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Course Material: International Financial Markets: The Monetary Model(s) and Foreign Exchange Market Eciency

Prof. Dr. Thomas Lux provides course material on international financial markets and the monetary model(s) and foreign exchange market efficiency. The document derives equations distinguishing the influence of macroeconomic fundamentals and expectations on exchange rates. Under rational expectations, today's exchange rate fully incorporates all available information about future macroeconomic fundamentals. Only new information can cause exchange rate changes, indicating an informationally efficient foreign exchange market. The derived exchange rate equation is analogous to the standard asset pricing equation.

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48 views2 pages

Course Material: International Financial Markets: The Monetary Model(s) and Foreign Exchange Market Eciency

Prof. Dr. Thomas Lux provides course material on international financial markets and the monetary model(s) and foreign exchange market efficiency. The document derives equations distinguishing the influence of macroeconomic fundamentals and expectations on exchange rates. Under rational expectations, today's exchange rate fully incorporates all available information about future macroeconomic fundamentals. Only new information can cause exchange rate changes, indicating an informationally efficient foreign exchange market. The derived exchange rate equation is analogous to the standard asset pricing equation.

Uploaded by

motaaziz
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Prof. Dr.

Thomas Lux Department of Economics


Chair of Monetary Economics University of Kiel
and International Finance

Course Material:
International Financial Markets

The Monetary Model(s) and Foreign Exchange Market Eciency

Take as a starting point the reduced form of the ex-price monetary model

st = mt − m∗t − η(yt − yt∗ ) + σ(it − i∗t ). (1)

Use the uncovered interest parity condition in discrete time

it − i∗t = Et [st+1 ] − st (2)

to derive
st = mt − m∗t − η(yt − yt∗ ) + σ(Et [st+1 ] − st ) (3)
with Et [st+1 ] = E[st+1 |It ] the conditional expectation of the exchange rate at time t + 1
given available information It at time t.
Solving for a closed form solution for st yields
1 ¡ ¢ σ
st = mt − m∗t − η(yt − yt∗ ) + Et [st+1 ], (4)
1+σ 1+σ
or in compact form
st = xt + δEt [st+1 ] (5)
1
¡ ∗ ∗
¢
with xt = 1+σmt − mt − η(yt − yt ) : the inuence of macroeconomic fundamentals and
σ
δ ≡ 1+σ and δEt [st+1 ]: the inuence of exchange rate expectations.

Note: exactly the same operations can be performed with the more involved reduced forms of
the sticky price and portfolio balance models, so that we would end up with a similar equation
distinguishing between the inuence of fundamentals and expectations in either case (albeit
with dierent denitions of xt and δ ).

Under rational expectations:

Et [st+1 ] = Et [xt+1 ] + δEt [st+2 ]. (6)

Repeated substitution of (6) into (5) leads to


∞
X
st = δ i Et [xt+i ]. (7)
i=0

1
Equation (7) emphasizes the inuence of expectations:
• all currently available knowledge on the future development of macro fundamentals is
already incorporated into today's exchange rates.
• only new information leads to exchange rate changes (informationally ecient forex
market ).

Note: Equation (7) has the same structure like the standard asset pricing equation:
∞
X
Pt = ρi Et [dt+i ] (8)
i=1

with Pt : the share price, ρ: discount factor and dt : dividends.

Literature
Hallwood, C./ McDonald, R. (2000): International Money and Finance , 3rd. ed. Oxford.

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