Open Economy Dynamics Exchange Rates Theories

Abstract

Exchange rate agreements are a nation’s set of rules that determine the international exchange value of the domestic currency and link a nation’s currency value to the currencies of other nations. Evolved out of the gold standard and the Bretton Woods pegged exchange rate system, today’s flexible exchange rates imply intervention by monetary authorities. Exchange rates are determined by the interaction of buyers and sellers, households, firms and financial institutions that buy and sell foreign currencies to make international payments in the foreign exchange market. If two parties agree to an exchange of bank deposits and execute the deal immediately, such exchange rates governing on the spot trading are called spot exchange rates. Covered interest parity (CIP) relates interest rates across countries and the rate of change between forward exchange rates and the spot exchange rate. Empirics and evidence show that the uncovered interest parity might not hold in actual markets. In contrast to uncovered interest parity, exchange rates tend to appreciate with a higher interest rate because of capital inflows. Carry trade and momentum trading tend to establish such a relationship. While the uncovered interest rate parity explains short run movements of exchange rates, the purchasing power parity (PPP) theory of the exchange rate determines long run market conditions. The purchasing power parity (PPP) appears as one of the most useful descriptions of the long-run exchange rate, when short-run relative price effects have worked themselves out or when inflationary forces dominate real changes. Tariffs, quotas and other restrictions on imports increase the relative profitability of traded goods and appreciate the equilibrium real exchange rate. A natural resource discovery increases the ratio of traded to non-traded goods and appreciates the real exchange rate. A faster rate of productivity growth in the traded goods sector relative to domestic non-traded goods and foreign traded goods appreciates the real exchange rate. Productivity growth differentials between tradable and non-tradable goods is important. A change in domestic consumer preferences towards traded goods depreciates the equilibrium. Home demand growth may be biased towards non-traded goods insofar as if the share of government spending in GDP increases and government spending is more biased to non-traded goods than is private spending, the equilibrium real exchange rate appreciates. If the home country accumulates net foreign assets, this allow it to enjoy interest income from the foreign country. The real exchange rate appreciates and the resulting payments deficit is financed by the interest income. Contrawise, an increase in net foreign indebtedness requires a payments’ surplus on goods account in order to service the foreign debt, which depreciates the exchange rate. A systematic divergence appears between a bilateral nominal and real exchange rates when comparing a developed country with a less developed country, which is known as the Balassa-Samuelson thesis. In addition to capital account transactions motivated by interest differentials, central bank intervention becomes important in keeping an exchange rate away from its PPP defined level. There is a linkage between foreign currency reserves and an extended Taylor-type optimal monetary policy rule for small open economies. Shrestha and Semmler (2011) therefore build a dynamic decision model with foreign currency reserves as a policy objective in the central bank’s loss function. By solving this model by the maximum principle and dynamic programming algorithm, Shrestha and Semmler (2011) show that the central bank could build up a buffer stock of foreign exchange reserves strategically useful to avoid speculative attacks on currency and possible financial crises, thereby enhancing the welfare of the economy.