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
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
Next, the monetary approach developed in Chapter 14 is combined with UIP. This
allows students to study the effects of permanent shocks in the short run and the long 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
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
4. A Complete Theory: Unifying the Monetary and Asset Approaches
a. Side Bar: Confessions of a Forex Trader
b. Long-Run Policy Analysis
5. Fixed Exchange Rates and the Trilemma
a. What Is a Fixed Exchange Rate Regime?
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
The monetary approach predicts the exchange rate should change by 4%, or a 4%
depreciation in the British pound and a 4% appreciation in the U.S. dollar. In actuality,
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
Chapter 13, this yields the arbitrage condition
The UIP condition is the fundamental equation of the asset approach to exchange
rates. Solving for the spot exchange rate, we can see which factors influence the spot
exchange rate, E$/peso:
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
rate and short–term interest rates are known.
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
exchange rate. In the textbook, the dollar is expected to depreciate against the euro. Here,
the dollar is expected to appreciate against the peso.
(1)
(2)
(3)
(4)
(5)
(6) = (2)
+ (5)
Interest Rate
on Dollar–
Denominated
Deposits
(annual)
Interest Rate
on Peso-
Denominated
Deposits
(annual)
Spot
Exchange
Rate
(today)
Expected
Future
Exchange
Rate (in
one year)
Expected Peso
Appreciation
against Dollar
(in one year)
Expected
Dollar
Return on
Peso
Deposits
(annual)
Investors
Prefer
0.04
0.12
0.102
0.092
−0.098
0.022
U.S. dollar
0.04
0.12
0.101
0.092
−0.089
0.031
U.S. dollar
deposits
0.04
0.12
0.1
0.092
−0.08
0.04
Indifferent
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
deposits
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
versus foreign) is illustrated as a function of the spot exchange rate.
In the previous table, we can see that, for given interest rates and expected exchange
The domestic return is independent of the exchange rate because U.S. investors do
not need to convert their currency to invest in U.S. dollar deposits. Therefore, the
domestic return (DR) line is horizontal. The position of this line depends on the domestic
interest rate.
The equilibrium exchange rate is the spot rate that equates the domestic return (1) to
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
until the two returns are equal.
A Change in the Domestic Interest Rate Suppose that the domestic (United States)
interest rate decreases from 4% to 3%. This is illustrated as a downward shift in the DR
line. The diagram implies that the spot exchange rate will increase.
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
exchange rate increases to $0.10 per peso. In Figure 15-2, this is illustrated as an upward
shift in the FR line. The diagram implies that the spot exchange rate will increase.
Summary
Figure 15-2 is a graphical illustration of the foreign exchange market. Note that the UIP
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
movements based on interest rates and expectations. Now we are ready to explain why
interest rates and expectations change, drawing on the monetary approach we saw in
Chapter 14.
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-
run equilibrium. When explaining exchange rate movements using the FX market, we
will study both. This provides an important link to Chapter 14.
Short-run assumptions
Long-run assumptions
The price level is fully flexible and adjusts to bring the money market to equilibrium. The
nominal interest rate is fixed and equal to the sum of the world real interest rate and
domestic inflation: i = r* +
π
.
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
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
notation used in the lecture notes for Chapter 14, H denotes home country and F denotes
foreign country. In the textbook, the United States is treated as the home country and
Europe is the foreign country.
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.
Note that both of these variables are independent of the nominal interest rate. Therefore,
the money supply curve is vertical.
Demand for real money balances: L(iH) × YH
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
money holdings, shifting portfolios toward interest–bearing assets. Borrowers will only
pushes up the nominal 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.
Figure 15-6(a) illustrates an increase in the money supply. In summary, changes in
the nominal money supply affect the market as follows:
APPLICATION
Can Central Banks Always Control the Interest Rate? A Lesson from the Crisis of
funds rate cause changes in other interest rates, in the same direction. Despite lowering
the Fed funds rate to zero in 2008, bank loan rates barely changed at all. Banks had
become much more risk averse and were adding a much larger risk premium to their base
interest rates than they had before 2008.
2. Buying nontraditional securities such as commercial paper and mortgage-backed
securities
3. Expanding the list of counterparties from which it would buy securities, to include
some nonbank institutions
The result: M0 more than doubled to over $1 trillion. However, most of this increase was
Did it work? The consensus seems to be that quantitative easing worked to steer the
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.
In summary, changes in real income affect the market as follows:
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
between temporary shocks and permanent shocks. Temporary shocks dissipate before
prices adjust. Permanent shocks affect the economy in the long run and price adjustment
will occur.
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.
❑ Expected exchange rates will remain unchanged because investors know that
■ Permanent shocks:
❑ The short-run equilibrium and long-run equilibrium are different.
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,
the growth rate of the money supply, or the inflation rate. A temporary policy will not
change the nominal anchor and inflexible expectations are, in fact, correct predictors. In
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.
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
The foreign interest rate is determined in the foreign money market. Although this is