CHAPTER 15: EXCHANGE RATE

DETERMINATION — COMPLETE
 FLOWCHART
15.2 PURCHASING-POWER PARITY (PPP)
THEORY

ABSOLUTE PPP (15-1): R = P / P*

R = exchange rate | P = domestic price | P* = foreign price
If P↑ → R↑ (depreciation) | If P↓ → R↓ (appreciation)

Foundation: Law of One Price

Identical goods must sell for same price everywhere (in same
currency) in competitive markets with no barriers

Why Absolute PPP FAILS (5 Reasons):

1. Non-Traded Goods 2. Trade Barriers

Haircuts, housing, services cannot Tariffs, transport costs, quotas prevent
arbitrage → prices differ widely (haircut price equalization across borders
$10 US vs $1 Brazil)

3. Different Baskets 4. Capital Flows

Price indices use different Large international capital movements
weights/goods → aggregate indices push exchange rates away from PPP
can differ even if individual goods independently of trade
match

5. Balassa-Samuelson Conclusion:
Productivity↑ in traded goods → ✗ Absolute PPP fails in SHORT RUN
wages↑ in all sectors → overall P↑ → ✓ Works as LONG-RUN benchmark
developing nations appear (many decades)
systematically cheap

RELATIVE PPP (15-2): R₁/R₀ = (P₁/P₀) / (P*₁/P*₀)

Focus on CHANGES, not levels
Home inflation > Foreign inflation → Currency depreciates
Home inflation < Foreign inflation → Currency appreciates
Example: Home 8%, Foreign 3% → Home currency depreciates ~5%
 Why Relative PPP works better: Structural differences (non-traded
goods) remain CONSTANT over time, so only INFLATION
DIFFERENTIAL matters for exchange rate change

Empirical Evidence on PPP:

Observation Finding

Traded commodities (wheat, oil, ✓ PPP works WELL — law of one price holds for arbitraged
steel) goods

✗ PPP works POORLY — includes non-traded goods (~50% of

Overall price indices (CPI)
economy)

Short-run (1–3 years) ✗ PPP fails — exchange rates jump quickly, prices adjust slowly

✓ PPP works reasonably — high-inflation countries see currency

Long-run (many decades)
depreciation

Can PERSIST 1–2 decades due to barriers, information costs,

Deviations from PPP
labor immobility
15.3 MONETARY APPROACH TO BALANCE OF
PAYMENTS & EXCHANGE RATES

Core Principle: Money determines both balance of payments (fixed

rates) and exchange rates (flexible rates). Long-run exchange rates
determined by relative money supplies and real income growth.

MONEY DEMAND (15-3): Mᵈ = kPY

k = desired ratio of money to income (stable) | P = price level | Y = real output
P↑ → Mᵈ↑ | Y↑ → Mᵈ↑ | k↑ → Mᵈ↑
Example: If GDP=$1B, k=1/5 → Mᵈ = $200M

MONEY SUPPLY (15-4): Mₛ = m(D + F)

m = money multiplier | D = domestic credit | F = foreign reserves
D↑ → Mₛ↑ | F↑ → Mₛ↑
Example: If monetary base=$1B, m=5 → Mₛ = $5B

UNDER FIXED EXCHANGE RATES:

AUTOMATIC ADJUSTMENT MECHANISM:

1. Central bank expands D (creates domestic credit) → Mₛ↑ above Mᵈ
2. Excess money spent on imports & foreign assets
3. Balance-of-payments DEFICIT emerges
4. Central bank sells FX to defend fixed rate → F↓
5. F↓ reduces monetary base → Mₛ falls back to Mᵈ
Result: D↑ is exactly offset by F↓ → Mₛ unchanged long-run

Cannot permanently expand money supply under fixed rate! Any

excess leaks out through BOP deficit → reserves deplete

UNDER FLEXIBLE EXCHANGE RATES:

AUTOMATIC ADJUSTMENT MECHANISM:

1. Mₛ↑ above Mᵈ (excess money supply)
2. Residents buy foreign goods/assets → demand foreign currency↑
3. Domestic currency DEPRECIATES (R↑)
4. Depreciation raises import prices → P↑
5. Higher P raises Mᵈ = kPY until Mᵈ = Mₛ
Result: Higher P and higher R (weaker currency), no reserve change

Fixed vs. Flexible Comparison:

Fixed: Money leaks through BOP deficit → reserves fall → Mₛ falls
(exchange rate fixed, reserves change)
Flexible: Money causes currency depreciation → prices rise → Mᵈ
rises (exchange rate changes, reserves stable)
EXCHANGE RATE FROM MONETARY APPROACH (15-5 to 15-7):
R = (Mₛ/M*ₛ) · (k*/k) · (Y*/Y)
Derived from: Money market equilibrium (Mₛ = Mᵈ for both countries) + PPP (P = RP*)

Effects:
• Mₛ↑ → R↑ (depreciation) — more dollars chasing same goods
• M*ₛ↑ → R↓ (appreciation) — foreign currency weakens
• Y↑ → R↓ (appreciation) — higher income → higher Mᵈ → prices must fall → appreciation
• Y*↑ → R↑ (depreciation) — foreign prices fall → foreign currency stronger
• k↑ → R↓ (appreciation) — higher money demand → domestic currency strengthens
• k*↑ → R↑ (depreciation) — foreign money demand rises

Empirical Support:
• Money growth and inflation move together (industrial countries)
• Developing countries with high money growth have high inflation
AND currency depreciation
• Japan (lowest money growth) had strongest currency relative to
developed countries

15.3d EXPECTATIONS, INTEREST

DIFFERENTIALS & EXCHANGE RATES

UNCOVERED INTEREST PARITY (15-8): i − i* = EA

i = home interest rate | i* = foreign interest rate | EA = expected appreciation of foreign
currency

Interpretation: Higher home interest rate must equal expected depreciation of home currency
to equalize returns

• i↑ while i* constant → i > i* → EA↑ (home currency expected to depreciate)

• i↓ while i* constant → i < i* → home currency expected to appreciate

MECHANISM — How Interest Rates Affect Exchange Rates:

1. U.S. interest rate↑ (i↑) → U.S. bonds more attractive
2. Investors buy U.S. bonds → demand for dollars↑
3. Dollar APPRECIATES immediately (R↓)
4. Dollar now expected to depreciate in future (EA↑)
5. New equilibrium: i − i* = EA

EXTENDED UIP WITH RISK PREMIUM (15-9): i − i* = EA + RP

RP = risk premium on foreign bond (compensation for currency/default/political risk)

• RP↑ → for given i and i*, EA must fall → domestic currency stronger
• RP↓ → EA must rise → domestic currency weaker
15.4/15.5 ASSET MARKET MODEL & PORTFOLIO
BALANCE

Key Difference from Monetary Approach:

• Monetary Approach: Domestic & foreign bonds are PERFECT
SUBSTITUTES (only relative money supplies matter)
• Asset Market Model: Bonds are IMPERFECT SUBSTITUTES
(investors require risk premium RP > 0)

Portfolio Balance Mechanism:

Investors hold 3 assets: money (M), domestic bonds (D), foreign bonds (F)
Total wealth = M + D + eF

Allocation depends on: Expected returns, risk, risk aversion

When i↑: Investors buy more domestic bonds → less foreign bonds → currency
appreciates
When i*↑ or EA↑: Foreign bonds more attractive → buy foreign currency → currency
depreciates
Equilibrium: All 3 asset markets clear simultaneously → exchange rate adjusts

Risk Premium Importance: The existence of RP means exchange rates

can deviate from interest parity. Countries viewed as risky require higher
interest rates to attract foreign investors.
15.6 EXCHANGE RATE OVERSHOOTING
(Dornbusch Model)

Definition: Exchange rate changes by LARGER % in short run than

fundamentals predict, then gradually reverses as prices adjust
Cause: Fast asset market adjustment vs. slow goods price adjustment

THREE-STEP OVERSHOOTING MECHANISM:

Step 1: SHOCK (t=0)

Unexpected money supply expansion (Mₛ↑)

Step 2: ASSET MARKET RESPONSE (minutes/hours)

• Home interest rate falls immediately (i↓)
• Home bonds become unattractive (i < i*)
• Investors shift to foreign bonds
• Demand for foreign currency SURGES
• Home currency depreciates SHARPLY (R↑↑)
✓ OVERSHOOTING: R jumps to R* (higher than long-run equilibrium R₁)

Step 3: GOODS MARKET ADJUSTMENT (weeks/months/years)

• Goods prices adjust SLOWLY (contracts, menu costs, wage stickiness)
• Home output initially falls → unemployment rises
• Eventually goods prices fall (disinflation)
• Home goods become more competitive
• Exports↑, imports↓ → trade improves
• Home interest rate gradually rises (i↑)
• Foreign bonds become less attractive
• Home currency APPRECIATES gradually (R falls back)
• Exchange rate drifts back to R₁ (long-run equilibrium)

Overshooting Graph Interpretation:

• t=0: R jumps to R* (overshoot point)
• t=0 to long-run: R gradually appreciates (moves down) toward R₁
• Long-run: R settles at R₁
• R* > R₁ (overshoot) — currency more depreciated in short run than long run

Nominal vs. Real Overshooting:

• Nominal: Nominal exchange rate overshoots (always true in
Dornbusch model)
• Real: Real exchange rate (relative prices) overshoots (often NOT true
due to price adjustment)
15.7 PRICING BEHAVIOR, INFLATION &
EXCHANGE RATES

Exchange Rate Pass-Through Definition: % change in prices / %

change in exchange rate (ranges 0–1)
• Pass-through = 1: Complete pass-through (10% depreciation → 10%
price↑)
• Pass-through = 0.5: Partial pass-through (10% depreciation → 5%
price↑)
• Pass-through = 0: No pass-through (prices sticky in local currency)

EMPIRICAL TIMELINE OF PASS-THROUGH:

Time Period Pass-Through % Interpretation

1 month ~0–2% Firms absorb cost shock without raising prices

3 months ~15–25% Some price adjustment as firms pass on costs

6 months ~40–60% Substantial portion of depreciation reflected in prices

12 months ~60–80% Most exchange rate change in prices

2+ years ~90–100% Long-run full adjustment

PRODUCER vs. CONSUMER PRICES:

• Producer/Import prices: ~95% pass-through in 1–3 months (respond
FAST)
• Consumer/Retail prices: ~50% at 6 months, ~75–80% at 12 months
(respond SLOW)

Why? Import inputs enter production at producer prices first. Retailers

have distribution margins and menu costs, so absorb costs through
lower margins before raising retail prices.

FACTORS AFFECTING PASS-THROUGH:

1. Pricing Currency 2. Market Structure

PCP (own currency) → high pass- Competitive markets → high pass-
through through
LCP (local currency) → low pass- Monopolistic → low pass-through
through

3. Time Horizon 4. Depreciation Size

Short run (1–2 mo) → low pass-through Large depreciation → immediate
Long run → pass-through → 1
 response
Small → firms absorb

5. Inflation Expectations Implication:

High expectations → higher pass- Depreciation may NOT immediately
through raise inflation, creating lag between
Low → lower pass-through exchange rate policy & inflation

GRADUAL PRICE ADJUSTMENT (15-7c):

ΔP/P = λ(Y − Ȳ) + (ΔM/M − ΔY/Y)
λ = price responsiveness to output gap
Y − Ȳ = output gap (demand pressure)
ΔM/M − ΔY/Y = monetary growth minus output growth

Meaning: Inflation responds to BOTH demand pressure AND excess money growth. Prices
adjust GRADUALLY, not instantly.

DELAYED OVERSHOOTING MODEL:

How Delayed Adjustment Changes Overshooting:

1. Money↑ → interest falls → currency overshoots (as before)
2. Depreciation raises import prices (producer prices↑ immediately)
3. Consumer prices do NOT rise immediately (sticky, local currency pricing)
4. Real exchange rate worsens (overvaluation persists longer)
5. Goods prices gradually rise over time
6. As prices rise, interest rates rise → currency appreciates slowly back

Result: Overshoot lasts MUCH LONGER (1+ years vs. few months). Exchange rate
shows PERSISTENT deviations from PPP.

PRICING CURRENCY STRATEGIES:

PRODUCER CURRENCY PRICING LOCAL CURRENCY PRICING (LCP)

(PCP) Exporters price in importing country's
Exporters price in own currency (e.g., currency (prices in dollars)
German firm prices in euros)
When euro depreciates:
When euro depreciates: ✓ Firm can keep dollar price constant
✓ Euro price to foreigners falls ✗ Firm absorbs depreciation (lower
immediately euro revenue per dollar)
✓ Import prices in importing country↑ ✗ Pass-through LOW & SLOW
immediately
✓ Pass-through HIGH & FAST Effect: Exchange rate changes have
little impact on consumer inflation
(short-run)
 Effect: Exchange rate changes
immediately push through to inflation

PRICING-TO-MARKET: Firms adjust markups based on exchange

rates. When currency weak, they absorb depreciation to keep market
share. When strong, they raise prices. Reduces pass-through
substantially.

SUMMARY: ALL FORMULAS & KEY

RELATIONSHIPS
Concept Formula/Definition Key Effects

P↑ → R↑ (depreciation) | Long-run
Absolute PPP R = P / P*
benchmark, fails short-run

Home inflation > Foreign inflation →

Relative PPP R₁/R₀ = (P₁/P₀)/(P*₁/P*₀)
depreciation | Works long-run

Money Demand Mᵈ = kPY P↑ or Y↑ → Mᵈ↑

Fixed rates: D↑ offsets F↓ | Flexible:

Money Supply Mₛ = m(D + F)
affects prices/rates

Exchange Rate R = (Mₛ/M*ₛ)·(k*/k)·(Y*/Y) Mₛ↑ → R↑ | Y↑ → R↓ | Y*↑ → R↑

i↑ → EA↑ → currency expected to

Interest Parity i − i* = EA
depreciate

RP↑ → currency stronger | RP↓ →

UIP + Risk i − i* = EA + RP
currency weaker

Price Inflation depends on demand gap &

ΔP/P = λ(Y−Ȳ) + (ΔM/M−ΔY/Y)
Adjustment money growth | Gradual adjustment
QUICK DECISION TREE: WHICH THEORY
APPLIES?

QUESTION: What exchange rate movement are you analyzing?

├─ SHORT-RUN (days/weeks/months):
│ ├─ Unexpected monetary expansion? → OVERSHOOTING MODEL
│ │ (Rate jumps too far, then gradually reverses)
│ ├─ Interest rate changed? → INTEREST PARITY
│ │ (i↑ → currency appreciates immediately)
│ └─ Risk premium changed? → ASSET MARKET MODEL
│ (RP↑ → currency appreciates)

├─ MEDIUM-RUN (1–2 years):

│ ├─ Prices slowly adjusting? → DELAYED OVERSHOOTING
│ │ (Overshoot lasts longer, real exchange rate sticky)
│ └─ Import prices changing? → PASS-THROUGH ANALYSIS
│ (Producer prices fast, consumer prices slow)

└─ LONG-RUN (5+ years):

├─ Relative money supplies different? → MONETARY APPROACH
│ (R ∝ Mₛ/M*ₛ — relative growth rates matter)
├─ Inflation differentials persistent? → RELATIVE PPP
│ (Depreciation ≈ inflation differential)
└─ Prices stable, no shocks? → ABSOLUTE PPP
(R ≈ P/P* — short periods not applicable)
EXAM QUICK REFERENCE: TOP 20 THINGS YOU
MUST KNOW

1. Absolute PPP Formula 2. Relative PPP Formula

R = P / P* (fails due to non-traded R₁/R₀ = (P₁/P₀)/(P*₁/P*₀) (works long-
goods) run)

3. Money Demand 4. Automatic Adjustment (Fixed

Mᵈ = kPY (rises with P or Y) Rates)
D↑ → Mₛ↑ → BOP deficit → F↓ offsets it

5. Automatic Adjustment (Flexible 6. Monetary Exchange Rate Equation

Rates) R = (Mₛ/M*ₛ)·(k*/k)·(Y*/Y)
Mₛ↑ → depreciation → P↑ → Mᵈ↑ until
balanced

7. Interest Parity Condition 8. UIP with Risk Premium

i − i* = EA (higher rates → expected i − i* = EA + RP (risk affects premium)
depreciation)

9. Overshooting Definition 10. Overshooting Mechanism

Rate changes more short-run than Money↑ → i↓ → overshoot → prices
long-run (3-step mechanism) rise → recovery

11. Pass-Through Timeline 12. Producer vs. Consumer Pass-

1mo: 0%, 3mo: 20%, 6mo: 50%, 12mo: Through
75%, LR: 100% Producers: 95% in 3 months |
Consumers: 50% in 6 months

13. Gradual Price Adjustment 14. Local Currency Pricing (LCP)

ΔP/P = λ(Y−Ȳ) + (ΔM/M−ΔY/Y) Prices in foreign currency → low pass-
(depends on demand + money) through → less inflation
15. Producer Currency Pricing (PCP) 16. Pricing-to-Market Behavior
Prices in home currency → high pass- Firms adjust markups → further
through → more inflation reduces pass-through

17. Asset Market Model Key 18. Balassa-Samuelson Effect

Bonds are imperfect substitutes → risk Developing nations appear cheaper
premium matters due to lower non-traded goods prices

19. Triffin Dilemma (Bretton Woods) 20. Long-Run Tendency

Can't maintain gold standard if currency All theories converge: PPP → relative
is also reserve currency money supplies matter most for long-
run rates