Exchange-Rate Dynamics

Martin D. D. Evans

• Publisher: Princeton University Press
• Year: 2011
• Print ISBN: 9780691150895
• eBook ISBN: 9781400838844
• Topic: Economics
• Subtopic: Foreign Exchange
• Index: Economics

A comprehensive and in-depth look at exchange-rate dynamics

Variations in the foreign exchange market influence all aspects of the world economy, and understanding these dynamics is one of the great challenges of international economics. This book provides a new, comprehensive, and in-depth examination of the standard theories and latest research in exchange-rate economics. Covering a vast swath of theoretical and empirical work, the book explores established theories of exchange-rate determination using macroeconomic fundamentals, and presents unique microbased approaches that combine the insights of microstructure models with the macroeconomic forces driving currency trading.

Macroeconomic models have long assumed that agents—households, firms, financial institutions, and central banks—all have the same information about the structure of the economy and therefore hold the same expectations and uncertainties regarding foreign currency returns. Microbased models, however, look at how heterogeneous information influences the trading decisions of agents and becomes embedded in exchange rates. Replicating key features of actual currency markets, these microbased models generate a rich array of empirical predictions concerning trading patterns and exchange-rate dynamics that are strongly supported by data. The models also show how changing macroeconomic conditions exert an influence on short-term exchange-rate dynamics via their impact on currency trading.

Designed for graduate courses in international macroeconomics, international finance, and finance, and as a go-to reference for researchers in international economics, Exchange-Rate Dynamics guides readers through a range of literature on exchange-rate determination, offering fresh insights for further reading and research.

• Comprehensive and in-depth examination of the latest research in exchange-rate economics
• Outlines theoretical and empirical research across the spectrum of modeling approaches
• Presents new results on the importance of currency trading in exchange-rate determination
• Provides new perspectives on long-standing puzzles in exchange-rate economics
• End-of-chapter questions cement key ideas

PART I

MACRO MODELS

CHAPTER 1

Macro Models without Frictions

This is the first of two chapters that examine the exchange-rate implications of macroeconomic models. My aim is not to survey all the macro models of exchange-rate determination, but rather to provide a theoretical overview of how exchange rates are linked to macro variables in environments that are familiar to students of macroeconomics. This overview serves two purposes. First, it highlights the degree to which the exchange-rate implications of widely used macro models accord with the empirical characteristics of exchange-rate behavior. Second, it establishes a theoretical benchmark for judging the success of the new micro-based exchange-rate models presented in subsequent chapters.

The macro models we study have standard features. There are two countries, each populated by a large number of identical utility-maximizing households. In this chapter we study models where households have access to a rich array of financial assets. More specifically, we assume that they all have access to markets for a complete set of contingent claims. As a result, households are able to share risk completely. This feature has important implications for the behavior of exchange rates in both endowment economies (where output is exogenous) and in production economies (where output is determined optimally by firms). Another standard feature of the models we study concerns the role of money. Here we assume that households derive utility from holding real balances and that central banks have complete control of their national money supplies. This framework has a long tradition in the international macro literature. When combined with the implications of complete risk-sharing, it allows us to characterize the differences between the behavior of real and nominal exchange rates in a straightforward manner.

The final noteworthy feature of the models presented herein concerns the behavior of prices. Although “price-stickiness” plays an important role in many international macro models, in this chapter we focus on models in which all prices are fully flexible. In so doing, our analysis abstracts from the complications caused by the presence of frictions in both financial and product markets. The exchange-rate implications of these frictions are examined in Chapter 2.

1.1 Preliminaries

1.1.1 Definitions

The focus of our analysis is on the behavior of the nominal spot exchange rate, which we refer to as the spot rate. The spot rate, denoted by S, is defined as the home price of foreign currency. Throughout, we take the United States as the home country, so S identifies the price of foreign currency in U.S. dollars. According to this definition, an appreciation in the value of the dollar is represented by a fall in S because it corresponds to a fall in the dollar price of foreign currency. Conversely, a rise in S represents a depreciation in the value of the dollar. Defining spot rates in this way can be a source of confusion at first, but it turns out to be very convenient when considering the determination of spot rates from an asset-pricing perspective. For this reason it is the standard definition used in the international finance literature.

The spot exchange rate identifies the price at which currencies can be traded immediately. Forward rates, by contrast, identify the price at which currencies can be traded at some future date. The k-period forward rate at time t,

, denotes the dollar price of foreign currency in a contract between two agents at time t for the exchange of ...

Table of contents

• Cover
• Title
• Copyright
• Contents
• Preface
• Part I Macro Models
• Part II Microstructure Models
• Part III Micro-Based Models
• References
• Index