleged “belief that British inflation is on its way down—permanently.”
5 Bank Run
There are 3 investors who live for two periods and have one unit of savings each. A storage technology returns the investment without interest after one period; a long-term project returns gross interest r∗ > 1 after two periods (or just the principal 1 if cancelled after one period).
One investor will be needy (impatient) and withdraw in period 1, two in- vestors will be greedy (patient) and hold deposits until period 2; but investors do not know whether they will be needy or greedy at the time of investment in period 0.
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Banks offer deposit contracts that pay a gross interest of r > 1 for with- drawals in period 1 and r̄ < r∗ for withdrawals in period 2. Risk-averse investors prefer bank deposits over direct investments and lend their units of savings to the bank. The single needy investor will withdraw r > 1 in period 1, whereas the two greedy investors may withdraw early or hold. The strategic framework for the two greedy investors A and B can be summarized as in the bank run game below (the lower-right payoffs are for investor B).
• Determine each investor’s best responses to the other investor’s possible choice.
• Show that there are two equilibria if (3 −r)r∗/2 > (3 − 2r)r∗: a bank run and no bank run.
Now suppose that, in the case of withdrawals by all investors, the central bank serves as a lender of last resort, prints money and pays r in cash to every investor. Of course, rational investors know that these 3r money units only buy 3 units of real goods under the storage technology so that the real payoffs in this crisis case are 1 to each investor.
• For this scenario, show which payoffs in the game below need to be replaced with 1.
• Under the scenario, state a condition on the relevant payoff when exactly one greedy investor holds on so that the only equilibrium is no bank run.
Investor B
Investor A Withdraw Hold
Withdraw (3 − r)r∗/2 r
(3 − r)r∗/2 (3 − 2r)r∗
Hold (3 − 2r)r∗ r̄
r r̄
Note. The rationale for the payoffs is as follows. If one greedy investor withdraws r early, the bank cancels r long-term investments to honor its contract and pays out r as a second withdrawal so that the remaining greedy investor receives (3 − 2r)r∗. If both greedy investors try to withdraw r each early, the bank goes bankrupt and each greedy investor gets (3 − r)r∗/2.
6 Debt Sustainability
We speak of a Ponzi scheme when an agent’s debt grows at a rate α such that interest payments on existing debt fall short of new borrowing relative to existing debt. What does a Ponzi scheme imply for the relationship between
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α and the real interest rate r∗? Explain why a Ponzi scheme would leave the borrower with unlimited resources as time passes. Will lenders be willing to tolerate this?
Now suppose that, at some date T in the future, the interest on the debt contracts is anticipated to permanently increase to some r∗′ so that α < r∗′
from T on forever. Can the borrower start to accumulate new debt at a rate α from today on? Would your answer change if the interest rate were anticipated to fall back to r∗ at some time T ′ > T?
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