Docstoc

floating

Document Sample
floating Powered By Docstoc
					Lecture Note

     Ickes

Floating
Exchange
Rates
               Floating Exchange Rates
Insulation

Dynamics             Econ 434 Lecture


                       Barry W. Ickes

                The Pennsylvania State University


                          Fall 2009
               How do Floating Rates Work?

Lecture Note

     Ickes

Floating           Floating rates give up monetary anchor
Exchange
Rates

Insulation

Dynamics
               How do Floating Rates Work?

Lecture Note

     Ickes

Floating           Floating rates give up monetary anchor
Exchange
Rates
                   Floating rates provide insulation from foreign monetary
Insulation
                   shocks and real shocks
Dynamics
               How do Floating Rates Work?

Lecture Note

     Ickes

Floating           Floating rates give up monetary anchor
Exchange
Rates
                   Floating rates provide insulation from foreign monetary
Insulation
                   shocks and real shocks
Dynamics
                   Fear of ‡oating comes from fears of destabilizing
                   speculation
               How do Floating Rates Work?

Lecture Note

     Ickes

Floating           Floating rates give up monetary anchor
Exchange
Rates
                   Floating rates provide insulation from foreign monetary
Insulation
                   shocks and real shocks
Dynamics
                   Fear of ‡oating comes from fears of destabilizing
                   speculation
                       Is that possible?
               How do Floating Rates Work?

Lecture Note

     Ickes

Floating           Floating rates give up monetary anchor
Exchange
Rates
                   Floating rates provide insulation from foreign monetary
Insulation
                   shocks and real shocks
Dynamics
                   Fear of ‡oating comes from fears of destabilizing
                   speculation
                       Is that possible?
                   Excessive volatility of exchange rates
               How do Floating Rates Work?

Lecture Note

     Ickes

Floating           Floating rates give up monetary anchor
Exchange
Rates
                   Floating rates provide insulation from foreign monetary
Insulation
                   shocks and real shocks
Dynamics
                   Fear of ‡oating comes from fears of destabilizing
                   speculation
                       Is that possible?
                   Excessive volatility of exchange rates
                       Does this reduce trade?
               How do Floating Rates Work?

Lecture Note

     Ickes

Floating           Floating rates give up monetary anchor
Exchange
Rates
                   Floating rates provide insulation from foreign monetary
Insulation
                   shocks and real shocks
Dynamics
                   Fear of ‡oating comes from fears of destabilizing
                   speculation
                       Is that possible?
                   Excessive volatility of exchange rates
                       Does this reduce trade?
                   All would be easy if PPP were true
               Fixed versus Floating Rates

Lecture Note

     Ickes

Floating
Exchange
Rates

Insulation

Dynamics
               Floating Rates in Developed Countries

Lecture Note

     Ickes

Floating
Exchange
Rates

Insulation

Dynamics
               Floating Rates in Developing Countries

Lecture Note

     Ickes

Floating
Exchange
Rates

Insulation

Dynamics
               How do Floating Rates Work?

Lecture Note

     Ickes

Floating
                   Exchange rate adjusts instead of international reserves
Exchange
Rates

Insulation

Dynamics
               How do Floating Rates Work?

Lecture Note

     Ickes

Floating
                   Exchange rate adjusts instead of international reserves
Exchange
Rates              Recall the balance of payments equation
Insulation

Dynamics                              CAt + KOt = ∆IRt                       (1)
               How do Floating Rates Work?

Lecture Note

     Ickes

Floating
                   Exchange rate adjusts instead of international reserves
Exchange
Rates              Recall the balance of payments equation
Insulation

Dynamics                              CAt + KOt = ∆IRt                       (1)

                   now CAt + KOt = 0.
               How do Floating Rates Work?

Lecture Note

     Ickes

Floating
                   Exchange rate adjusts instead of international reserves
Exchange
Rates              Recall the balance of payments equation
Insulation

Dynamics                                CAt + KOt = ∆IRt                        (1)

                   now CAt + KOt = 0.
                       implies if current account is in balance so is capital
                       account, and vice versa
               How do Floating Rates Work?

Lecture Note

     Ickes

Floating
                   Exchange rate adjusts instead of international reserves
Exchange
Rates              Recall the balance of payments equation
Insulation

Dynamics                                CAt + KOt = ∆IRt                        (1)

                   now CAt + KOt = 0.
                       implies if current account is in balance so is capital
                       account, and vice versa
                       if CA > 0 then KO < 0, and vice versa
               How do Floating Rates Work?

Lecture Note

     Ickes

Floating
                   Exchange rate adjusts instead of international reserves
Exchange
Rates              Recall the balance of payments equation
Insulation

Dynamics                               CAt + KOt = ∆IRt                         (1)

                   now CAt + KOt = 0.
                       implies if current account is in balance so is capital
                       account, and vice versa
                       if CA > 0 then KO < 0, and vice versa
                       since ∆IR = 0 shocks to CA or KO e¤ect e not MB
               How do Floating Rates Work?

Lecture Note

     Ickes

Floating
                   Exchange rate adjusts instead of international reserves
Exchange
Rates              Recall the balance of payments equation
Insulation

Dynamics                               CAt + KOt = ∆IRt                         (1)

                   now CAt + KOt = 0.
                       implies if current account is in balance so is capital
                       account, and vice versa
                       if CA > 0 then KO < 0, and vice versa
                       since ∆IR = 0 shocks to CA or KO e¤ect e not MB
                       insulation
               How do Floating Rates Work?

Lecture Note

     Ickes

Floating
                   Exchange rate adjusts instead of international reserves
Exchange
Rates              Recall the balance of payments equation
Insulation

Dynamics                               CAt + KOt = ∆IRt                         (1)

                   now CAt + KOt = 0.
                       implies if current account is in balance so is capital
                       account, and vice versa
                       if CA > 0 then KO < 0, and vice versa
                       since ∆IR = 0 shocks to CA or KO e¤ect e not MB
                       insulation
                       monetary autonomy
               Simple Model

Lecture Note

     Ickes         Flexible prices, assume PPP holds
Floating
Exchange
Rates

Insulation

Dynamics
               Simple Model

Lecture Note

     Ickes         Flexible prices, assume PPP holds
Floating
                   PPP implies P and e are positively related (since P is
Exchange
Rates
                   exogenous)
Insulation

Dynamics
               Simple Model

Lecture Note

     Ickes         Flexible prices, assume PPP holds
Floating
                   PPP implies P and e are positively related (since P is
Exchange
Rates
                   exogenous)
Insulation         Money market equilibrium implies
Dynamics
                                       M
                                         = l (i + δ, Y )                    (2)
                                       P
               Simple Model

Lecture Note

     Ickes         Flexible prices, assume PPP holds
Floating
                   PPP implies P and e are positively related (since P is
Exchange
Rates
                   exogenous)
Insulation         Money market equilibrium implies
Dynamics
                                        M
                                          = l (i + δ, Y )                     (2)
                                        P

                       where we have used interest parity condition to substitute
                       for i
               Simple Model

Lecture Note

     Ickes         Flexible prices, assume PPP holds
Floating
                   PPP implies P and e are positively related (since P is
Exchange
Rates
                   exogenous)
Insulation         Money market equilibrium implies
Dynamics
                                        M
                                          = l (i + δ, Y )                     (2)
                                        P

                       where we have used interest parity condition to substitute
                       for i
                       notice that e does not appear.
               Simple Model

Lecture Note

     Ickes         Flexible prices, assume PPP holds
Floating
                   PPP implies P and e are positively related (since P is
Exchange
Rates
                   exogenous)
Insulation         Money market equilibrium implies
Dynamics
                                         M
                                           = l (i + δ, Y )                    (2)
                                         P

                       where we have used interest parity condition to substitute
                       for i
                       notice that e does not appear.
                            in full equilibrium δ = 0
               Simple Model

Lecture Note

     Ickes         Flexible prices, assume PPP holds
Floating
                   PPP implies P and e are positively related (since P is
Exchange
Rates
                   exogenous)
Insulation         Money market equilibrium implies
Dynamics
                                         M
                                           = l (i + δ, Y )                       (2)
                                         P

                       where we have used interest parity condition to substitute
                       for i
                       notice that e does not appear.
                            in full equilibrium δ = 0
                       so if M is given, there is only one P that satis…es (2)
               Simple Model

Lecture Note

     Ickes         Flexible prices, assume PPP holds
Floating
                   PPP implies P and e are positively related (since P is
Exchange
Rates
                   exogenous)
Insulation         Money market equilibrium implies
Dynamics
                                         M
                                           = l (i + δ, Y )                       (2)
                                         P

                       where we have used interest parity condition to substitute
                       for i
                       notice that e does not appear.
                            in full equilibrium δ = 0
                       so if M is given, there is only one P that satis…es (2)
                   We have …gure 1
               Full Equilibrium
               Figure 1


Lecture Note

     Ickes                e                LL
                                                             PP
Floating
Exchange
Rates

Insulation

Dynamics

                          ˆ
                          e




                                          P1                      P



                                  Figure: Full Equilibrium
               Full Equilibrium

Lecture Note

     Ickes

Floating           Suppose money supply increases
Exchange
Rates

Insulation

Dynamics
               Full Equilibrium

Lecture Note

     Ickes

Floating           Suppose money supply increases
Exchange
Rates                  PP does not move, but LL shifts to right
Insulation

Dynamics
               Full Equilibrium

Lecture Note

     Ickes

Floating           Suppose money supply increases
Exchange
Rates                  PP does not move, but LL shifts to right
Insulation             e must rise (dollar depreciates)
Dynamics
               Full Equilibrium

Lecture Note

     Ickes

Floating           Suppose money supply increases
Exchange
Rates                  PP does not move, but LL shifts to right
Insulation             e must rise (dollar depreciates)
Dynamics
                   P "=) e " for any value of P
               Full Equilibrium

Lecture Note

     Ickes

Floating           Suppose money supply increases
Exchange
Rates                  PP does not move, but LL shifts to right
Insulation             e must rise (dollar depreciates)
Dynamics
                   P "=) e " for any value of P
                       PP shifts upwards
               Full Equilibrium

Lecture Note

     Ickes

Floating           Suppose money supply increases
Exchange
Rates                  PP does not move, but LL shifts to right
Insulation             e must rise (dollar depreciates)
Dynamics
                   P "=) e " for any value of P
                       PP shifts upwards
                       insulation against foreign price shocks
               Full Equilibrium

Lecture Note

     Ickes

Floating           Suppose money supply increases
Exchange
Rates                  PP does not move, but LL shifts to right
Insulation             e must rise (dollar depreciates)
Dynamics
                   P "=) e " for any value of P
                       PP shifts upwards
                       insulation against foreign price shocks
                   What about rise in Y ?
               Full Equilibrium

Lecture Note

     Ickes

Floating           Suppose money supply increases
Exchange
Rates                  PP does not move, but LL shifts to right
Insulation             e must rise (dollar depreciates)
Dynamics
                   P "=) e " for any value of P
                       PP shifts upwards
                       insulation against foreign price shocks
                   What about rise in Y ?
                       from (2) money demand rises, so given M, P must fall
                       =) LL shifts left, e #
               Full Equilibrium

Lecture Note

     Ickes

Floating           Suppose money supply increases
Exchange
Rates                  PP does not move, but LL shifts to right
Insulation             e must rise (dollar depreciates)
Dynamics
                   P "=) e " for any value of P
                       PP shifts upwards
                       insulation against foreign price shocks
                   What about rise in Y ?
                       from (2) money demand rises, so given M, P must fall
                       =) LL shifts left, e #
                       same for fall in i
               Statics
               Figure 10


Lecture Note

     Ickes
                      e     LL        LL1
                                            PP
Floating
Exchange
Rates

Insulation           e1
Dynamics




                     ˆ
                     e




                           P1                    P
                                 P2
               Insulation

Lecture Note
                   Insulation properties of ‡exible exchange rates in real
     Ickes
                   model
Floating
Exchange
Rates

Insulation

Dynamics
               Insulation

Lecture Note
                   Insulation properties of ‡exible exchange rates in real
     Ickes
                   model
Floating           Assume domestic price level is given and study output
Exchange
Rates              changes
Insulation

Dynamics
               Insulation

Lecture Note
                   Insulation properties of ‡exible exchange rates in real
     Ickes
                   model
Floating           Assume domestic price level is given and study output
Exchange
Rates              changes
Insulation         Goods market equilibrium requires Y = AD, so
Dynamics
                             Y    = α A      br + T + φq                       (3)
                                                     e
                                  = α A      b (i   π ) + T + φq               (4)
                                                                     1
                   which is the open-economy IS curve (and α       1 a +m ).
               Insulation

Lecture Note
                   Insulation properties of ‡exible exchange rates in real
     Ickes
                   model
Floating           Assume domestic price level is given and study output
Exchange
Rates              changes
Insulation         Goods market equilibrium requires Y = AD, so
Dynamics
                             Y    = α A      br + T + φq                     (3)
                                                      e
                                  = α A      b (i   π ) + T + φq             (4)
                                                                    1
                   which is the open-economy IS curve (and α     1 a +m ).
                   Assume perfect capital mobility, i = i + δ, and for now
                   let δ = 0. Then,
                              Y =α A       b (i     π e ) + T + φq           (5)
               Insulation

Lecture Note
                   Insulation properties of ‡exible exchange rates in real
     Ickes
                   model
Floating           Assume domestic price level is given and study output
Exchange
Rates              changes
Insulation         Goods market equilibrium requires Y = AD, so
Dynamics
                             Y    = α A       br + T + φq                     (3)
                                                       e
                                  = α A       b (i   π ) + T + φq             (4)
                                                                    1
                   which is the open-economy IS curve (and α     1 a +m ).
                   Assume perfect capital mobility, i = i + δ, and for now
                   let δ = 0. Then,
                              Y =α A       b (i      π e ) + T + φq           (5)
                       Income depends positively on T , q, and A, and negatively
                       on the interest rate.
               Insulation

Lecture Note
                   Insulation properties of ‡exible exchange rates in real
     Ickes
                   model
Floating           Assume domestic price level is given and study output
Exchange
Rates              changes
Insulation         Goods market equilibrium requires Y = AD, so
Dynamics
                             Y    = α A       br + T + φq                     (3)
                                                       e
                                  = α A       b (i   π ) + T + φq             (4)
                                                                    1
                   which is the open-economy IS curve (and α     1 a +m ).
                   Assume perfect capital mobility, i = i + δ, and for now
                   let δ = 0. Then,
                              Y =α A       b (i      π e ) + T + φq           (5)
                       Income depends positively on T , q, and A, and negatively
                       on the interest rate.
                       Since q    eP , =) ∆Y > 0, this is YY curve
                                   P         ∆e
               IS Curve

Lecture Note

     Ickes

Floating
Exchange
Rates

Insulation

Dynamics
               Increase in Money Supply

Lecture Note

     Ickes
                                   LL0         LL1
Floating                 e
Exchange
Rates                                                      YY
Insulation

Dynamics                 e1


                         e0



                                                           Y




                             Figure: Output and the Exchange Rate
               Insulation

Lecture Note

                                 M
     Ickes         Increase in   P   shifts LL right, causes e to rise
Floating
Exchange
Rates

Insulation

Dynamics
               Insulation

Lecture Note

                                 M
     Ickes         Increase in   P   shifts LL right, causes e to rise
Floating
Exchange
                       monetary policy can a¤ect income
Rates

Insulation

Dynamics
               Insulation

Lecture Note

                                 M
     Ickes         Increase in   P   shifts LL right, causes e to rise
Floating
Exchange
                       monetary policy can a¤ect income
Rates
                   What about shifts in YY ?
Insulation

Dynamics
               Insulation

Lecture Note

                                 M
     Ickes         Increase in   P   shifts LL right, causes e to rise
Floating
Exchange
                       monetary policy can a¤ect income
Rates
                   What about shifts in YY ?
Insulation

Dynamics               …scal policy, trade policy (∆T ), or change in i shifts YY
               Insulation

Lecture Note

                                 M
     Ickes         Increase in   P   shifts LL right, causes e to rise
Floating
Exchange
                       monetary policy can a¤ect income
Rates
                   What about shifts in YY ?
Insulation

Dynamics               …scal policy, trade policy (∆T ), or change in i shifts YY
                       hence it only a¤ects the exchange rate
               Insulation

Lecture Note

                                 M
     Ickes         Increase in   P   shifts LL right, causes e to rise
Floating
Exchange
                        monetary policy can a¤ect income
Rates
                   What about shifts in YY ?
Insulation

Dynamics                …scal policy, trade policy (∆T ), or change in i shifts YY
                        hence it only a¤ects the exchange rate
                   tari¤ or oil discovery raises T , YY shifts right, e rises =)
                   no e¤ect on Y
               Insulation

Lecture Note

                                 M
     Ickes         Increase in   P   shifts LL right, causes e to rise
Floating
Exchange
                        monetary policy can a¤ect income
Rates
                   What about shifts in YY ?
Insulation

Dynamics                …scal policy, trade policy (∆T ), or change in i shifts YY
                        hence it only a¤ects the exchange rate
                   tari¤ or oil discovery raises T , YY shifts right, e rises =)
                   no e¤ect on Y
                        …scal policy is impotent (with respect to Y )
               Insulation

Lecture Note

                                 M
     Ickes         Increase in   P   shifts LL right, causes e to rise
Floating
Exchange
                        monetary policy can a¤ect income
Rates
                   What about shifts in YY ?
Insulation

Dynamics                …scal policy, trade policy (∆T ), or change in i shifts YY
                        hence it only a¤ects the exchange rate
                   tari¤ or oil discovery raises T , YY shifts right, e rises =)
                   no e¤ect on Y
                        …scal policy is impotent (with respect to Y )
                             but it does e¤ect NX ; fall in e implies less competitive, so
                             if output is unchanged the composition has switched
                             towards domestic goods
               Insulation

Lecture Note

                                 M
     Ickes         Increase in   P   shifts LL right, causes e to rise
Floating
Exchange
                        monetary policy can a¤ect income
Rates
                   What about shifts in YY ?
Insulation

Dynamics                …scal policy, trade policy (∆T ), or change in i shifts YY
                        hence it only a¤ects the exchange rate
                   tari¤ or oil discovery raises T , YY shifts right, e rises =)
                   no e¤ect on Y
                        …scal policy is impotent (with respect to Y )
                             but it does e¤ect NX ; fall in e implies less competitive, so
                             if output is unchanged the composition has switched
                             towards domestic goods

                   ‡exible exchange rate insulates economy from real shocks
               Insulation

Lecture Note

     Ickes
                   Notice that monetary policy is still important to
Floating           determination of e
Exchange
Rates

Insulation

Dynamics
               Insulation

Lecture Note

     Ickes
                   Notice that monetary policy is still important to
Floating           determination of e
Exchange
Rates              shocks to M lead to changes in e
Insulation

Dynamics
               Insulation

Lecture Note

     Ickes
                   Notice that monetary policy is still important to
Floating           determination of e
Exchange
Rates              shocks to M lead to changes in e
Insulation
                       it is not the case that ‡exible exchange rates means
Dynamics
                       market determines e instead of policy
               Insulation

Lecture Note

     Ickes
                   Notice that monetary policy is still important to
Floating           determination of e
Exchange
Rates              shocks to M lead to changes in e
Insulation
                       it is not the case that ‡exible exchange rates means
Dynamics
                       market determines e instead of policy
                   main di¤erence is how shocks are translated into ∆M vs.
                   ∆e
               Insulation

Lecture Note

     Ickes
                   Notice that monetary policy is still important to
Floating           determination of e
Exchange
Rates              shocks to M lead to changes in e
Insulation
                       it is not the case that ‡exible exchange rates means
Dynamics
                       market determines e instead of policy
                   main di¤erence is how shocks are translated into ∆M vs.
                   ∆e
                   But what matters for welfare are shocks to q not e
               Insulation

Lecture Note

     Ickes
                   Notice that monetary policy is still important to
Floating           determination of e
Exchange
Rates              shocks to M lead to changes in e
Insulation
                       it is not the case that ‡exible exchange rates means
Dynamics
                       market determines e instead of policy
                   main di¤erence is how shocks are translated into ∆M vs.
                   ∆e
                   But what matters for welfare are shocks to q not e
                   If we lived in PPP world, adjustment to shocks via ∆P
                   and e = e would work as well as adjustment via ∆e
               Insulation

Lecture Note

     Ickes
                   Notice that monetary policy is still important to
Floating           determination of e
Exchange
Rates              shocks to M lead to changes in e
Insulation
                       it is not the case that ‡exible exchange rates means
Dynamics
                       market determines e instead of policy
                   main di¤erence is how shocks are translated into ∆M vs.
                   ∆e
                   But what matters for welfare are shocks to q not e
                   If we lived in PPP world, adjustment to shocks via ∆P
                   and e = e would work as well as adjustment via ∆e
                       It is when there are nominal rigidities that ∆e may be
                       preferred
               Exception

Lecture Note

     Ickes
                   The exception to insulation result is money demand shocks
Floating
Exchange
Rates

Insulation

Dynamics
               Exception

Lecture Note

     Ickes
                   The exception to insulation result is money demand shocks
Floating               …xed rates provide better insulation if money demand is
Exchange
Rates                  volatile
Insulation

Dynamics
               Exception

Lecture Note

     Ickes
                   The exception to insulation result is money demand shocks
Floating               …xed rates provide better insulation if money demand is
Exchange
Rates                  volatile
Insulation
                   under ‡exible exchange rates a shock to l ( ) =) LL shifts
Dynamics
                    ! Y or P to change
               Exception

Lecture Note

     Ickes
                   The exception to insulation result is money demand shocks
Floating               …xed rates provide better insulation if money demand is
Exchange
Rates                  volatile
Insulation
                   under ‡exible exchange rates a shock to l ( ) =) LL shifts
Dynamics
                    ! Y or P to change
                       under …xed exchange rates money supply is endogenous
               Exception

Lecture Note

     Ickes
                   The exception to insulation result is money demand shocks
Floating               …xed rates provide better insulation if money demand is
Exchange
Rates                  volatile
Insulation
                   under ‡exible exchange rates a shock to l ( ) =) LL shifts
Dynamics
                    ! Y or P to change
                       under …xed exchange rates money supply is endogenous
                       Money market equilibrium condition is M = l (i + δ, Y )
                                                             P
               Exception

Lecture Note

     Ickes
                   The exception to insulation result is money demand shocks
Floating               …xed rates provide better insulation if money demand is
Exchange
Rates                  volatile
Insulation
                   under ‡exible exchange rates a shock to l ( ) =) LL shifts
Dynamics
                    ! Y or P to change
                       under …xed exchange rates money supply is endogenous
                       Money market equilibrium condition is M = l (i + δ, Y )
                                                                P
                       if e = e, δ = 0. If l ( ) " then M ", LL does not shift
               Exception

Lecture Note

     Ickes
                   The exception to insulation result is money demand shocks
Floating               …xed rates provide better insulation if money demand is
Exchange
Rates                  volatile
Insulation
                   under ‡exible exchange rates a shock to l ( ) =) LL shifts
Dynamics
                    ! Y or P to change
                       under …xed exchange rates money supply is endogenous
                       Money market equilibrium condition is M = l (i + δ, Y )
                                                                 P
                       if e = e, δ = 0. If l ( ) " then M ", LL does not shift
                       rise in l ( ) would cause i > i , but this attracts capital
                       in‡ow
               Exception

Lecture Note

     Ickes
                   The exception to insulation result is money demand shocks
Floating               …xed rates provide better insulation if money demand is
Exchange
Rates                  volatile
Insulation
                   under ‡exible exchange rates a shock to l ( ) =) LL shifts
Dynamics
                    ! Y or P to change
                       under …xed exchange rates money supply is endogenous
                       Money market equilibrium condition is M = l (i + δ, Y )
                                                                 P
                       if e = e, δ = 0. If l ( ) " then M ", LL does not shift
                       rise in l ( ) would cause i > i , but this attracts capital
                       in‡ow
                       with e = e, excess supply of foreign exchange causes M ",
                       restoring i = i
               Exception

Lecture Note

     Ickes
                   The exception to insulation result is money demand shocks
Floating               …xed rates provide better insulation if money demand is
Exchange
Rates                  volatile
Insulation
                   under ‡exible exchange rates a shock to l ( ) =) LL shifts
Dynamics
                    ! Y or P to change
                       under …xed exchange rates money supply is endogenous
                       Money market equilibrium condition is M = l (i + δ, Y )
                                                                 P
                       if e = e, δ = 0. If l ( ) " then M ", LL does not shift
                       rise in l ( ) would cause i > i , but this attracts capital
                       in‡ow
                       with e = e, excess supply of foreign exchange causes M ",
                       restoring i = i
                   Easy to see with IS-LM diagram
               Money Demand Shock

Lecture Note

     Ickes
                  IS curve is goods market equilibrium
Floating
Exchange
Rates

Insulation

Dynamics
               Money Demand Shock

Lecture Note

     Ickes
                  IS curve is goods market equilibrium
Floating
Exchange
Rates
                  LM curve is money market equilibrium
Insulation

Dynamics
               Money Demand Shock

Lecture Note

     Ickes
                  IS curve is goods market equilibrium
Floating
Exchange
Rates
                  LM curve is money market equilibrium
Insulation        BB curve is external balance condition with perfect capital
Dynamics          mobility
               Money Demand Shock

Lecture Note

     Ickes
                  IS curve is goods market equilibrium
Floating
Exchange
Rates
                  LM curve is money market equilibrium
Insulation        BB curve is external balance condition with perfect capital
Dynamics          mobility
                  Start at point A
               Money Demand Shock

Lecture Note

     Ickes
                  IS curve is goods market equilibrium
Floating
Exchange
Rates
                  LM curve is money market equilibrium
Insulation        BB curve is external balance condition with perfect capital
Dynamics          mobility
                  Start at point A
                      rise in l ( ) causes LM   ! LM 0
               Money Demand Shock

Lecture Note

     Ickes
                  IS curve is goods market equilibrium
Floating
Exchange
Rates
                  LM curve is money market equilibrium
Insulation        BB curve is external balance condition with perfect capital
Dynamics          mobility
                  Start at point A
                      rise in l ( ) causes LM ! LM 0
                      would cause i " in closed economy
               Money Demand Shock

Lecture Note

     Ickes
                  IS curve is goods market equilibrium
Floating
Exchange
Rates
                  LM curve is money market equilibrium
Insulation        BB curve is external balance condition with perfect capital
Dynamics          mobility
                  Start at point A
                      rise in l ( ) causes LM ! LM 0
                      would cause i " in closed economy
                           with e = e, capital in‡ow =) M ", LM 0 ! LM
               Money Demand Shock

Lecture Note

     Ickes
                  IS curve is goods market equilibrium
Floating
Exchange
Rates
                  LM curve is money market equilibrium
Insulation        BB curve is external balance condition with perfect capital
Dynamics          mobility
                  Start at point A
                      rise in l ( ) causes LM ! LM 0
                      would cause i " in closed economy
                           with e = e, capital in‡ow =) M ", LM 0 ! LM
                           with ‡exible e, e #=) fall in competitiveness shifts IS to
                           left !end at C
               Money Demand Shock

Lecture Note

     Ickes
                  IS curve is goods market equilibrium
Floating
Exchange
Rates
                  LM curve is money market equilibrium
Insulation        BB curve is external balance condition with perfect capital
Dynamics          mobility
                  Start at point A
                      rise in l ( ) causes LM ! LM 0
                      would cause i " in closed economy
                           with e = e, capital in‡ow =) M ", LM 0 ! LM
                           with ‡exible e, e #=) fall in competitiveness shifts IS to
                           left !end at C

                  So best insulation depends on source of shocks to economy
               BB Curve

Lecture Note

     Ickes

Floating
Exchange
                  BP condition, B = CA + KO = 0
Rates

Insulation

Dynamics
               BB Curve

Lecture Note

     Ickes

Floating
Exchange
                  BP condition, B = CA + KO = 0
Rates
                  KO = β(i i     δ), where β measures capital market
Insulation
                  integration
Dynamics
               BB Curve

Lecture Note

     Ickes

Floating
Exchange
                  BP condition, B = CA + KO = 0
Rates
                  KO = β(i i        δ), where β measures capital market
Insulation
                  integration
Dynamics
                  If δ = 0 in full equilibrium, then we have
                  B = CA + β(i i ) = 0
               BB Curve

Lecture Note

     Ickes

Floating
Exchange
                  BP condition, B = CA + KO = 0
Rates
                  KO = β(i i        δ), where β measures capital market
Insulation
                  integration
Dynamics
                  If δ = 0 in full equilibrium, then we have
                  B = CA + β(i i ) = 0
                  Let CA = T     mY + φq
               BB Curve

Lecture Note

     Ickes

Floating
Exchange
                  BP condition, B = CA + KO = 0
Rates
                  KO = β(i i            δ), where β measures capital market
Insulation
                  integration
Dynamics
                  If δ = 0 in full equilibrium, then we have
                  B = CA + β(i i ) = 0
                  Let CA = T        mY + φq
                                1
                  or, i = i +   β   T     mY + φq : equation of BB curve
               BB Curve

Lecture Note

     Ickes

Floating
Exchange
                  BP condition, B = CA + KO = 0
Rates
                  KO = β(i i            δ), where β measures capital market
Insulation
                  integration
Dynamics
                  If δ = 0 in full equilibrium, then we have
                  B = CA + β(i i ) = 0
                  Let CA = T        mY + φq
                                1
                  or, i = i +   β   T     mY + φq : equation of BB curve
                  If β ! ∞ we have perfect capital mobility and BB is
                  horizontal: i must equal i
               Money Demand Shock
               IS-LM diagram


Lecture Note

     Ickes

Floating                                    LM'
Exchange                   i                       LM
Rates

Insulation

Dynamics

                                    B
                                        A
                           i*                           BB
                                C




                                                  IS

                                                        Y
               Volatility

Lecture Note

     Ickes

Floating
Exchange
Rates

Insulation
                    Why are exchange rates so volatile?
Dynamics
               Volatility

Lecture Note

     Ickes

Floating
Exchange
Rates

Insulation
                    Why are exchange rates so volatile?
Dynamics            Key is that currencies are assets
               Volatility

Lecture Note

     Ickes

Floating
Exchange
Rates

Insulation
                    Why are exchange rates so volatile?
Dynamics            Key is that currencies are assets
                    Information gets absorbed quickly into asset prices
               Volatility

Lecture Note

     Ickes

Floating
Exchange
Rates

Insulation
                    Why are exchange rates so volatile?
Dynamics            Key is that currencies are assets
                    Information gets absorbed quickly into asset prices
                    Changes in information mean that asset prices move
                    quickly
               Volatility

Lecture Note

     Ickes

Floating
Exchange
Rates

Insulation
                    Why are exchange rates so volatile?
Dynamics            Key is that currencies are assets
                    Information gets absorbed quickly into asset prices
                    Changes in information mean that asset prices move
                    quickly
                    Asset prices adjust faster than other prices
               Dynamics

Lecture Note

     Ickes

Floating          Adjustment to full equilibrium
Exchange
Rates

Insulation

Dynamics
               Dynamics

Lecture Note

     Ickes

Floating          Adjustment to full equilibrium
Exchange
Rates             Now δ 6= 0, money market equil. depends on expectations
Insulation

Dynamics
               Dynamics

Lecture Note

     Ickes

Floating          Adjustment to full equilibrium
Exchange
Rates             Now δ 6= 0, money market equil. depends on expectations
Insulation                 bt +1 et
                           e
                  Now δ        et
Dynamics
               Dynamics

Lecture Note

     Ickes

Floating          Adjustment to full equilibrium
Exchange
Rates             Now δ 6= 0, money market equil. depends on expectations
Insulation                 bt +1 et
                           e
                  Now δ        et
Dynamics
                      what is bt +1 ? Assume rational expectations
                              e
               Dynamics

Lecture Note

     Ickes

Floating          Adjustment to full equilibrium
Exchange
Rates             Now δ 6= 0, money market equil. depends on expectations
Insulation                 bt +1 et
                           e
                  Now δ        et
Dynamics
                      what is bt +1 ? Assume rational expectations
                              e
                      we know that e ! e, its long-run equilibrium value
                                           e
               Dynamics

Lecture Note

     Ickes

Floating          Adjustment to full equilibrium
Exchange
Rates             Now δ 6= 0, money market equil. depends on expectations
Insulation                 bt +1 et
                           e
                  Now δ        et
Dynamics
                      what is bt +1 ? Assume rational expectations
                              e
                      we know that e ! e, its long-run equilibrium value
                                           e
                  Key assumption: prices (or Y ) adjust slower than e
               Dynamics

Lecture Note

     Ickes

Floating          Adjustment to full equilibrium
Exchange
Rates             Now δ 6= 0, money market equil. depends on expectations
Insulation                 bt +1 et
                           e
                  Now δ        et
Dynamics
                      what is bt +1 ? Assume rational expectations
                              e
                      we know that e ! e, its long-run equilibrium value
                                           e
                  Key assumption: prices (or Y ) adjust slower than e
                      Then e does not move to e instantaneously.
                                              e
               Dynamics

Lecture Note

     Ickes

Floating          Adjustment to full equilibrium
Exchange
Rates             Now δ 6= 0, money market equil. depends on expectations
Insulation                 bt +1 et
                           e
                  Now δ        et
Dynamics
                      what is bt +1 ? Assume rational expectations
                              e
                      we know that e ! e, its long-run equilibrium value
                                           e
                  Key assumption: prices (or Y ) adjust slower than e
                      Then e does not move to e instantaneously.
                                                e
                      Suppose that θ is the speed of adjustment to the new
                      equilibrium
               Dynamics

Lecture Note

     Ickes

Floating          Adjustment to full equilibrium
Exchange
Rates             Now δ 6= 0, money market equil. depends on expectations
Insulation                 bt +1 et
                           e
                  Now δ        et
Dynamics
                      what is bt +1 ? Assume rational expectations
                              e
                      we know that e ! e, its long-run equilibrium value
                                           e
                  Key assumption: prices (or Y ) adjust slower than e
                      Then e does not move to e instantaneously.
                                                e
                      Suppose that θ is the speed of adjustment to the new
                      equilibrium
                           higher θ =) quicker adjustment to full equilibrium
               Dynamics

Lecture Note

     Ickes

Floating
Exchange
Rates
                  Money demand is now
Insulation
                              M            e
                                           e        et
Dynamics                        = l i +θ                 ,Y   (6)
                              P                et
               Dynamics

Lecture Note

     Ickes

Floating
Exchange
Rates
                  Money demand is now
Insulation
                               M               e
                                               e        et
Dynamics                         = l i +θ                    ,Y         (6)
                               P                   et

                  If et > e =) lower cost of holding money =) l [ ] "
                          e
               Dynamics

Lecture Note

     Ickes

Floating
Exchange
Rates
                  Money demand is now
Insulation
                               M               e
                                               e        et
Dynamics                         = l i +θ                    ,Y         (6)
                               P                   et

                  If et > e =) lower cost of holding money =) l [ ] "
                          e
                  Notice higher P =) lower M , money market equilibrium
                                                P
                  requires lower l (). Requires higher i
               Dynamics

Lecture Note

     Ickes

Floating
Exchange
Rates
                  Money demand is now
Insulation
                               M                 e
                                                 e        et
Dynamics                         = l i +θ                      ,Y       (6)
                               P                     et

                  If et > e =) lower cost of holding money =) l [ ] "
                          e
                  Notice higher P =) lower M , money market equilibrium
                                                P
                  requires lower l (). Requires higher i
                      requires e < e =) MM curve is negatively sloped
                                   e
               Overshooting

Lecture Note

     Ickes         Suppose we start in equilibrium (e0 , P0 ) and then ∆M > 0
Floating
Exchange
Rates

Insulation

Dynamics
               Overshooting

Lecture Note

     Ickes         Suppose we start in equilibrium (e0 , P0 ) and then ∆M > 0
Floating               we know in long run e "
Exchange
Rates

Insulation

Dynamics
               Overshooting

Lecture Note

     Ickes         Suppose we start in equilibrium (e0 , P0 ) and then ∆M > 0
Floating               we know in long run e "
Exchange
Rates                  new equilibrium is e, P1
Insulation

Dynamics
               Overshooting

Lecture Note

     Ickes         Suppose we start in equilibrium (e0 , P0 ) and then ∆M > 0
Floating               we know in long run e "
Exchange
Rates                  new equilibrium is e, P1
Insulation
                   Suppose P adjusts slower than e
Dynamics
               Overshooting

Lecture Note

     Ickes         Suppose we start in equilibrium (e0 , P0 ) and then ∆M > 0
Floating               we know in long run e "
Exchange
Rates                  new equilibrium is e, P1
Insulation
                   Suppose P adjusts slower than e
Dynamics
                       with ∆P = 0   M   > l (i , Y )
                                     P
               Overshooting

Lecture Note

     Ickes         Suppose we start in equilibrium (e0 , P0 ) and then ∆M > 0
Floating               we know in long run e "
Exchange
Rates                  new equilibrium is e, P1
Insulation
                   Suppose P adjusts slower than e
Dynamics
                       with ∆P = 0 M > l (i , Y )
                                     P
                       so e must rise so money demand will increase
               Overshooting

Lecture Note

     Ickes         Suppose we start in equilibrium (e0 , P0 ) and then ∆M > 0
Floating               we know in long run e "
Exchange
Rates                  new equilibrium is e, P1
Insulation
                   Suppose P adjusts slower than e
Dynamics
                       with ∆P = 0 M > l (i , Y )
                                     P
                       so e must rise so money demand will increase
                       e % e1 in …gure 3
               Overshooting

Lecture Note

     Ickes         Suppose we start in equilibrium (e0 , P0 ) and then ∆M > 0
Floating               we know in long run e "
Exchange
Rates                  new equilibrium is e, P1
Insulation
                   Suppose P adjusts slower than e
Dynamics
                       with ∆P = 0 M > l (i , Y )
                                     P
                       so e must rise so money demand will increase
                       e % e1 in …gure 3
                       as P0 % P1 we move along MM to e
               Overshooting

Lecture Note

     Ickes         Suppose we start in equilibrium (e0 , P0 ) and then ∆M > 0
Floating               we know in long run e "
Exchange
Rates                  new equilibrium is e, P1
Insulation
                   Suppose P adjusts slower than e
Dynamics
                       with ∆P = 0 M > l (i , Y )
                                     P
                       so e must rise so money demand will increase
                       e % e1 in …gure 3
                       as P0 % P1 we move along MM to e
                            notice MM anchored by rational expectations
               Overshooting

Lecture Note

     Ickes         Suppose we start in equilibrium (e0 , P0 ) and then ∆M > 0
Floating               we know in long run e "
Exchange
Rates                  new equilibrium is e, P1
Insulation
                   Suppose P adjusts slower than e
Dynamics
                       with ∆P = 0 M > l (i , Y )
                                     P
                       so e must rise so money demand will increase
                       e % e1 in …gure 3
                       as P0 % P1 we move along MM to e
                            notice MM anchored by rational expectations
                       we follow the path of arrows
               Overshooting

Lecture Note

     Ickes         Suppose we start in equilibrium (e0 , P0 ) and then ∆M > 0
Floating               we know in long run e "
Exchange
Rates                  new equilibrium is e, P1
Insulation
                   Suppose P adjusts slower than e
Dynamics
                       with ∆P = 0 M > l (i , Y )
                                     P
                       so e must rise so money demand will increase
                       e % e1 in …gure 3
                       as P0 % P1 we move along MM to e
                            notice MM anchored by rational expectations
                       we follow the path of arrows
                       notice the exchange rate overshoots its full equilibrium
                       change
               Overshooting

Lecture Note

     Ickes         Suppose we start in equilibrium (e0 , P0 ) and then ∆M > 0
Floating               we know in long run e "
Exchange
Rates                  new equilibrium is e, P1
Insulation
                   Suppose P adjusts slower than e
Dynamics
                       with ∆P = 0 M > l (i , Y )
                                     P
                       so e must rise so money demand will increase
                       e % e1 in …gure 3
                       as P0 % P1 we move along MM to e
                            notice MM anchored by rational expectations
                       we follow the path of arrows
                       notice the exchange rate overshoots its full equilibrium
                       change
                            e1   e0 > e   e0
               Overshooting
               Figure 3


Lecture Note

     Ickes                     LL 0         LL1
                          e
Floating                  e1
Exchange                                               PP
Rates

Insulation

Dynamics                  e


                          e0                                MM 1



                                                            P
                               P0            P1

                                Figure: Overshooting
               Intuition

Lecture Note

     Ickes
                    Why does the exchange rate overshoot?
Floating
Exchange
Rates

Insulation

Dynamics
               Intuition

Lecture Note

     Ickes
                    Why does the exchange rate overshoot?
Floating
                        This follows from the assumptions about adjustment speed.
Exchange
Rates

Insulation

Dynamics
               Intuition

Lecture Note

     Ickes
                    Why does the exchange rate overshoot?
Floating
                        This follows from the assumptions about adjustment speed.
Exchange                Notice that ∆M > 0 =) that at unchanged prices there is
Rates
                        an excess supply of money.
Insulation

Dynamics
               Intuition

Lecture Note

     Ickes
                    Why does the exchange rate overshoot?
Floating
                        This follows from the assumptions about adjustment speed.
Exchange                Notice that ∆M > 0 =) that at unchanged prices there is
Rates
                        an excess supply of money.
Insulation
                        To restore money market equilibrium the opportunity cost
Dynamics
                        of holding domestic money must fall so that money
                        demand can increase. The only way this can happen is if
                        agents expect that δ < 0 so that i + δ can fall.
               Intuition

Lecture Note

     Ickes
                    Why does the exchange rate overshoot?
Floating
                        This follows from the assumptions about adjustment speed.
Exchange                Notice that ∆M > 0 =) that at unchanged prices there is
Rates
                        an excess supply of money.
Insulation
                        To restore money market equilibrium the opportunity cost
Dynamics
                        of holding domestic money must fall so that money
                        demand can increase. The only way this can happen is if
                        agents expect that δ < 0 so that i + δ can fall.
                        But the only way that agents can rationally expect the
                        exchange rate to depreciate is if the exchange rate
                        immediately jumps above the new full equilibrium value.
               Intuition

Lecture Note

     Ickes
                    Why does the exchange rate overshoot?
Floating
                        This follows from the assumptions about adjustment speed.
Exchange                Notice that ∆M > 0 =) that at unchanged prices there is
Rates
                        an excess supply of money.
Insulation
                        To restore money market equilibrium the opportunity cost
Dynamics
                        of holding domestic money must fall so that money
                        demand can increase. The only way this can happen is if
                        agents expect that δ < 0 so that i + δ can fall.
                        But the only way that agents can rationally expect the
                        exchange rate to depreciate is if the exchange rate
                        immediately jumps above the new full equilibrium value.
                                                   M
                    As P rises M is now …xed, so   P   falls, equilibrium requires
                    l ( ) to fall
               Intuition

Lecture Note

     Ickes
                    Why does the exchange rate overshoot?
Floating
                        This follows from the assumptions about adjustment speed.
Exchange                Notice that ∆M > 0 =) that at unchanged prices there is
Rates
                        an excess supply of money.
Insulation
                        To restore money market equilibrium the opportunity cost
Dynamics
                        of holding domestic money must fall so that money
                        demand can increase. The only way this can happen is if
                        agents expect that δ < 0 so that i + δ can fall.
                        But the only way that agents can rationally expect the
                        exchange rate to depreciate is if the exchange rate
                        immediately jumps above the new full equilibrium value.
                                                    M
                    As P rises M is now …xed, so    P   falls, equilibrium requires
                    l ( ) to fall
                        requires e to fall along the adjustment path, but this
                        means e must initially overshoot
               Arbitrage

Lecture Note

     Ickes         We can see that arbitrage opportunities would arise if e
                   did not overshoot.
Floating
Exchange
Rates

Insulation

Dynamics
               Arbitrage

Lecture Note

     Ickes         We can see that arbitrage opportunities would arise if e
                   did not overshoot.
Floating
Exchange
Rates
                       In the full equilibrium we know that δ = 0 and that i = i .
Insulation

Dynamics
               Arbitrage

Lecture Note

     Ickes         We can see that arbitrage opportunities would arise if e
                   did not overshoot.
Floating
Exchange
Rates
                       In the full equilibrium we know that δ = 0 and that i = i .
Insulation
                       Because e > e0 , no overshooting would imply that the
                       exchange rate would appreciate – and the currency
Dynamics
                       depreciate – on the path to the new equilibrium.
               Arbitrage

Lecture Note

     Ickes         We can see that arbitrage opportunities would arise if e
                   did not overshoot.
Floating
Exchange
Rates
                       In the full equilibrium we know that δ = 0 and that i = i .
Insulation
                       Because e > e0 , no overshooting would imply that the
                       exchange rate would appreciate – and the currency
Dynamics
                       depreciate – on the path to the new equilibrium.
                   But if the currency depreciates in value and domestic
                   interest rates equal foreign interest rates why would
                   anyone hold domestic currency?
               Arbitrage

Lecture Note

     Ickes         We can see that arbitrage opportunities would arise if e
                   did not overshoot.
Floating
Exchange
Rates
                       In the full equilibrium we know that δ = 0 and that i = i .
Insulation
                       Because e > e0 , no overshooting would imply that the
                       exchange rate would appreciate – and the currency
Dynamics
                       depreciate – on the path to the new equilibrium.
                   But if the currency depreciates in value and domestic
                   interest rates equal foreign interest rates why would
                   anyone hold domestic currency?
                   They will dump dollars and buy foreign currency. This will
                   make the exchange rate increase. When will the dumping
                   of domestic currency end?
               Arbitrage

Lecture Note

     Ickes         We can see that arbitrage opportunities would arise if e
                   did not overshoot.
Floating
Exchange
Rates
                       In the full equilibrium we know that δ = 0 and that i = i .
Insulation
                       Because e > e0 , no overshooting would imply that the
                       exchange rate would appreciate – and the currency
Dynamics
                       depreciate – on the path to the new equilibrium.
                   But if the currency depreciates in value and domestic
                   interest rates equal foreign interest rates why would
                   anyone hold domestic currency?
                   They will dump dollars and buy foreign currency. This will
                   make the exchange rate increase. When will the dumping
                   of domestic currency end?
                       Until agents expect su¢ cient currency appreciation to
                       make them once again willing to hold domestic currency.
               Implications

Lecture Note

     Ickes

Floating
Exchange
Rates              Does this imply that arbitrage pro…ts can be made?
Insulation

Dynamics
               Implications

Lecture Note

     Ickes

Floating
Exchange
Rates              Does this imply that arbitrage pro…ts can be made?
Insulation         On the contrary, it is only when the exchange rate
Dynamics           overshoots to e1 today that there are no arbitrage pro…ts.
               Implications

Lecture Note

     Ickes

Floating
Exchange
Rates              Does this imply that arbitrage pro…ts can be made?
Insulation         On the contrary, it is only when the exchange rate
Dynamics           overshoots to e1 today that there are no arbitrage pro…ts.
                   The overshooting model thus o¤ers an explanation of why
                   asset prices respond rapidly to new information.
               Implications

Lecture Note

     Ickes

Floating
Exchange
Rates              Does this imply that arbitrage pro…ts can be made?
Insulation         On the contrary, it is only when the exchange rate
Dynamics           overshoots to e1 today that there are no arbitrage pro…ts.
                   The overshooting model thus o¤ers an explanation of why
                   asset prices respond rapidly to new information.
                   Of course in practice the economy is subject to many
                   shocks, so asset prices ‡uctuate in the kind of saw-tooth
                   pattern that is characteristic of these markets.
               Implications

Lecture Note

     Ickes
                   This is a great model: important result, not obvious, and
Floating           simple assumptions
Exchange
Rates

Insulation

Dynamics
               Implications

Lecture Note

     Ickes
                   This is a great model: important result, not obvious, and
Floating           simple assumptions
Exchange
Rates                  Paul Samuelson once remarked that there are very few
Insulation             ideas in economics that are both (a) true and (b), not
Dynamics               obvious. Overshooting model is certainly one of those rare
                       ideas.
               Implications

Lecture Note

     Ickes
                   This is a great model: important result, not obvious, and
Floating           simple assumptions
Exchange
Rates                  Paul Samuelson once remarked that there are very few
Insulation             ideas in economics that are both (a) true and (b), not
Dynamics               obvious. Overshooting model is certainly one of those rare
                       ideas.
                   Explains an important element of ‡exible exchange rates
                    ! immense volatility (unexpected)
               Implications

Lecture Note

     Ickes
                   This is a great model: important result, not obvious, and
Floating           simple assumptions
Exchange
Rates                  Paul Samuelson once remarked that there are very few
Insulation             ideas in economics that are both (a) true and (b), not
Dynamics               obvious. Overshooting model is certainly one of those rare
                       ideas.
                   Explains an important element of ‡exible exchange rates
                    ! immense volatility (unexpected)
                   How does it …t with the facts?
               Implications

Lecture Note

     Ickes
                   This is a great model: important result, not obvious, and
Floating           simple assumptions
Exchange
Rates                  Paul Samuelson once remarked that there are very few
Insulation             ideas in economics that are both (a) true and (b), not
Dynamics               obvious. Overshooting model is certainly one of those rare
                       ideas.
                   Explains an important element of ‡exible exchange rates
                    ! immense volatility (unexpected)
                   How does it …t with the facts?
                       not as good as hoped
               Implications

Lecture Note

     Ickes
                   This is a great model: important result, not obvious, and
Floating           simple assumptions
Exchange
Rates                  Paul Samuelson once remarked that there are very few
Insulation             ideas in economics that are both (a) true and (b), not
Dynamics               obvious. Overshooting model is certainly one of those rare
                       ideas.
                   Explains an important element of ‡exible exchange rates
                    ! immense volatility (unexpected)
                   How does it …t with the facts?
                       not as good as hoped
                              model implies that in the wake of monetary shocks, the
                              spot rate would be more volatile than forward rate; we
                                  t
                              don’ tend to see this
               Implications

Lecture Note

     Ickes

Floating
Exchange
Rates

Insulation

Dynamics
               Anticipated Policies

Lecture Note
                   Overshooting model =) that anticipated policies have
     Ickes
                   immediate e¤ects.
Floating
Exchange
Rates

Insulation

Dynamics
               Anticipated Policies

Lecture Note
                   Overshooting model =) that anticipated policies have
     Ickes
                   immediate e¤ects.
Floating           Consider announcement ∆M > 0 next period.
Exchange
Rates

Insulation

Dynamics
               Anticipated Policies

Lecture Note
                   Overshooting model =) that anticipated policies have
     Ickes
                   immediate e¤ects.
Floating           Consider announcement ∆M > 0 next period.
Exchange
Rates                  This will cause an appreciation of e and a rise in Y in the
Insulation             new full equilibrium.
Dynamics
               Anticipated Policies

Lecture Note
                   Overshooting model =) that anticipated policies have
     Ickes
                   immediate e¤ects.
Floating           Consider announcement ∆M > 0 next period.
Exchange
Rates                  This will cause an appreciation of e and a rise in Y in the
Insulation             new full equilibrium.
Dynamics               At impact, however, ∆Y = 0 (or ∆P = 0).
               Anticipated Policies

Lecture Note
                   Overshooting model =) that anticipated policies have
     Ickes
                   immediate e¤ects.
Floating           Consider announcement ∆M > 0 next period.
Exchange
Rates                  This will cause an appreciation of e and a rise in Y in the
Insulation             new full equilibrium.
Dynamics               At impact, however, ∆Y = 0 (or ∆P = 0).
                       So asset prices bear the full brunt of the change
               Anticipated Policies

Lecture Note
                   Overshooting model =) that anticipated policies have
     Ickes
                   immediate e¤ects.
Floating           Consider announcement ∆M > 0 next period.
Exchange
Rates                  This will cause an appreciation of e and a rise in Y in the
Insulation             new full equilibrium.
Dynamics               At impact, however, ∆Y = 0 (or ∆P = 0).
                       So asset prices bear the full brunt of the change
                       Notice that e increases as in the case of an unexpected
                                    e
                       increase in the money stock.
               Anticipated Policies

Lecture Note
                   Overshooting model =) that anticipated policies have
     Ickes
                   immediate e¤ects.
Floating           Consider announcement ∆M > 0 next period.
Exchange
Rates                  This will cause an appreciation of e and a rise in Y in the
Insulation             new full equilibrium.
Dynamics               At impact, however, ∆Y = 0 (or ∆P = 0).
                       So asset prices bear the full brunt of the change
                       Notice that e increases as in the case of an unexpected
                                    e
                       increase in the money stock.
                       So the MM curve shifts up, and e overshoots
               Anticipated Policies

Lecture Note
                   Overshooting model =) that anticipated policies have
     Ickes
                   immediate e¤ects.
Floating           Consider announcement ∆M > 0 next period.
Exchange
Rates                  This will cause an appreciation of e and a rise in Y in the
Insulation             new full equilibrium.
Dynamics               At impact, however, ∆Y = 0 (or ∆P = 0).
                       So asset prices bear the full brunt of the change
                       Notice that e increases as in the case of an unexpected
                                    e
                       increase in the money stock.
                       So the MM curve shifts up, and e overshoots
                   Note that e increases before the money supply rises.
               Anticipated Policies

Lecture Note
                   Overshooting model =) that anticipated policies have
     Ickes
                   immediate e¤ects.
Floating           Consider announcement ∆M > 0 next period.
Exchange
Rates                  This will cause an appreciation of e and a rise in Y in the
Insulation             new full equilibrium.
Dynamics               At impact, however, ∆Y = 0 (or ∆P = 0).
                       So asset prices bear the full brunt of the change
                       Notice that e increases as in the case of an unexpected
                                    e
                       increase in the money stock.
                       So the MM curve shifts up, and e overshoots
                   Note that e increases before the money supply rises.
                       =) Y " starts to rise even before the money supply "
               Anticipated Policies

Lecture Note
                   Overshooting model =) that anticipated policies have
     Ickes
                   immediate e¤ects.
Floating           Consider announcement ∆M > 0 next period.
Exchange
Rates                  This will cause an appreciation of e and a rise in Y in the
Insulation             new full equilibrium.
Dynamics               At impact, however, ∆Y = 0 (or ∆P = 0).
                       So asset prices bear the full brunt of the change
                       Notice that e increases as in the case of an unexpected
                                    e
                       increase in the money stock.
                       So the MM curve shifts up, and e overshoots
                   Note that e increases before the money supply rises.
                       =) Y " starts to rise even before the money supply "
                            " q causes net exports to "
               Anticipated Policies

Lecture Note
                   Overshooting model =) that anticipated policies have
     Ickes
                   immediate e¤ects.
Floating           Consider announcement ∆M > 0 next period.
Exchange
Rates                  This will cause an appreciation of e and a rise in Y in the
Insulation             new full equilibrium.
Dynamics               At impact, however, ∆Y = 0 (or ∆P = 0).
                       So asset prices bear the full brunt of the change
                       Notice that e increases as in the case of an unexpected
                                    e
                       increase in the money stock.
                       So the MM curve shifts up, and e overshoots
                   Note that e increases before the money supply rises.
                       =) Y " starts to rise even before the money supply "
                            " q causes net exports to "
                   When ∆M > 0 actually occurs, there is no discontinuous
                   e¤ect on e, because that has already been absorbed in the
                   price.
               Anticipated Policies

Lecture Note
                   Of course in practice anticipated policies are not fully
     Ickes
                   believed.
Floating
Exchange
Rates

Insulation

Dynamics
               Anticipated Policies

Lecture Note
                   Of course in practice anticipated policies are not fully
     Ickes
                   believed.
Floating                We may expect the money supply to rise, but only
Exchange
Rates                   probabilistically.
Insulation

Dynamics
               Anticipated Policies

Lecture Note
                   Of course in practice anticipated policies are not fully
     Ickes
                   believed.
Floating                We may expect the money supply to rise, but only
Exchange
Rates                   probabilistically.
Insulation              A still relatively simple case would be a 50-50 bet that the
Dynamics                money supply will increase. Let π be the probability that it
                        rises, so that the exchange rate would be e1 .
                                                                   e
               Anticipated Policies

Lecture Note
                   Of course in practice anticipated policies are not fully
     Ickes
                   believed.
Floating                We may expect the money supply to rise, but only
Exchange
Rates                   probabilistically.
Insulation              A still relatively simple case would be a 50-50 bet that the
Dynamics                money supply will increase. Let π be the probability that it
                        rises, so that the exchange rate would be e1 .
                                                                   e
                        Then with probability 1 π the exchange rate would stay
                        at e0 .
                           e
               Anticipated Policies

Lecture Note
                   Of course in practice anticipated policies are not fully
     Ickes
                   believed.
Floating                We may expect the money supply to rise, but only
Exchange
Rates                   probabilistically.
Insulation              A still relatively simple case would be a 50-50 bet that the
Dynamics                money supply will increase. Let π be the probability that it
                        rises, so that the exchange rate would be e1 .
                                                                   e
                        Then with probability 1 π the exchange rate would stay
                        at e0 .
                           e
                             In that case the expected exchange rate will be
                             E (e) = πe1 + (1 π )e2 .
                                e      e            e
               Anticipated Policies

Lecture Note
                   Of course in practice anticipated policies are not fully
     Ickes
                   believed.
Floating                We may expect the money supply to rise, but only
Exchange
Rates                   probabilistically.
Insulation              A still relatively simple case would be a 50-50 bet that the
Dynamics                money supply will increase. Let π be the probability that it
                        rises, so that the exchange rate would be e1 .
                                                                   e
                        Then with probability 1 π the exchange rate would stay
                        at e0 .
                           e
                             In that case the expected exchange rate will be
                             E (e) = πe1 + (1 π )e2 .
                                e      e            e
                             Hence, the MM curve would shift up only half way.
               Anticipated Policies

Lecture Note
                   Of course in practice anticipated policies are not fully
     Ickes
                   believed.
Floating                We may expect the money supply to rise, but only
Exchange
Rates                   probabilistically.
Insulation              A still relatively simple case would be a 50-50 bet that the
Dynamics                money supply will increase. Let π be the probability that it
                        rises, so that the exchange rate would be e1 .
                                                                   e
                        Then with probability 1 π the exchange rate would stay
                        at e0 .
                           e
                             In that case the expected exchange rate will be
                             E (e) = πe1 + (1 π )e2 .
                                e      e            e
                             Hence, the MM curve would shift up only half way.
                             Then once the uncertainty is resolved (the Fed raises the
                             money stock or does not), the MM curve either shifts up
                             again or down.
               Anticipated Policies

Lecture Note
                   Of course in practice anticipated policies are not fully
     Ickes
                   believed.
Floating                We may expect the money supply to rise, but only
Exchange
Rates                   probabilistically.
Insulation              A still relatively simple case would be a 50-50 bet that the
Dynamics                money supply will increase. Let π be the probability that it
                        rises, so that the exchange rate would be e1 .
                                                                   e
                        Then with probability 1 π the exchange rate would stay
                        at e0 .
                           e
                             In that case the expected exchange rate will be
                             E (e) = πe1 + (1 π )e2 .
                                e      e            e
                             Hence, the MM curve would shift up only half way.
                             Then once the uncertainty is resolved (the Fed raises the
                             money stock or does not), the MM curve either shifts up
                             again or down.
                   The key point is that asset prices move when there is
                   news, or new information. Not on old information.

				
DOCUMENT INFO