Reading 5: Currency Exchange & Equilibrium

Page No. 119Date / /EconomicsReading 5 : Currency Exan changeRates: Understanding EquilbriumValue*IntroductionExerchange Rate : Price of one unit of currency in termof ath anotherSpot Exchange Rate: Exthange rate for immediate deliveryForward exch rate : Exch rate for a transaction to bedone in future$3Price CurrenyEBase CurrenyE- Dep$2$3$4€ - Appreciated$ - App€€-€ $ 7 Dep Spread = offer price - Bid pricePage No. 120It is also called as "pips"Date//-ForeignExchangeQuatationsQuoteonSwissfrancs(CHF)PerBid(0USDO952-0.9536(=0.9521=0.9521-36)CHF36DCHFisthebasecurrencyandUSDisthepricedcurreny(quotesDBid priceis$0.9521;askpriceis$ 0.9536CHFCHFSpread(indollar):0.9536-0.9521=USD0.0015( orIS"pips'=0.0015xExampleZAR# of deci52ZAR57For$YenuseX100$forpipsDAppreciation : Closing value% Dep : Opening valueOpening valueclosing value$. Apps":571= 9.62%Zar : Dep -5252I=8.77%57Bid-AskspreadonspotorforwardforeigncurrencyquotionBidAskBBBBank will BuyBank will SellBank always buy BidAsk > Bid Bid Ask speedPage No.121Ask.Bid-=Date//If base currency is bought ( party is said to have paid the offer-If base Currency is sold , party is said to have hit the bidInterbank Market:Where dealers buy & sell foreign exchamoung themselvesDBid-ask spread provided by a dealer to clients is widerthanbid-askspreadusedtointheinter bankmarket10 onSpreads are states as 'PIPs' IPIP =Imals10,000FactorAffectingSpreadBid - ask spreadSpot MarketBid-Askspreadinquoted to clientsinterbank marketSpread in the interbank marketfor two curfencies involvedCurrencies involved (liquidity)Direct relationship 7Size of the transactionhigh volume currency pairsHigher Size - Larger spreadDemandCommond lower spreadDirect relationship)Liquidity8am - 11am (NYC) & 13:00 to :00 (Londop)Relationship bet dealer & clientTime of day ( riquidity ) Most liquiddealer will give favorable latesNarrowspreadwhenbothNyLondonmarketsareopenMarket volatility (Risk)Higher volatility leads to higher spread Ask > Bid (pips)PrimiumCt)Page No. 122Ask Bid (Pips)DiscDate / /Forwardspreadsaretuelyrelatedto maturityLonger maturitycontracts-liquidCounterparty credit RiskInterestrateRiskTHUMB RULEUp the bidBDown the / ask& multiply& divideThisruleisveryhelpfulatthetimeofConversion of rate*HowtouseBid / Aid priceA TrickDButhowdoyouKnowwhetherthebidortheaskistheappropriaterate9Up-the-bidmultiply& down - the -ask , divideBid meansupdownAsk meansturning € into$€turning $ into € Page No. 123Date//Example : Using Bid 1 Ask pricesbidaskDealer quote : C AUD1.5060 - 1.5067up GBPCalculate the proceeds of converting I million GBPSincewearegoing"up"thequoteusebidfprice&multiply :-ImillionGAPX1.5060=1,506,000AUDCalculate the proceeds of converting I million AUD using askprice + I million AuD = 663, + 702.13 GBP1.5067Triangular arbitrage oppor tunityTwo artbitrage ConstraintsBid shown by a dealer inCross-rate - bids must be lowerthe interbank market can notthan the implied cross-ratebe higher than askasksCross RateTherateexch with rate bet" two Currencies implied by their exchaCommonthirdcurrency.Rales :(A)=bid( 8)Bbid( B) Cbid(B) =bid() Offer(B)=Ioffer(g)bid Page No.124Date/Example: SupposeyouhavetheUSD/GBPfollowingquotes:2 quotes /w commonCHF/ USDcurrencyo3currency(ThecommonThecurrencyisthe USD-crossratedefinesthevalueoftheGBPVstheCHFGiventhe0followingFXrates:Just algebraUSD 1.560 & CHF 1.4860GBPset up to quotes soUSDthe common currencycancel0CalculatetheGBPcrossexchrate.CHFUSDCHF=CHFGBPusoGBPD1.560USD1.4860 CHF = 2.3182 CHEGBPUSDGBPIfyouwantGBPtakethetreciprocalof2.3182 :CHFxGBP. 0.4314(2.3182)CHFExample: : Bid₹=:65.1020$=1-2/25Ask$652030€1.3135Calculatemarket-impliedbid-askquotes€onR Page No. 125Can only transact at dealers goutesDate//1Bid x Bid = BidAsx X Ask = Ask2Inverted bid = = New askInvertedask=NewbidNew bidNewask65,203x 1.3135 = 85.644165.1020X1.2125= 78.9361I=0.0116=0.012685.644178.9361Thetriangle:AVisualRepresentationDealerToconvertCHFinto GBP , there are two paths : 7 quotesPath # I : Exch CHF for GBP at (HF/ GBP x 2.3182Path #2 : Exch CHFforUSDatCHF/USD1.4.860andthenconvert theUSDintoGBPatUSD1.560GBPNo arbitrage requirement : The twopathstogetfromCHFtoGBPmustmustyieldthesameresults.D Visualize thecurrencytriangleUSDCHE uso . 14866CHFIGBPCKF23182GBPThe Triangle Reseprolcal of bid = offer pricePage No. 126Resprotcal of offer = Bid priceDate//Example:CrossRateswithBid-Ask - QuotesUSD # 0.60 - 0.6015USD 0.0933 - 0.0935 -AuDMXNComputeimpliedMXNcrossrates10.0933AUDRemember : Theequationneedstobe set up to cancel0the commoncurrency.MXN=1== 10.70MXN = 10.72USDbidUSD0.0935USDofferMXN0offeroffer>bidUSD0.60 - 0.6015MXN10-70-10.72AUDUSDBid X Bid = BideUSDDXMXN =MXNAsk X Ask = Ask,AUDUSDAuD0.60 USD X10-70 MXN = 6.42 MXN (bid)AUDUSDAuD0.6015 USD10.72 MXN, = 6.4481 MXN (ask)AUDUSDAUDofferDealingwithArbitrageQuestionsExamquestiondealingwitharbitragerevolvearoundthereissues : Page No. 127Date / /IVerify the arbitrage (does an opportunity exist meaning***quoted rate # calculate rate 1)2Structure the trade to exploit the opportunity (sell overvaluedat qouted rate buy undervalued) The direction is the key3Calculatetheprefitgivenaninitial investment (manystartwiththethirdcurrencysuchas USD)Bid too highfor dealerProblem : Triangular ArbitrageAsk too lowout of bizContinuing our example, if DealerquotesSure to goldMXN6.30 DoAuD6.3025DABid too highDB> CAStructerea profitable orbitrage tradeCross Rate6.420, / 6.4481Ask too lowDAKCB6.3025MXNAUD (Arbitrage trade)Sol": Recallthat the acrossbid laskquote:MXN = 6.420 } crossAUD6.9481 rateGoaroundthetriangleonewaytoseeifthereisarbitiage profitsanyIfnot , try the other way$100Up= bid ,100 0.606USDdown = ask divide0.600-6usand a 0933 >up=bidMXN/AUD 6 30251006.30.75AUDMXN0.0935MXN/ AUD 6.30 Big Page No. 128Date//Convert Im USD to MXN at USD0.0935Down - divide$1,000,000 = MXN 10, 695, 187MYN0-0935Convert MXNtoAUDatMXN6.3025Down-divideMXN 10,695,187 = AUD 1,696,975 AUD6.3025ConvertAUDto USDatUSD 0-60Up - multiplyAUD- AUD1,695,675 X 0.60 = USD 1,018,185- Profit=USD18,185or1.82%*TriangularArbitrageExampleBid : £=1.1189E = 0.7526$= 1.18 20DAsk£1.1213$0.7545€1.1824€ 891,822Price Currency$1,325,381Base CurrencyMultiply with Divide bybidaskE(up the$1054,133quote )( Down the£1,000,000quotes£1,000,000€1,120,976E 793,340E1,254,202 Page No. 129Date / /Spot Market Vs Forward MarketSpot rates:- Exchanges rates for immediate deliveryForward rate :- Exchanges rates for currency exchange on aspecified future date.- Typical for 30, 60 , or 90 days-Both parties are obligated to complete the transaction atthe future date(Bid - ask) Spread :- is calculated just as for spot rates- Typically forward spread > Spot spreadForward & Spot RatesForward prem / disc = F -SoCurrencyForward PremForward discF >SoF < SoBase(Forward prem=Forward rate - Spot rate >0 Premor discountDiscPipOften expessed as point (decimal X 10,000 typically)Forward disc : : Forward value < Spotvalue- Negative pointsForward prem : Forward value > Spot value- positive points Page No. (30Date / /Example : Find the forward CAD disc or prem for the followingAUD / CADSpot = 1-051U; 30 - day forward = +3.91.015194+4.1CAD Prem = 3.9 = 0.00039 - 0.0004110,000Forward= 1.0511 + 0.00391.01519 + 0.0004= 1.05149 - 1.05231Example: Bid : spot $ = 11820Forward points = -15.2Ask1-1824(3 month)-14.63 month forward bid rate = 1.1820 - 15.2 =1.180410,0003 month forward ask rate = 1.1824 - 14.6 =1.180910,000Example : Spot rate MXN = 19.26Forward rate MXN = 18.35USDUSDCalculate forward prem / discUSD disc : 0.91 = -4.72%18.35MXN prem:0.91 = 4.95%19.26 Page No. 13115th Dec' 2022 ThuesdayDate / /Forward Contract :Any exch rate P transaction that has a settlementdate longer than Tt2 -Forward prem / disc = Forward rate - Spot rateExample: Given a qoute of A/B + if F -5020 we say thatthe currency Bli-e the base currency) is trading atprem in the forward market.Market - to - Market ValueValue of a forward contract prior to its expirationV6 = (FPe - FP ( Contract size)+ R ( days360Here the days are no of days remaining to maturityof the forward contractForward prem / disc for a given Currency ExBid :-Spot $=1.1820Forward points (3M) = -15.2Ask€1.1824-14.63M forward bid rate = 1.1820 - 10,000 15.2 = 1.18043M forward ask rate = 1.1820 - 14.6 = 1.180910,000 Page No. 132Date//Ex 2 Spot rate MXN / USD = 19.26Forwardrate MXN USD = 18.35Calculate forward prem/discUSD disc : 0.91 = -4.72%18.35MXN Prem 0.91 = 4.95%19.26ForwardContract:-AnyexchratetransactionthathasasettlementdatelongerthanT+2ForwardpremLdisc= Forward late - Spot rateMarket - to - MarketValueofforwardAfter inception T a forwardcontractisvaluedassuminganoffsetting position is taken by the traderofH is sold selling - FuturetheVt = Value in (priceSP - Pur Priceunits of long currencyCurrency of the Vt =FP -FP )(Contract size)forward ContractbasdayIt360Days = no. of days toFVmaturity (T-t)FPE = Forward price(bidat timetfor a new contract maturingR= the int rate of theat time T (long Currency =base)price currency$Ce-Lary Page No. 133Date / /ExampleweYibislong IM CAD 90-days forward against Fx AUD & at1.05358 FPAuD / CADThirtydayslaterqoutesint(rates are as follows :-Spot1.0612 / 1.0614Int Rates:AUD=>30- day90-30=6030 - day1.12%+4.9/ 5.260- day+ 8.6 / 9060 - day1.16%90- day+16.6/16.890 - day1.20%180 day+423/48.3FPE 1.0612 t [8.6/10000]Compute : Mark - to- Market value of the Contract in AUDsolnoffsettingcontractwouldbetoconvert CAD for AUDusinga60-dayforwardpriceUsebidof1.0612t8.6 = 1-06 20610,000SPppVE =(1.06206 - 1.05358) C11,000,000 = t $8,463.64I0-0116)((5)M2M : Profit I LossthatisrealizedblefromclosingoutapositionForwardContract:1mlnGBPRate : 1.3000 USDTerm : 6 mothsSpot rate after 90 days : 1.3100 90-day forward GBP point :+1201.3105tlas90 days LIBOR 4% Page No. 134Date / /All-in three - month forward rate : 1.3100 t120)= 1.322010,000CF at the settlement date : 1.3220 - -1.300x1,000,000 = USD 22,000Market - to - Mark value : USD 220,000- USD 217,821It 0.04 X ( go 360 )Note :- Factors that affect the bid- - ask spread :Spread in the interbank market for two currencies involvedSize of the transactionRelationship bet dealer & clientTerm of the forward contract Clarger the term wider the spread)Covered Int Rate Parity (CIRP)CIRP:- Forward Prem / disc will just offset diff in int rateBig point #.1 : The Currency with the higher nominal intratewill trate at a forward discBig point #2 : When CIRP holds, an investor will make thesame return holding either currencyIf : The USD rate is 8% & the euro rate. is 6%Then : USD will trade at a forward disc of 2% relativeto the euro (if URP holders )W Page No. 135Date//Anyforwardprem or discexactlyoffsetsthediffintinrateSo thattheinvestorswouldearntthesamerate of returnF=ItiAbase currencyintrateinthedemoinatorSoliigTheformalCIRPrelationshipForward contract maturityAnSpot XIt Price currency(360= Forward ( zero arbitrage)+ [base currency B360no)A/BProblem : Convered Int ArbitrageSuppose:1- year int rate in USD =8.0%1.3X-}11.08 (100) # 1.35- 1-year int rate in euro = 6%- Current spot ratein USD / EUR = $1.3-QuotedUSD/EUR1-yrforward=$1.351.06#1.3X 1.081.35BarrowRequired106 $10.1.04low intrule-Calculate the corrects 1-yr forward late=0.02x1000-Describle the corrects arbitrage tradev20- Calculate arbitrage profits &borrowzailPage No. 136Lend &Date / /Borrow tLend EEUR marketis overvalued in the501"1-yrintrateinUSD=8%foward-yrintrateinEUR=6%ICurrentspotrateisusp=1-3Vsquute of 1.352EUR3Arbitiage free = 1.30 xI+0.08= $ 1.32454Forward rate[1 +0.06sellI in forward markeQouted USD/EUR of : 1.350 > 1.3245Invest or lending EuEURisoverpricedintheforwardmarketIwhy? Itshouldtakeonly1.3245USDtobuyaEURbut,thequited forward rate is1-35USDperEURopp at spetToday:tinspotBuyBuy low, Sell High- - Step 1 :- Sell EUR forward Vs USD, & buy EUR at spot Vs USDStep 2:BorrowUSD&investEURforlyrIn one Yr-UsetheinvestmentproceedsCEURtodelivertheagainstforwardcontract&transactionproceeds(uso)fromthetoforwardreplytheloanCash Flowst=0:1Borrow$1000at8%2Convert$1000at(repay$1080 in one yr)spot$1.30 10 = € 769.233Invest€769.23at6%(receive $ 815.38 in one yr)4Sell €815.38 forward@$1.35/€ (prcoccods of $1,100.76)NetOF=0(onlyborrowedfundsused!) RuDRffp / only does long not hold in Mont RayPage No. 137Date / /Cash flow t=1 yr later :1 Receive investment proceeds of € 815.382 Settle forward by delivering 815.38 & receiving 1100.763 Repay loan of$10804 Arbitrage profit = $1100.76 - $ 1080 = $20.76same good should cost same in diff Country after adj exch rateRelative PPPB =BaseUnconvered Int rate parity ECTTB) ECTTA) - Diff +veSpot=>Relative PPP : Changes in exchange rate will just offsetexch cate is Changes in price levels (ie diff in inflation)funtion of inflation bet" 2 CountriesEx - ante E (%DS) (A/B) = EITTA) - E(TB) -Diff in expected inflationCountries with higher (relative) inflation expect to see theircurrencies depreciate (by the inflation diff)Uncovered - not bound by arbitragei.if forward currency contracts are not available orifCapital flows are restricted so as the to preventarbitrage f this situation is called as the uncoveredInt rate 6 parityAssumption- Investor are risk neutralEx -ante version of PPPSame as relative PPP but uses expectedInflation of actual inflationthen uncovered int rate parity will also holdex -ants version of PPP as well as international Fisher relation hold Page No. 131Date//Absolute pppParityRelative PPPCoveredUncoveredDerives the nov-arbitragederives . the expected futureforward ratesepot rateAssumed by arbitrageNot bound by arbitrageForward Rate. : F = expected future spot rate, use say that forwardIParityrate is an unbiased est of the futurespot rateif uncovered int rate parity holds forwards rate parityalso holdsInternational Parity ConditionsRiskis0International Fisher Relation (IFR)same globallyAssuming real ratesare Constantreal rate purity)RA - RB = E(TTA) - E(TTB)Ci.e int rate differencial - inflation diff)it Nominal Int Rate = (It Real int rate) ( It Expected inflation)Domestic Fisher Relation:InfationR = r + E (II)Nominal IntReal intRaterate Page No. 139Date / /* Uncovered Int Rate Parityexch rateDiff in int latea are equal to diffin expecte dchanges inRelativeformPPP + InternationalFisherrelation=UncoveredintintoparityLinks spot exch rates T expected spot exch rates, &b nominal int rateR$ = 8%ECADS)=RA - RBRE = 6%AIBCovereddisc for $= 2%UncoveredE (A$)=-2%SimilarityForward is unbiased predictor of Spot ratesCovered&uncovered IRP are relatedWhy ! Because y F= E(S,) if forward rate parity holdersUncovered IRP : Forecast future spot = ECS1)Remember this is a non-trade priceCovered IRP : Calculate the forward rateFAll the elements are tradable (S.F, is, (f)Covered IRP is bound by arbitageAbsoute PPP = F price lvl in D cassing = D country price basket 1vl-law of One plice, rather except it is conceinsaofaddthan sig single good Page No. KoDate / /International Parity Relation3VForward discForward rate parity !Exch rate expectations.movementsor premhadsUncovered intCovered int parityrate parityRelative purchasing power panilInt rate differentialsinflation rate differentialInternational Fisher effects4!Un covered IRP holds itIF = ECS,)AKAforwardrateparityOR2PPP AND IFR hold,Fintree ExampleDetermining Forward Rate750USA$India27.10%$ 1mln50mln$ /m/n+ 27.int10%$ 1-02mln255 mln,<53.9255&₹55 mln53.921.02 Page No. 141Date / /Forward rate = S x (1 + Int rate )Clt Int rate)"Forward rate = 50 X Cl 10x)(1+2). )city= 53.92Int Rate ParityInt rate (Ind) = 20%Int rate (USA) = 10%F= S. X Cl + lnt rate) = ₹54.54#50(1+1nt rate)"$Expected spot = (0 x(1.1538) = ₹ 54.5°rate(1.05 76)Real intInflation RateRate = 47.Ind = (1+20%) = 15 38%at 4%)USA = 107.) = 5.76%(It 4%)Covered int :ForcedbyafbitrageItisalwaystruelate parityF, = S x (Itil(HTSUncovered int rate: Not forced by arbitrage H may not be trueparityECS.) =(Ltrltr Page No. 142Date / /Ex : Spot rate : $1.2€1-yr forward rate : $1.3 €USD int rate :9% Euro int rate: 7%1.3 = 1.2(1.09)Determineifanarbitrageopportunityexists.(1-07)1.07 = 1.21.07XSoln Forward rate = 1 + USD int rate1.07Spot rateI t Euro int rate10771.222Forward rateItEurointrateVsI + USD int rateSpot rate1.3 X I ot7%VsI+9%1.211591 Vs 1-09Invest = 0.069 per 100 BorrowECoveredint rate Parity:Nominal int rate - Nominal int rate = 7. Forward plem / discUncovered int rate parity :Nominal int rate - Nominal int rate B = Expected % D spot rate.Both Covered & Uncovered int rate parity :Forward exch rate will be an unbiased predictor of the future spotials% Ex ante purchasing power parity :A spot rate = Expected inflation - Expected inflations Page No. 143Date//Fisher Effect :Naminal int rateA -Nominal int rate = Expected inflat" - Expected inflat'sBoth ex ante PPP & fisher effects(Notical int rateA - Nominal int rates) % A spot rate = Expected infationaExpected infath BUse of international parity ConditionsFuture Spot RateForward exch ratesEst using purchasing powerEst using covering int parityparity / un covered int rate parityForced by arbitrage and isNot forced by arbitrage and doesalways truenot work in the short termif uncovered int rate parity holds then covered int rateparity holds (forward exch rate is an unbiased predictorof the future spot rate)Carry Trade Profitable of Forwarde rate is biased est of futur spotifuncovered int rate parity does not work in the shortrateterm one Can profit by investing in higher yieldingcurrency and borrowing in lower yielding currency.Assume that USD int rate = 1% while GBP int rate =3% &spot 450/ABP = 1.5 & is expected to remain the sameat the end of the yr Page No. 194Actual W dep" by 3%Date / /Return = Int earned on invest - funding cost - Currency dep= 3% - 1% - 0%= 2%Investor borrows in lower yielding currency (funding Currency)and invests in higher yielding currency and hope thathigh yielding currency will dep less than int ratedifferentialIt assumes that uncovered int rate parity does not workin the short termCarry trade generates tve returns durings the periods of lowvdalitityRisky of Carry TradeCarry trade is a leveraged bet Magnifi risk /setvinCash Risk : Due to non-normal distribution of Carry trude returnsIn times of higher volatility the country with the higherint rate typically sees its currency dep by a greateramt than uncovered IRP suggests.0-Ve sekewness and tve excess Kur tosis of return distributionNon - normal , more peaked , fatter tails & -ve skowenessprob of larger loss is higher ( elicrash risk of the carry trade) PageNo. 145Date//1Profitable only if uncovered int rate parity does not holds2Funding currency may appreciate Signifiantly against thecurrency of the invest* Balance of Payments AccountsCurrent Account Influences:Price desticity of demand Size of initial deficit1Flow mechanism - Influence of XA rates on domestic imports & export pieIncrease the supply of that Currency In the marketsand hence puts downward pressure on the exch valueof that currenyCurrent account It Supply :- Appreciation of CurrencyCurrent account Deficit o- Dep of currencylawes intial for deficits with import export prices sensitiv to exch rate movAppreciation / Dep of currency would help eliminatethe initialimbalance in the long run Imports & exports with highPrice clast2Portfolio Composition mechanismThe current Alc deficient will usually offset the capital A/c surplesCountries with Current account deficits usually have Capitalaccount surplusesInvestor Countries portfolio composition is dominated by fewinvestee countrieslead to dep of investee countries currenciesinvestor countries decide to reduce the holding it canDeficits eventually cause Curry to dep Page No. 196Date//Currunt A/C Cant last fover3Debt sustanability ChannelWhen lul of debt goes too high relative to GDP theremay be a rapid dep of the borrower's currencyCapital account surplus means borrowing > lendingFor deficit countries, rising debt / GDP ratio will lead toFor surplus countries rising assets / GDP ratio will lead todep of currencyapp of Currency.Capital (Fiancial) accountCapital account flows are determined by relative real rates ofreturn Higher real rate countries attract capital flows & hence,appreciation of domastic currencyExcessive (sopeculative) Capital flows can lead to excessive realapprectation and can be problematic for Some emerging marketeconomicsExcessive emberging market capital inflows createproblems such as:-Unwarranted appreciation of the EM currencyIncreases in external debtAn asset bubbleExcessive Consumption that contributes to huge growth in domesticcredit and or current account deficitOverinvest" in risky pro jests B = BorrowingR Int RateReal ratePage No. 147is DomesticDate / /5(9)* Potential effects of monetary & fiscal policyMundell Flembing model (ST)Impactsof inflation not modeled (focuses on int rate)Capital mobilityMonetaryFiscal PolicyHighLowRV it &E(2)BP,RT,IT, E(S)ExpansionaryUncertainDepExpansionaryExpensionaryDepUncertainContractionaryContractionaryApp"UncertainExpansionaryContractionaryContractionaryUncertainAppRTCT E(b)Rt rt E(s)JCapital MobilityInt Ratelost doest mall utHighTrade flow LowmatterExpansionaryExpansionaryExpan sionary monetary &Monetary policyFiscal PolicyFiscal policyAggregate demandInt Ratesgovt borrowingin net importsExportsInflow of CapitalInt RatesdepDep DLAppDDContractionary:- ADV timports Exports Page No. 148Date / /Monetory Approach to ExchRate Determination (Inflation impact)Pure Monetary ModelDornbusch overhooting modelPPP holds at any point inprices are sticky i.e inflexible in thetime & output is held constantshort term (PPP does not hold in theshort term )Expansionary monetary policyprices & it value of CurrencyExpansionary monetarypolicyintrates & a larger thanPPP implieddep" of the domestic currencyinflation excessive depMundell Flaming & PortfolioBalance approachShort TermLong- TelmLiWith free capital flows fGovt has to reverse course leadingexpansionary fiscal policy leadsto depto Currency app" via higherint ratesif it doesn't reverse Course itAppriciationwill have to monetire its debt Lprint money) again leading to dep"tep Page No.149Date/FixedExchforexResetupRateNeed$*Regimesto main ageMundell - Fleming model predicts exch rate movements underflexible exch rate systemsUnder fixed exch rate systems t the dep of local currencyunder an expansionary monetary policy (high Capital mobility)would necessitate the govt buying back of its own Currency(offsetting the expansionary stance )Can't have independent monetary policy under fixed ratesystem.tPure Monetary Modellag) Dornbusch Modified ModelX7.in money supply lead toShort Run:- Prices have limitedanXYin price lul & thenflexibility and domestic currencyan Xx dep of domestic Currencydep" PPP does not holdShort coming :- Assumption that PPPLong Run:- Price will&,holds both in short term &Domestic Currency will appriates &long termMove toward values predicate dby conventional monetary approachPortfolio Balance Approach (LT)Mundell- - Fleming model looks at short term implications offiscal policy.Partfalio balance approach looks at long - term implications of fiscalpolicy In the long term, govt may find it increasingly difficultfind Sustained deficits, leading to dep of the currencyEventually Page No. 150Date / /Objectives of Central bank or govt intervation and capital LookieObjectiveEnsure that the domestic currency does not appreciateexcessivelyReduced the aggregate volume of inflow of foreign CapitalAllow the pursuit of independent monetary policy withoutbeing hindered by their impact on currency valuesEffectivenessCentral bank Can interveng in FX markets or policy marketsCan employ Capital controls.Effectiveness of intervention in FX markets depends on thesize of central bank reserve relative to trading volumeof their currency. Usually not effective for developedCountriesDeveloped CountriesEmerging market countriesForeign exch reserveForeign exch reserveCurrency trading volumeCurrency trading volumeLowRelatively HighLess ability to manageexch rateSome ability to manageexch rate Page No. 151Date / /Warnings Sign of Curreny CrisisTerm of trade deteriorateDiamatic decline in official foreign exch reservesCurrency value rises above historical mean MRLInflationincreasesLiberalized Capital market ( Free flows of Capital)Money Supply relative to bank reserves increaseBanking crisis ( an be coincident) Nominal credit relativeBoom - bust cycle equity marketto bank reserveReal exch rate substantially higher than its mean -reverting lulDramatic decline in foreign exch reseves.Deteriortion in term of trade Cratio of exports to imports)