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Exchange Rates II: The Asset Approach in the Short Run
This chapter develops the asset approach to short run exchange rate determination by linking UIP to a model of short-run interest rate determination. It then integrates the monetary model into the asset model to establish a unified model of exchange rate determination in the short and long run. It concludes by looking at fixed rates and discussing the trilemma.
The long run is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is past the ocean is flat again.
John Maynard Keynes, A Tract on Monetary Reform, 1923
1. The monetary model does well in explaining the long-run behavior of exchange rates, but not the short run. Return to the U.S.-Canada example from Chapter 14.
2. There are large deviations from PPP in the short run. This chapter develops the asset approach to exchange rates, which was developed as an alternative to the monetary approach in order to explain exchange rates in the short run.
3. The basic insight of the asset approach is that currencies are assets. In Chapter 13 we applied arbitrage arguments to derive UIP: expected returns of assets in different countries should be the same when denominated in the same currency. UIP characterizes the FX market in the short run.
4. The monetary approach assumes flexible prices, so it is better suited for long-run analysis. The asset approach permits sticky prices, so it is more appropriate for short-run analysis. They complement each other, and can be merged to create a complete theory of exchange rates.
5. The last part of the chapter adapts the model to fixed exchange rates.
As we saw in the last chapter, the monetary approach to exchange rates may work in the long run, but it is a poor guide to what happens in the short run. To recap this distinction, let’s return to the Canada–U.S. comparison with which we opened the last chapter—only this time we’ll focus on developments in the short run.
From March 2005 to March 2006, the Canadian price level (measured by the consumer price index) rose from 126.5 to 129.3, an increase of 2.2%. The U.S. price level rose from 193.3 to 199.8, an increase of 3.4%. U.S. prices therefore increased 1.2% more than Canadian prices. But over the same period, the loonie (Canadian dollar) rose in value from $0.8267 to $0.8568, an appreciation of 3.6%.1
Because Canadian baskets cost 2.2% more in loonie terms, and because each loonie cost 3.6% more in U.S. dollar terms, the change in the U.S. dollar price of the Canadian basket was approximately the sum of these two changes, or about 5.8%. Over the same period, however, the U.S. dollar price of U.S. baskets rose only 3.4%. Taking the difference, Canadian baskets ended up 2.4% more expensive than U.S. baskets, meaning that the U.S. real exchange rate with Canada rose by 2.4%, a real depreciation. This pattern was not unusual. In the previous year from March 2004 to March 2005, the real depreciation had been even larger, at 7.5%, so over two years Canadian goods rose in price by about 10% compared with U.S. goods.
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As we have already noted, evidence of this kind suggests that substantial deviations from purchasing power parity (PPP) occur in the short run: the same basket of goods generally does not cost the same everywhere at all times. These short-run failures of the monetary approach prompted economists to develop an alternative theory to explain exchange rates in the short run: the asset approach to exchange rates, the subject of this chapter.
The asset approach is based on the idea that currencies are assets. The price of the asset in this case is the spot exchange rate, the price of one unit of foreign exchange. To explain the determination of exchange rates in the short run, we can draw on what we learned about arbitrage. Recall from Chapter 13 that arbitrage plays a major role in the foreign exchange (forex, or FX) market by forcing the expected returns of two assets in different currencies to be equal. This insight led us to derive the uncovered interest parity (UIP) condition. Because it characterizes the forex market equilibrium in the short run, UIP is further explored and extensively applied in this chapter.
Compare the two models: Explain that the key assumption of the asset approach is short-run price stickiness. The monetary approach assumes flexible prices, which are appropriate to the long run. Emphasize that they are not inconsistent, and that we will soon integrate the two models to develop a unified model of exchange rate determination, in short run and long run.
The asset approach differs from the monetary approach in its time frame and assumptions. The monetary approach applies more to a long run of several years or even decades; the asset approach applies more to a short run of a few weeks or months, or maybe a year or so at most. In the monetary approach, we treat goods prices as perfectly flexible, a plausible assumption in the long run; in the asset approach, we assume that goods prices are sticky, a more appropriate assumption in the short run. Each theory is valid but only in the right context. Thus, rather than supplanting the monetary approach, the asset approach complements it, and provides us with the final building blocks necessary to construct a complete theory of exchange rates.
So far, we have assumed that exchange rates are determined by market forces in the goods, money, and forex markets—so our theory is relevant when the exchange rate floats, and the authorities leave it to find its own market-determined level. Can our theory also tell us anything about fixed exchange rates? Yes. At the end of the chapter, we see how the same theoretical framework can be applied to a fixed exchange rate regime.