Eco 365 Topic 3 Exchange Rates

ECO 365 - Topic 3Exchange Rates and the Short RunKunal DasguptaDasgupta (UofT) Topic 3 1 / 36OverviewThe monetary approach, based on PPP, works well only as a LongRun theory when prices are exible. But prices may fail to adjust in the Short Run (when prices are"sticky"), so the monetary approach is NOT valid for Short Runanalysis. In this topic, we develop the asset approach, which complements themonetary approach in providing a unied theory of exchange rates. Dasgupta (UofT) Topic 3 2 / 36Forex market equilibrium UIPThe (approximate) UIP condition is given byThis is thefundamental equation of the asset approach to exchangerates. This holds when the Forex market is in equilibrium. Dasgupta (UofT) Topic 3 3 / 36Forex market equilibrium ExampleFirst, let us look at the data. Dasgupta (UofT) Topic 3 4 / 36Forex market equilibrium ExampleNext, we plot the data. Dasgupta (UofT) Topic 3 5 / 36Forex market equilibrium Comparative StaticsAn increase in the home interest rate, i$ . Dasgupta (UofT) Topic 3 6 / 36Forex market equilibrium Comparative StaticsA decrease in the foreign interest rate, ie . Dasgupta (UofT) Topic 3 7 / 36Forex market equilibrium Comparative StaticsA decrease in expected exchange rate Ee$ =e .Dasgupta (UofT) Topic 3