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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.

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