WEEK 6 - Economic Models of Exchange Rate Determination and Volatility Flashcards
Where does the Flexible Monetary Model originate from and what does it view?
- > Hume’s theory of Price-Specie Flow
- > Links exchange rate movement to BoP equilibrium
- > Hume’s analysis strict monetary approach to prices and BoP
- > Basically, Exchange rate is relative price of money supply in dif countries
- > Capital ignored so interest rates not considered
What are the three assumptions of the flexible monetary model?
- Aggregate Supply is Vertical
- Demand for real money balances is stable function of only few domestic maceoecon variables
- PPP obtains at all times
What is meant by Demand for real money is a stable function domestic macroecon variables?
- No capital considered, so no interest rates
- Ms = Md
Where:
Md = kPy k>0
Showing Md is a function of income
What is meant by the PPP obtains at all times?
Well Absolute PPP holds at all times so exchange rate always right
Anything above is an overvaluation and anything below is an undervaluation
SEE GRAPH AND CALCULATION IN NOTES
What does the Domestic Money Supply consist of?
Ms = D + R Where: Ms = Domestic Money Base D = Domestic bond holdings R = Foreign Reserves of Foreign Currency
-> Authorities can conduct OMO or foreign exchange operations (FXO)
Resulting in:
dMs = dD + dR
SEE GRAPH IN NOTES
What does the equilibrium look like in the Flexible Monetary Model look like?
EQUILIBRIUM IN ALL 3 MKTS
SEE GRAPH IN NOTES
What are the effects of a devaluation in the Flexible Monetary Model?
- > Due to a devaluation -> S1 to S2
- > Devaluation means currency underappreciated.
- > Which means more exports -> AD1 to AD2
- > Higher exports means more reserves not domestic credit (so MS increases)
- > Due to inflation from more exports, new equilibrium from P1 to P2
SEE GRAPH IN NOTES
What do we see with monetary expansion under fixed rates in the Flexible Model?
D1 rise to D2
So, MS1 -> MS2
Affects inflation -> Price lvls up (P1 to p2)
Currency now overvalued ->Now has to intervene in mkt -> Reserves drop and Ms drops back to Ms1 again
SEE GRAPH IN NOTES
What do we see with monetary expansion under floating rates in the Flexible Model?
- D1 to D2
- PPP up
- AD1 to AD2
- No intervention so R stays the same, depreciation from S1 to S2
SEE GRAPH IN NOTES
What do we see with an increase in income under fixed rates in the Flexible Model?
AS1 to AS2 (More supply as incomes increase increase (Productivity))
So, P1 to P2 -> Means exchange should appreciate -> So intervene to buy foreign currency and sell domestic -> So R1 to R2 -> So, M1 to M2 -> So P1 to P2
SEE GRAPH IN NOTES
What do we see with an increase in income under floating rates in the Flexible Model?
AS1 to AS2 -> Prices go down ->Exchange appreciates (No change in money mkt)
SEE GRAPH IN NOTES
What do we see with an increase in foreign prices under fixed rates in the Flexible Model?
New change in PPP needed as the P* now changing -> So from PPP1 to PPP2
- > Currency now overvalued
- > Technically appreciating so intervention to increase prices to P2 -> Buying up foreign reserves (R1 to R2) to increase Md
- > Prices increasing to P2
SEE GRAPH IN NOTES
What do we see with an increase in foreign prices under floating rates in the Flexible Model?
No change in any other mkt except appreciation
-> Because floating rates act as shock absorber
SEE GRAPH IN NOTES
What is the alternative flexible price monetary model?
- > Developed by Frankel, Mussa and Bilson
- > Also assumes PPP holds continuously
- > In addition to existing variables also adds in interest rate parity conecpt
What is the differing MD Functions?
Md =
m-p = ηy - σr
Foreign Md=
m-p = ηy* - σr*
What is the PPP and the uncovered interest rate parity denoted as? Why does UIRP also hold in this model?
PPP:
s = p - p*
UIP holds since the model assumes that domestic and foreign bonds are perfect substitutes
UIP:
Es = r - r*
How do we get the domestic and foreign prices and what is it denoted as?
p = m - ηy + σr p* = m* - ηy* - σr*
By combining the Md function together
What are the domestic and foreign prices denotations also showing?
An exchange rate equation, where the spot exchange
is determined by the right hand variables
What does the exchange rate equation predict? AND WHAT IS ITS DERIVATION
p* = m* - ηy* - σr*
1 Relative money supplies affect exchange rates;
2 Relative levels of national income influence exchange rates and;
3 Relative interest rates affect exchange rates
What were some of the failures of the flexible price monetary model?
- > Assumption in PPP holding constantly
- > Prices both upward and downward flexible
_. Model not useful in explaining observed exchange rate departures from PPP
What is the underlying principles in the Dornbusch Model?
- > that prices in the goods market and wages in labour markets are sticky
- > exchange rate is determined in “flex-price” market.
- > UIP hold continuously
- > Instant adjustment due to perfect capital mobility and asset substitutability
- > So continuous equilibrium in money mkt
What is meant by an ‘overshooting’ as used in the Dornbusch model?
> short-run excessive movement in exchange rates
- > As a result of speed of adjustment across mkts
- > Goods mkt prices are sticky but price adjust instantly in fin mkts
-> So in SR, mass depreciation or appreciation but in LR slowly comes back to equilibrium (or goes back to PPP)
How do you derive the goods mkt (GG slope) in the sticky (Dornbusch) model?
The goods-market equilibrium schedule represents the equality of demand and supply
Positively sloping (Maths not really needed tbf)
SEE SLOPE IN NOTES
How do you derive the money mkt schedule (MM slope) in the sticky (Dornbusch) model?
Equilibrium supply and demand of money
dp/ ds = -σΘ
Where:
dp = (log) demanded domestic price inflation
ds = (log) demanded spot rate
Θ = Expected rate of depreciation of currency
SEE SLOPE IN NOTES
