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Exchange Rates II: The Asset Approach in the Short Run 1. Use the money market and FX diagrams to answer the following questions about the relationship between the British pound () and the U.S. dollar ($). The exchange rate is in U.S. dollars per British pound, E $/ . We want to consider how a change in the U.S. money supply affects interest rates and exchange rates. On all graphs, label the initial equilibrium point A. a. Illustrate how a temporary decrease in the U.S. money supply affects the money and FX markets. Label your short-run equilibrium point B and your long-run equilibrium point C. Answer: See the diagram below. S-23 i $ i 1 $ i 2 $ MS 1 MS 2 MD 1 A C B ER i 1 $ i 2 $ DR 1 DR 2 FR 1 E 1 E 2 B E $/ M 1 US P 1 US M 2 US P 1 US A = C 4 15 b. Using your diagram from (a), state how each of the following variables changes in the short run (increase/decrease/no change): U.S. interest rate, British interest rate, E $/ , E e $/ , and the U.S. price level. Answer: The U.S. interest rate increases, the British interest rate does not change, E $/ decreases, E e $/ does not change, and the U.S. price level does not change. c. Using your diagram from (a), state how each of the following variables changes in the long run (increase/decrease/no change relative to their initial values at point A): U.S. interest rate, British interest rate, E $/ , E e $/ , and U.S. price level. Answer: All of the variables return to their initial values in the long run. This is because the shock is temporary, implying the central bank will increase the money supply from M 2 to M 1 in the long run. 2. Use the money market and FX diagrams from (a) to answer the following questions. This question considers the relationship between the Indian rupees (Rs) and the U.S. dollar ($). The exchange rate is in rupees per dollar, E Rs/$ . On all graphs, label the ini- tial equilibrium point A. a. Illustrate how a permanent increase in Indias money supply affects the money and FX markets. Label your short-run equilibrium point B and your long-run equi- librium point C. Answer: See the following diagram. Thick arrows indicate temporary movement while thinner ones indicate the movements in the long run. In the short run, prices are fixed. Therefore the real money supply changes from MS 1 to MS 2 , thus temporarily lowering the domestic interest rate. In the long run, as prices rise, the real money supply and interest rate return to their original level. In the for- eign exchange market, FR shifts to the right and stays there permanently because of an expected depreciation of rupees. S-24 Solutions Chapter 4(15) Exchange Rates II: The Asset Approach in the Short Run i Rs i 1 Rs i 2 Rs MS 1 MS 2 MD 1 A C B ER i 1 Rs i 2 Rs DR 1 DR 2 FR 1 FR 2 E 1 E 2 E 3 M 2 IN P 2 IN A C B E Rs/$ M 1 IN P 1 IN M 2 IN P 1 IN b. By plotting them on a chart with time on the horizontal axis, illustrate how each of the following variables changes over time (for India): nominal money supply M IN , price level P IN , real money supply M IN /P IN , Indias interest rate i Rs , and the exchange rate E Rs/$ . Answer: See the following diagrams. c. Using your previous analysis, state how each of the following variables changes in the short run (increase/decrease/no change): Indias interest rate i Rs , E Rs/$ E e Rs/$ , and Indias price level P IN . Answer: Indias interest rate decreases, the U.S. interest rate remains unchanged, E Rs/$ increases, E e Rs/$ increases, and Indias price level remains unchanged. d. Using your previous analysis, state how each of the following variables changes in the long run (increase/decrease/no change relative to their initial values at point A): Indias interest rate i Rs , E Rs/$ E e Rs/$ , Indias price level P IN . Answer: Indias interest rate remains unchanged, the U.S. interest rate remains unchanged, E Rs/$ increases, E e Rs/$ increases (remains unchanged in transition from short to long run), Indias price level increases. e. Explain how overshooting applies to this situation. Answer:The short-run exchange rate overshoots its long-run value, E E as in the text Figure 4-13 (15-13). We can see this in the impulse response diagrams shown previously. The overshooting is caused by the investors adjustment of exchange rate expectations coupled with lower domestic interest rates. Since the rupees in- terest rate falls, investors must be compensated by a rupee appreciation for UIP with U.S. interest rate to hold. For a rupee appreciation to be possible, it must depreciate more in the short run than its longer-run value. Solutions Chapter 4(15) Exchange Rates II: The Asset Approach in the Short Run S-25 M IN P IN i Rs TT n E Rs/$ M IN /P IN M IN /P IN 1 1 2 2 3. Is overshooting (in theory and in practice) consistent with purchasing power parity? Consider the reasons for the usefulness of PPP in the short run versus the long run and the assumption weve used in the asset approach (in the short run versus the long run). How does overshooting help to resolve the empirical behavior of exchange rates in the short run versus the long run? Answer: Yes, overshooting is consistent with PPP. Investors forecast the expected ex- change rate based on the theory of PPP. When there is some change in the market, the investors know the exchange rate will change to equate relative prices in the long run. This is why we observe overshooting in the short runthe investors incorporate this information into their short-run forecasts. Exchange rates are volatile in the short run. The theorys implication that there is exchange rate overshooting (in response to per- manent shocks) is one explanation for short-run volatility in exchange rates. 4. Use the money market and foreign exchange (FX) diagrams to answer the following questions. This question considers the relationship between the euro () and the U.S. dollar ($). The exchange rate is in U.S. dollars per euro, E $/ . Suppose that with fi- nancial innovation in the United States, real money demand in the United States de- creases. On all graphs, label the initial equilibrium point A. a. Assume this change in U.S. real money demand is temporary. Using the FX and money market diagrams, illustrate how this change affects the money and FX markets. Label your short-run equilibrium point B and your long-run equilib- rium point C. Answer: See the following diagram. The long-run values are the same as the ini- tial values because the shock is temporary. Also because the shock is temporary, we assume that the reversal of real money demand occurs before the price level adjuststhat is, MD returns from MD 2 to MD 1 before the price level changes. S-26 Solutions Chapter 4(15) Exchange Rates II: The Asset Approach in the Short Run i $ i 1 $ i 2 $ i 1 $ i 2 $ MS 1 MD 1 MD 2 A CAC B ER DR 1 DR FR 1 E 1 M 1 US / P 1 US E 2 B E $/ b. Assume this change in U.S. real money demand is permanent. Using a new dia- gram, illustrate how this change affects the money and FX markets. Label your short-run equilibrium point B and your long-run equilibrium point C. Answer: See the following diagram. In the long run, the price level will have to increase to adjust for the drop in real money demand (assuming the central bank does not change the money supply, M). That is, the nominal interest rate returns to its initial value in the long run. This requires that the price level increase to reduce real money supply. The drop in real money demand will have to be met one-for-one with a drop in real money supply (generated by an increase in the price level). In this case, the expected exchange rate changes because the shock is permanent. Therefore, FR schedule in the forex market also shifts upward. Solutions Chapter 4(15) Exchange Rates II: The Asset Approach in the Short Run S-27 ER i 1 $ i 2 $ DR 1 DR FR 1 FR 2 E 1 E 2 E 3 A C B E $/ i $ i 1 $ i 2 $ MS 1 MS 3 MD 1 MD 2 M 1 US / P 1 US M 1 US / P 2 US A C B 2 c. Illustrate how each of the following variables changes over time in response to a permanent reduction in real money demand: nominal money supply M US , price level P US , real money supply M US /P US , U.S. interest rate i $ , and the exchange rate E $/ . Answer: See the following diagrams. M US P US i $ TT n E $/H9280 M US /P US M US /P US 2 21 1 5. This question considers how the FX market will respond to changes in monetary policy. For these questions, define the exchange rate as Korean won per Japanese yen, E WON/ . Use the FX and money market diagrams to answer the following questions. On all graphs, label the initial equilibrium point A. a. Suppose the Bank of Korea permanently decreases its money supply. Illustrate the short-run (label the equilibrium point B) and long-run effects (label the equilib- rium point C) of this policy. Answer: See the following diagram. In the short run, prices are fixed. Therefore the real money supply changes from MS 1 to MS 2 , thus temporarily raising the Ko- rean interest rate. In the long run, as prices fall, the real money supply and interest rate return to their original levels. In the foreign exchange market, FR shifts to the left and stays there permanently because of an expected appreciation of won. S-28 Solutions Chapter 4(15) Exchange Rates II: The Asset Approach in the Short Run i won i 1 won i 2 won i 1 won i 2 won MS 1 MS 2 MD 1 M 1 K / P 1 K M 2 K / P 2 K M 2 K / P 1 K A C B ER DR 1 DR FR 1 FR 2 E 1 E 3 E 2 AC B E won/ 2 b. Now, suppose the Bank of Korea announces it plans to permanently decrease its money supply but doesnt actually implement this policy. How will this affect the FX market in the short run if investors believe the Bank of Koreas announcement? Answer: See the following diagram. In this case, interest rates on won- denominated deposits dont change because the Bank of Korea doesnt cut the money supply. However, because investors expected the Bank of Korea to cut the money supply, they expect the won will appreciate relative to the yen, causing a decrease in the return on yen-denominated deposits in the short run. Notice the resulting change in the exchange rate is relatively small (compared with the dra- matic decrease we see in a). i won i 1 won i 1 won MS 1 MD 1 M 1 K / P 1 K A B ER DR 1 FR 1 FR 2 E 1 E 2 AB E won/ c. Finally, suppose the Bank of Korea permanently decreases its money supply but this change is not anticipated. When the Bank of Korea implements this policy, how will this affect the FX market in the short run? Answer: In this case, the expected exchange rate is unchanged because the in- vestors didnt expect the decrease in the money supply. Solutions Chapter 4(15) Exchange Rates II: The Asset Approach in the Short Run S-29 i won i 1 won i 2 won i 2 won i 1 won MS 1 MS 2 MD 1 M 1 K / P 1 K M 2 K / P 1 K A B ER DR 1 DR FR 1 E 1 E 2 A B E won/ 2 d. Using your previous answers, evaluate the following statements: i. If a country wants to increase the value of its currency, it can do so (tem- porarily) without raising domestic interest rates. ii. The central bank can reduce both the domestic price level and the value of its currency in the long run. iii. The most effective way to increase the value of a currency is through sur- prising investors. Answer: Though it is theoretically possible, as shown in (b), it is not a good pol- icy because it is bad for the policy makers reputation in the long run. i. True; shown in (b). ii. False; shown in (a) A reduction in price level implies an exchange rate ap- preciation by PPP. iii. False; shown in (b) and (c) compared with (a). The most dramatic appreci- ation in the won occurs when the reduction in M is coupled with investors anticipating the appreciation in the won. In general, a policy must be cred- ible for it to have an effect in the long run. 6. In the late 1990s, several East Asian countries used limited flexibility or currency pegs in managing their exchange rates relative to the U.S. dollar. This question considers how different countries responded to the East Asian Currency Crisis (19971998). For the following questions, treat the East Asian country as the home country and the United States as the foreign country. Also, for the diagrams, you may assume these countries maintained a currency peg (fixed rate) relative to the U.S. dollar. Also, for the following questions, you need consider only the short-run effects. a. In July 1997, investors expected that the Thai baht would depreciate. That is, they expected that Thailands central bank would be unable to maintain the currency peg with the U.S. dollar. Illustrate how this change in investors expectations af- fects the Thai money market and the FX market, with the exchange rate defined as baht (B) per U.S. dollar, denoted E B/$ . Assume the Thai central bank wants to maintain capital mobility and preserve the level of its interest rate and abandons the currency peg in favor of a floating exchange rate regime. Answer: If Thailand is willing to let its currency float against the dollar, then Thailands central bank can maintain monetary policy autonomy and interna- tional capital mobility. See the following diagram: S-30 Solutions Chapter 4(15) Exchange Rates II: The Asset Approach in the Short Run i baht i 1 baht i 1 baht MS 1 MD 1 M 1 T / P 1 T A B ER DR 1 FR 1 FR 2 E 1 E 2 A B E baht/$ b. Indonesia faced the same constraints as Thailandinvestors feared Indonesia would be forced to abandon its currency peg. Illustrate how this change in in- vestors expectations affects the Indonesian money market and the FX market, with the exchange rate defined as rupiahs (Rp) per U.S. dollar, denoted E Rp/$ . As- sume the Indonesian central bank wants to maintain capital mobility and the cur- rency peg. Answer: If Indonesia wants to maintain the currency peg against the dollar and maintain international capital mobility, it will have to give up monetary policy autonomy. In this case, Indonesia has to increase the domestic interest rate to keep investors from dumping their rupiah-denominated deposits for U.S. dollars and move their investments out of Indonesia (this would then cause a depreciation in the rupiah). i rup i 1 rup i 2 rup i 1 rup i 2 rup MS 1 MS 2 MD 1 M 1 I / P 1 I M 2 I / P 1 I A B ER DR 1 DR 2 FR 1 FR E 1 A B E rupiah/$ 2 c. Malaysia had a similar experience, except that it used capital controls to maintain its currency peg and preserve the level of its interest rate. Illustrate how this change in investors expectations affects the Malaysian money market and the FX market, with the exchange rate defined as ringgit (RM) per U.S. dollar, denoted E RM/$ . You need show only the short-run effects of this change in investors expectations. Answer: See the following diagram. In the absence of capital controls Malaysian interest rate would have to rise. However, by preventing investors from taking ad- vantage of arbitrage, Malaysia creates a disequilibrium. The investors require i 2 RM to keep their deposits in Malaysia, but they only receive i 1 RM . Because of the cap- ital controls imposed by Malaysia, investors cannot withdraw their ringgit- denominated deposits (selling ringgit in exchange for dollars in the FX market). In effect, the foreign market equilibrium diagram shown below does not work/exist. This allows Malaysia to maintain monetary policy autonomy and a fixed exchange rate at the same time. Solutions Chapter 4(15) Exchange Rates II: The Asset Approach in the Short Run S-31 i RM i 1 RM i 2 RM i 1 RM i 2 RM MS 1 MD 1 M 1 M / P 1 M A ER DR 1 FR 1 FR 2 E 1 A B E RM/$ d. Compare and contrast the three approaches just outlined. As a policy maker, which would you favor? Explain. Answer: There is no “correct” answer to this question. The cases above highlight the trilemma because each country can choose a different option depending on their domestic or international priorities. They need to compare the benefits of having any two of (a) fixed exchange rates, (b) monetary autonomy, and (c) in- ternational capital mobility against the cost of not having the third one. 7. Several countries have opted to join currency unions. Examples include the Euro area, the CFA franc union in West Africa, and the Caribbean currency union. This in- volves sacrificing the domestic currency in favor of using a single currency unit in multiple countries. Assuming that once a country joins a currency union it will not leave, do these countries face the policy trilemma discussed in the text? Explain. Answer: These countries do face the trilemma because they are committed to main- taining the first policy goal of a fixed exchange rate. Joining a currency union effec- tively means a country has a fixed exchange rate without the need for government intervention because the money supply is controlled by a regional central bank for member countries. This effectively reduces the choice to a dilemma between mone- tary policy autonomy versus international capital mobility. Typically, countries that are parts of a currency union sacrifice monetary policy autonomy; policy decisions are made jointly rather than independently. 8. During the Great Depression, the United States remained on the international gold standard longer than other countries. This effectively meant that the United States was committed to maintaining a fixed exchange rate at the onset of the Great Depression. The U.S. dollar was pegged to the value of gold along with other major currencies, including the British pound, the French franc, and so on. Many researchers have blamed the severity of the Great Depression on the Federal Reserve and its failure to react to economic conditions in 1929 and 1930. Discuss how the policy trilemma ap- plies to this situation. Answer: The United States was committed to the fixed exchange rate with gold; consequently, policy makers had to sacrifice either monetary policy autonomy or cap- ital mobility, just as the trilemma suggests. Based on the information given in the question, we can assume that the policy did not respond to the U.S. business cycle (policy makers did not exercise monetary policy autonomy). Thus, if we assume in- ternational capital mobility, the United States could not react to the business cycle with a monetary expansion until it abandoned the gold standard. 9. On June 20, 2007, John Authers, investment editor of the Financial Times, wrote the following in his column “The Short View”: The Bank of England published minutes showing that only the narrowest pos- sible margin, 54, voted down an interest rate hike last month. Nobody fore- saw this. . . . The news took sterling back above $1.99, and to a 15-year high against the yen. Can you explain the logic of this statement? Interest rates in the United Kingdom had remained unchanged in the weeks since the vote and were still unchanged after the minutes were released. What news was contained in the minutes that caused traders to react? Use the asset approach. Answer: The news item indicates that investors did not expect the decision to leave interest rates unchanged would be divisive. They thought that any increases in inter- est rates would happen further in the future. Higher interest rates would lead to an appreciation in the pound sterling. When the minutes showed that interest rate in- creases were more likely than previously thought, investors came to expect an appre- ciation sooner rather than later. This caused an appreciation in the current spot ex- change rate. 10. We can use the asset approach to both make predictions about how the market will react to current events and understand how important these events are to investors. Consider the behavior of the Union/Confederate exchange rate during the Civil War. How would each of the following events affect the exchange rate, defined as Confederate dollars per Union dollar, E C$/$ ? a. The Confederacy increases the money supply by 2,900% between July and De- cember of 1861. Answer: The Confederate money supply increases, th
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