Page 16 - FINAL CFA II SLIDES JUNE 2019 DAY 4

LOS 11.k: Explain the potential effects of READING 11: CURRENCY EXCHANGE RATES: UNDERSTANDING EQUILIBRIUM VALUE
monetary and fiscal policy on exchange rates.

MODULE 11.3: EXCHANGE RATE DETERMINANTS, CARRY TRADE, AND
Fixed Exchange Rate Regimes CENTRAL BANK INFLUENCE

EMP (RMP) would lead to domestic currency depreciation (appreciation) as stated above. The government would then have to
purchase (sell) its own currency in the foreign exchange market. This essentially reverses the expansionary (restrictive) stance.

In the real world, governments cannot both manage exchange rates as well as pursue independent monetary policy. To manage
monetary policy, it must either let exchange rates float freely or restrict capital movements to keep them stable.

MONETARY APPROACH TO EXCHANGE RATE DETERMINATION

Monetary models only take into account the effect of MP on exchange rates (FP excluded). In Mundell-Fleming model, we
assume that inflation play no role in exchange rate determination. Under monetary models, we assume that output is fixed, so
that MP primarily affects inflation, which in turn affects exchange rates: 2 Main approaches:

Pure monetary model:
The PPP holds at any point in time and output is held constant. An EMP (RMP) leads to an increase (decrease) in prices and a
decrease (increase) in the value of the domestic currency (x% increase in the money supply leads to an x% increase in price
levels and then to an x% depreciation of domestic currency). This approach disregards expectations about future EMP or RMP.

Dornbusch overshooting model:
Assumes prices are sticky (inflexible) in the short term and, hence, do not immediately reflect changes in MP (i.e. PPP does not
hold in the short term). It concludes that exchange rates will overshoot the long-run PPP value in the short term.
• Given an EMP, prices increase, but over time; leads to a decrease in interest rates—and a larger-than-PPP-implied domestic
currency depreciation due to capital outflows. Long-term, exchange rates gradually increase toward their PPP implied values.

• Similarly, a RMP leads to excessive appreciation of the domestic currency in the short term, and then a slow depreciation
toward the long-term PPP value.