Historical Perspective 20th Century-today
-Discount policy and the real bills doctrine
-Discovery of open market operations
-The Great Depression 1930s
-Reserve requirements as a policy tool
------Thomas Amendment to the Agricultural Adjustment Act of 1933
-War finance and the pegging of interest rates (WW II)
-Targeting money market conditions
------Procyclical monetary policy
-Targeting monetary aggregates (1970s-80s)
-New Fed operating procedures
------De-emphasis of federal funds rate
-De-emphasis of monetary aggregates
------Borrowed reserves target
-Federal funds targeting again
------Greater transparency
-Preemptive strikes against inflation
-Preemptive strikes against economic downturns and financial disruptions
------LTCM 1999
------Enron 2001
------Subprime meltdown 2007-2008
-International policy coordination 2008-2011
· (slightly revised version by Rock 2011-12-15):
KEY IDEAS for Chapters in Book for Students for Learning & exams
Mishkin, 8th edition, Money, Banking and Financial Markets, 2007, but, with comments by Rock; also Mishkin changed treatments in 9th Edition (2010)
=============================================================
Ch17 (8th edition) THE FOREIGN EXCHANGE MARKET
-In the 8th Ed Read the text material, pages 431-457
-Questions at end of chapter: p.456
--(Note: In the 6th edition (Study guide) this chapter coverage is found in—Mish6ed_ch07_StGuide…
--(Note: In the 9th edition, this chapter is the same number—This edition has several changes that make it more clear and comprehensible (section on Exchange Rates in the Short Run” and added a brief new section “Application: The Subprime Crisis and the Dollar”(p.454) It also dropped the section in the 8th edition called “The Euro, The first Seven years” [i.e. 1999-2006]. These changes can be read in the reading named “Mish9ed_c17_ALMOSTallwSGsumOnly.pdf”.
--(Note: Be sure to study the sample questions from Study guide in the new 9ed edition: the document is named: Mish9ed_c17_SGALLwANS_017.pdf
========================
NOTES
*FOREIGN EXCHANGE
-Exchange rate {FX-rate}: price of one currency in terms of another
-Foreign exchange market: the financial market where exchange rates are determined
-Spot transaction: immediate (two-day) exchange of bank deposits
------Spot exchange rate
-Forward transaction: the exchange of bank deposits at some specified future date
-------Forward exchange rate
-Appreciation: a currency rises in value relative to another currency
-Depreciation: a currency falls in value relative to another currency
------Devaluation = usually refers to a action by a country to bring about the depreciation of its currency
-When a country’s currency appreciates, the country’s goods abroad become more expensive and foreign goods in that country become less expensive and vice versa
-Over-the-counter market (a decentralized market with many buyers and sellers; mainly banks) is where most trade in foreign exchange (buying and selling deposits in different currencies) occurs.
====================================================
***The FOREIGN TRADE approach to EXCHANGE RATE DETERMINATION
p.437
*EXCHANGE RATES IN THE LONG RUN
*Law of one price(arbitrage eliminates any price differences in identical products)
------Economists usually start their logic here for discussing foreign exchange
*Theory of Purchasing Power Parity (PPP) (goods should cost the same no matter what country they are purchased in; if not then we can say the real exchange rate is different than the market exchange rate); this theory can be true with a perfect competition market assumptions and no other complications; it includes these additional assumptions:
------All goods are identical in both countries
------Trade barriers and transportation costs are low
------All goods and services are traded across borders
p.436 (9ed 438)
Figure 2 of domestic & foreign price levels and exchange rates over time (1973-current) of the US and UK.
This data show that the PPP exchange rate calculation (the chart uses the relative price levels of the two countries CPI-UK/CPI-US as the measure of relative PPP) is NOT very accurate in the short run since the relative prices of the two countries are often quite different than the market FX rate for the US $ and the UK Pound…even though the trend line for both curves is the same (UK prices and UK Pound both rose relative to the US prices and $).
*Why doesn’t the PPP theory predict prices in the short run?
-All the goods and services in different countries are not identical
-There are trade barriers (both tariffs and ‘non-tariff barriers’)
-Some goods and services are not traded between countries (housing, land, and many services.
-It leaves out the possibility of other reasons for foreign exchange transactions, namely the desire by investors to make investments in other countries’ assets. (So we develop another more inclusive theoretical model just below.)
========================================================
***The ASSET MARKETS MODEL of EXCHANGE RATE DETERMINATION
This chapter explains behavior in the foreign exchange market by using the asset-market approach to exchange rate determination. This asset-market approach is now the dominant method of analyzing exchange rate movements in economics literature, and it has major advantages over the more conventional treatment of the foreign exchange market typically found in money and banking textbooks.
The asset-market approach, in contrast to earlier approaches emphasizing import and export demand (PPP approach), can be used to explain a feature of the foreign exchange market that has received much attention in the press in recent years: the high volatility of exchange rates even in the short run. This is not well explained by the earlier flow approach because it does not predict that exchange rates should be highly volatile.
The asset-market approach is developed in several steps. First, the long-run determinants of the exchange rate are laid out, and then the information about the long-run determinants is embedded in a model of the short-run determination of exchange rates. The key idea is that the demand for domestic currency (say dollar) assets is determined by the relative expected return on these assets.
p.437 (9th ed. p. 439)
*FACTORS THAT AFFECT EXCHANGE RATES IN THE LONG RUN
--(1)Relative price levels in different countries (higher US prices compared to foreign prices tends to make $ Depreciate)
--(2)Trade barriers(more barriers relative to other countries makes $ appreciate)
--(3)Consumer Preferences for domestic versus foreign goods
------Higher Foreign demand for US-made goods (compared to foreign-made ones) tends to make the $ Appreciate
-----------(=rising export demand for US goods->Appreciation
------Higher US demand for Foreign-made goods (compared to US-made ones) tends to make $Depreciate)
-----------(= rising import demand for foreign goods US consumers -> Depreciation)
--(4)Productivity differences in countries (output/labor, or output/capital; or output/(all factors of production)
------Higher productivity by US labor or capital (relative to other countries) tends to make $ appreciate
p.438
*EXCHANGE RATES IN THE SHORT RUN: A SUPPLY AND DEMAND ANALYSIS
-This views the exchange rate as the price of domestic assets in terms of foreign assets
-The Supply curve for domestic assets
--------Assume amount of domestic assets is fixed (supply curve is vertical)
--------This supply of dollar-assets in the U.S. is mainly the quantity of (i) bank deposits, (ii) bonds and other debt instruments, and, (iii) equities or corporate stock shares. {The relatively fixed (in short run) and relatively more liquid kinds of assets, not including many in things like real property of land, rental properties, which are more like long term foreign investment placements.)
-The Demand curve for domestic assets
--------Most important determinant is relative expected return of domestic assets
--------At lower current FX values of the dollar (everything else equal), the quantity demanded of dollar assets is higher
p.439
*COMPARING EXPECTED RETURNS on DOMESTIC and FOREIGN ASSETS
-The basic idea here is that from a U.S. (domestic resident)investor’s point of view (or any investor in any country) what matters ultimately is the expected returns from assets in his/her own (domestic) currency.
---Thus these returns can be seen as the interest earned in one’s own currency whether it is earned directly in domestic assets or earned, first in foreign assets and then finally turned into domestic currency.
---So the domestic investor will invest wherever they can get the highest return in terms of their own currencies (assuming they will do most or all of their consuming in their own currency)
---For this course you can forget all of the algebra in this section except for the crucial formula the captures almost all these ideas in one equation:
p.441
*The INTERST PARITY CONDITION
{i-rate-domestic} = {i-rate-foreign} MINUS ( % change in FX-rate}
[where ‘FX-rate’ = the (Foreign Currency/Domestic currency) ratio ]
In words: The domestic interest rate EQUALS the foreign interest rate MINUS the expected appreciation of the domestic currency
(In relation to this foreign currency, ‘appreciation’ means the ‘FX-rate’ rises).
{NOTE: You are not responsible for all the rest of the algebra, unless you find it clarifies things for you since some are mathematically inclined. I will not ask you algebraic questions about this condition, but you should understand the intuition and be able to estimate the direction of any changes, although not the quantity of changes.}
Fig. 3 Graph:
Quantity of US Assets (US) on horizontal
Price of Euros in dollars (i.e. FX here is Euros/$ rate) on vertical
àLower FX (dollar lower value in Euros) then demand great for $-assets (less for Euro-assets)
àHigher FX (dollar is higher value in Euros) then demand for $-assets is less (and in contrast Euro-assets appear relatively good deal to buy)
*EXPLAINING CHANGES IN EXCHANGE RATES USING ASSET-MARKET MODEL
*{Why do economist put forward a short run theory of FX changes that can differ from the one for long run changes? Some reasons: (1) Because the FX rate DOES change in the short run, from day to day and it can be quite volatile. (2) The amount of FX transactions daily is much greater (>25x greater) than imports and exports traded, so there are likely other reasons for currency trading than just supporting international trade.
-CAUSES of Shifts in the demand for domestic assets:
--------(a) Domestic interest rate changes à {if domestic interest rates rise, then the demand curve for domestic assets has an increase: a shift to right [e.g. see Fig. 4.] so that at every exchange rate the quantity of domestic assets demanded is greater}
--------(b) Foreign interest ratechanges à {if foreign interest rates rise, then demand curve for domestic assets has an decrease: a shift to left [e.g. Fig. 5.] so that at every exchange rate the quantity of domestic assets demanded is less}
--------(c) Expected future exchange rate changes à {anything that causes a rise in the expected future exchange rate means that the Euros/$ ratio is expected to rise and thus the dollar appreciates, leading to a rise in the relative rate of return in dollar-assets and thus demand curve for domestic assets has an increase: a shift to right [e.g. Fig. 6.] }
--------------Note that all of the 4 long run determinants of the exchange rate can also affect the expected future exchange rate also so any changes in these could have a positive or negative effect on the demand for dollar-assets.
p. 448 {9th ed., p.447}
Summary Table 2. {With additional factors from later in chapter}
This table summarizes nearly all of the factors (long run factors and the short run ones also) that cancause shifts in the demand for domestic assets.
-Factors leading to an increase in the Euro/$ exchange rate ($-appreciation), Ceteris paribus(assuming all else remains the same):
---1. Domestic interest rate increase
---2. Expected domestic trade barriers increase(relative to foreign)
---3. Expected export (of domestic-produced goods) demand increase
---4. Expected productivity increase(domestic relative to foreign)
---5. Expected domestic inflation Decrease (=>higher expected real domestic interest rates)
-Factors leading to a Decrease in the Euro/$ exchange rate ($-Depreciation), Ceteris paribus(assuming all else remains the same):
---a. FOREIGN interest rate increase
---b. Expected DOMESTIC (U.S.) price increases in goods/services
---c. Expected import(of foreign-produced goods) demand increase
---d. Expected domestic inflation increase (=>lower expected real domestic interest rate)[see Fig.7]
How to best learn this model? Role Play an Investor:
For help in understanding why the relative expected return on domestic assets determine exchange rates think of them acting through their effects on the demand curve for domestic assets. These effects will cause shifts in the demand curve for domestic currency in order to buy more (or less) assets on the domestic market. (And, since they are nearly perfectly negatively correlated, simultaneously the increase in demand for domestic currency will be associated with an equivalent decrease in the demand curve for foreign currency as it allows a decrease in the demand for foreign-currency assets, and thus the shift moves in the opposite direction). Students should put themselves in the shoes of an investor who is thinking about putting his or her money into foreign or domestic assets, since this can help in understanding the theory in practical terms.
When a factor changes, ask yourself whether at the same exchange rate, you would earn a higher expected return on domestic assets—if so, the demand curve has shifted to the right (for domestic currency). This kind of thinking will help you predict which way the exchange rate changes.
Several summary tables in the chapter should help to master the material. Make sure you can explain each of these effects in practical terms for an investor. (Obviously the demand curves are the total of all investors in the market, but assuming full rationality and equal expectations held by all investors any time [not true in reality of course], they would all move in the same direction in the foreign exchange market.
--------------------------------
pp.447–449 (9th ed., p.448-450)
*APPLICATIONS: CHANGES IN THE EQUILIBRIUM EXCHANGE RATE
Example One:
*I. Changes in INTEREST RATE (Nominal change)
----Need to remember that the market (or ‘Nominal’) interest rate is really the combination (Fisher equation as economists call it) of two components:
----Nominal i-rate = Sum of (1) Real i-rate PLUS (2) price inflation
----So when there is a Nominal i-rate increase the resulting effect on exchange rates depends on what the source of the change comes from:
--------(Source 1) When domestic REAL interest rates rise, the domestic currency appreciates.
èThis is shown graphically (Fig.4, go back to p.444)
--------(Source 2) When domestic interest rates rise due to an expected increase in INFLATION, the domestic currency Depreciates
èThis is shown graphically(Fig.7, p.450)
--------------------------
pp.449-451 (9th ed. pp.450-451)
*APPLICATIONS: CHANGES IN THE EQUILIBRIUM EXCHANGE RATE
Example Two:
*II. Changes in the MONEY SUPPLY
-Exchange Rate Overshooting
-Monetary Neutrality
-----In the long run, a one-time percentage rise in the money supply is matched by the same one-time percentage rise in the price level
-The exchange rate falls by more in the short run than in the long run
-Helps to explain why exchange rates exhibit so much volatility
-Higher domestic money supply causes the domestic currency to depreciate.
---(A) Short Run & Long Run effects: An increase in the money supply is assumed to lead to an equal change of a higher domestic price level (inflation)(this idea of equal percentage changes in money supply and price level is called “money neutrality”) and this, in turn, causes a decrease in the expected future exchange rate (shift of demand curve for domestic assets—decrease in demand). Net effect: Domestic currency Depreciation.
---(B) Short run, BUT Temporary Effect: As the money supply is increased the price level may take time to rise, so in effect, temporarily the real money supply (i.e. = M-supply/Price-Level) will rise for some time.
-------(C) But, continuing with this reasoning, from (B), the rise in the real money supply is also assumed to cause the nominal and real domestic interest rates to fall; this will cause a decrease in the expected relative rate of return from domestic assets and so this will be an additional reason for decrease in the expected future exchange rate (shift of demand curve for domestic assets—decrease in demand).
-------------(D) But in the longer run, the real money supply is assumed to return to its original level as prices rise (i.e. the bottom part of the ratio rises eventually in this ratio: = M-supply/Price-Level). The real interest rate rises back to its original level and thus the demand for domestic assets returns to original level (considering only the effect of the real money supply and its effect on interest rates)
-Fig.8, p. 450 (9th ed., p. 451) represents these changes:
----from equilibrium 1 to 2 effects of (A), (B), and (C)
----while from equilibrium point 2 to point 3 represents the final effect of (D).
-This is an example of what is called Exchange Rate Over-shooting when one change (money supply increase) can cause a change in one direction but then over time also a readjustment back in the other direction. {“Over-shooting” means to go beyond the place (equilibrium) where system will come finally over time to rest.}
----Net total effect of money supply increase: Domestic currency Depreciation
--------------------------
p.451
*Application: Why are Exchange Rates so Volatile?
-When anything affects the expected relative returns on domestic assets compared to foreign assets, things will change in the asset markets and hence in exchange markets and the FX-rate. Expectations alone can cause FX-rate changes.
----------------------------
p.452
*Application: The Dollar and Interest Rates
While there is a strong correspondence between real interest rates and the exchange rate, the relationship between nominal interest rates and exchange rate movements is not nearly as pronounced
Fig. 9, p.452
Value of the Dollar and Interest Rates (from 1973-2005)
Relationship among (a) Nominal interest rate; (b) Real interest rate; and (c) ‘Effective Exchange Rate (calculated as an Index number)
{NOTE: For later data since 2005, see 9th edition, Fig. 9, p. 453: Same chart but through 2008.
Since 2005, all three of these indicator changed drastically:
---(a) nominal rates rose several percent and then collapsed downward quite sharply in 2008;
---(b) real interest rates rose sharply and then, in 2008 fell and became sharply negative (nearly zero nominal, meant real rates 2-3% below zero) and
---(c) the effective exchange rate fell (dollar depreciation) also from 2005-2008, …BUT since 2008 (data still not in 9th edition of 2010) there has been a strengthening of the dollar (appreciation) in the so-called ‘flight from risk’ in much of the world,
---------------------------------------
*Application: The Euro’s first Seven years [1999-2006] {and Rock’s update}
-Author explains the changes in the FX-rate (dollars vs. euros) in terms of the ‘asset markets’ and the difference in interest rates in the US and the EU over the whole period of 1999-2006.
-In this period The Euros/Dollar rate fluctuated and has continued to do so:
---1999: Began at 1.15 dollars per euro
---1999-2000, by mid 2000 the rate fell to 0.83 dollars per euro (Low)
---2000-2005: rose to over 1.20 dollars per euro by end of 2005
---{Since then, fluctuations between 1.20 and 1.50
2005-2011 the rate has risen as high as about 1.50 dollars per euro and most recently it is back down to under 130 dollars per euro.}
---{In this year, 2011, alone, the dollars per euro rate went from 1.29 in January, to a high of 1.48 (about a 20% rise) and now this week it is down to 1.30 Dec.14, 2011, about a 15% decline from the peak.)
---------------------------------------------------------------
*Application: The Subprime Crisis and the Dollar (only in 9th edition, p.454)
-With the subprime mortgage-backed-securities collapse in prices began in late 2007, the effects on the dollar exchange rates led to a depreciation of the dollar.
----The fall in prices of securities (and their falling liquidity) was a “balance sheet asset depreciation” since these assets were held by financial institutions.
----“Subprime” (definition): Loans to bad credit risk people. People got mortgage loans, but who normally would not get a loan due to being bad credit risk…i.e. adverse selection occurred. This was often with the collusion of lenders (mainly brokers for the ultimate lenders), who sometimes on purpose targeted bad risk borrowers because it was easy to convince them to borrow and others could make higher profits also on these. So, mortgage brokers just wanted to maximize the number of loans, which they could pass along to others and hence not keep these risky loans themselves.)
-Dollar DEPRECIATION: The Dollar fell for a year Aug.2007-July 2008 (between 6-10% against several currencies) to a new low in value by mid-July 2008 against the Euro. This was when the perception was that it was only the USA that would be seriously harmed by the financial crisis.
-But then a REVERSAL: From July to October 2008 (when US financial firms were going famously bankrupt: Lehman Brothers (investment bank) most famously) the DOLLAR APPRECIATED quite strongly, by over 20% against the Euro and some 15% against most other currencies.
-WHY DID THIS HAPPEN?
---(a) The author argues that many central banks lowered interest rates in anticipation of liquidity and real economy problems; hence the “asset markets” theory can explain part of the story.
---(b) But the author also argues that in very troubled times, investors run scared to what they consider the most stable and secure assets in a very uncertain time. Thus this “flight to quality” (moving to those assets “perceived to be least risky”) could also explain the dollar appreciation after mid-2008 as investors and other financial institutions wish to park their wealth more and more in US Treasuries (U.S. government debt).
-------------------------------------------------------------------
The new changes to this chapter (changes in 9th edition (2010) can be found among readings for the course and the document is named: Mish9ed_c17_ALMOSTallwSGsumOnly.pdf
·
Начало формы
Ch.18 PART 1
KEY IDEAS for Chapters in Book for Students to focus on for Learning & exams
Mishkin, 8th edition, Money, Banking and Financial Markets, 2007
(But, with some comments by Rock and also attention to the real world events and research that haschanged some of the treatments in the 9th Edition (2010).
=============================================================