Question

Go to the internet and find a news article published within the last three months that discusses macroeconomic effects of exchange rates, summarize key points and post in the Discussions area.

Answer 1

https://www.ecb.europa.eu/press/key/date/2017/html/ecb.sp171103.en.html

- The author makes two propositions:

a. There is an empirical evidence that central bank asset purchase programmes are often associated with substantial cross-border capital flows.

b. Asset purchases affect exchange rate in the same way as monetary policy - through expectations of interest rate differentials.

- The author discusses the second propsition in detail.

- Uncovered Interest Parity (UIP): It predicts a correation between today's interst rate differntials and tomorrow's exchange rate changes. However, the asset market approach to exchange rates is in opposition to UIP. The apprach suggests that as an asset price, exchange rates should fully reflect today’s expectations about the future, just as equity prices reflect the expected discounted stream of future earnings and other relevant information. The implication is that the current level of the exchange rate should be a function of the average of current and future expected short-term interest rates.

- Empirical evidence suggests that monetary policy, by influencing short-term interest rate differentials, could directly affect the exchange rate and, hence, real activity and prices.

- The dollar defied upward pressure, however, it continued to depreciate persistently, despite the marked widening in future expected interest rates. One reason why this might have been the case is that the signalling and the portfolio rebalancing channels of asset purchases might have worked in opposite directions. In imperfect markets, investors may give different weights to conflicting information.

- Asset purchases are monetary policy actions that can be anticipated by market participants, just like changes in key policy rates. Unlike conventional monetary policy, however, they have direct implications for the expected supply of and demand for internationally traded bonds and, hence, for the level of the exchange rate that, all other things being equal, clears the resulting capital flows.

- In an integrated global financial system, unconventional policy measures have been shown to often trigger large cross-border capital flows. To the extent that such policies can be anticipated by market participants, financial intermediaries could be expected to price in the resulting shift in the relative supply of and demand for currency before capital flows take place. As a consequence, international portfolio rebalancing considerations may, at times, drive a wedge between expected future short-term rates and the exchange rate.

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