Page 185 - DECO503_INTERNATIONAL_TRADE_AND_FINANCE_ENGLISH

Unit 15 : Theories of Determination of Exchange Rate (PPP, Monetary)

Notes
() − k
m in any future period will equal ( ) . The current exchange rate, e (t) = (1/ ζ )  ⋅ ˆ mt  +
ˆ mt


() − ˆ m t
1/ (ζ η+ ) ⋅  mt () , fully reflects the component of the money supply that is thought to be


 
permanent, but is less strongly affected by the component of the money supply that is thought to be
() = −1/
( ) − ˆ m t
transitory. The expected change in the exchange rate, D e et   (ζ + η ) ⋅  mt ( ) , reflects
 


the expected disappearance of the transitory component of m. The information received by economic
agents between t and t + 1 is measured by difference between the actual level of m (t + 1) and the level
that was expected at time t. E (m (t + 1); t) = ( ) . A fraction, α , of this difference is attributed to an
ˆ mt
increase in the premanent component of m, and the remaining fraction, −1 α , is attributed to the
transitory component in m (t + 1), where the fraction α is an increasing function of the ratio of the
variance of disturbances to the permanent component of m to the variance of transitory disturbances
to the permanent component of m to the variance of transitory disturbances to m.
The unexpected change in the exchange rate,
() = ( { αζ + 
( + 1
( ) , reflects,
D u et  / )  ( −1 α ) (ζ η+/ ) }  ⋅ mt ) − ˆ m t 



as it should, the information received by economic agents between t and t + 1. Consistent with common
sense, this unexpected change in the exchange rate is greater the greater is then deviation of the
money supply from its expected level and the greater is the fraction of this deviation that is attributed
to a change in the permanent component of the money supply.
This example illustrates the key point that the nature of the stochastic process governing the behavior
of the exchange rate depends on the process generating the behavior of the money supply and on the
information about this process that is available to economic agents. In particular, this example
illustrates that the response of the exchange rate to a change in the money supply depends on the
extent to which this change was unanticipated and on the extent to which any unanticipated change
is thought to indicate a permanent change in the money supply.
Aside from its theoretical usefulness, however, the assumption that economic agents use their
knowledge of the (fixed) stochastic process generating the money supply as the primary ingredient
in forming the expectations necessary for determining the exchange rate is not likely to provide a
fully adequate empirical explanation of actual exchange rate movements. One likely reason for this
inadequacy is that economic agents use many sources of information, other than the observed money
supply series and other easily measured variables, in forming and revising their expectations
concerning future money supply behavior. For example, the depreciation of the French franc on the
day following the election of President Mitterand clearly was not due to any observed policy change
(registered in the behavior of the money supply or other variables) since President Mitterand did not
assume office until 3 weeks later. It must have been due to a change in expectations about future
policy resulting from the fact of his election.
Another important barrier to monetary explanations of actual exchange rate movements arises from
the lack of adequate measures of the exogenous factors affecting the demand for money and of
expectations concerning the future behavior of these factors. Almost certainly, there have been shifts
in the demands to hold national monies that are not accounted for either by changes in the traditional
arguments appearing in money demand functions (such as levels of national income) or by changes
in expectations about future exchange rate movements induced by changes in expectations about
money supply behavior. In theory, such demand shifts should play a role of coordinate importance
with changes in money supplies (and changes in expectations about future money) supplies in
determining movements in exchange rages. The inadequacy of measures of money demand shifts
means, therefore, that a substantial fraction of actual exchange rate movements will not be adequately
explained by monetary models.
One possible way around this difficulty is to adopt the view that changes in exchange rates which
cannot be explained by changes in the actual or expected behavior of money supplies must be due to

LOVELY PROFESSIONAL UNIVERSITY 179