Exchange Rates II: Short-Run Asset Approach
Uploaded by
Fawaz AliExchange Rates II: Short-Run Asset Approach
Uploaded by
Fawaz AliCommon questions
Powered by AICountries in a currency union like the Eurozone, CFA franc union, or Caribbean currency union face the policy trilemma, where they cannot simultaneously maintain a fixed exchange rate, free capital movement, and independent monetary policy. By adopting a single currency, these countries sacrifice independent monetary policy, as the central bank's policies are not tailored to the individual needs of each member country. This allows for free capital movement and stable exchange rates internally but limits the countries' ability to respond individually to local economic shocks through monetary policy adjustments .
During the 1997-1998 East Asian currency crisis, Thailand shifted to a floating exchange rate regime, allowing the baht to depreciate in response to speculative attacks. Indonesia attempted to maintain its currency peg while preserving capital mobility, which proved ineffective and led to a crisis. Malaysia implemented capital controls to maintain the ringgit's peg, successfully defending its currency and interest rate levels in the short run . The Malaysian approach was more effective in maintaining short-term stability, as capital controls insulated the economy from speculative pressure, although it restricted capital mobility . This strategy, however, may not be sustainable or desirable in the long run due to potential adverse impacts on investor confidence and economic growth.
When the Bank of Korea announces a permanent increase in the money supply but does not implement the change immediately, investors anticipating future inflation might sell the won, leading to a depreciation without any immediate change in interest rates . If the policy is implemented unexpectedly, the immediate effect is more severe due to investor surprise, causing a sharp depreciation as they adjust portfolios suddenly . Hence, expectation management plays a crucial role in the magnitude of the currency's response, where surprise changes can lead to more volatile and unpredictable market reactions.
A temporary decrease in U.S. real money demand lowers the U.S. interest rate, temporarily depreciating the dollar relative to the euro and increasing the exchange rate E$/e. As this is a temporary change, the long-run effects may reverse as money demand resumes normal levels, adjusting the interest rates and exchange rate back towards the initial equilibrium . If the decrease in real money demand is permanent, the initial depreciation of the dollar is reinforced by a long-term increase in the money supply relative to demand. This permanent change leads to an increased price level and a higher nominal exchange rate E$/e in the long run as the economy adjusts to higher money supply expectations permanently affecting prices .
In the short run, a permanent increase in the Bank of Korea's money supply lowers domestic interest rates, leading to capital outflows and a depreciation of the won against the yen, increasing the exchange rate Ewon/Y . In the long run, the increased money supply elevates the domestic price level, potentially stabilizing the currency at a new, depreciated level as price adjustments catch up with the monetary base expansion. However, the exact long-run effects can vary based on inflation expectations and relative economic performance compared to Japan .
Surprising investors can be an effective short-run strategy due to the sudden and unanticipated adjustments in investor expectations and behaviors, leading to immediate and potentially significant shifts in currency value. Without prior anticipation, investors must rapidly alter their positions in response to new information, causing volatility and rapid exchange rate adjustments as markets absorb the changes. It leverages the element of uncertainty to produce outcomes that might not be achieved through anticipated policy changes, as these gradual changes allow investors to hedge and adjust beforehand, minimizing impact . However, reliance on surprise actions can undermine long-term credibility if overused, as it may erode trust in the central bank's policy consistency and transparency .
Abandoning the currency peg led to immediate depreciation of the Thai baht, which allowed the currency to find a new equilibrium in response to market forces. Initially, this resulted in increased inflationary pressure due to higher import costs and localized economic disruption as the foreign debt burden increased for Thai firms. However, the floating regime also restored monetary policy independence, enabling Thailand to adjust interest rates to address domestic economic conditions rather than defend an overvalued exchange rate . Over time, this strategy facilitated economic recovery by making exports more competitive due to the weaker baht, although initial conditions were challenging .
A permanent decrease in India's money supply initially increases India's interest rate iRs as the liquidity effect dominates. This causes the rupee to appreciate, decreasing the exchange rate ERs/$ in the short run. The price level PIN initially does not change but decreases as the equilibrium adjusts over time. The expected exchange rate Ee Rs/$ decreases initially but stabilizes as expectations adjust to the new long-term equilibrium . In the long run, the reduced nominal money supply relative to demand leads to a lower price level PIN and a subsequent decrease in the real money supply, stabilizing the variables at new equilibrium values but with the rupee remaining appreciated relative to its initial value due to decreased inflation expectations .
Overshooting occurs when the exchange rate's immediate reaction to a monetary policy change is more extreme than its long-term adjustment. For instance, if the money supply in a country is decreased, the immediate effect is an increase in the interest rate, leading to an appreciation of the currency that exceeds its long-run appreciation. This over-adjustment happens because prices are sticky in the short run, and the full impact of the money supply change on inflation and real economic variables takes time to materialize, leading to gradual long-term adjustment of exchange rates .
In the short run, a temporary increase in the U.S. money supply lowers the U.S. interest rate, causing capital to flow out, depreciating the U.S. dollar against the British pound, which raises the exchange rate E$/£. The expected exchange rate Ee $/£ increases momentarily due to the anticipated effects. Meanwhile, the U.S. price level remains unchanged initially . In the long run, as the price level PUS adjusts upward, the real money supply returns to its original level, restoring the U.S. interest rate and reverting the exchange rate E$/£ to its initial value. The expected exchange rate Ee $/£ also returns to its original anticipation once price adjustments occur fully .