Exchange Rates II: The Asset Approach

15
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.

MS 1 MS 2
iRs ER

A C A C
i 1 Rs i 1 R$ DR 1

B B
i 2 Rs i 2 R$ DR 2

FR 2
MD 1 FR 1

M 2IN M 1IN M2IN E1 E3 E 2 E Rs/$

2
P IN P 1IN P 1IN

S-133
S-134 Solutions ■ Chapter 15 Exchange Rates II: The Asset Approach in the Short Run

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$/£, Ee$/£, and the U.S. price level.
Answer: The U.S. interest rate increases, the British interest rate does not
change, E$/£ decreases, Ee$/£ 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$/£, Ee$/£, 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 M2 to M1 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 ($). The exchange rate is in rupees per dollar, ERs/$. On all graphs, label the ini-
tial equilibrium point A.
a. Illustrate how a permanent increase in India’s 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.

MS 1 MS 2
iRs ER

A C A C
i 1 Rs i 1 R$ DR1

B B
i 2 Rs i 2 R$ DR2

FR 2
MD1 FR 1

M 2IN M 1IN M 2IN E1 E3 E 2 E Rs/$

2
P IN P 1IN P 1IN
 Solutions ■ Chapter 15 Exchange Rates II: The Asset Approach in the Short Run S-135

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
MIN, price level PIN, real money supply MIN/PIN, India’s interest rate iRs, and the
exchange rate ERs/$.
Answer: See the following diagrams.

M IN i Rs

P IN E Rs/$

T T n

MIN/PIN MUS/PUS

c. Using your previous analysis, state how each of the following variables changes
e
in the short run (increase/decrease/no change): India’s interest rate iRs, ERs/$ ERs/$ ,
and India’s price level PIN.
Answer: India’s interest rate decreases, the U.S. interest rate remains unchanged,
e
ERs/$ increases, ERs/$ increases, and India’s 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
e
point A): India’s interest rate, Japan’s interest rate, ERs/$, ERs/$ , and India’s interest
e
rate iRs, ERs/$ ERs/$, and India’s price level PIN.
Answer: India’s interest rate remains unchanged, the U.S. interest rate remains
e
unchanged, ERs/$ increases, ERs/$ increases (remains unchanged in transition from
short to long run), India’s price level increases.
e. Explain how overshooting applies to this situation.
Answer: The short run exchange rate overshoots its long-run value, E3 in text
Figure 15-13.We can see this in the impulse response diagrams shown previously.
The overshooting is caused by the investors’ adjustment of exchange rate expec-
tations coupled with the increase in the spot rate associated with lower domes-
tic interest rates.
S-136 Solutions ■ Chapter 15 Exchange Rates II: The Asset Approach in the Short Run

3. Is overshooting (in theory and in practice) consistent with PPP? Consider the rea-
sons for the usefulness of PPP in the short run versus the long run and the assump-
tion we’ve 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 run—the investors incorpo-
rate this information into their short-run forecasts. Exchange rates are volatile in the
short run. The theory’s implication that there is exchange rate overshooting (in re-
sponse to permanent 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
adjusts—that is, MD returns from MD2 to MD1 before the price level changes.

MS1
i$ ER

A C A C
i 1$ i 1$ DR1

B B
i 2$ i 2$ DR2

MD1 FR1
MD 2

M 1US / P 1US E1 E2 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 this case, the expected exchange rate
changes because the shock is permanent. 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 re-
 Solutions ■ Chapter 15 Exchange Rates II: The Asset Approach in the Short Run S-137

duce 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).
MS3 MS1
i$ ER

A A C
i 1$ i 1$ DR1
C

B B
i 2$ i 2$ DR2

FR2
MD1
FR1
MD2

M 1US / P2US M 1US / P1US E1 E3 E 2 E $/€

c. Illustrate how each of the following variables changes over time in response to a
permanent reduction in real money demand: nominal money supply MUS, price
level PUS, real money supply MUS/PUS, U.S. interest rate i$, and the exchange rate
E$/€.
Answer: See the following diagrams.

M US i$

P US E $/€

T T n

MIN/PIN MUS/PUS
S-138 Solutions ■ Chapter 15 Exchange Rates II: The Asset Approach in the Short Run

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,
EWON/¥. Use the FX and money market diagrams to answer the following questions.
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.

MS2 MS1
iwon ER

B B
i 2won i 2won DR2

A C C A
i 1won i 1won DR1

MD1
FR2 FR1

M 2K / P1K M 1K / P1K M 2K / P 2K E2 E3 E1 E won/¥

b. Now suppose the Bank of Korea announces it plans to permanently decrease its
money supply but doesn’t actually implement this policy. How will this affect the
FX market in the short run if investors believe the Bank of Korea’s announcement?
Answer: See the following diagram. In this case, interest rates on won-denomi-
nated deposits don’t change because the Bank of Korea doesn’t 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 result-
ing change in the exchange rate is relatively small (compared with the dramatic
decrease we see in [a]).

MS1
iwon ER

A B B A
i 1won i 1won DR1

MD1
FR2 FR1

M 1K / P1K E2 E1 E won/¥
 Solutions ■ Chapter 15 Exchange Rates II: The Asset Approach in the Short Run S-139

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 didn’t expect the decrease in the money supply.

MS2 MS1
iwon ER

B B
i 2won i 2won DR2

A A
i 1won i 1won DR1

MD1
FR1

M 2K / P1K M 1K / P1K E2 E1 E won/¥

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:
i. True; shown in (b)
ii. False; shown in (a)
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.
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 (1997–1998).
For the following questions, treat the East Asian country as the home country and
the United States as the foreign country.You may assume these countries maintained
a currency peg (fixed rate) relative to the U.S. dollar. Also, 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 Thailand’s 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 EB/$. 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.
S-140 Solutions ■ Chapter 15 Exchange Rates II: The Asset Approach in the Short Run

Answer: If Thailand is willing to let its currency float against the dollar, then
Thailand’s central bank can maintain monetary policy autonomy and interna-
tional capital mobility. See the following diagram:

MS1
ibaht ER

A B A B
i 1baht i 1baht DR1

FR2
MD1
FR1

M 1T / P1T E1 E2 E baht/$

b. Indonesia faced the same constraints as Thailand—investors 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 ERp/$. 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 moving their rupiah-denominated deposits out of Indonesia (this
would cause a depreciation in the rupiah).

MS2 MS1
irup ER

B B
i 2rup i 2rup DR2

A A
i 1rup i 1rup DR1

MD1 FR2
FR1

M 2I / P1I M 1I / P1I E1 E r u p iah /$

 Solutions ■ Chapter 15 Exchange Rates II: The Asset Approach in the Short Run S-141

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
ERM/$. You need show only the short-run effects of this change in investors’ ex-
pectations.
Answer: See the following diagram. In this case, by preventing investors from
taking advantage of arbitrage, Malaysia creates a disequilibrium. The investors re-
2
quire iRM to keep their deposits in Malaysia, but they only receive i1RM. Because of
the capital controls imposed by Malaysia, investors cannot withdraw their ring-
git-denominated deposits (selling ringgit in exchange for dollars in the FX mar-
ket). This allows Malaysia to maintain monetary policy autonomy and a fixed ex-
change rate at the same time.

MS1
iring ER

B
i 2ring i 2ring

A A
i 1ring i 1ring DR1

FR2
MD1
FR1

M 1M / P1M E1 E r in g g it t /$

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 chose a different option.
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.
S-142 Solutions ■ Chapter 15 Exchange Rates II: The Asset Approach in the Short Run

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, 5–4, voted down [an interest] rate hike last month. Nobody fore-
saw this. . . . The news took the sterling back above $1.99, and to a 15-year high
against the yen.
Can you explain the logic of this statement? Interest rates in the United Kingdom
had remained unchanged after the vote and were still unchanged after the minutes
were released. What was contained in the news that caused traders to react? Use the
asset approach.
Answer: The news item indicates that investors did not expect the decision to leave
interest rates unchanged would be divisive. They thought that any increases in inter-
est rates would happen further in the future. Higher interest rates would lead to an
appreciation in the pound sterling. When the minutes showed that interest rate in-
creases were more likely than previously thought, investors came to expect an appre-
ciation sooner rather than later. This caused an appreciation in the current spot ex-
change rate.
10. We can use the asset approach both to make predictions about how the market will
react to current events and to understand how important these events are to investors.
Consider the behavior of the Union/Confederate exchange rate during the Civil
War. How would each of the following events affect the exchange rate, defined as
Confederate dollars per Union dollar, EC$/$?
a. The Confederacy increases the money supply by 2,900% between July and De-
cember of 1861.
Answer: The home money supply increases, the exchange rate increases, and the
Confederate dollar depreciates.
b. The Union Army suffers a defeat in Battle of Chickamauga in September 1863.
Answer: Appreciation in the Confederate dollar is expected because a military
victory means decreased risk, the exchange rate decreases, and the Confederate
dollar appreciates.
c. The Confederate Army suffers a major defeat with Sherman’s March in the au-
tumn of 1864.
Answer: Depreciation in the Confederate dollar is expected because of military
defeat/increased risk; the exchange rate increases, and the Confederate dollar
depreciates.