ECF2721

Topic 5 Q and A

Short-Run Determination of Exchange Rates:

Asset Market Approach
 The Asset Market Model

Home Money Market FX Market

Expected
i$ MS1 $ return

1 1 i$1 1’
i$ DR1

MD1
FR

M $1 M/P E1 E$/€
1
P $

2
[RECAP] Model Specification and Some Key
Assumptions
 Money Market
 (1) Real Money Supply

 M is the stock of money (M1) and P is the price level
 M is determined by the Central Bank
 P is sticky in the short run
 Both M and P and independent of the interest rate
 An increase (decrease) in M will shift MS to the right (left)
 An increase (decrease) in P will shift the MS to the left (right)
 Note: that this change in P only happens in the long run when
the shock is permanent (topic 6)
The Money market

 (2) Real Money Demand

 L(i) is a negative function; Money demand is a decreasing function of

the nominal interest rate
 An increase (decrease ) in i will result in a movement up and to the left
(down and to the right) along the money demand curve.
 Real income, Y is exogenously determined.
 An increase (decrease) in Y will shift MD to the right (left)
 (3) In Equilibrium:
 Real Money Supply = Real Money demand = M/P
 Interest rates adjust freely to bring the money market into equilibrium
 Interest rates can adjust independently of Fisher effect.
The Foreign Exchange Market (FX Market)

Equilibrium in the foreign exchange market is given by the

UIP equation

Interest rate on Interest rate on Expected rate of

dollar deposits euro deposits depreciation of the
= dollar
Dollar rate of
return on dollar
deposit Expected dollar rate of
return on euro deposits

5
The Foreign Exchange Market (cont’)

• The UIP equation can be written as:

 Ee 
i  i*    1
  E 
Domestic interest rate Foreign interest rate     
Expected rate of depreciation
of the domestic currency
                 
Domestic return Expected foreign return

• DR = i (RHS) and FR curve = (LHS)

• An increase (decrease) in i will shift DR curve up (down)
• i* and Ee are exogenously determined.
• An increase (decrease) in i* or Ee will shift the FR curve to the right
(left)
• Forex market equilibrium determines the nominal exchange rate, E,
given all the other variables.
6
1. Use the Australian money market and foreign exchange (FX) market to answer the
following questions. This question considers the relationship between the British pounds (₤)
and Australian dollar ($). Let the exchange rate be defined as Australian dollars per British
pound, E$/₤. Suppose that the Bank of England, the central bank of the U.K., increases the
money supply of the U.K. Assume this change in the U.K. money supply is temporary.

(a) Using the money market for Australia and FX market diagrams below
(replicate them in your answer book), illustrate how this change affects
the money market in Australia and the FX markets. Label your short-run
equilibrium point as B and your long-run equilibrium point as C. Be sure
to use the Australian money market and the exchange rate defined as
AU$ per £, E$/£.
ANSWER
 With the temporary increase of the money supply of the U.K., the
interest rate in the U.K. falls.
 So, the FR curve shifts downward (to FR2).
 Since the shock is temporary, people do not revise the expected future
spot exchange rate.
 The new equilibrium exchange rate in the short-run decreases (to point
E1 to E2).
 (1)A temporary increase in UK Money Supply: Short Run

Home Money Market FX Market

Expected
i$ MS1 $ return

1 A =B i$1 B A
i$ DR1
FR1
MD
FR2

M $1 M/P E2 E1 E$/₤
1
P $

8
(b) Using your diagram from (a), state how the current and expected future exchange
rates, E$/₤ and Ee$/₤, change in the short-run (increase/decrease/no change relative to
their initial values at point A).

 As shown in the diagram in (a),

 E$/₤ falls in the short-run (E1 to E2),
 but Ee$/₤ does not change (stays at E1).
Long Run Adjustment

 In the long-run, the interest rate in the U.K. goes back

to the original level.
 So the FR curve shifts back to FR1.
 In the long-run, the exchange rate will be exactly the
same as the initial level.
(1) A temporary increase in UK Money Supply:
Long Run

MS1
i$ Returns
(in $)

A=B=C B A=C
i1   i1     DR1

MD1 FR2
FR1

M1/P1 M$/P$ E2 E1 E$/₤

(c) Using your diagram from (a), state how the current and expected future exchange
rates, E$/₤ and Ee$/₤, change in the long-run (increase/decrease/no change relative to their
initial values at point A).

 As shown in the diagram:

 In (a), E$/₤ goes back to the initial level,
 E1, in the long-run (no change),
 Ee$/₤ does not change (stays at E1).
2. Use the money market and FX diagrams to answer the following questions. This
question considers the relationship between the euro (€) and the Australian dollar ($). Let the
exchange rate be defined as AU dollars per euro, E$/€. On all graphs, label the initial
equilibrium point A. Suppose that the real income in Australia fell. Assume this change in the
Australian real income is temporary. Using the FX and money market diagrams, illustrate
how this change affects the money and FX markets. Label your short-run equilibrium point B
and your long-run equilibrium point C
 Answer:
 See the following diagram.
 Question 2: A temporary decrease in the home income
Home Money Market FX Market
Expected
i$ MS1 $ return

1 A i$1 A
i$ DR1
2 B
i$ i$2 DR2
B
MD1
FR
MD2

M $1 M/P E1 E2 E$/€
1
P $

14
Short Run Effects

 Short Run
 i$ falls
 E$/€ increases (the $ depreciates)
 Ee$/ € , does not change
The shock is temporary, therefore in will not affect
future expectations
 P$ does not change.
 Prices are sticky in the short run
Long Run Effects

 Long Run
 In the long run the shock is fully reversed
 The long-run values are the same as the initial values
because the shock is temporary.
 Also because the shock is temporary, we assume
that the reversal of real money demand occurs before
the price level adjusts
 That is, MD returns from MD2 to MD1 before the
price level changes.
Short and Long Run Effects Diagram