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Short-Run Policy Analysis
We begin by studying temporary shocks. These shocks do not affect long-run prices or
expected exchange rates.
A Temporary Shock to the Home Money Supply Figure 15-8 illustrates the effects of a
temporary increase in the home money supply. The reverse would apply to a temporary
decrease in the home money supply. In these cases, the home price level remains
unchanged, as does the expected exchange rate.
In summary:
A Temporary Shock to Foreign Money Supply Figure 15-9 illustrates the effects of a
temporary increase in the foreign money supply. The reverse would apply to a temporary
decrease in the foreign money supply. The foreign price level remains unchanged, as
does the expected exchange rate.
In summary:
APPLICATION
The Rise and Fall of the Dollar, 1999–2004
During the 1990s, many countries followed monetary policies that used long-run nominal
anchors. Whereas the European Central Bank (ECB) has an explicit inflation target, the
Federal Reserve uses an implicit one. According to the Fisher effect, nominal anchoring
The Federal Reserve reacted more aggressively to an impending recession during
2000 to 2001, lowering nominal interest rates more than the ECB. Here, the data also
support the model; the dollar depreciated as expected.
After 2001, the Federal Reserve persisted in keeping the nominal interest rate below
4 A Complete Theory: Unifying the Monetary and Asset Approaches
This section combines the asset approach and the monetary approach to exchange rate
determination. This allows us to analyze the short-run and long-run effects of both
temporary and permanent shocks.
From the asset approach:
Home money market equilibrium:
Foreign money market equilibrium:
Foreign exchange market equilibrium (UIP condition):
In the asset approach, the spot exchange rate, EH/F, and the nominal interest rates, iH and
iF, adjust to ensure the money market is in equilibrium and the UIP condition is satisfied.
The expected future exchange rate is derived from the monetary approach:
Home money market equilibrium:
Foreign money market equilibrium:
Purchasing power parity condition:
S I D E B A R
Confessions of a Forex Trader
We learned in Chapter 13 that the foreign exchange market involves large volumes of
transactions. Many of these transactions involve derivatives (hedging and speculation)
that require investors to forecast the future exchange rate. There are three basic strategies
for forecasting exchange rates:
1. Economic fundamentals. This approach uses theoretical models, similar to those
2. Politics. Political instability can affect the exchange rate. Factors such as war
3. Technical methods. This approach relies on statistical methods to predict
A survey of U.K. forex traders shows they are divided equally among the three methods
mentioned earlier. Also, time plays a role in which method they decide to use. In the very
Long-Run Policy Analysis
The more comprehensive model is complicated but has the benefit of linking short-run
A Permanent Shock to the Home Money Supply Figure 15-12 illustrates the effects of
a permanent increase in the home money supply. The reverse would apply to a permanent
decrease in the home money supply. In these cases, the expected exchange rate changes
The Long Run The long-run effects of this shock are derived from the monetary
approach:
The Short Run The short-run effects of this shock are derived from both the asset
approach (interest rates) and the monetary approach (to determine the expected exchange
rate):
Adjustment from Short Run to Long Run The key change as the markets move from
short run to long run is the price level. In the short run, the price level is fixed. In the long
The real money supply increases in the short run, then decreases back to its initial value
in the long run. This implies the nominal interest rate and domestic return adjust back to
their initial values.
Also, note that because prices adjust slowly over time, the adjustment from short run
to long run is shown as a gradual change in variables over time (Figure 15-12).
The long run—from the monetary approach:
The short run—from the asset and monetary approaches:
The increase in the home money supply implies that the home price level will be lower in
the long run. This is associated with an appreciation in the home currency, so the
expected exchange rate decreases in the short run. The net effect is an appreciation in the
home currency in the short run.
The transition is as follows:
An Example This example is the reverse of the case study from the textbook. Assume
the following:
■ The home money supply decreases by 3%.
■ Prices are sticky in the short run and are fully flexible in the long run.
■ This leads to a 2-percentage-point increase in the home interest rate.
The previous assumptions imply that the real money supply decreases in the short run and
returns to its initial value as the price level decreases to bring the money market into
Overshooting
There are some key differences between temporary and permanent changes in the money
supply. Note that in the case of a permanent change in the money supply, the exchange
rate changes by more in the short run than in the long run. That is, the exchange rate
overshoots its long-run value. This is known as overshooting.
This is shown Figure 15-13. Note that it applies to either an increase or a decrease in
the home money supply. Consider how a permanent decrease in the money supply would
affect these variables:
■ In the short run, the money supply jumps down to its new level.
S I D E B A R
Overshooting in Practice
Countries with a nominal anchor are committing to specific values for nominal variables
(such as the spot exchange rate, the money supply, or the inflation rate). This pins down
the economy’s long-run nominal interest rates, and ultimately its exchange rates. The
adoption of a nominal anchor rules out permanent policy changes that would affect the
long-run values of prices and exchange rates.
The data show whether countries committed to a nominal anchor have less volatile
5 Fixed Exchange Rates and the Trilemma
The preceding model applies to a floating exchange rate regime. The FX market adjusts
to reflect changes in the home and the foreign money market. This section considers the
model in the context of regime choice: fixed versus floating.
What Is a Fixed Exchange Rate Regime?
We consider the case of a fixed exchange rate (hard pegs or narrow bands) without
capital controls. In this case, the government must engage in foreign exchange market
intervention to control the value of the currency. The central bank is responsible for these
interventions through buying and selling foreign currency to keep the exchange rate fixed
at .
Pegging Sacrifices Monetary Policy Autonomy in the Short Run: Example
UIP shows that the fixed exchange rate implies the home nominal interest rate must be
equal to the foreign nominal interest rate because the exchange rate is not expected to
change.
This implies that the home money market is linked to the foreign money market:
Note that each time the foreign interest rate changes, the home country must adjust the
home money supply. If the central bank were to choose a different money supply, the
We can use the model for short-run analysis. The difference is that the home money
supply is no longer exogenous; it depends on the foreign interest rate. Instead, the
exchange rate is exogenous.
■ Floating exchange rate regime. The central bank chooses the money supply
(exogenous), which determines the nominal interest rate in the money market.
Pegging Sacrifices Monetary Policy Autonomy in the Long Run: Example
This section studies the long-run implications of the home country adopting a fixed
exchange rate regime versus a floating exchange rate regime.
From PPP:
We can use the model for long-run analysis, noting that the home price level and the
money supply are no longer exogenous.
■ Floating exchange rate regime. The central bank chooses the growth in the money
The Trilemma
The fixed versus floating exchange rate regime highlights some trade-offs facing policy
makers. The following three expressions highlight possible policy goals:
1. (fixed exchange rate [promotes stability in trade and investment])
S I D E B A R
Intermediate Regimes
Countries often implement an exchange rate regime that is somewhere between fixed and
floating. In terms of the trilemma, this means the country is between two points. For
example, exchange rate bands and managed float allow for some flexibility in the
exchange rate. With an exchange rate band, the country is able to enjoy some of the
benefits of a fixed exchange rate while maintaining capital mobility and some monetary
policy autonomy.
APPLICATION
The Trilemma in Europe
Denmark has adopted a fixed exchange rate regime, pegging the Danish krone to the
euro. This implies that Denmark has sacrificed its monetary policy autonomy. What if
Denmark wanted monetary policy autonomy?
It has two options: sacrifice (1) the fixed exchange rate, or (2) international capital
mobility. The United Kingdom has opted to sacrifice (1) to achieve monetary policy
6 Conclusions
This chapter combines the models used in the previous two chapters to develop a
comprehensive model of exchange rate determination. Combining the UIP condition
APPLICATION
News and the Foreign Exchange Market in Wartime
It is difficult to measure changes in exchange rate expectations. This application
considers exchange rate movements during wars because dramatic changes in a
The U.S. Civil War 1861–1865 During the U.S. Civil War (1861–1865), the
Confederacy (South) issued its own currency, the Confederate dollar, to finance the war
effort against the Union (North). Figure 15-18 plots the exchange rate (Confederate
The Iraq War In 2003, a U.S.-led coalition invaded Iraq with the intent of overthrowing
the government, headed by Saddam Hussein. Figure 15-19 shows the exchange rates for
Teaching Tips
Teaching Tip 1: The “Application: Can Central Banks Always Control the Interest
Rate?” explores the limits to a central bank’s ability to influence the economy once
