Exchange rate volatility: Intraregime Volatility: Monetary Model
Exchange rate volatility
Exchange rate volatility: Intraregime Volatility: NOEM
Exchange rate volatility: Interregime Volatility
Intrying to explain intraregime volatility in terms ofmacroeconomic fundamentals, the monetary modelof the exchange rate has become something of aworkhorse. In essence this model posits that exchangerates are determined by the interaction ofmoney supply (usually assumed to be exogenous, i.e.,predetermined by the central bank) and money demand(which is a function of interest rates and incomelevels) terms between the home country and itstrading partners. Other things being equal, an increasein the home money supply leads to a proportionatedepreciation in the exchange rate.
In the flexible price version of the monetarymodel, exchange rate volatility is explained in termsof a ‘‘magnification effect’’ that arises because of thelink in the model between the current (spot) exchangerate and the future expected exchange rate(Bilson 1978). The model may be written simply as:
st ¼ft þEt st þ1, (1)
where st denotes the nominal exchange rate, ft is acomposite fundamental comprising home and foreignmoney supplies and income terms (suitablyweighted with income elasticities), and Etstþ1 is theexpected exchange rate in period tþ1. The expectedexchange rate in each future period of the life of theunderlying asset (money) is determined by expectedmoney supplies and expected income levels and sothe current spot exchange rate in thismodel becomesa function of current fundamentals (money andincome) in other words, period-t variables andthe expected fundamentals in all future periods.More formally, the current spot price is the presentdiscounted value of all expected fundamentals. Tothe extent that a current change in themoney supplysignals to agents an expected increase in future periodfundamentals, this can cause the exchange rate tomove bymore than the current change in the period-tfundamentals, ft . By simply observing the currentexchange rate and the current change in fundamentals,a magnified response of the former with respectto the latter will be seen. This is the so-called magnificationeffect.
The monetary model has also been used to demonstratethe implications that speculative bubbles or,more generally, any nonfundamental factor can havefor exchange rate volatility. A speculative bubbleor nonfundamental factor can be added to equation(1) as:
st ¼ft þEt st þ1 þbt ; (2)
where bt represents a speculative bubble termand canimpart exchange rate volatility over and above thatgenerated by themacroeconomic fundamentals.Thespeculative bubble can be a rational bubble, whichmeans it is consistentwith the underlyingmodel (i.e.,equation 1), or nonrational and therefore not necessarilyconsistent with anymodel. The introductionof a speculative term into the monetary model cangenerate excessive volatility of the exchange rate withrespect to the fundamentals (seeMacDonald 2007).