Summer2009,Econ311 IntermediateMacroeconomics

THEASSETSMARKETMODEL

1.INTRODUCTION
Answering the question why do exchange rates exist? is conceptually equivalent to answering the question why does money exist? Money exists as a medium of exchange within the borders of a given country in order to facilitate trades of goods and services in that economy (remember that trade occurs because of specialization of agents in the economy). Very much in the same way, agents in different countries specialize in producing certain goods and services and trade these goods across borders is facilitated by the existence of exchange rates a device that allows to change one countrys money for the other countrys money which in turn allows trading of goods and services. After a brief discussion on how exchange rates are quoted we will introduce the idea of real exchange rates which basically is a price of one countrys goods in terms of other countrys goods. Then we move on to study the implications of exchange rates on the return on assets in different countries. Finally but probably the most important topic in this lecture we will derive the uncovered and covered interest rate parity conditions the first step in linking exchange rates and open macroeconomics.

2.NOMINALANDREALEXCHANGERATE
Since an exchange rate is a price of a currency in terms of another currency there are two ways to quote an exchange rate: the direct or American way as domestic currency per unit of foreign currency and conceptually it gives the amount of domestic currency paid to obtain one unit of foreign currency - example: : if E $ / = 1.43 that means that it needs $1.43 to buy one euro () the indirect or European way as foreign currency per unit of domestic currency and conceptually it gives the amount of foreign currency paid to obtain one unit of domestic currency - example: if E/ $ = 0.70 that means that it needs 0.70 to buy one dollar ($) If you look at the numbers above and it seems to you that 1.43 = 1/0.70 you are actually right, it must hold that

E $ / =

1 E/$

The two examples above involve nominal exchange rates that link domestic and foreign currencies, in other words the price of one currency in terms of another currency. However what is important in any economy (and for any agent in an economy) is the amount of goods and services that can be consumed. The picture below is again a very brief representation of two countries, each with its own goods and currency and the only existing (so far) link in between: the (nominal) exchange rate that links the two currencies. What about the link between the goods produced in the two countries, i.e. how many units of domestic goods are needed to buy one unit of foreign goods? This is what we call the real exchange rate.

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Now lets start with one unit of foreign goods which is worth P euroswhich in turn can be exchanged for P E $ / dollarswhich in turn buy

P E $ / P$

units of domestic goods. The chain above shows that one unit of foreign goods can buy

exactly

P E $ / P$

units of foreign goods, thus the real exchange rate of foreign goods for domestic goods is

domestic / foreign =

P E $ / P$

It shows how many units of domestic goods are needed to buy one unit of foreign goods. This is exactly the counterpart of the nominal exchange rate E $ / . Of course if we think in terms of how many units of foreign goods are needed to buy one unit of domestic goods we should calculate

foreign /domestic =
Finally at this point we introduce some terminology:

P$

P E $ /

P$ E/$ P

(i) an appreciation of the domestic currency represents an increase in its value relative to another currency: one unit of domestic currency ($) can buy more units of foreign currency () or equivalently one unit of foreign currency () buys fewer units of domestic currency ($); given our direct quotation system it translates into a decrease in E $ / . (ii) a depreciation of the domestic currency represents a decrease in its value relative to another currency: one unit of domestic currency ($) can buy fewer units of foreign currency () or equivalently one unit of foreign currency () buys more units of domestic currency ($); given our direct quotation system it translates into a increase in E $ / .

NO-ARBITRAGE AND THE TRIANGLE CONDITION. So far above we only considered two currenciesobviously in the real
world there are several currenciesFor simplicity lets consider here three currencies: the dollar ($), the euro () and the yen (). We can define three exchange rates in this case: E$/ - the price of euros in terms of dollar E$/ - the price of yens in terms of dollar E/ - the price of euros in terms of yen

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Is there any relation that three exchange rates should satisfy? Lets start with one euro which will buy exactly E$/ dollarswhich in turn buy E$//E$/ yensThus one euro can buy (via the dollar vehicle currency) exactly E$//E$/ yens. But the direct quotation euro/yen says that one euro buys exactly E/ yens. This means that it must be the case that E/ = E$//E$/ Otherwise, if the above equality is not satisfied you are able to make a sure profit.

3. SPOT AND FORWARD EXCHANGE RATES

The exchange rate that is relevant for todays transactions is called the spot exchange rate. However lets be a bit more systematic in our approach and consider two dates: today (called time 0) and tomorrow (called time 1). The diagram below shows the timeline and the relevant exchange rates for each date. for each moment in time there exists a spot exchange rate: for time 0 the spot exchange rate in effect at time 0 is E $ / while for time 1 the spot exchange rate in effect at time 1 is E $ / . at time 1 there is an expected exchange rate E $ / at time 1 there is a forward exchange rate F$ / . While the spot exchange rates are clear in terms of what represent lets discuss the expected and forward exchange rates. As of time 0 the market forms expectations about the spot exchange rate that will prevail on the FOREX at time 1 and this expected exchange rate is E $ / . It is important to understand that this expected exchange rate is a theoretical concept that has no counterpart in reality. Moreover the expected exchange rate can actually be far away from the actual spot exchange rate that will prevail on the market at time 1. Finally the forward exchange rate: imagine that at time 0 you find out that you will have to pay 100,000 at time 1. As of time 0 you dont know what will be the spot exchange rate at time 1 which means you are exposed to the exchange rate risk. You would like to hedge against this risk and enter a contract which guarantees an exchange rate at time 1. This contract that is written at time 0 but guarantees an exchange rate at time 1 is called a forward exchange rate contract. The guaranteed exchange rate at time 1 is F$ / . For example if F$ / = 1.25 it means that as of time 0 you are locked into an exchange rate of $1.25 for one euro, exchange rate that will be used at time 1. It is important to understand that you will have to use this exchange rate at time 1 regardless of what the spot exchange rate E $ / will prevail on the market at that time. Lets 1 continue our example and suppose that at time 1 the spot exchange rate is E $ / = 1.15 which means that using the market you would pay $1.15 per euro. However you already signed a forward contract that forces you to pay $1.25 per euro. [Of course you wish you never had signed the contract, but consider the case in which the spot exchange rate at time 1 is
1 e 0 1

E1 $ / = 1.35 then of course you would be happy for the forward contract]. The profit per euro for the counterpart trader for the
forward contract you signed is obviously:

F$ / E1 $ /
revenue cos t

Lets interpret the revenue and cost ideas in the formula above: the trader has to buy euros from the market at an exchange rate

E1 $ / and gives these euros to you, i.e. the trader gets dollars from you, at an exchange rate F$ / .

4. UNCOVERED AND COVERED INTEREST RATE PARITY CONDITIONS

First a definition which for sure looks familiar to you, the rate of return on any investment is defined as

rate of return =

payoff (assets value end of period ) cost (assets value beginning of period ) 100 cost (assets value beginning of period )

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Now lets consider the following two investment opportunities: a domestic deposit that offers an interest rate R$ per dollar ($) invested a foreign deposit that offers an interest rate R per euro () invested REMARK: to be able to use the domestic deposit you should deposit dollars (and only dollars) while to be able to use the foreign deposit you should deposit euros (and only euros). The spot exchange rate today (time 0) is E $ / while the expected exchange rate for tomorrow (time 1) is given by E $ / . Next we will calculate the return on the investment for each deposit. If you deposit one dollar domestically you will end up at time 1 with 1 + R$ dollars therefore the return to this investment is simply R$ . Now lets start with the same one dollar which buys 1/ E $ / euroswhich deposited in the foreign deposit yields e at time 1 exactly [1/ E $ /] (1 + R ) euroswhich are expected to be exchanged for [1/ E $ /] (1 + R ) E $ / dollars. Bottom line is that the return on the initial dollar when invested in the foreign deposit is:
e [1/ E $ /] (1 + R ) E $ / $1 e E$ / e

return =

$1

= (1 + R )

E $ /

It is important to understand that this return represents return to dollars since the end value of the deposit is calculated in dollars while the initial investment is also in dollars. Lets summarize our calculations so far: if you invest one e dollar domestically you get a return of R$ while the same dollar E $ / 1 . The uncovered interest rate condition (UIP) states that invested in the foreign deposit yields a return of (1 + R ) in equilibrium the two rates of return have to equal each other:

E $ /

R$ = (1 + R )
Why should this be true? Lets assume that actually

e E$ /

E $ /
e E$ /

R$ < (1 + R )

E $ /

Which means that investing one dollar in the foreign deposit yields a higher return than investing domesticallyeverybody will try to take advantage of this higher return abroadhowever in order to invest abroad one needs euros thus all holders of dollars will try to exchange the dollars for euros thus depreciating the dollar (a high demand for euros together with an increased supply of dollars will depreciate the dollar). But a depreciation of the dollar means that E $ / increasesbut look at the right hand side of the above relation: as long as E $ / increases this right hand side decreasesfor how long will E $ / increase? Until the right hand side decreases enough to equal the left hand side, i.e. until the equality
e E$ /

R$ = (1 + R )

E $ /

is establishedbut this is exactly the UIP condition. You can think of the case when we start with the inequality

R$ > (1 + R )

e E$ /

E $ /

1 E $ /

when everybody will want dollars to invest in the domestic depositthis will put pressure to appreciate the dollar thus will decreasethe right hand side will increase until the equality (UIP) is re-established. Back to the UIP

R$ = (1 + R )

e E$ /

E $ /

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which can be re-written with a simple algebraic manipulation (approximation) as

R$ = R +
Notice that this has a nice interpretation:

e E$ /

E $ /

return on domestic deposi

R$ {

return on foreign deposit

R {

e E$ / E $ /

return on exchange rate fluctuations

E $ / 14 4 244 3

It shows that the return on the domestic deposit must equal the sum of the return on foreign deposit and the expected return (which can be positive or negative) on the exchange rate fluctuations. To understand why the last term represents a return rate remember that E $ / is what you pay today to get euros while E $ / is the price you get per euro at time 1. In the derivations above we used the expected exchange rate for time 1, however this is not necessarily equal to the spot exchange rate at time 1. Moreover we already introduced the forward exchange rate F$ / - an exchange rate that can be contracted at time 0 and be in effect at time 1. Thus using a forward exchange rate instead of the expected exchange rate means that as of time 0 the investor can guarantee the profit at time 1 instead of just an expected profit based on the expected exchange rate. The new condition obtained is called the covered interest rate parity condition (CIP) and it writes as
e

R$ = R +

F$ / E $ /

The forward rates are available for contracting on the FOREX and they are quoted every day for intervals of 1 month, 3 months and so onThe diagram below shows the spot and forward exchange rates (the right column).

(DataavailablefromtheOZFOREXwebsite.Reprintedherewithoutpermission).

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Next lets draw the UIP condition in a diagram with domestic interest rate R$ on the horizontal axis and spot exchange rate E $ / on the on the vertical axis. Since the UIP is
e E$ /

R$ = R +

E $ /

it is clear that the relation between R$ and spot exchange rate E $ / is an inverse one therefore the UIP curve is downward slopping as shown. Notice that from the UIP condition we can write

E $ / =

1 e E$ / 1 + R$ R

which shows more obviously the downward slopping relation between the domestic interest rate and spot exchange rate. There are four variables involved in the UIP condition with two of them appearing on the axis of the UIP diagram. That means
e that the other two, namely the foreign interest rate R and expected exchange rate E $ / , are parameters for the diagram a change in these variables would shift the UIP curve. [A change in domestic interest rate or spot exchange rate youd move along

the UIP curve].

REMARK. We can get immediately the slope of the UIP curve as constant, the curve flattens out as R$ increases. Now lets take a look at the shifts in the UIP curve. A CHANGE IN THE FOREGIN INTEREST RATE. From

dE $ / dR$

1 E e . Obviously the slope is not = $ / 1 + R R $

E $ / =

1 1 + R$ R

e E$ /

we see immediately that an increase in R will increase E $ / for each level of R$ in other words the UIP curve shifts up; a decrease in R will decrease E $ / for each level of R$ in other words the UIP curve shifts down. In the diagram we 0 1 assume the initial foreign interest rate is at level R then it decreases to R (the UIP curve shifts up from UIP0 to UIP 1 ); then the foreign interest rate increases from
0 2 R to R (the UIP curve shifts up from UIP0 to UIP2 ).

A CHANGE IN THE EXPECTED EXCHANGE RATE. From

E $ / =

1 1 + R$ R
e

e E$ /

we see immediately that an increase in E $ / will increase E $ / for each level of e R$ in other words the UIP curve shifts up; a decrease in E $ / will decrease E $ / for each level of R$ in other words the UIP curve shifts down. In the diagram we 0 1 assume the initial expected exchange rate is at level E $ / then it increases to E $ / (the UIP curve shifts up from UIP0 to UIP 1 ); then the expected exchange rate decreases from E $ / to E $ / (the UIP curve shifts up from UIP0 to UIP2 ).
0

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5. EQUILIBIRUM IN THE FOREX MARKET

Among the four variables from the UIP condition the domestic interest rate R$ is controlled by the central bank of the domestic country. In other words the domestic interest rate is taken as given and therefore the spot exchange rate is determined from the UIP condition. This is shown in the diagram: the equilibrium spot exchange rate is found at the intersection of the UIP curve and the vertical line at the fixed domestic interest rate. Next we can study the way the equilibrium spot exchange rate reacts to changes in the domestic interest rate and in the parameters.

A CHANGE IN DOMESTIC INTEREST RATE. Suppose the domestic interest rate increases from R$ to R$ . The effect is a decrease in the spot exchange rate. Notice however that in reaching this conclusion we assumed that the foreign interest rate and the expected exchange rate are unchanged. This is the idea of studying the changes in equilibrium by changing only one variable at a time. A change in domestic interest rate implies a movement along the UIP curve.
0 1

A CHANGE IN FOREIGN INTEREST RATE. Suppose the
0 foreign interest rate increases from R to 1 R . The effect is

A CHANGE IN EXPECTED EXCHANGE RATE. Suppose the expected exchange rate increases from E $ / to E $ / . The effect is an increase in the spot exchange rate. Notice again that in reaching this conclusion we assumed that the domestic interest rate and the foreign interest rate are unchanged. This is the idea of studying the changes in equilibrium by changing only one variable at a time. A change in expected exchange rate implies a shift of the UIP curve.
0 1

an increase in the spot exchange rate. Notice again that in reaching this conclusion we assumed that the domestic interest rate and the expected exchange rate are unchanged. This is the idea of studying the changes in equilibrium by changing only one variable at a time. A change in foreign interest rate implies a shift of the UIP curve.

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6. THE MONEY MARKET AND THE FOREX MARKET

Lets look at the FOREX market diagram on the left and the money market diagram on the right. The horizontal axis on the diagram on the left represents domestic interest rate while the vertical axis on the diagram on the right also represents domestic interest rate.

If we rotate the diagram on the right clockwise with 90 degrees and then paste it at the bottom of the diagram on the left (notice the common axis the domestic interest rate R$ ) we get the diagram shown here. Domestic interest rate R$ is determined on the domestic money 0 market; in turn the spot exchange rate E $ / is determined in the FOREX market. About the diagrams: the top diagram has nothing special, the measurement on both axis are as usual (on the horizontal axis the variable R$ increases from left to right, on the vertical axis the variable E $ / increases upward); the bottom diagram though has something special the measurement on the vertical axis is reversed, the variable ( M / P ) increases downwardly (remember that this diagram was obtained from the original money market diagram using a 90 degrees clockwise rotation). In what follows we will always consider that the economy starts from equilibrium and the variables will be labeled with a 0 to indicate the initial state in the economy. We will consider a change in the money supply, foreign interest rate and expected exchange rate.

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A CHANGE IN DOMESTIC MONEY SUPPLY. Lets consider a change in domestic money supply M

, a change that impacts the

S

money market. The economy is initially at points 0 in both diagrams and the initial values for variables are M 0 (for money 0 0 supply), R$ (for domestic interest rate) and E $ / (for spot exchange rate). The parameters are fixed at R (for foreign interest rate) and E $ / (for expected exchange rate). Now consider an increase in domestic money supply from M 0 to M1 . This shifts the vertical real money supply line 0 1 downward. As a result domestic interest rate decreases from R$ to R$ . In the top diagram the spot exchange rate increases from E $ / to E $ / , i.e. a depreciation of domestic currency. The economy ends at points 1 in both diagrams. This is an analysis in the short-run since we do not consider the response neither in the foreign interest rate nor in the expected exchange rate.
0 1 S S

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A CHANGE IN FOREIGN INTEREST RATE. Lets consider now a change in foreign interest rate R , a change that impacts the FOREX market. The economy is initially at points 0 in both diagrams and the initial values for variables are M 0 (for money 0 0 0 supply), R$ (for domestic interest rate), E $ / (for spot exchange rate) and R (for foreign interest rate). The remaining parameter is fixed at E $ / (for expected exchange rate). Now consider an increase in foreign interest rate from R to R . This shifts the UIP curve upward. As a result spot exchange rate increases from E $ / to E $ / , i.e. a depreciation of domestic currency. Notice that there are not changes in the domestic interest rate since there is no intervention in the money market. The economy ends at points 1 in both diagrams on the left. This is an analysis in the short-run since we do not consider the response neither in the domestic money supply nor in the expected exchange rate. What if the Central Bank (FED) considers the depreciation as undesirable, i.e. the FED would prefer to have the spot exchange rate remaining at the level E $ / . How can the FED do this? The answer is simple: a decrease in domestic money supply; this would increase the domestic interest rate which in turn will force the spot interest rate to decrease back to the initial level. The economy ends at points 2 in both diagrams on the right.
0 0 1 S

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A CHANGE IN EXPECTED EXCHANGE RATE. Lets consider now an increase in expected exchange rate E $ / , a change that impacts the FOREX market. The economy is initially at points 0 in both diagrams and the initial values for variables are
S e ,0 0 0 M0 (for money supply), R$ (for domestic interest rate), E $ / (for spot exchange rate) and E $ / (for expected exchange rate).

The remaining parameter is fixed at R (for foreign interest rate). Now consider an increase in expected exchange rate from E $ / to E $ / . This shifts the UIP curve upward. As a result spot 0 1 exchange rate increases from E $ / to E $ / , i.e. a depreciation of domestic currency. Notice that there are not changes in the domestic interest rate since there is no intervention in the money market. The economy ends at points 1 in both diagrams on the left. This is an analysis in the short-run since we do not consider the response neither in the domestic money supply nor in the foreign interest rate. Again, what if the Central Bank (FED) considers the depreciation as undesirable, i.e. the FED would prefer to have the spot exchange rate remaining at the level E $ / . The answer of course is the same: a decrease in domestic money supply; this would increase the domestic interest rate which in turn will force the spot interest rate to decrease back to the initial level. The economy ends at points 2 in both diagrams on the right.
0 e ,0 e ,1

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