CHAPTER 7 – MODERN MODELS OF EXCHANGE RATE DETERMINATION
7.1 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
7.1 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
