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2023 Asset Market Approach

The document discusses the asset market approach to understanding short-run exchange rate fluctuations, emphasizing that these changes are primarily driven by investor behavior in financial markets rather than trade-related transactions. Key factors influencing exchange rates include relative interest rates and expectations of future exchange rate movements. The analysis highlights that a rise in domestic interest rates can attract foreign investment, leading to currency appreciation, while expectations of currency depreciation can deter investment, causing depreciation.

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7 views16 pages

2023 Asset Market Approach

The document discusses the asset market approach to understanding short-run exchange rate fluctuations, emphasizing that these changes are primarily driven by investor behavior in financial markets rather than trade-related transactions. Key factors influencing exchange rates include relative interest rates and expectations of future exchange rate movements. The analysis highlights that a rise in domestic interest rates can attract foreign investment, leading to currency appreciation, while expectations of currency depreciation can deter investment, causing depreciation.

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© © All Rights Reserved
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THE ASSET MARKET APPROACH:

DETERMINING SHORT RUN EXCHANGE RATES

By Dr. Md. Sarafraz Equbal


Background
• We have seen that exchange rate fluctuations in the long run stem
from volatility in market fundamentals including relative price levels
(purchasing-power-parity), relative productivity levels, preferences
for domestic or foreign goods, and trade barriers.
• However, fluctuations in exchange rates are sometimes too large and
too sudden to be explained solely by such factors. Exchange rates can
change by two percentage points or more in a single day.
• But variations in the determinants usually do not occur frequently or
significantly enough to fully account for such exchange rate
irascibility.
• Therefore, to understand why exchange rates can fluctuate sharply in
a particular day or week, we must consider other factors besides
relative price level behavior, productivity trends, preferences, and
trade barriers.
• We need to develop a framework that can demonstrate why exchange
rates fluctuate in the short run.
Background
• To understand short run exchange rate behavior, it is important to
recognize that foreign exchange market activity is dominated by
investors in assets such as Treasury securities, corporate bonds,
bank accounts, stocks, and real property.
• Today, only about two percent of all foreign exchange transactions
are related to the financing of exports and imports. This relation
suggests that about 98 percent of foreign exchange transactions are
attributable to assets being traded in global markets.
• Because these markets are connected by sophisticated
telecommunication systems and trading occurs on a 24-hour basis,
investors in financial assets can trade rapidly and modify their
outlooks of currency values almost instantaneously.
• Over short periods such as a month, decisions to hold domestic or
foreign assets play a much greater role in exchange rate
determination than the demand for imports and exports does.
Asset Market Approach
• According to this approach, investors consider
two key factors when deciding between
domestic and foreign investments:
1. relative levels of interest rates and
2. expected changes in the exchange rate itself over
the term of the investment.
• These factors, account for fluctuations in
exchange rates that we observe in the short run.
Relative Levels of Interest Rates
• The level of the nominal (money) interest rate is a first approximation
of the rate of return on assets that can be earned in a particular country.
• Differences in the level of nominal interest rates between economies are
likely to affect international investment flows, as investors seek the
highest rate of return.
• When interest rates in the United States are significantly higher than
interest rates abroad, the foreign demand for U.S. securities and bank
accounts will increase, that increases the demand for the dollars needed
to buy those assets, thus causing the dollar to appreciate relative to
foreign currencies.
• In contrast, if interest rates in the United States are on average lower
than interest rates abroad, the demand for foreign securities and bank
accounts strengthens and the demand for U.S. securities and bank
accounts weakens. This weakness will cause the demand for foreign
currencies needed to buy foreign assets to increase and the demand for
the dollar to decrease, resulting in a depreciation of the dollar relative
to foreign currencies.
Initially, the equilibrium exchange rate is $1.50 per
pound. Referring to Figure, assume that an
expansionary monetary policy of the U.S. Federal
Reserve results in a fall in interest rates to three
percent, while interest rates in the UK are at six
percent. U.S. investors will be attracted to the
relatively high interest rates in the UK and will
demand more pounds to buy UK Treasury bills.
The demand for pounds rises to D1 in the figure.

Concurrently, the UK investors will find investing


in the US less attractive than before, so fewer
pounds will be offered to buy dollars for purchases
of U.S. securities. The supply of pounds decreases
to S1 in the figure.

The combined effect of these two shifts is to cause


the dollar to depreciate to $1.60 per pound.

Alternatively, if interest rates were lower in the


United Kingdom than in the United States, the
dollar would appreciate against the pound as
Americans made fewer investments in the United
Kingdom and the UK investors made more
investments in the United States.
Relation between interest rates, investment flows, and exchange rates

Real Interest rate =Nominal Interest −Rate Inflation Rate

For international investors, it is the relative changes in the real interest rate
that matter.

• If a rise in the nominal interest rate in the United States is accompanied by


an equal rise in the U.S. inflation rate, the real interest rate remains
constant. In this case, higher nominal interest rates do not make dollar
denominated securities more attractive to UK investors.

▫ This is because rising U.S. inflation will encourage U.S. buyers to seek out low
priced UK goods that will increase the demand for pounds and cause the dollar to
depreciate.

▫ British investors will expect the exchange rate of the dollar in terms of the pound,
to depreciate along with the declining purchasing power of the dollar. The higher
nominal return on U.S. securities will be offset by the expectation of a lower
future exchange rate, leaving the motivation for increased UK investment in the
United States unaffected.
• Only if higher nominal interest rates in the
United States signal an increase in the real
interest rate will the dollar appreciate; if they
signal rising inflationary expectations and a
falling real interest rate, the dollar will
depreciate.
Expected Change in the Exchange Rate
• Differences in interest rates may not be all investors
need to know to guide their decisions.
• They must also consider that the return actually realized
from an investment is paid out over some future period.
• This time frame means that the realized value of that
future payment can be altered by changes in the
exchange rate itself over the term of the investment.
• Investors must think about possible gains or losses on
foreign currency transactions in addition to interest rates
on assets.
• Expectations about the future path of the exchange rate
itself will figure prominently in the investor’s
calculation of what he or she will actually earn from a
foreign investment denominated in another currency.
• Even a high interest rate would not be attractive if one
expects the denominating currency to depreciate at a
similar or greater rate and erase all economic gain.
• Conversely, if the denominating currency is expected to
appreciate, the realized gain would be greater than what
the interest rate alone would suggest, and the asset
appears more lucrative.
Figure illustrates the effects of investor expectations of changes
in exchange rates over the term of an investment.
Assume that the equilibrium exchange rate is initially $1.50
per pound. Suppose that UK investors expect that in three
months the exchange value of the dollar will appreciate
against the pound.
By investing in three month U.S. Treasury bills, UK
investors can anticipate a foreign currency gain: today,
selling pounds for dollars when dollars are relatively cheap,
and, in three months, purchasing pounds with dollars when
dollars are more valuable (pounds are cheap).
The expectation of foreign currency gain will make U.S.
Treasury bills seem more attractive and the UK investors
will purchase more of them.
In the figure, the supply of pounds in the foreign exchange
market shifts rightward from S0 to S1 and the dollar
appreciates to $1.45 per pound today. In this way, future
expectations of an appreciation of the dollar can be self
fulfilling for today’s value of the dollar.
• Referring to the previous example, UK investors expect that the
dollar will appreciate against the pound in three months.

▫ What triggers these expectations?

• The answer lays in the long run determinants of exchange rates.

▫ The dollar will be expected to appreciate if there are expectations that


the U.S. price level will decrease relative to the UK price level, U.S.
productivity will increase relative to UK productivity, U.S. tariffs will
increase, the U.S. demand for imports will decrease, or the UK demand
for U.S. exports will increase.
Given anticipated gains resulting from an appreciating dollar, UK
investment will flow to the United States that causes an increase in
today’s value of the dollar in terms of the pound, as shown in the
following flowchart:

Any long run factor that causes the expected future value of the dollar
to appreciate will cause the dollar to appreciate today.

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