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Money and Banking

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Title: Money and Banking


1
Money and Banking
  • Spring 2007
  • Martin Andreas Wurm
  • University of Wisconsin - Milwaukee

2
Exchange Rates
  • Required Reading Mishkin, Ch. 19

3
Exchange Rates
  • 2. Openness in financial markets
  • The short run Interest Rate parities
  • As the choice of goods in open goods markets was
    enriched by foreign goods, so does openness in
    financial market allow a saver to hold foreign
    assets in addition to domestic ones.
  • While holding foreign money for reasons of saving
    in principle is a possibility, we will reduce our
    analysis to interest paying assets, i.e. foreign
    bonds.

4
Exchange Rates
  • 2. Openness in financial markets
  • The short run Interest Rate parities
  • How does an investor choose between a domestic
    and a foreign asset?
  • Lets consider the easiest example The choice
    between a 1-year domestic bond and a 1-year
    foreign bond.

5
Exchange Rates
  • 2. Openness in financial markets
  • The short run Interest Rate parities
  • The return on a domestic bond is easily
    determined
  • Let it be the domestic interest rate in the
    United States. Every Dollar you put into this
    bond in period t gives you a return of (1it)
    Dollars in period t1

6
Exchange Rates
  • 2. Openness in financial markets
  • The short run Interest Rate parities
  • The return on a foreign bond is a little bit more
    complex
  • Lets say you want to buy a British bond today.
    For one dollar you get Et British pounds today.
    Let denote the return on a British bond in
    British Pounds one year from now. Then for every
    Dollar invested you receive British Pounds
    tomorrow

7
Exchange Rates
  • 2. Openness in financial markets
  • The short run Interest Rate parities
  • However, being American, you will have further
    have to convert this return back into Dollars.
  • As we already have pointed out exchange rates
    float around, so the exchange rate tomorrow is
    going to be different from E today. In order to
    determine the value of the return on a British
    asset, we will, therefore, have to use the
    expected exchange rate tomorrow to transform
    the return in Pounds back into Dollars.

8
Exchange Rates
  • 2. Openness in financial markets
  • The short run Interest Rate parities
  • Finally note, that in order to convert Pounds
    back to Dollars, you have to multiply the amount
    in pounds by
  • , since we defined E to be the price of
    Pounds in Dollars.
  • Thus, the return on one Dollar invested in a
    British bond in t is given by

9
Exchange Rates
  • 2. Openness in financial markets
  • The short run Interest Rate parities
  • To summarize
  • Return on a domestic bond
  • Return on a foreign bond

10
Exchange Rates
  • 2. Openness in financial markets
  • The short run Interest Rate parities
  • How do individuals choose between one or the
    other asset? If agents are assumed to care only
    about the expected return on bonds they will but
    only the bond which offers the highest return
    denoted in one currency.
  • This in turn increases the price of that bond and
    lowers its returns. Through this process called
    arbitrage the expected returns in equilibrium
    will be identical.

11
Exchange Rates
  • 2. Openness in financial markets
  • The short run Interest Rate parities
  • Thus in equilibrium
  • This arbitrage condition is known as uncovered
    interest parity or interest parity condition.

12
Exchange Rates
  • 2. Openness in financial markets
  • The short run Interest Rate parities
  • While this condition is empirically too strong
    since it ignores risk and transaction costs it
    is still a relatively good approximation of what
    drives international capital flows.
  • Alternatively it can be approximately written as

13
Exchange Rates
  • 2. Openness in financial markets
  • The short run Interest Rate parities
  • The second specification allows for a more
    intuitive interpretation
  • The return on the domestic bond should be equal
    to the return on the foreign bond minus expected
    depreciation of the foreign currency compared to
    the domestic currency.

14
Exchange Rates
  • 2. Openness in financial markets
  • The short run Interest Rate parities
  • If for example the interest rate in the U.S. Is
    2 and the interest rate in the U.K. is 4 then
    in equilibrium investors will expect the Pound to
    depreciate by 2 over the Dollar.
  • If they expect the Pound to depreciate by less,
    then they will hold only the British bond, if
    they expect the Pound to depreciate by more than
    this, they will only hold the American bond.

15
Exchange Rates
  • 3. Summary
  • Goods and financial markets
  • The exchange of goods and services between
    domestic and foreign markets largely depends on
    the real exchange rate between two goods.
    Generally trade tends to be more of a long run
    determinant of exchange rates
  • The exchange of assets between domestic and
    foreign markets depends on the relative rates of
    return in two countries and on the expected rate
    of nominal appreciation of the domestic currency.
    It generally tends to determine exchange rates in
    the short run.

16
Exchange Rates
  • 3. Summary
  • Goods and financial markets
  • To see this consider the following If nations
    allow their interest rate (which determines the
    return on bonds) to deviate strongly from
    interest rates in the rest of the world the
    nominal exchange rate will fluctuate strongly if
    purchasing power parity holds.
  • As large exchange rate fluctuations are
    undesireable (they create uncertainty), interest
    rates in two different countries which share
    large mutual capital flows should not be expected
    to deviate too far from each other. (See e.g.
    figure 11.3.)

17
Exchange Rates
  • 3. Summary

Figure 11.3. American and British T-Bill rates
from 1979 to 2005. Source Bank of England
18
Exchange Rates
  • 3. Summary
  • Goods and financial markets
  • In an extreme case the case of fixed exchange
    rate regimes the country which keeps up this
    regime, will adjust its interest rate completely
    to movements in the interest rate of the country
    its currency is fixed to.
  • Since interest rates are determined largely by
    monetary policy, a fixed exchange rate regime,
    thus, rules out the option to use monetary policy
    to increase output in the short run.
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