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CH 15: Exchange Rates II: The Asset Approach in The Short Run

1) The document discusses the asset approach model of exchange rates in the short run. It shows how exchange rates are determined by interest rate parity between the home country and foreign country. 2) A temporary expansion of the home money supply (US) causes the home interest rate to fall, which leads to depreciation of the home currency according to interest rate parity. 3) A temporary expansion of the foreign money supply (eurozone) causes the foreign interest rate to fall. This shifts the foreign return curve downward, leading to appreciation of the home currency to restore interest rate parity.

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MD. SHAHINUR RAHMAN
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213 views9 pages

CH 15: Exchange Rates II: The Asset Approach in The Short Run

1) The document discusses the asset approach model of exchange rates in the short run. It shows how exchange rates are determined by interest rate parity between the home country and foreign country. 2) A temporary expansion of the home money supply (US) causes the home interest rate to fall, which leads to depreciation of the home currency according to interest rate parity. 3) A temporary expansion of the foreign money supply (eurozone) causes the foreign interest rate to fall. This shifts the foreign return curve downward, leading to appreciation of the home currency to restore interest rate parity.

Uploaded by

MD. SHAHINUR RAHMAN
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PPTX, PDF, TXT or read online on Scribd
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Ch 15: Exchange Rates II:

The Asset Approach in the


Short Run
The Asset Approach: Applications and Evidence

 Exchange rates in the asset approach (short run version):


Panel b: FX market
• The downward-sloping FR shows the relationship between
-the exchange rate and
-the expected dollar rate of return on foreign deposits
[i€ + (Ee$/ € − E$/ €)/E$/ €]
• The horizontal DR shows the dollar rate of return on U.S. deposits (the
U.S. nominal interest rate i$)
• In equilibrium, foreign and domestic returns are equal (uncovered interest
parity holds) and the FX market is in equilibrium at point 1′
• So, the spot exchange rate is determined at E1$/ €
Short-Run Policy
Analysis:
A Temporary
Shock to the
Home Money
Supply
 U.S. money supply is increased temporarily from M1US to M2US
 

sticky prices
U.S. real money supply will increase to M2US /1 US real money
supply curve shifts from MS1 to MS2 in panel (a)
 U.S. real money demand is unchanged
so the money market equilibrium shifts from point 1 to point 2
the nominal interest rate falls from i1$ to i2$
[The expansion of the U.S. money supply causes the U.S. nominal interest
rate to fall.]
• A temporary monetary policy shock leaves the long-run expected
exchange rate Ee$/ € unchanged
(Assuming all else equal)
-European monetary policy unchanged, the euro interest rate
remains fixed at i €
-Then the foreign return FR curve in panel (b) is unchanged and the
new FX market equilibrium is at point 2′.
• The lower domestic return i2$ is matched by a lower foreign return.
[The foreign return is lower because the U.S. dollar has depreciated
from E1$/ € to E2$/ € ]
Short-Run Policy
Analysis:
A Temporary
Shock to the
Foreign Money
Supply
• home money supply, home and foreign real income and price
levels, and the expected future exchange rate are all fixed.
• The home money market is in equilibrium at point 1 and the FX
market is in equilibrium at point 2.
• changes in the foreign money supply have no effect on the home
money market in panel (a), equilibrium remains at point 1
• The shock is temporary, so long-run expectations are unchanged
• Because the foreign money supply has expanded temporarily, the
euro interest rate falls
• Foreign returns are diminished, all else equal, by a fall in euro
interest rates, so the foreign return curve FR shifts downward
• The home exchange rate has decreased (the U.S. dollar has
appreciated)
• Eventually, the equality of foreign and domestic returns
is restored, uncovered interest parity holds again, and
the foreign exchange market reaches a new short-run
equilibrium (point 1)

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