Summary
International money and finance - summary week 3
- Course
- Institution
- Book
An in-depth summary of chapter 7 of the book International Finance (UVA-specific edition), including essential terms and pictures.
[Show more]
Connected book
Book Title:
Author(s):
- Edition:
- ISBN:
- Edition:
More summaries for
-
International money and finance - summary week7
-
International money and finance - summary week 6
-
International money and finance - summary week 5
Seller
Follow
natyprycova
Reviews received
Content preview
CHAPTER 7 – MODERN MODELS OF EXCHANGE RATE DETERMINATION7.1 INTRODUCTION
• PPP (purchasing power parity) theory is a lot about arbitrage and not really about
capital movement
o But there has been a massive growth in capital markets
• Expectations of exchange rate will determine which currencies to buy or sell
o If currency is expected to depreciate → agents will switch out of that currency
and into currencies that are expected to appreciate
7.2 UNCOVERED INTEREST RATE PARITY
• Exchange rate as a relative asset price → agents can switch between currencies
o Asset price → its present value is influenced by expected rate of return
• Two factors international investors bear when considering which to purchase
o Rate of interest (on both)
o Expected exchange rate
• International bond market equilibrium
o 𝐸𝑠 = 𝑟𝑢𝑘 − 𝑟𝑢𝑠 → uncovered interest parity condition
• UIP – Uncovered interest parity condition
o Expected rate of depreciation of the pound against the dollar is equal to the
interest rate differential between UK and US bonds
o Example: if the US interest rate is 10%, UK 4% → on average international
investors apparently expect the pound to depreciate by 6%
o UIP implies that the expected rate of return on domestic and foreign bonds
are equal
o Requires capital to be extremely mobile
o Also UK and US bonds have to equally risky → UK and US bonds to be the
perfect substitutes
7.3 THE MONETARY MODELS OF EXCHANGE RATE DETERMINATION
• 3 major monetary models
o 1. Flexible-price
▪ All prices in the economy are flexible → both upwards and downward
both in short and long run
o 2. Sticky-price (Dornbusch)
▪ Short run – prices and wages are sticky
▪ Medium to long run → they adjust
o 3. Real-interest-rate-differential
▪ Combines the role of inflationary expectations (flexible model) and
sticky prices
• Supply and demand are key determinants of exchange rates
• All the models have the UIP condition
, o They assume that domestic and foreign bonds are equally risky → expected
rates of return are equalized
7.4 THE FLEXIBLE-PRICE MONETARY MODEL
• Developed by Frankel and Mussa and Bilson
• Assumes that PPP holds continuously
• It introduces relative money shocks → determine the exchange rate
• Conventional money demand function → equilibrium:
o 𝑚 − 𝑝 = 𝜂𝑦 − 𝜎𝑟
▪ m – log of the domestic money shock
▪ p – log of domestic price level
▪ y – log of domestic real income
▪ r – nominal domestic interest rate
o 𝑚 ∗ −𝑝 ∗= 𝜂𝑦 ∗ −𝜎𝑟∗ → same but foreign
• PPP holds continuously → s = p – p*
• Uncovered interest parity holds → Es = r – r*
• Domestic price level
o 𝑝 = 𝑚 − 𝜂𝑦 + 𝜎𝑟
• Foreign price level
o 𝑝 ∗= 𝑚 ∗ −𝜂𝑦 ∗ +𝜎𝑟 ∗
• 𝑠 = (𝑚 − 𝑚 ∗) − 𝜂(𝑦 − 𝑦 ∗) + 𝜎(𝑟 − 𝑟 ∗) → reduced form exchange rate equation
o 1. Relative money supply affect exchange rate
▪ Percentage increase in the home money supply leads to exactly
equivalent depreciation of the currency
▪ Percentage increase in the foreign money supply leads to exactly
equivalent appreciation of the currency
o 2. Relative levels of national income influence exchange rates
▪ If domestic income is to rise → increase in transaction demand for
money → fall in domestic prices → appreciation of the currency to
maintain PPP
▪ Increase in foreign income → fall in foreign price level → depreciation
of the currency domestic
o 3. Relative interest rates affect exchange rates
▪ Increase in domestic interest rate → depreciation of domestic
currency
• Fall in demand for money → depreciation
• Increase in interest rate causes inflation to increase →
decrease demand for money → increased expenditure → rise
in domestic prices → depreciation to remain PPP
▪ Expected rise in the foreign prices → fall in demand for foreign
currency → appreciation of the domestic currency
o Based on assumption that all prices are fully flexible
7.5 THE DORNBUSCH STICKY-PRICE MONETARY MODEL
The benefits of buying summaries with Stuvia:
Guaranteed quality through customer reviews
Stuvia customers have reviewed more than 700,000 summaries. This how you know that you are buying the best documents.
Quick and easy check-out
You can quickly pay through credit card or Stuvia-credit for the summaries. There is no membership needed.
Focus on what matters
Your fellow students write the study notes themselves, which is why the documents are always reliable and up-to-date. This ensures you quickly get to the core!
Frequently asked questions
What do I get when I buy this document?
You get a PDF, available immediately after your purchase. The purchased document is accessible anytime, anywhere and indefinitely through your profile.
Satisfaction guarantee: how does it work?
Our satisfaction guarantee ensures that you always find a study document that suits you well. You fill out a form, and our customer service team takes care of the rest.
Who am I buying these notes from?
Stuvia is a marketplace, so you are not buying this document from us, but from seller natyprycova. Stuvia facilitates payment to the seller.
Will I be stuck with a subscription?
No, you only buy these notes for $6.96. You're not tied to anything after your purchase.
Can Stuvia be trusted?
4.6 stars on Google & Trustpilot (+1000 reviews)
53068 documents were sold in the last 30 days
Founded in 2010, the go-to place to buy study notes for 14 years now