International Finance

#3. Chapter 3: The determination of the

exchange rate: an asset market approach

1
Introduction
We learned in Chapter 1:
◦ The exchange rate is determined by (1) the interest
rates of two countries and (2) the expected future
exchange rate.

For further understanding of EXR:

◦ How the interest rate is determined ( domestic money
market).
◦ What affects the expectations about future exchange
rates.

2
Outline
Money (definition, etc.)
Aggregate real money demand
Equilibrium in the money market
Simultaneous equilibrium in forex and money
markets
The Money Supply and the Exchange Rate in the
Short Run
Money, the Price Level, and the Exchange Rate in
the Long Run
Inflation and Exchange Rate Dynamics

3
Money
Roles of Money:
◦ Medium of Exchange (means of payment)
◦ Unit of Account (measure of value)
◦ Store of Value (money is held to transfer purchasing power
from the present into the future).

Definition of Money:
◦ Money supply = the monetary aggregate, M1 (the total
amount of currency and checking account deposits held by
households and firms).

4
Money Supply
How the money supply is determined:
◦ Money supply is controlled by the central bank.

◦ Assumption: the central bank simply sets the size of the

money supply at the level it desires.
( Note: Although the procedures of controlling money
supply are in fact more complex, we make this
assumption.)

5
Money Demand
The Demand for Money by Individuals:
◦ Determined by (1) the expected return on assets, (2)
the riskiness of the assets’ return, (3) the assets’
liquidity.

The Aggregate Money Demand:

◦ The determinants can be derived on the analogy of the
individuals’ demand for money.
Aggregate Money Demand
Threemain factors determine aggregate money
demand (Md; the total money demand in the
economy).
1. The interest rate. (R rises Md falls)
2. The price level. (P rises Md rises)
3. Real national income (Y rises Md rises)

Aggregate money demand equation:

Md = P x L(R,Y) <14-1>

7
Aggregate Real Money Demand
Aggregate Real Money Demand (by rearranging <14-
1>):

Md/P = L(R,Y) <14-2>

Why Md is assumed to be proportional to the

price level (P)?
◦ If all prices doubled, other things being equal, the
money value of individuals’ transactions would
simply double.

8
Aggregate Real Money Demand
(cont’d)
Fig. 14-1 shows:
◦ How aggregate real money demand is affected by the
interest rate, given a fixed level of real income.
Fig. 14-2 shows:
◦ How changes in real income causes the schedule to
shift.

9
Interaction of Money Supply and
Demand
Equilibrium in the money market:
M s = Md <14-3>
Ms/P = L(R,Y) <14-4>
Fig. 14-3:
◦ The aggregate real money demand schedule intersects
the real money supply schedule to give an equilibrium
interest rate.
◦ If there is initially an excess supply of (demand for)
money, the interest rate falls (rises).
10
Figure 14-3: Determination of Equilibrium
Interest Rate
Interest
rate (R)
Note: Y and P are given
Real Money Supply

R2 2

R1 1
Aggregate Real
R3 3 Money Demand,
L(R,Y)

Real Money
Q2 Ms/P (=Q1) Q3 Holdings

11
Figure 14-4: Effect of an Increase in the
Money Supply on the Interest Rate
Interest
Rate (R)
Note: Y and P are given

Real Money Supply

Real Money Supply

Increases (M1
M2 )

R1 1
Aggregate Real
Money Demand,
2
R2 L(R,Y)

Real Money
M1/P M2/P Holdings

12
Figure 14-5: Effect of a Rise in Real
Income on the Interest Rate
Interest Rate
(R)
Note: P and Ms are given
Real Money Supply
Increase in Real
Income (Y1 → Y2)

R2 2

R1 1 1’

L(R,Y2)

L(R,Y1)

Ms/P(=Q1) Q2 Rates of return

(in VND terms)
13
Interaction of Money Supply and
Demand (cont’d)

The effect of increasing Ms (Fig.14-4):

◦ An increase (fall) in Ms lowers (raises) the interest
rate, given the price level and output.

The effect of a rise in Y (Fig.14-5):

◦ An increase (fall) in Y raises (lowers) the interest rate,
given the price level and the money supply.

14
Simultaneous Equilibrium in the Money
Market and the Forex Market
Question:
◦ How monetary changes affect the exchange rate.

Assumption:
◦ The price level (and also real output) are taken as given. →
The short-run analysis.
◦ Note: The long-run analysis allows for the complete
adjustment of the price level and for full employment of all
factors of production.
Fig. 14-6:
◦ A combination of two diagrams (forex market and money
market equilibrium).
15
 Figure 14-6
Yen/USD
EXR (E) Return on Yen
Deposits

Foreign
Exchang 1’
E1 Expected Return
e Market on USD Deposits
R*+(Ee-E)/E

Rate of Return (in

0 Yen terms)
R1
L(R,Y)

Domestic Japanese Real

Ms/P
Money 1 Money Supply
Market

Japanese Real
Money Holdings
Effect of Money Supply Changes on the
Exchange Rate
The effect of increase in JP money supply:
(Fig.14-8) Assumption:
◦ Expected EXR is fixed.
◦ No change in foreign money supply & interest rate.

1. Domestic Money 2. Domestic Interest 3. Exchange Rate

Supply Rate (Domestic/ Foreign)

Increase Fall Depreciation

Reduction Rise Appreciation

17
 Figure 14-8
Yen/USD
EXR (E) Return on Yen
Deposits

Foreign E2 2’
Exchang 1’
E1 Expected Return
e Market on USD Deposits
R*+(Ee-E)/E

Rate of Return (in

0 Yen terms)
R2 R1
L(R,Y)

Domestic Japanese Real

M1/P
Money 1 Money Supply
Market (M1→M2)
M2/P
2

Japanese Real
Money Holdings
 Effect of Money Supply Changes on the
Exchange Rate (cont’d)
The effect of increase in foreign (US) money supply
on EXR (¥/$): (Fig.14-9)
◦ The change in foreign money supply does not disturb the
domestic money market equilibrium.

1. Foreign 2. Expected return 3. Downward-slopi 4. EXR

Money on foreign ng curve (top (domestic/
Sup ply currency panel) foreign)
Increase Decrease Shift leftward Ap preciation
Reduction Increase Shift rightward Depreciation

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 Yen/USD
EXR (E) Figure 14-9
On Point 1” → R1>R2*+
(Ee-E1)/E1 Return on Yen Increase in US
Deposits Money Supply
→Fall in US Interest
1” 1’ Rate (R1* →R2*)
E1
Excess demand on
Japanese assets →More E2 2’
R1*+(Ee-E)/E
demand for Yen → Yen
appreciation (E1 →E2). R2*+(Ee-E)/E

Rate of Return (in

0 Yen terms)
R1
On Point 2’ → R1=R2*+ L(R,Y)
(Ee-E2)/E2
Japanese Real
Ms/P Money Supply
1
(M1→M2)

Japanese Real
Money Holdings
Money, the Price Level, and the Exchange
Rate in the Long Run
Short-run analysis:
◦ Relies on the simplifying assumptions:
◦ → Price levels and exchange rate expectations are given
(constant).

For further understanding of exchange rate

determination, we need to learn:
◦ The long-run analysis of exchange rate determination.
◦ How monetary factors affect a country’s price level in the
long-run.

21
The Long-run Analysis of the Exchange
Rate Determination
Long-run analysis:
◦ Assumption: An economy maintains the long-run
equilibrium where all wages and prices have adjusted to
their market-clearing level.
◦ Price are perfectly flexible and always adjust to preserve
full employment.

The Long-run Equilibrium Price Level:

◦ The value of P that satisfies the condition (14-5):
◦ → P= Ms/L(RLR, YLR), where the subscript, LR, denotes the
long-run equilibrium level.
22
The Long-run Analysis of the Exchange
Rate Determination
Long-run analysis:
◦ Assumption: An economy maintains the long-run
equilibrium where all wages and prices have adjusted to
their market-clearing level.
◦ Price are perfectly flexible and always adjust to preserve
full employment.

The Long-run Equilibrium Price Level:

◦ The value of P that satisfies the condition (14-5):
◦ → P= Ms/L(RLR, YLR), where the subscript, LR, denotes the
long-run equilibrium level.
23
The Long-run Analysis of the Exchange
Rate Determination (cont’d)
Why no effect on the long-run values?
◦ The full-employment output level is determined by the
economy’s endowments of labor and capital.
◦ The interest rate is determined in the money market, where
P increases in proportion to Ms in the long-run, which
results in no change of the long-run level of the interest
rate.
◦ Example: Currency Reform (see pp.354-355 in Krugman
and Obstfeld, 2006). 24
Inflation and Exchange Rate Dynamics

Question?

◦ Why we need to consider a long-run analysis?

◦ See the next Figure.

Two issues:
◦ Exchange rate fluctuates in the short-run, but appears to
follow the PPP in the long-run.
◦ The interest parity condition and the PPP suggest different
movement of exchange rate.
25
In the long-run, PPP may be a good indicator of
actual exchange rate movements
Permanent Money Supply Changes and
the Exchange Rate
The effect of a permanent increase in money supply
on the exchange rate. (Fig.14-12)
◦ Assumption (i): The economy starts with all variables at their
long-run levels.
◦ Assumption (ii): Output remains constant during the
adjustment process.
◦ (1) affects exchange rate expectations (Ee).
◦ (2) A rise in E is greater than the case of no change in Ee.
◦ (3) The price level adjust gradually to its long-run
equilibrium. 27
 Yen/USD
EXR (E)
Return on Yen Figure 14-12
Deposits

2’ E2 2’ Long-run
E2 equilibrium
Short-run
equilibrium if Ee
did not change E3 4’
3’
R*+(Ee2-E)/E
1’
E1
R*+(Ee1-E)/E
Rate of Return
0 (in Yen terms)
R2 R1 R2 R1
L(R,Y)

M1/P1 M2/P2
1 4

M2/P1 M2/P1
2 Japanese Real 2
Money Supply

Japanese Real (b) Adjustments to

Money (a) Short-run effects long-run equilibrium
Holdings
Permanent Money Supply Changes and
the Exchange Rate (cont’d)
Short-run effects (1→4):
◦ A permanent Ms increase affects expected EXR.

Adjustment to long-run equilibrium (5→8):

◦ Price level increase is proportional to Ms increase.
(1) Increase in (2) Decrease in (3) Increase in E (4) Increase in E
M (M1→ M2) R (R1→ R2) (point 3’) If Ee is (point 2’) If Ee
constant rises
(5) Increase in P (6) Increase in (7) Decrease in E (8) Long-run
(P1→ P2) R (R2→ R1) (point 4’) If Ee equilibrium EXR
does not change (point 4’) where
further. E3> E1.

29
Permanent Money Supply Changes and
the Exchange Rate (cont’d)
Exchange Rate Overshooting:
◦ Initial depreciation after a (permanent) rise in money supply is
greater than its long-run response.
◦ Overshooting is caused by the short-run rigidity of the price
level, while the exchange rate changes instantaneously.
◦ Finally, the long-run increases in the price level and the
exchange rate are proportional to the increase in the money
supply. →Why?

30
Exchange
rate

E2
2’
E3 3’
E 4
4
E2 1’
E5
R*+(Ee-E)/E

0 Rate of Return
R2 R3 R1 R5 L1(R,Y1
1 )L2(R,Y2
M1/P1
)
2
L3(R,Y3)
M2/P1
3

M/P
Question
Which one of the following statements is the most accurate?
( a) A decrease in the money supply lowers the interest rate while an increase
in the money supply raises the interest rate, given the price level and
output.
(b) An increase in the money supply lowers the interest rate while a fall in
the money supply raises the interest rate, given the price level.
(c) An increase in the money supply lowers the interest rate while a fall in
the money supply raises the interest rate, given the output level.
(d) An increase in the money supply lowers the interest rate while a fall in
the money supply raises the interest rate, given the price level and output.
(e) None of the above

32
 Figure 14-6
Price (Dollar)

Sd

E
$950
e f G Sd+w+t
$900
a c
b d F
$800 Sd+w

Dd

20 40 50 60 80
Quantity of motorbikes