International Money and Finance

Lecture 2
http://giorgiofazio.googlepages.com
The Exchange Rate and the BoP
I The nominal exchange rate clearly affects the CA of the BoP,
making it more/less convenient to import or export goods

Nominal exchange rate and the European trade balance with

Japan
Price of an MP3 player in Japan is PU = 17711.2. If the exchange
U
rate is 136.24U/1Euro„ PEuro = 130 (i.e. 17711.2/136.24). If the
U
U weakens to 148.09, PEuro = 120
⇒ European imports from Japan become cheaper and more
Japanese goods should flow to EMU countries.
I However, price changes are also important, so we should look
at real exchange rates (foreign value (*) relative to home
value)
S · P∗
P
PPP
Purchasing Power Parity

Definition
“The same goods or basket of goods should sell for the same price
in different countries, when measured in common currency”

P = S · P∗

I A Big Mac bought in London should cost the same as one

bought in New York, once expressed in the same currency
I If relative prices change by x% then the exchange rate will also
change by x%
I The purchasing power of two currencies can be calculated by
comparing the price of a common good in two countries
I See the Hamburger Standard
Elasticities View of Exchange Rate Determination

This theory was developed when capital flows were often restricted
∴ are treated as exogenous
The exchange rate is determined by the flow of currency through
the FOREX market ⇒ by the demand and supply of foreign
exchange
Exports increase foreign currency: foreigners buy domestic (sell
foreign) currency to pay the domestic exporters →Supply schedule
Imports decrease foreign currency: domestic importers pay foreign
exporters in their currency → Demand schedule
Elasticities View of Exchange Rate Determination
Demand & Supply of Foreign Currency

Demand for foreign currency

DD = P ∗ · QM
where P ∗ is fixed and QM = f − (PM ) = f − (P ∗ · S). As
S ↓⇒ PM ↓⇒ QM ↑ . Downward sloping in S
Supply of Foreign Currency

P
SS = ( )QX
S
where P is fixed and QX = f − (P ∗ ) = f − ( PS ). As
S ↑⇒ P ∗ ↓⇒ QX ↑ . Slope of SS depends on the elasticity of
demand for the HC exports. If this is elastic ⇒ SS is upward
sloping in S
Elasticities View of Exchange Rate Determination

S 6 SS( P Q )
S X

DD(P ∗ QM )

-
Quantity of Foreign Exchange
Elasticities View of Exchange Rate Determination

I In this model, capital flows are exogenous (shift parameters).

I Ceteris Paribus
I higher domestic relative to foreign interest rates⇒Capital
Inflows (SS to the right)
I lower domestic relative to foreign interest rates ⇒Capital
Outflows (DD to the right)

i ↓, S ↑
i ↑, S ↓

I Opposite to Asset Approach Predictions

Elasticities View of Exchange Rate Determination

S 6 SS( P Q )
S X

S1 S1

DD(P ∗ QM )

-
Quantity of Foreign Exchange
Elasticities View of Exchange Rate Determination
Pegging the Exchange Rate

SS
S
6 S1 S1

S̄ c p

D1 D1
DD
-
Quantity of Foreign Exchange
Elasticities View of Exchange Rate Determination
Pegging the Exchange Rate

SS
S
6 S1 S1

d q

S̄ c p

D1 D1
DD
-
Quantity of Foreign Exchange
Elasticities View of Exchange Rate Determination
Unstable Exchange Rates

S
6

S0

SS

DD
-
Quantity of Foreign Exchange

Clearly, stability depends on elasticities (Marshall-Lerner:

condition for a depreciation to improve the trade balance)
Elasticities View of Exchange Rate Determination
Unstable Exchange Rates
Elasticities View of Exchange Rate Determination
J-Curve

Elasticities approach ignores time: Exchange rates adjust

immediately, but Prices and demand could change with a lag
In the short run, a depreciation could raise spending on imports
more than export earnings (J-Curve)

(+)

t
TB=0
Time

(-)
Forward Rate, Arbitrage, Speculation
Basic arbitrage

I Choice 1: Invest in domestic currency risk free bill

I Choice 2: Buy foreign currency, invest in foreign risk free bill,
and hedge currency exposure in forward market
I An investor should be indifferent between investing 1000 Euros
in a MTL T-bill or a US T-bill if the proceeds at maturity are
the same
F
1 + i = (1 + i ∗ )
S
 ∗ F
1 + i = (1 + i )
S
Define
F −S F
p= = −1
S S
F
⇒p+1=
S
∗
1 + i = (p + 1)(1 + i )
∗ ∗
1 + i = p + pi +1+i
∗ ∗
i = p + pi +i

pi ∗ is usually very small and can be ignored

∗ ∗ F −S
i =i +p=i +
S
| {z }
Covered Interest Parity

Ft − St
it = it∗ +
S
| {zt }
Forward Premium

I If i < i US
I Sale of Euros for US$ in the spot market, S ↑
I Sale of US$ in the forward market F ↓(⇒Buy Euros in the
forward market)
I Forward dollar at a discount (Forward Euros at a premium)
Covered Interest Parity

F −S
p= <0
S
I Covered Differential = CD
I CD = i − i ∗ − p > 0 ⇒Capital Inflow
I CD = i − i ∗ − p < 0 ⇒Capital Outflow
I CD = i − i ∗ − p = 0 ⇒Portfolio Equilibrium
Pure Speculation

I If F < S e , speculators will buy foreign currency forward

I If F > S e , speculators will buy home currency forward
I In equilibrium, F = S e

Example ($ as home currency)

Speculators expect a $ depreciation
F = 0.45 (2.22) and S e = 0.50 (2)
At time t, take 1000 $ buy Forward Euros
At time t + 1, take delivery of 2222 Euros and sell them for 1111$
Forward ER
Starting points for Supply: A = S, B = F , and at B, CD = 0.
If F ↑, CD<0, sell Dollar @S, sell Euros @F (buy Dollars @F)
⇒Supply of Euros (foreign currency here) Forward increases
Starting points for Demand by speculators: At D, F = S e
⇒ Net Speculative Demand for F Euros is zero
If F < S e , speculators will buy Euros Forward, Net Demand increases
F,S

$/1 Euro
6

D
Net Arbitrage Supply

E
C

Net Speculative Demand

A

 -
(-) 0 Q (+)
Quantity of Forward Euros
Risk Premium

I In equilibrium F = S e , Forward premium is an unbiased

predictor of future S
I Implicit assumption of speculators’ risk neutrality
I In the previous figure speculators were risk averse (C 6= D)
I F is not an unbiased predictor because of speculators risk
aversion
I S e − F is a measure of the risk premium
Uncovered Interest Parity

An investor holds a foreign asset without covering in the forward

market
e
(1 + i ∗ )St+k
1 + it =
St
As before, rearrange:
e
St+k − St
it = it∗ + ; it = it∗ + ∆s et+k
St
UD = i − i ∗ − p > 0 ⇒ Capital Inflow
UD = i − i ∗ − p < 0 ⇒ Capital Outflow
UD = i − i ∗ − p = 0 ⇒ Portfolio Equilibrium
Holds if investors are risk neutral
Ex Ante PPP

From UIP, the expected exchange rate change is equal to the interest
rate differential
∆ste+1 = it − it∗
decompose it into real interest rate and expected inflation
it = rt + ∆pe ; it∗ = rt∗ + ∆p∗e
With arbitrage on real capital rt = rt∗, obtain
e e ∗e
∆st+1 = ∆pt+1 − ∆pt+1
Some useful concepts from econometrics

I stationary process: a random process where all of its

statistical properties do not vary with time
I Processes whose statistical properties do change are referred
to as nonstationary.
I Random walk: a simple type of discrete stochastic process
whose increments form a white noise.
I A series is integrated of order n, I (n), when it needs to be
differenced n times to become stationary. A stationary series is I (0)

I Two nonstationary series, integrated of the same order, are

cointegrated if there exists a linear combination of the two
which is stationary.
Covered Interest Parity Evidence
Frenkel and Levich (1975), using 3-months T-bills for UK and USA.
Allow for transaction costs, 80 % within the neutral band
f-s
6
CIP

-
i − i∗
Covered Interest Parity Evidence
f − s = i − i∗

I Aliber (1973)
I uses Eurodollar bonds and finds that all deviations from CIP
are within the neutral bands ⇒ Deviations due to political risk
I Frenkel and Levich (1977)
I note that this is true only for tranquil periods. In turbulent
periods a smaller percentage is explained by transaction costs
I Clinton (1988): bands should be ≈ 0.06%. However, profit
opportunities are not large nor persistent
I Taylor (1987, 1989): uses higher quality data and finds few
profitable violations, even during uncertainty and turbulence.
Also, finds a maturity effect: profitable opportunities increase
with maturity (maybe because of banks’ prudential limits for
shorter periods).
CIP Evidence
Regression based tests

ft − st = α + β(i − i ∗ )t + ut

H0 : α = 0, β = 1

I Evidence in support of CIP, but α 6= 0, β = 1

I α 6= 0, transaction costs?
I However, this evidence only says CIP holds on average, not at
every instant, so not informative on efficiency (Taylor, 1989)
I Balke and Wohar (1998): examine dymamics of deviations
from CIP for UK-US and find many small deviations and some
large ones. Estimate a Threshold Auto-Regression (TAR)
model: deviations outside transaction bands (asymmetric
impulse response functions, IRFs) have less persistence than
deviations inside the bands (symmetric IRFs).
FOREX Market Efficiency

Efficient markets reflect all available information ∴ speculators

cannot make abnormal profits
This does not imply equal returns in equilibrium, nor constant
equilibrium expected returns over time
Further for the FOREX, Central Bank interventions should not be
ingnored.
Three forms of market efficiency
I Weak: current price incorporates all information contained in
past prices
I Semi-Strong: current price incorporates all public information
(including past prices)
I Strong: prices reflect all possible information
UIP evidence
and FOREX efficiency
The uncovered interest parity hypothesis is also useful to test for FOREX
efficiency.
I Early tests: how random are exchange rate changes?
I Poole (1967) finds significant first order serial correlation in
the 1920s (possibility to trade and make profits)
I Only if (i − i∗) is a constant and expectations are rational,
UIP implies a random walk in the exchange rate. However, the
RW is inconsistent with UIP
I Cumby+Obstfeld (1981) test for and reject that deviations
from UIP are random.
I Yet, nominal exchange rate series for the floating period are
difficult to distinguish from a RW.
I Alternative test: are filter rules profitable?
I Dooley+Shafer (1984), Levich+Thomas (1993) find that they are

I Engel+Hamilton (1990) : “long swings” in the Dollar

UIP Evidence
Regression based tests

From CIP: i − i∗ = f k − s ⇒

e
∆st+k = fd
e
st+k − st = ftk − st

e
st+k = ftk
Forward rate as an unbiased predictor of the future spot rate.
UIP Evidence
Regression based tests

Assume rational expectations (actual and expected differ beacuse

of a rational expectation forecast error)
e
∆st+k = ∆st+k + φt+k

Under UIP:

∆st+k = β0 + β1 (i − i ∗ )t + φt+k

I H0 : β1 = 1, and φt+k uncorrelated with informational

available at time t, i.e. E [φt+k |Ω] = 0
UIP Evidence
Regression based tests

e
Assume rational expectations and CIP: ∆st+k = it − it∗ = fdt

∆st+k = β0 + β1 (ftk − st ) + νt+k ; (1)

I H0 : β 1 = 1 and νt+k uncorrelated with information available

at time t, i.e. E [νt+k |Ω] = 0
I Most evidence rejects UIP. For US$ rates β1 often −1 (forward
discount bias).
UIP Evidence
Regression based tests

I Alternatively, many early tests regressed:

0
st+k = β0 + β1 ftk + νt+k (2)

I equation 1≡equation 2 iff β1 = 1. If β1 6= 1 ⇒

st+k = β0 + β1 ftk + [(1 − β1 )st + νt+k ]

I so that ν 0 = [(1 − β1 ]st + ν]

I If st is nonstationary, it has high variance. Since OLS tends to
minimise the residual variance, it will tend to drive β towards 1
to reduce the influence of the unit root in the error term;
UIP Evidence
Regression based tests

I Stylised fact: nominal exchange rates are nonstationary and

often random walks:
I so that β = 0 indipendently of whether the market is efficient;
I further, ftk = st+k
e
= st , so that β is unidentified;
I
in practice (f k − s) would not be zero because it would correspond
to the measurement error
UIP Evidence

Orthogonality of forward rate forecast error to information set

st+k − ftk = ΓΨt + νt+k

Alternatively:

E [νt+k |..., Ψt−1 , Ψt , Ψt+1 , ...] = 0

using non-linear cross-equation restrictions in a VAR.

I Time varying risk premium?
I MacDonald and Torrance (1990) find evidence of time varying
risk premium using MMS data
Real Interest Parity

e
it = rt + ∆pt+k ; it∗ = rt∗ + ∆pt+k
∗e

So
e
rt = it − ∆pt+k ; rt∗ = it∗ − ∆pt+k
∗e

∆s e = ∆pt+k
e ∗e
− ∆pt+k ; ∆s e = it − it∗
| t+k {z } | t+k {z }
Ex−Ante PPP UIP

Combining
e
rt − rt∗ = (it − it∗ ) − (∆pt+k ∗e
− ∆pt+k )

rt = rt∗
Real Interest Parity
Evidence
Preliminary Tests via OLS

∆pt+1 − ∆pt∗+1 = α + β(i − i ∗)t + υt+1

[H0 : α = 0, β = 1]
Evidence from Cumby and Obstfeld (1983) is of rejection. Other
evidence (Unit Root, STAR, SETAR) is mixed
Frenkel (1991): country premium, not currency premium reduced
e
rt − rt∗ = (it − it∗ ) − (∆pt+k ∗e
− ∆pt+k )

rewrite as

e
rt −rt∗ = (it − it∗ − fd ) + (fd − ∆st+k ) + (∆s e − ∆pt+k
e ∗e
+ ∆pt+k )
| {z } | {z } | t+k {z }
CD Currency Risk Ex−Ante PPP
| {z }
Currency Premium
Capital Mobility

It can be measured at different levels:i

I LOOP for money
I “price” of $ in New York = “price” of $ in London
I UIP
I UIP holds through arbitrage ⇒capital mobility is a
pre-condition
I Real Interest Rates Parity, rt = rt∗
I This is implied by PPP+UIP
I NS-NI: National savings (NS) and national investment (NI)
relationship
Long Term Capital Mobility
Feldstein and Horioka (1980)
Highly mobile capital implies equalisation of the rates of return
national savings and investment should be uncorrelated for a small country or have
low correlation for a large country
NS=S+(T-G). Fiscal expansion: NS→NS’

r NS’
6
NS

C
r0 A

-
NS, I

If the KA is closed, B is the new equilibrium. If the KA is open, r = r0

Feldstein-Horioka Puzzle

   
I S
=α+β + uit
Y it Y it
Assumption: savings are exogenous
H0 : β = 0 or at least β < 1, H1 : β = 1
FH evidence on 16 OECD countries, 1960-1974:

( YI ) = 0.035 + 0.89 ( YS ) R 2 = 0.91

(0.018) (0.074)
FH puzzle
Why is capital immobile?

I Currency risk premium

∗
it+k,t = it+k,t + ∆st+k,t + λt+k,t

I Government restraints on capital flows (Frankel (1994)

presents evidence that it begins to work in the 1980s)
I Institutional rigidities (Banks may be forced to invest locally)
Alternative explanations for high Savings-Investment
Correlations:
I CA targeting
I Solvency Constraint
I endogeneity