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Internal And External Balance With Adjustable Or Fixed Exchange Rates Notes

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INTERNAL AND EXTERNAL BALANCE WITH ADJUSTABLE OR FIXED EXCHANGE RATES


Cointegration - if 2 variables are related


Non mean reverting - difference between the 2 variables is increasing


PPP o Prices should be the same all the way round the world
 This is accommodated by nominal exchange rates o Absolute PPP doesn't take into account the share of tradeables and non-tradeables
 One basket might contain a higher share of tradeables
 Different tastes and preferences o UIP 'The Economics of Exchange Rates' Taylor 1995


Speculative efficiency o 'In an efficient speculative market, prices should fully reflect information available to market participants and it should be impossible for a trader to earn excess returns to speculation.' o Uncovered interest parity condition - 'If the risk neutral efficient markets hypothesis holds, then the expected foreign exchange gain from holding one currency rather than another (the expected ER change) must be just offset by the opportunity cost of holding funds in this currency rather than the other (the IR differential).' o Testing foreign exchange market efficiency:
 Random walk in the ER - if rational expectations and nominal IR differential is identically equal to a constant (with drift if the constant is non-zero)
 Random walk model generally inconsistent with uncovered IR parity condition
 Time series for the major nominal ER's are extremely hard to distinguish empirically from random walks
 Empirical results generally don't favour the efficient markets hypothesis under risk neutrality o Rethinking efficiency I: Risk premia
 Rejection of risk neutral efficient markets hypothesis 'may be due to the risk aversion of market participants or to a departure from the pure rational expectations hypothesis, or both.'


If risk averse, uncovered interest parity needs a risk premium because agents demand a higher rate of return than the interest differential in return for the risk of holding foreign currency
 'empirical risk premium models have so far been unable to explain to any significant degree the variation in the excess return from forward market speculation.' o Rethinking efficiency II: Expectations
 'The peso problem refers to the situation where agents attach a small probability to a large change in the economic fundamentals, which does not occur in sample.' - skewed distribution of forecast errors even if agents' expectations are rational - may generate apparent evidence of non-zero excess returns from forward speculation


Rational bubbles may also show up non-zero excess returns even when agents are risk neutral o Rethinking efficiency III: survey data studies
 'overall conclusion that emerges from survey data studies appears to be that both risk aversion and departures from rational expectations are responsible for rejection of the simple efficient markets hypothesis.' o Other parity conditions
 Covered interest parity


PPP

'If there are no barriers to arbitrage across international financial markets, then arbitrage should ensure that the interest differential on similar assets, adjusted for covering in the forward foreign exchange market the movement of currencies at the maturity of the underlying assets, be continuously equal to zero, so that covered interest parity should hold.' Tests seem to find that there are few profitable violations of this condition

'Absolute PPP implies that the ER is equal to the ratio of the 2 relevant national price levels.'


'Relative PPP posits that changes in the ER are equal to changes in relative national prices.'


Late 1970s - in light of the very high variability of real ER's - collapse of PPP - extreme position largely abandoned o Then many studies which could not reject the hypothesis of random walk behaviour in real ER's o 'led to the rather widespread belief that PPP was of little use empirically and that RER movements were highly persistent.' o Recently tested for cointegration between nominal ER and relative prices (i.e. testing for long run PPP) by testing for mean reversion in the RER
 More favourable (degree of test power problems etc.) Models of ER determination o Prior to 1970s - main model was Mundell-Fleming model - generally an open Keynesian model
 But its treatment of stock market equilibrium was inadequate in that the stock flow implications of IR differential changes are not worked out.
 So more recent models focus on stock equilibrium o Flexible prices model
 Monetary approach to the ER
 ER is relative price of 2 monies


Attempts to model that relative price in terms of relative supply and demand for these monies o Money demand assumed to depend on real income, price level adn nominal IR


Assume continuous PPP


So an increase in domestic money supply, relative to foreign money stock, depreciates the domestic currency in terms of the foreign currency


A rise in domestic real income leads to an excess demand for domestic money stock so residents reduce expenditure and prices fall until equilibrium achieved o PPP means that falling domestic prices (with foreign prices constant) leads to an appreciation of the domestic currency in terms of the foreign currency


Depreciation follows from an increase in the domestic IR as this reduces domestic demand for money
 Model only concentrates on equilibrium in the money market.


Assume perfect substitutability of domestic and foreign assets, domestic and foreign bond markets essentially become a single market

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