Exchange Rates, Monetary Policy, and Sovereign Risk

Luiz Felipe L. E. do Amaral

(leitees2@illinois.edu)
Department of Economics - University of Illinois at Urbana-Champaign

March 4, 2016

Luiz Felipe L. E. do Amaral (leitees2@illinois.edu)

Exchange Rates,
(Department
Monetary of
Policy,
Economics
and Sovereign
- University
March
Riskof4,Illinois
2016 at Urbana-C
1 / 26

I. Introduction

Introduction

Perhaps the most important variable in international economics is the

exchange rate.
In this lecture, well build a model of exchange rate determination.
Moreover, well see how this model can be used to:
1. Study how monetary policy affects the exchange rate.
2. Study how sovereign risk affects the exchange rate.

Luiz Felipe L. E. do Amaral (leitees2@illinois.edu)

Exchange Rates,
(Department
Monetary of
Policy,
Economics
and Sovereign
- University
March
Riskof4,Illinois
2016 at Urbana-C
2 / 26

II. Definitions

Exchange Rates

It is useful to start with some definitions.

Exchange rates are the relative price of one currency in terms of
another.
They are called exchange rates because they are rates of exchange
between currencies.
Here in the U.S. we can interpret exchange rates as the price (in
U.S. dollars) of other currencies (e.g., euros, yen, pounds,...).

Luiz Felipe L. E. do Amaral (leitees2@illinois.edu)

Exchange Rates,
(Department
Monetary of
Policy,
Economics
and Sovereign
- University
March
Riskof4,Illinois
2016 at Urbana-C
3 / 26

II. Definitions

Exchange Rates

Exchange rates are quoted as foreign currency per unit of domestic

currency or domestic currency per unit of foreign currency.
How much can be exchanged for one dollar? U89.40/US$.
How much can be exchanged for one yen? US$0.011185/U.
Exchange rates also change over time.
If a currency becomes more valuable it is said to appreciate.
Other currencies then become cheaper.

If a currency becomes less valuable, it is said to depreciate.

Other currencies then become more expensive.

Luiz Felipe L. E. do Amaral (leitees2@illinois.edu)

Exchange Rates,
(Department
Monetary of
Policy,
Economics
and Sovereign
- University
March
Riskof4,Illinois
2016 at Urbana-C
4 / 26

II. Definitions

Exchange Rates
Figure 1: Exchange Rates

Luiz Felipe L. E. do Amaral (leitees2@illinois.edu)

Exchange Rates,
(Department
Monetary of
Policy,
Economics
and Sovereign
- University
March
Riskof4,Illinois
2016 at Urbana-C
5 / 26

II. Definitions

Monetary Policy
All over the world, Central Banks determine the amount of currency
circulating in the economy, this is the money supply, M S .
On the other side of the market, households and firms determine the
money demand: M D = P L(R, Y ).
Part of the money demand is the real demand for liquidity,
L(R, Y ): the amount of currency in real terms i.e., measured in
goods and services instead of dollars that agents want to hold.
It depends negatively on the interest rate, R: the larger the interest
rate, the more agents will want to keep their wealth in
interest-earning deposits and not in currency.
It depends positively on income, Y : the larger the income, the more
agents will want to consume and, therefore, they will need to carry
more currency.

Part of the money demand is the price level, P : higher prices

imply that agents must carry more currency to buy the same
basket of goods.

Luiz Felipe L. E. do Amaral (leitees2@illinois.edu)

Exchange Rates,
(Department
Monetary of
Policy,
Economics
and Sovereign
- University
March
Riskof4,Illinois
2016 at Urbana-C
6 / 26

II. Definitions

Monetary Policy

Together, the money demand and the money supply make the money
market.
The money market is in equilibrium when the money demand is
equal to the money supply:
M D = M S P L(R, Y ) = M S

MS
= L(R, Y )
P

This equilibrium determines the equilibrium interest rate.

Luiz Felipe L. E. do Amaral (leitees2@illinois.edu)

Exchange Rates,
(Department
Monetary of
Policy,
Economics
and Sovereign
- University
March
Riskof4,Illinois
2016 at Urbana-C
7 / 26

II. Definitions

Monetary Policy
Figure 2: Determination of the Equilibrium Interest Rate

Luiz Felipe L. E. do Amaral (leitees2@illinois.edu)

Exchange Rates,
(Department
Monetary of
Policy,
Economics
and Sovereign
- University
March
Riskof4,Illinois
2016 at Urbana-C
8 / 26

II. Definitions

Monetary Policy
The money market equilibrium depends on the money supply, which is
determined by the Central Bank.
Changes that the Central Bank make to the money supply are
called monetary policy.
When the money supply increases, the monetary policy is
expansionary.
An expansionary monetary policy decreases the interest rate.
When the money supply decreases, the monetary policy is
contractionary.
A contractionary monetary policy increases the interest rate.

Luiz Felipe L. E. do Amaral (leitees2@illinois.edu)

Exchange Rates,
(Department
Monetary of
Policy,
Economics
and Sovereign
- University
March
Riskof4,Illinois
2016 at Urbana-C
9 / 26

II. Definitions

Sovereign Risk

Sovereign risk is the risk that a government could default on its debt
(sovereign debt) or other obligations. Also, the risk generally
associated with investing in a particular country, or providing funds to
its government. Also called country risk.

Luiz Felipe L. E. do Amaral (leitees2@illinois.edu)

Exchange Rates,
(Department
Monetary of
Policy,
Economics
and Sovereign
- University
March
Riskof
4, Illinois
2016
at 10
Urbana-C
/ 26

III. Exchange Rate Determination

The Foreign Exchange Market

The market in which international currency trades take place is called
the foreign exchange market.
The main participants are commercial banks, non-bank financial
institutions, non-bank businesses that operate internationally, and
central banks.
But buying and selling in the foreign exchange market are
dominated by commercial and investment banks (interbank
trade)
It takes place in many financial centers, but is concentrated in major
cities like London, New York, Tokyo, Frankfurt and Singapore.
It moves daily an amount of US$4 trillion dollars (April 2010). In April
1989, this value was US$600 billion.

Luiz Felipe L. E. do Amaral (leitees2@illinois.edu)

Exchange Rates,
(Department
Monetary of
Policy,
Economics
and Sovereign
- University
March
Riskof
4, Illinois
2016
at 11
Urbana-C
/ 26

III. Exchange Rate Determination

The Foreign Exchange Market

Since the foreign exchange market looks very much like a global market
for a financial asset, it is natural to model exchange rates as assets.
Then, factors that affect the demand for assets should also affect
the demand for foreign currency.
But what affects the demand for an asset?
Return.
Risk.
Liquidity.
To keep things simple, lets assume (for now) that all currencies bear
the same risk, and are equally as liquid, so that we can focus on the
rates of return.
The rate of return of a currency (say, the euro) is just the interest
rate on euro deposits.

Luiz Felipe L. E. do Amaral (leitees2@illinois.edu)

Exchange Rates,
(Department
Monetary of
Policy,
Economics
and Sovereign
- University
March
Riskof
4, Illinois
2016
at 12
Urbana-C
/ 26

III. Exchange Rate Determination

Exchange Rates and Asset Returns

However, is it enough to compare interest rates between two
currencies?
In other words, should individuals simply hold their wealth in the
currency with the highest interest rate?
Suppose that the dollar interest rate is 2% per year and the euro
interest rate is 4% per year. Suppose that the exchange rate today is
$1/e, and in a year it is expected to be $0.97/e. Should agents hold
their wealth in dollars or in euros?
A year from now, a $100 deposit in dollars will be worth $102
($100 1.02 = $102).
But how much will a $100 deposit in euros be worth?

Luiz Felipe L. E. do Amaral (leitees2@illinois.edu)

Exchange Rates,
(Department
Monetary of
Policy,
Economics
and Sovereign
- University
March
Riskof
4, Illinois
2016
at 13
Urbana-C
/ 26

III. Exchange Rate Determination

Exchange Rates and Asset Returns

Suppose that today an agent with $100 makes a deposit in euros.
Since today the exchange rate is $1/e, a $100 deposit in euros is
worth today e100.
Since the deposit is in euros, it will earn the euro interest rate.
Thus, in a year, this deposit will be worth e104.
However, a year from now the exchange rate is expected to be
$0.97/e. Therefore, in a year e104 will be worth $100.88
(0.97 104 = 100.88).
Even though euros pay a higher interest rate, by the end of the year
dollar deposits are worth more than euro deposits.
In fact, the return on a dollar deposit is 2%, whereas the return on
a euro deposit is (100.88 100)/100 = 0.88%.

Luiz Felipe L. E. do Amaral (leitees2@illinois.edu)

Exchange Rates,
(Department
Monetary of
Policy,
Economics
and Sovereign
- University
March
Riskof
4, Illinois
2016
at 14
Urbana-C
/ 26

III. Exchange Rate Determination

Exchange Rates and Asset Returns

So, a year from now, those who invest in dollars will have earned a 2%
return, whereas those who invest in euros will have earned a 0.88%
return.
Can this be an equilibrium?
No! Otherwise, no one would hold euros.
In equilibrium, the return on dollars must be equal to the return on
euros (when they are both measured in terms of the same currency).

Luiz Felipe L. E. do Amaral (leitees2@illinois.edu)

Exchange Rates,
(Department
Monetary of
Policy,
Economics
and Sovereign
- University
March
Riskof
4, Illinois
2016
at 15
Urbana-C
/ 26

III. Exchange Rate Determination

Exchange Rates and Asset Returns

The return on dollars (measured in dollars) is simply the dollar interest
rate, R.
The return on euros (measured in dollars) is more complex, and
comprised of two terms:
The interest rate on euros, R .
By how much the euro is expected to appreciate against the dollar,
e E
E$/e
$/e
,
E$/e

where E denotes the exchange rate of euros in terms of

dollars (i.e., the price of euros).
Then in equilibrium we have the so called interest parity condition:
R = R +

e
E$/e
E$/e

E$/e

Luiz Felipe L. E. do Amaral (leitees2@illinois.edu)

Exchange Rates,
(Department
Monetary of
Policy,
Economics
and Sovereign
- University
March
Riskof
4, Illinois
2016
at 16
Urbana-C
/ 26

III. Exchange Rate Determination

The Interest Parity Condition

Lets understand the interest parity condition better.
Suppose that it doesnt hold.
e
In particular, assume that R > R + (E$/e
E$/e )/E$/e .
Then, the return on dollars in higher than the return on euros.
As a consequence, no one will want euros, so people will want to
trade euros for dollars.
As people trade euros for dollars, the exchange rate (i.e., the price
of euros, E) falls.
As E falls, the expected appreciation of the euro,
e
e /E
(E$/e
E$/e )/E$/e , increases (it is equal to ((E$/e
$/e ) 1).
Therefore, the return on euros increases.
e
The process is the opposite if R < R + (E$/e
E$/e )/E$/e , so that in
this case the return on euros falls.

Luiz Felipe L. E. do Amaral (leitees2@illinois.edu)

Exchange Rates,
(Department
Monetary of
Policy,
Economics
and Sovereign
- University
March
Riskof
4, Illinois
2016
at 17
Urbana-C
/ 26

III. Exchange Rate Determination

The Equilibrium Exchange Rate

Figure 3: Determination of the Equilibrium Dollar/Euro Exchange
Rate

Luiz Felipe L. E. do Amaral (leitees2@illinois.edu)

Exchange Rates,
(Department
Monetary of
Policy,
Economics
and Sovereign
- University
March
Riskof
4, Illinois
2016
at 18
Urbana-C
/ 26

IV. Monetary Policy and Exchange Rates

Monetary Policy and Exchange Rates

How can monetary policy affect the exchange rate?
Through its effect on interest rates.
Figure 4: Money Markets/Exchange Rate Linkages

Luiz Felipe L. E. do Amaral (leitees2@illinois.edu)

Exchange Rates,
(Department
Monetary of
Policy,
Economics
and Sovereign
- University
March
Riskof
4, Illinois
2016
at 19
Urbana-C
/ 26

IV. Monetary Policy and Exchange Rates

Monetary Policy and Exchange Rates

Figure 5: Simultaneous Equilibrium in the U.S. Money Market and
the Foreign Exchange Market

Luiz Felipe L. E. do Amaral (leitees2@illinois.edu)

Exchange Rates,
(Department
Monetary of
Policy,
Economics
and Sovereign
- University
March
Riskof
4, Illinois
2016
at 20
Urbana-C
/ 26

IV. Monetary Policy and Exchange Rates

Monetary Policy and Exchange Rates

Consider an increase in the supply of U.S. dollars:
If the supply of dollars increase, in the U.S. money market, the
U.S. interest rate will fall.
The fall in the dollar interest rate decreases the return on dollars,
decreasing the demand for dollars. Thus, the dollar depreciates
(E$/e increases).
Finally, consider a increase in the supply of euros.
If the supply of euros increase, in the E.U. money market, the
E.U. interest rate will fall.
The fall in the euro interest rate decreases the return on euros,
increasing the demand for dollars. Thus, the dollar appreciates
(E$/e decreases).

Luiz Felipe L. E. do Amaral (leitees2@illinois.edu)

Exchange Rates,
(Department
Monetary of
Policy,
Economics
and Sovereign
- University
March
Riskof
4, Illinois
2016
at 21
Urbana-C
/ 26

IV. Monetary Policy and Exchange Rates

Monetary Policy and Exchange Rates

Figure 6: Effect on the Dollar/Euro Exchange Rate and the Dollar
Interest Rate of an Increase in the U.S. Money Supply

Luiz Felipe L. E. do Amaral (leitees2@illinois.edu)

Exchange Rates,
(Department
Monetary of
Policy,
Economics
and Sovereign
- University
March
Riskof
4, Illinois
2016
at 22
Urbana-C
/ 26

IV. Monetary Policy and Exchange Rates

Monetary Policy and Exchange Rates

Figure 6: Effect of an Increase in the European Money Supply on the
Dollar/Euro Exchange Rate

Luiz Felipe L. E. do Amaral (leitees2@illinois.edu)

Exchange Rates,
(Department
Monetary of
Policy,
Economics
and Sovereign
- University
March
Riskof
4, Illinois
2016
at 23
Urbana-C
/ 26

V. Sovereign Risk and Exchange Rates

Sovereign Risk and Exchange Rates

The preceding analysis is based on the assumption that all currencies
bear the same risk.
What are the consequences of dropping this assumption?
We start with two assumptions:
1. Euros are riskier than U.S. dollars.
2. The interest parity condition holds:
R = R +

e
E$/e
E$/e

E$/e

Can this be an equilibrium?

No! If the return (in dollars) of euros and dollars are the same,
but euros are riskier, no one will hold euros.

Luiz Felipe L. E. do Amaral (leitees2@illinois.edu)

Exchange Rates,
(Department
Monetary of
Policy,
Economics
and Sovereign
- University
March
Riskof
4, Illinois
2016
at 24
Urbana-C
/ 26

V. Sovereign Risk and Exchange Rates

Sovereign Risk and Exchange Rates

So investors will not hold euros because they can earn the same return
holding dollars while bearing a smaller risk.
Therefore, to convince investors to hold euros, the return on euros
must be higher than the return on dollars, that is euros must pay
a risk premium relative to U.S. dollars.
Denote this risk premium by , what will the equilibrium look like?
The foreign exchange market will be in equilibrium if the return
on dollars is equal to the return on euros plus the risk premium.
The interest parity condition then becomes:
R = R +

e
E$/e
E$/e

E$/e

Luiz Felipe L. E. do Amaral (leitees2@illinois.edu)

Exchange Rates,
(Department
Monetary of
Policy,
Economics
and Sovereign
- University
March
Riskof
4, Illinois
2016
at 25
Urbana-C
/ 26

V. Sovereign Risk and Exchange Rates

Sovereign Risk and Exchange Rates

Some questions remain unanswered:

What determines ?
Should be larger the more risky a currency is?
Should it be smaller the more international reserves the Central
Bank owns?

How can monetary policy affect the exchange rate when there is
sovereign risk?
How can the Central Bank reduce sovereign risk? Should it do so?
These are all question for another time...

Luiz Felipe L. E. do Amaral (leitees2@illinois.edu)

Exchange Rates,
(Department
Monetary of
Policy,
Economics
and Sovereign
- University
March
Riskof
4, Illinois
2016
at 26
Urbana-C
/ 26