15 Exchange Rates II: The Asset Approach in the Short Run
Notes to Instructor
Chapter Summary
This chapter combines the asset approach, based on the uncovered interest parity (UIP)
condition from Chapter 13, with the monetary approach from Chapter 14 to develop a
comprehensive model of exchange rate determination. Within the model, we can study
how temporary and permanent shocks affect the economy in both the short run and the
long run. It is important to link the two models to understand why exchange rate
Comments
The authors continue to use the case of the United States and the Eurozone as a template
for understanding relative prices and exchange rates in two different regions. Here, a
more generic notation (home versus foreign) is used. This chapter uses some important
building blocks from Chapters 13 and 14:
• Money market: Determination of nominal interest rates, assuming sticky prices in
the short run, and flexible prices in the long run based on the quantity theory of
money
• Foreign exchange market: Determination of spot exchange rates based on UIP
permanent shock changes the expected exchange rate consistent with PPP. This leads to
overshooting of the exchange rate in the short run.
An alternative presentation would begin with the comprehensive model, studying the
effects of temporary and permanent shocks in the short run and the long run. Although
temporary shocks do not have long-run implications for the variables in the model, the
1. Exchange Rates and Interest Rates in the Short Run: UIP and Forex Market
Equilibrium
a. Risky Arbitrage
i. Short-Term Interest Rates
ii. Exchange Rate Expectations
b. Equilibrium in the Forex Market: An Example
c. Adjustment to Forex Market Equilibrium
d. Changes in Domestic and Foreign Returns and Forex Market Equilibrium
e. Summary
2. Interest Rates in the Short Run: Money Market Equilibrium
a. Money Market Equilibrium in the Short Run: How Nominal Interest Rates
Are Determined
i. The Assumptions
ii. The Model
b. Money Market Equilibrium in the Short Run: A Graphical Solution
c. Adjustment to Money Market Equilibrium in the Short Run
d. Another Building Block: Short-Run Money Market Equilibrium
3. The Asset Approach: Applications and Evidence
a. The Asset Approach to Exchange Rates: Graphical Solution
i. The U.S. Money Market
b. Short-Run Policy Analysis
i. A Temporary Shock to the Home Money Supply
4. A Complete Theory: Unifying the Monetary and Asset Approaches
a. Side Bar: Confessions of a Forex Trader
b. Long-Run Policy Analysis
i. A Permanent Shock to the Home Money Supply
ii. The Long Run
c. Overshooting
d. Side Bar: Overshooting in Practice
5. Fixed Exchange Rates and the Trilemma
a. What Is a Fixed Exchange Rate Regime?
b. Pegging Sacrifices Monetary Policy Autonomy in the Short Run: Example
c. Pegging Sacrifices Monetary Policy Autonomy in the Long Run: Example
6. Conclusions
a. Application: News and the Foreign Exchange Market in Wartime
Lecture Notes
The monetary approach to exchange rate determination is a poor model for predicting
exchange rate changes in the short run because of a key assumption of the monetary
approach: prices are flexible.
For example, consider the prices of a basket of goods in two countries, the United
States and the United Kingdom. Initially, the price of this basket is £100 in the United
Kingdom and $175 in the United States. The exchange rate is currently $1.75 per pound,
Now suppose the price of a typical basket of goods increases by 10% in the United
Kingdom, so the purchasing power of the British pound has decreased for U.K. residents.
At the same time, assume the U.S. price level increased by 6% and the pound‒dollar
exchange rate decreases by 1%.
The monetary approach predicts the exchange rate should change by 4%, or a 4%
From the last chapter, we know that there is evidence supporting PPP in the long run
but not in the short run. This suggests another theory is needed to explain these short-run
1 Exchange Rates and Interest Rates in the Short Run: UIP and Forex
Market Equilibrium
Consider two alternative one-year investment strategies:
• a U.S. dollar‒denominated account with interest rate i$
Risky Arbitrage
In risky arbitrage, the investor does not cover her deposits abroad with a forward
contract. She must forecast the expected future exchange rate to find her expected dollar-
denominated return on peso-denominated deposits. From the UIP approximation in
The left-hand side is the return on dollar-denominated deposits. The right-hand side is the
expected return on peso-denominated deposits plus the expected depreciation of the
dollar.
According to this expression, the current exchange rate depends on home and foreign
interest rates and the expected exchange rate.
Note that the asset approach to exchange rates assumes that the expected exchange
Short–Term Interest Rates Short-term interest rates (home and foreign) are observed by
market participants. Investors know the interest rates on deposits at home (the United
Exchange Rate Expectations Exchange rate expectations are based on the monetary
Equilibrium in the Forex Market: An Example
This example mirrors the example in the textbook, except here we use the peso–dollar
(1)
(2)
(3)
(4)
(5)
(6) = (2)
+ (5)
Interest Rate
on Dollar–
Interest Rate
on Peso-
Spot
Exchange
Expected
Future
Expected Peso
Appreciation
Expected
Dollar
Investors
Prefer
0.04
0.12
0.101
0.092
−0.089
0.031
U.S. dollar
deposits
0.04
0.12
0.099
0.092
−0.071
0.049
Peso
deposits
0.04
0.12
0.098
0.092
−0.061
0.059
Peso
The above data, as well as the corresponding examples from the textbook, are included in
the Excel workbook for this chapter. In addition, FX market diagrams are included for all
four examples.
Figure 15-2 is an FX market diagram—our graphical representation of the FX
market. In this diagram, the expected return on two investment strategies (domestic
0.04
0.12
0.102
0.092
−0.098
0.022
U.S. dollar
Adjustment to Forex Market Equilibrium
In the table, we see that if the spot exchange rate is more than $0.10 per peso, the return
on U.S. dollar deposits exceeds the return on peso deposits. In this case, investors will
Changes in Domestic and Foreign Returns and Forex Market Equilibrium
Now, we will consider changes in the equilibrium spot exchange rate. In summary:
■ ↑Ee$/peso → ↑E$/peso ($ depreciation, peso appreciation)
In all three of the following cases, the domestic return is less than the foreign return at the
prevailing spot exchange rate, $0.10 per peso. Investors will shift their deposits away
from domestic deposits in favor of foreign deposits. The foreign currency will appreciate
A Change in the Domestic Interest Rate Suppose that the domestic (United States)
A Change in the Foreign Interest Rate Suppose that the foreign interest rate increases
A Change in the Expected Future Exchange Rate Suppose the expected future
Summary
Figure 15-2 is a graphical illustration of the foreign exchange market. Note that the UIP
condition is the equilibrium condition in this market. According to the asset approach to
2 Interest Rates in the Short Run: Money Market Equilibrium
The model in the preceding section provides us with a way to explain exchange rate
Money Market Equilibrium in the Short Run: How Nominal Interest Rates Are
Determined
Interest rates are determined in the money market. Here, we consider the money market
The Assumptions It is important to distinguish between short–run equilibrium and long-
Short-run assumptions
The price level is fixed: P = . The nominal interest rate is fully flexible and adjusts to
bring the money market to equilibrium.
Long-run assumptions
The price level is fully flexible and adjusts to bring the money market to equilibrium. The
Why is the short run different from the long run?
First, it is common to assume sticky prices, also known as nominal rigidity, in the short
run. Prices are not fully flexible in the short run because of rigidities in price adjustment,
which result from factors such as long-run labor contracts or menu costs (costs associated
The Model From the monetary approach, we know money market equilibrium is
achieved when real money demand is equal to real money supply. Following the generic
Money Market Equilibrium in the Short Run: Graphical Solution
Figure 15-4 shows the money market equilibrium based on the general money demand
functions assumed previously.
■ MH is set by the central bank.
■ H is assumed to be fixed in the short run. In the long run, PH adjusts to bring the
Demand for real money balances: L(iH) × YH
■ L(iH) × YH is a negative function of the nominal interest rate. As the nominal
Adjustment to Money Market Equilibrium in the Short Run
The nominal interest rate adjusts to equate real money balances demanded and supplied.
If the interest rate is more than the market–clearing rate, then real money supplied will
exceed real money demanded (point 2 on Figure 15-4). The public will seek to reduce its
If the nominal interest rate is less than the market–clearing rate, then real money
demanded is more than real money supplied. The public seeks to increase its money
holdings because it is forgoing relatively little in interest. At this lower interest rate,
Another Building Block: Short–Run Money Market Equilibrium
Figure 15-5 summarizes the monetary model, illustrating how a country’s interest rate
Changes in Money Supply and the Nominal Interest Rate
The money supply curve depends on the nominal money supply and the price level. This
section considers the short–run effects.
In the short run, only the central bank can change the real money supply because the
price level is fixed.
APPLICATION
Can Central Banks Always Control the Interest Rate? A Lesson from the Crisis of
2008–09
The financial crisis of 2008–09 posed some special problems for central banks. For
example, the Fed uses federal funds rate as its policy rate. Normally, changes in the Fed
Another problem is the zero lower bound (ZLB) issue. Once the central bank has
lowered its policy rate to zero, there isn’t much more it can do. The Fed’s
response was quantitative easing. Here are three examples of the extraordinary
The result: M0 more than doubled to over $1 trillion. However, most of this increase was
held by banks as excess reserves. That meant M1 and M2 hardly changed at all.
The Bank of England and, eventually, the European Central Bank used similar
procedures at various points during the crisis.
Changes in Real Income and the Nominal Interest Rate
Figure 15-6(b) illustrates an increase in money demand caused by an increase in real
income. Changes in real income affect money demand because they affect the public’s
desire to spend. When real income rises, the public plans to spend more and therefore
needs more money balances to conduct such transactions. This leads to an increase in
money demand.
The Monetary Model: The Short Run Versus the Long Run
Note that the short–run analysis yields results that differ significantly from those we
found using the monetary approach in the long run.
Because of the differences in the models’ implications, it is important to distinguish
It may be useful to emphasize this distinction now. Students often are confused about
temporary versus permanent and short run versus long run.
■ Temporary shocks:
❑ The long-run equilibrium is always the same as the initial equilibrium because
the effects of the shock disappear before price adjustment occurs.
■ Permanent shocks:
❑ The short-run equilibrium and long-run equilibrium are different.
❑ Often, the economy will not return to its initial equilibrium point in the long
run.
There are some apparent contradictions between the short– and long-run models. In
both the short run and the long run, raising the growth rate of the money supply leads to
an exchange rate depreciation. However, in the short run, low interest rates and currency
depreciation go together; but in the long run, high interest rates and currency depreciation
go together.
The explanation for this apparent contradiction lies in expectations. In the short run,
expectations tend to be inflexible. This is true whether we look at future exchange rates,
When you think about how expectations are formed, it’s a good idea to pretend
you’re from Missouri, the “Show-Me” state. If the actual inflation rate does not change
much, expectations of future inflation will not change much either.
3 The Asset Approach: Applications and Evidence
In this section, we use the previous model to understand how shocks affect the money
The Asset Approach to Exchange Rates: Graphical Solution
The asset approach to exchange rates includes two diagrams: the home money market
The U.S. Money Market [Figure 15-7(a)]
1. MS represents the home real money supply. This line is vertical for two reasons.
First, by assumption the nominal money supply (set by the central bank) is
2. MD represents home real money demand. This line is downward-sloping because,
as the nominal interest rate rises, the opportunity cost of holding money balances
The Market for Foreign Exchange [Figure 15-7(b)]
1. FR represents the return on foreign deposits in domestic currency. As the spot
exchange rate rises, the home currency depreciates, so the return on foreign-
2. Because domestic investors do not need to convert currency to deposit funds into
a domestic account, the return on these deposits is independent of the spot
Capital Mobility Is Crucial This model of exchange rate determination hinges on
arbitrage. Therefore, if a country imposes capital controls, then the investor no longer has
Putting the Model to Work The two diagrams in Figure 15-7 are linked. The money
market tells us the equilibrium nominal interest rate in the home country. This is
determined by the intersection of MS and MD. The nominal interest rate is DR in the