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Expected Differential
r (r * + x)
Foreign Asset
r*
Expected Differential
r xr* = r (r * + x)
If domestic and foreign interest-bearing assets are perfect substitutes, as assumed by monetary models, then international asset market equilibrium requires the expected differential in returns to be zero. i.e. r (r * + x) = 0 or r = r *+x Uncovered interest parity (UIP) condition UIP represents one of the asset market equilibrium conditions of most monetary models and plays a central role in exchange rate determination in these models.
(1)
(2)
(3)
(3')
Relative PPP
eP * = P where = a constant
(4)
e =
P
P*
(5')
e=
M
m1P * YF
(5)
Implications
Extending the model to two countries assuming an identical form for the foreign demand for money function allows us to determine P*.
P* = M* m1YF *
MYF *
M * YF
Given , the nominal exchange rate is determined by relative money supplies, and relative (full-employment) output levels. In log form the equation can be rewritten as:
m= e = m m * + ( yF yF *) LOG M etc.
1. There are 4 financial assets : domestic and foreign monies, domestic and foreign bonds. 2. Domestic and foreign bonds are traded internationally, domestic money is held only by domestic residents, foreign money is held only by foreign residents. 3. International investors are risk neutral, implying domestic and foreign bonds are perfect substitutes. Therefore uncovered interest parity must hold. 4. Output is exogenously given, at full employment level. 5. Relative PPP holds. 6. Prices are perfectly flexible.
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The demand for nominal money balances is assumed to depend on the price level, income, and the interest rate. The demand for money function is specified to be linear when expressed in logs:
M d = PY exp( r ) income elasticity of M d
(1)
= interest semi-elasticity of M d
Domestic Money Supply
Ms =M
(2)
(3)
Taking logs:
p = m y + r (3')
(4)
In LOGS:
y = yF
(4')
(5)
(6)
Relative PPP
eP * = P
(7)
e =
P P*
(7 ')
(8)
Equation (8) is often presented in its own right as an equation explaining exchange rate determination. It forms the basis of the most common empirical tests of the monetary model. It indicates that the nominal exchange rate is determined by relative money supplies, relative prices ( ), real income levels and relative interest rates. 8
Note the final term implies: r > 0 e This prediction is in apparent contrast to that of the Mundell-Fleming model. Explanation: r > 0 M d ( MME ) P > 0 ( PPP) e > 0 Note that the contrast is more apparent than real. Underlying (8) there is no representation of capital mobility. In (8) r is viewed as an exogenous variable which affects e via its effect on the demand for money. Equation (8) can be developed further by incorporating the assumption of UIP.
(9)
Expectation and the equilibrium exchange rate Substituting (9) into(8) with time subscripts added:
* et = mt mt * + t ( yFt yFt ) + [ Et (et +1 et )]
(10)
i.e. zt represents the fundamental determinants of the exchange rate as viewed by the ERE monetary model
et = zt Et (et +1 ) + (1 + ) (1 + )
(10')
The current nominal exchange rate depends on: 1. Current economic fundamentals, zt 2. The expected future value of e Agents with rational expectations are assumed to understand the process of exchange rate determination and use this understanding in forming exchange rate expectations. Hence expectations of future exchange rates are formed using (10'') :
Et (et +1 ) = Et ( zt +1 ) + Et (et +1 ) (1 + ) (1 + )
Generally:
Et (et + j ) = Et ( zt + j )
(1 + )
(1 + )
Et (et + j +1 )
(11)
(11) indicates that the current exchange rate depends not only on the current values of economic fundamentals, but also on the expected future values of fundamentals into infinite future. This provides one possible explanation of exchange rate volatility i.e. volatile expectations. The equation also indicates that the precise effect of current changes in fundamentals, i.e. zt , will depend on whether, and how, these current changes affect expectations of future values of fundamentals.
The exchange rate and the money supply
The ERE monetary approach focuses on relative money supply changes as the principal determinant of exchange rate movements. Assume , yF , yF *and m * to be constant. Therefore current changes in z are purely the consequence of current changes in m.
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Effect of changes in mt on et depends on whether and how current changes in mt affect expectations of future values of m .
Alternative money supply processes
(i)
mt + j = m + ut + j Et (mt + j ) = m
(ii)
mt + j = mt + j 1 + ut + j Et (mt + j ) = mt
i.e. the best forecast of any future value of m is its current value.
(iii)
mt + j = mt + j 1 + ut + j Et (mt + j ) = mt + jmt
Assuming mt 1 = 0
et = (1 + )mt
Lies in different effects of current changes in m on expected future values of m (i) (ii) (iii) rise in m expected to be temporary rise in m expected to be permanent rise in m taken as a signal of a permanent increase in the rate of growth of m.
Each has different consequences for the demand for money: (i) (ii) (iii)
1. It helps explain, via PPP, why high inflation countries tend to have depreciating currencies. 2. It identifies the importance of expectations for exchange rate determination. 3. It contributes to our understanding of exchange rate volatility via its emphasis on expectations.
Weaknesses
1. It assumes continuous PPP this is in direct contradiction of the facts of exchange rate behaviour. 2. It takes relative prices and real incomes to be given exogenously, rather than determined endogenously. 3. In assuming risk neutrality it: (a) identifies a limited range of assets whose relative supplies are important for exchange rate determination. (b) Precludes a role for the current account in exchange rate determination
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1. Four financial assets: domestic and foreign monies, domestic and foreign bonds. 2. Domestic and foreign bonds are traded internationally, money is not. 3. International investors are risk neutral, therefore UIP must hold. 4. Output is exogenously given, at full employment level (assumption is relaxed later in the paper). 5. Domestic output is an imperfect substitute for world output. 6. The price of domestic output is instantaneously fixed, but responds gradually to excess demand or supply in the goods market. 7. The country is small world variables are given exogenously. 8. Agents have rational exchange rate expectations. The model can be viewed as a dynamic AD-AS model. Prices are fixed in the (very) short run, and, in its variable output version, the framework generates short-run results very similar to those of the M-F model. However, in the long run, prices are flexible
(1)
p = log of domestic prices y = log of domestic income/output r = domestic interest rate md = log of demand for money
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(2)
(3)
(3')
Rearranging
p = m y + r
(4)
where p = LR equilibrium price level. In long run, with m, yF and r * given exogenously, adjustments in p ensure money market equilibrium.
Uncovered Interest Parity
r = r *+x
(5)
(6)
(6) states that the domestic currency is expected to adjust towards its long-run equilibrium value, e , at a rate which is proportional to the difference between e and the current value of e. (Dornbusch demonstrates that this is consistent with rational expectations). Substituting (6) into (5):
r = r * + (e e)
r r * = ( e e) e < e x > 0:requires r > r * e > e x < 0:requires r < r *
(7)
(71)
or
r > r *requires x > 0, requires e < e r < r * requires x < 0, requires e > e
Relationship between e and p consistent with overall asset market equilibrium (money market equilibrium and UIP)
p = m yF + r * p = m yF + r
p p = (r r*)
(8)
( 8' )
or
ee =
1
( p p)
( 8'' )
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Interpretation:
p > p requires, for money market equilibrium, r>r*: for consistency with UIP this requires x>0 which, in turn, requires e < e
A: p > p r > r* e < e B: p < p r < r * e > e
Given p, the exchange rate adjusts to maintain overall asset market equilibrium, on the QQ schedule. The economy always lies on QQ.
Demand for Domestic Output
The demand for domestic output, d, is determined in the same way as in the MundellFleming model and depends on: Exogenous domestic expenditure: Domestic Competitiveness: Domestic Income/Output: The Domestic Interest Rate: (all variables other than r in logs) To simplify notation, p* (exogenously given and constant) is normalised at zero: p*=0 with output fixed at its full-employment level, i.e. y = yF , d is determined by:
d = u + (e p ) + y F r ; < 1
u e + p*p y r
(9)
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Price Adjustment
Goods market equilibrium is a feature only of long-run equilibrium. The price of domestic output is instantaneously fixed, but adjusts gradually in response to disequilibrium, i.e. excess demand or supply, in the goods market:
p = (d y ) p = dp / dt = rate of change of domestic prices
(10)
=
NB:
With y=yF
p = (d yF )
(10' )
If d = yF there is goods market equilibrium and p = 0 . Substituting for d from (9) into (10' ):
p = [u + (e p ) (1 ) yF r ]
(10'' )
Goods market equilibrium, the long-run value of competitiveness, and the long-run relationship between e and p.
Goods market equilibrium, i.e. y = d , p = 0, is a feature of long-run equilibrium. Setting p = 0 in (10'' ) and noting that in the long run r=r*:
u + (e p ) (1 ) yF r* = 0
Rearranging this equation allows us to determine the long-run value of competitiveness, or the long run real exchange rate e p
ep=
[ r * + (1 ) yF u ]
(11)
The long-run relationship between e and p is implicit in (10) but can be written explicitly as:
1 e = p + [ r * + (1 ) yF u ]
(12)
Note: Equations (4) and (12) together allow us to determine the effects of changes in any exogenous variable on the long-run values of p and e.
Simultaneous goods and money market equilibrium Although goods market equilibrium is a feature only of long-run equilibrium, for the diagrammatic analysis combinations of e and p consistent with goods market (and money market) equilibrium in the short run need to be identified.
This allows us to determine whether, at any given point in time, there is excess demand, excess supply, or equilibrium in the goods market. Set yF = d in (9), and rearrange:
(e p) = r + (1 ) yF u
(13)
This equation represents the condition for goods market equilibrium in the short run but from the condition describing goods market equilibrium in the long run (i.e. (11)):
(e p ) = r * + (1 ) yF u
Subtracting from (13):
(e e ) ( p p ) = (r r*)
But from (8), relating to money market equilibrium:
p p
r r* =
(e e ) = ( p p ) + (e e ) = p p = ( + )
( p p)
(e e ) +
( p p) (14)
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This equation represents combinations of p and e consistent with simultaneous goods and money market equilibrium in the short run.
Slope = At A AB At B
<1 +
:
BC At C
: : : :
Points to right of schedule : d > y p > 0 Points to left of schedule d < y p < 0 Summary of Key Relationships Long-run value of p p = m yF + r * Long-run value of e
e = p+ 1
(4)
[ r * + (1 ) yF u ]
(12)
( p p)
( 8'' )
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(14)
Long-Run Effects
Price Level: From (4) with yF , r * constant
p = m
(15)
(16)
(17)
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i.e. in the long-run domestic competitiveness is unchanged implying relative PPP is maintained in the long run following a monetary expansion
A fall in r is consistent with UIP only if x<0 i.e. the domestic currency is expected to appreciate given expectations formation x = (e e) , this requires e ' > e2 Hence the exchange rate overshoots its new L-R value.
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The gain in competitiveness and the reduction in r both increase demand for domestic output. Excess demand in the goods market causes p to rise gradually, increasing r, accompanied by an appreciation of the domestic currency, i.e. falling value of e. The economy moves up QQ, with excess demand falling, until the new long-run equilibrium is achieved.
Extent of Overshooting
ee =
( p p)
e = p = m
but p = 0 ;
e m =
1 e = 1 + m
( > m )
The extent of overshooting is greater (i) (ii) The smaller is (interest semi-elasticity of md) - increase in m requires larger fall in r for MME The smaller is (expectations coefficient) - a larger difference between e and e is needed to generate value of x consistent with UIP.
Rational Expectations
Dornbusch shows there is a unique value of consistent with RE, i.e. expectations which are correct .
Variable output Assume prices are sticky but y adjusts to clear the goods market. Price adjustment is given by:
p = ( y yF )
1. While consistent with relative PPP (following purely nominal shocks) in the long run, it provides an explanation of why real exchange rates might depart from their PPP values for sustained periods. 2. It identifies a possible reason for exchange rate overshooting. 3. It is a fully specified macroeconomic model which allows analysis of the interaction between the nominal exchange rate, prices and output.
Weaknesses
1. Relative supplies of assets other than money are irrelevant for exchange rate determination. 2. The current account plays no role in exchange rate determination.
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