Economic Environment Analysis Lecture 6 PDF

Economic Environment Analysis Lecture 6 Last weeks 1. Financial globalization. 2. National income accounting. 3. Balance of payments accounting. This week 1. The Foreign Exchange Market 2. International interest parity conditions 3. Monetary models of exchange rates Exchange Rat...

Economic Environment Analysis Lecture 6 Last weeks 1. Financial globalization. 2. National income accounting. 3. Balance of payments accounting. This week 1. The Foreign Exchange Market 2. International interest parity conditions 3. Monetary models of exchange rates Exchange Rates Exchange Rates You need to buy sunglasses, and are deciding between two options: Option A: 100€ Option B: 100$ How do you compare the prices? Exchange Rates Exchange rates are the relative price of currencies. Plays a central role in international trade because they allow us to compare the prices of goods and services produced in different countries. Exchange rates are quoted as foreign currency per unit of domestic currency or domestic currency per unit of foreign currency. Two types of quotations: Direct: price of foreign currency in terms of domestic currency 1 $ = 𝐸! € Indirect: price of domestic currency in terms of foreign currency 𝐸" $ = 1 € In the following, we use the first (more standard, although not most intuitive) convention. Exchange Rates Exchange rates can change in two ways. Appreciation: is an increase in the value of a currency relative to another currency. An appreciated currency is more valuable (more expensive) and therefore can be exchanged for (can buy) a larger amount of foreign currency. If the euro appreciates versus the dollar, what happens to 𝐸 ! ? If the euro appreciates versus the dollar, it takes less euros to buy a dollar. Instead of 1 euro for 1 dollar, now it takes ½ euro for buying one dollar. Before 𝐸 ! = 1, now 𝐸 ! = ½. Exchange Rates Exchange rates can change in two ways. Depreciation: is a decrease in the value of a currency relative to another currency. A depreciated currency is less valuable (less expensive) and therefore can be exchanged for (can buy) a smaller amount of foreign currency. If the euro depreciates versus the dollar, it takes more euros to buy a dollar. Instead of 1 euro for 1 dollar, now it takes 2 euros for buying one dollar. Before 𝐸 ! = 1 , now 𝐸 ! = 2. Exchange Rates Exchange Rates Exchange Rates How do exchange rates affect trade? Assume that the euro appreciates against the dollar. Export: ! Those Spanish sunglasses before costed 100€ x ! = 100$, now they cost ! " 100€x ! = 200$ for an American consumer. " All else equal, an appreciation of a country’s currency makes its goods more expensive for foreigners. Import: Those American sunglasses before costed 100$ x E # = 100€, now they cost 100$ x E # = 50€ for an Spanish consumer. All else equal, an appreciation of a country’s currency makes foreign goods cheaper for domestic consumers. Exchange Rates How do exchange rates affect trade? All else equal, a depreciation of a country’s currency makes its goods less expensive for foreigners, and foreign goods are more expensive domestic consumers. In other words, a depreciation lowers the relative price of a country’s export and raises the relative price of its import. The Foreign Exchange Market Markets where foreign currencies and other assets are exchanged for domestic ones Decentralized. Over the counter between participants. Interbank transactions (or involving other financial institutions) largely dominant. Permanent. Concentrated: Few markets concentrate most of trading (London, NY, …) Very small transaction costs High liquidity and volumes About 6,000 billion $ / day Key role of the dollar High volatility of the nominal exchange rate The Foreign Exchange Market Spot rate: Price agreed today for a contract to buy and sell FOREX immediately (immediate trade). Forward Rate: Price agreed today for a (forward) contract to buy and sell FOREX in the future (7, 14-day, 1, 3, 6, 12-month). No money changes hands now. Trades on futures markets. Example: On January 10, 2017, two banks agree to trade on June 10, 2017, 1M € at the rate of € 0.9 per $. Other derivatives also traded (swaps, options,…). Not covered in the course. Total of transactions (per day), in millions $ Total transactions by currency Most used currency in the world for international payments in SWIFT from December 2019 The US Dollar at the center of the market Share of transactions by currency pair (in %) Others The dollar as a vehicle currency Dollar main vehicle currency for forex transactions. To exchange Australian dollars into Mexican peso, less expensive to transact through US $. High liquidity so low transaction costs (1 to 2 basis points (0.01 - 0.02%) for $10 millions on €/$) Network effects. Economics of currency use like economics of language. Coordination of forex participants on the dollar. International interest parity conditions The Demand of Currency Deposits What influences the demand of (willingness to buy) deposits denominated in domestic or foreign currency? Rate of return: the percentage change in value that an asset offers during a time period. No need for inflation adjustment with daily transactions. Rates of return that investors expect to earn are determined by: interest rates that the assets will earn expectations about appreciation or depreciation Risk and liquidity play a minor role in exchange rate markets. The investor’s choice Let’s unpack this. An investor has the choice between: 1. Invest one euro in (riskless) bond (treasury bond): 1 + 𝑟€ 2. Buy dollars with this euro at rate $⁄%, invest in US Treasury bonds: 1 + 𝑟$ In one year, at what rate, can she sell her dollars? 𝐸 ' : expected euro/dollar exchange rate The investor’s choice The investor’s returns A risk neutral investor should be indifferent between the two investments: 𝐸' 1 + 𝑟€ = 1 + 𝑟$ 𝐸 𝐸' − 𝐸 = 1 + 𝑟$ 1 + 𝐸 𝐸' − 𝐸 ≈ 1 + 𝑟$ + 𝐸 𝑟$ (𝐸 ' − 𝐸) is approximately 0. The investor’s returns Uncovered interest parity condition (UIP): the foreign exchange market is in equilibrium when deposits of all currencies offer the same expected rate of returns. 𝐸' − 𝐸 Return on € asset 𝑟€ = 𝑟$ + Return on $ asset 𝐸 Else if expected returns on € assets and $ assets differ, profit maximiser investors would buy the asset with higher expected return. %! If E ↑ (€ depreciates today): return on $ assets 1 + 𝑟$ ↓ % Why? If € depreciates (cheaper), $ appreciates (for given interest rates and 𝐸 ' given): more expensive to buy and invest in $ assets today and return in $ falls  Equilibrium in Foreign Exchange Market Equilibrium is at point 3, where the expect euro returns on dollar and euro deposit are equal. Point 1: expected return on dollar assets< return on euro assets: investors unwilling to hold dollar deposits. Sellers lower their price, euro appreciates (E ↓). Point 2: expected return on dollar assets> return on euro assets: investors unwilling to hold euro deposits. Sellers lower their price, euro depreciates (E ↑)  The role of the domestic interest rate An increase in the interest rates on euro deposits, leads to: 1. Higher returns on euro deposits 2. Owners of dollar deposits will sell them to buy euros Need to lower price 3. Euro appreciates until the returns are again equalized.  The role of the foreign interest rate An increase in the interest rates on dollar deposits, leads to: 1. Higher returns on dollar deposits 2. Owners of euro deposits will sell them to buy dollar Need to lower price 3. Euro depreciates until the returns are again equalized.  The role of expectations A decrease in the expected exchange rate, leads to: 1. Higher returns on dollar deposits 2. Owners of euro deposits will sell them to buy dollar Need to lower price 3. Euro depreciates until the returns are again equalized. Exchange rate volatility Today’s exchange rate depends on expected exchange rates which itself depends on all information that can influence future exchange rates. For instance, future changes in interest rates (which themselves depend on future monetary policies, which depend on production, inflation…) Exchange rates are forward looking, like any asset price. $ interest rate shock on $/€ forex rate € interest rate shock on $/€ forex rate Expectations shock on $/€ forex rate Empirical validity of UIP condition 𝐸' − 𝐸 𝑟€ = 𝑟$ + 𝐸 Strong assumptions: Perfect mobility of capital (zero transaction costs). Rational expectations: agents do not make systematic errors in forecasting and use all information. No speculative bubble. No risk aversion: only expected returns matter for the choice of investors. Assets are perfectly substitutable (US Treasury bond and German bond). Risk premium and UIP If agents are risk averse, they want to diversify assets and do not want to hold too many assets in one currency (for example in €): if share of € assets increases in portfolio then must be compensated by a “risk premium” on holding € assets 𝐸' − 𝐸 𝑟€ = 𝑟$ + +𝜌 𝐸 This risk premium depends on the portfolio structure and can vary with time. Empirical validity of UIP condition Unexpected increase of differential of interest rate (𝑟€ − 𝑟$ ) implies a € appreciation today. For given expectations on 𝐸 ' , implies an expected depreciation (or less of expected appreciation) If rational expectations, 𝐸 ' is on average = future realized exchange rate 𝐸()$ 𝐸()$ − 𝐸( = 𝑟€ − 𝑟$ + 𝑒𝑟𝑟𝑜𝑟 𝐸( With 𝐸 𝑒𝑟𝑟𝑜𝑟 = 0. A random walk does better than UIP. Best predictor of future exchange rate is today’s exchange rate: 𝐸 𝐸()$ = 𝐸(. Better than UIP for horizons of 1 to 12 months (UIP does better in medium/long-run).  Uncovered Interest Parity in the short-run Interest rate differentials and nominal exchange rate changes (in %), USD vs. German DM The empirical failure of UIP? Risk premium non observable, varies with time. Speculative behaviours and bubbles. UIP still useful? Yes to understand the response of exchange rates to unexpected changes of fundamentals (interest rates, …) Exchange rates and the returns on assets One possible riskless arbitrage. Covered interest parity condition: Link between E, the forward rate F (one year) and the interest rate differential. An investor has the choice between: 1. Invest one euro in a euro denominated bond: 1 + 𝑟€. 2. Convert this euro in dollar at rate 1/E, invest $ denominated bond: 1 + 𝑟$. Will resell dollars at rate F contracted today (no risk). Two possible investment strategies F: forward exchange rate (known and contracted today, no risk) Covered interest parity condition (CIP) Arbitrage between two riskless investments: 𝐹 𝐹 1 + 𝑟€ 1 + 𝑟€ = 1 + 𝑟$ → = ≈ 𝑟€ − 𝑟$ 𝐸 𝐸 1 + 𝑟$ * Covered interest parity condition (CIP): the forward premium is equal to % the interest rate differential: 𝐹−𝐸 ≈ 𝑟€ − 𝑟$ 𝐸 If not true, easy to make a profit (riskless). If F>E, an investor must be compensated with a higher interest rate on euro than on dollar. Empirical validity of the CIP Free capital movements (arbitrage) Agents are profit maximizers (do not give up a riskless opportunity of profit) Covered interest parity condition perfectly satisfied except in exceptional circumstances (e.g. 2008 financial crisis) Not true in the 1980s due to restrictions on capital movements. Empirical validity of the CIP Deviations from CIP on euro/dollar markets (Libor rates) Monetary models of exchange rates Monetary Policy and Exchange Rates How does monetary policy affect exchange rates? Integrating money supply, interest rate determination, and exchange rate determination. In the short term, the exchange rate adjusts but prices are rigid/sticky. In the long-run, nominal exchange rates reflect differences in the supply of money. The dynamics of the exchange rate from the short to the long term= the overshooting result. Monetary Policy and Exchange Rates The exchange rate adjusts instantaneously but goods prices are more rigid. The money demand Three factors affect the demand for money/liquidity (by firms and households): 1. Interest rate (on a riskless asset such as Treasury Bond, TB), 𝑟€. 2. Price level, 𝑃€. 3. Transactions (GDP), 𝑌€. The money demand The interest rate is the opportunity cost of holding the most liquid asset, money. easily used to pay for goods and services (or to repay debt) but money does not pay interest rate (or lower than less liquid assets such as TBs). ↑ of interest rate 𝑟€ → ↓ demand of money : firms and households buy assets less liquid (TBs, saving accounts,…) that pay 𝑟€ Demand for money increases with economic activity (think GDP) as firms and households transactions increase. Determinants of money demand 𝑀€! = 𝑃€𝐿(𝑟€, 𝑌€) With 𝑃€ being the price level and 𝐿(𝑟€, 𝑌€) the liquidity demand. +€# In real terms, = 𝐿 𝑟€, 𝑌€. ,€ In short term, P is rigid (Keynesian assumption). Demand for money decreases with (𝑟€) and increases with GDP (𝑌€). Money market equilibrium such that: 𝑀€- = 𝑀€! Money supply 𝑀€- determined by the Central Bank. The money market An expansionary monetary policy A booming economy Monetary Policy and Exchange Rates Monetary Policy and Exchange Rates An expansionary monetary policy An economy in recession What about expectations on exchange rate? Up to now, a change in monetary policy has no impact on expected exchange rates 𝐸 ' But should have an impact on future exchange rates if prices flexible in the long term. Monetary neutrality in the long run: a change in money supply only affects prices in the long run and has no effect on the real economy. Output is determined by factors of production. Inflation moves one for one with money growth in long run. Nominal exchange rate should adjust accordingly. Prices and money in the long run  Prices and money in the long run Source: Jones. 1990 to 2011. Exchange rate, money and prices in the long run Nominal exchange rate = price of foreign currency in units of the domestic currency. In long term : 𝑀€- ↑ → 𝐸€↑ and 𝑃€ ↑ An increase in money supply is followed by a depreciation of € with respect to $ in long run. Otherwise, some relative prices (European to US) would be affected with real effects ≠ Monetary neutrality Remark. Purchasing Power Parity in the long run: 𝐸€𝑃$ = 𝑃€ Exchange rate and money in the long run Exchange rate and money in the long run Monetary policy, exchange rates and overshooting What is the effect of a permanent increase in money supply 𝑀€- on exchange rate dynamics? Main result: instantaneously, the € overshoots its long run value = it depreciates by more than in long run (= Dornbush’s overshooting result) Result of slow adjustment of goods prices and immediate adjustment of the exchange rate. High volatility of exchange rate in short run even with forward looking rational agents. Monetary policy, exchange rates and overshooting Increase money supply. Long run: E↑ Short run: 1. rational agents know that in the future, E↑ : change the expectations (𝐸 ' ↑) and E ↑ immediately. 2. interest rate fall 𝑟€ ↓ (prices are rigid) +€$ Between ST and LT, prices adjust slowly: 𝑃€↑ ; , ↓ ; 𝑟€ ↑ € Monetary policy, exchange rates and overshooting Monetary policy, exchange rates and overshooting Monetary policy, exchange rates and overshooting Summary Summary Forex markets are very liquid and the volume of transactions is huge, predominantly in dollar, the vehicle currency. Equilibrium in Forex markets rely on an arbitrage condition that leaves investors indifferent between investing in two different currencies (uncovered interest parity). Without risk premium nor transaction costs, this condition states that future exchange rate changes should reflect interest rate differentials. This does not hold well in the data in the short-run but UIP remains a good benchmark to interpret how exchange rates react to news (on interest rates, economic activity). Monetary models of exchange rates show that permanent changes in money supply lead to a depreciation in the long-term of the currency, with some overshooting in the short-run due to price rigidities.