CFA Level II: Economics – Exchange Rate Models

Current Account and Exchange Rates

Current deficits tend to lead to depreciation of the domestic currency. There are 3 mechanisms used to understand this effect.

The flow supply/demand mechanism states that current account deficits lead to excess supply of the domestic currency as net exporters convert revenues into their local currencies by selling the importer’s currency.

The portfolio balance mechanism says that net exporters tend to have portfolios of currencies denominated by a few currencies they “invest” their capital deficits into. When these exporting countries decide to rebalance their currency portfolio, this may cause significant depreciation in the net importing countries.

The debt sustainability mechanism described a situation when a net importer may be financing their capital account surplus through loans. When the countries debt-to-GDP ratio gets too high, capital flight might occur due to the increased risk of default, and the country’s currency will depreciate.

Mundell-Flemming Model and Exchange Rates

The Mundell-Flemming Model primarily describes the effects of monetary and fiscal policy in floating exchange rate regimes. It considers a high capital mobility condition and a low capital mobility condition.

In a high capital mobility situation, expansionary fiscal and monetary policy have opposite effects on the currency exchange rates. Currency depreciation will occur when expansionary monetary policy and restrictive fiscal policy take place.

In a low capital mobility country, expansionary monetary and fiscal policy will lead to currency depreciation.

Pure Monetary Exchange Rate Models

These two models focus on monetary policy and inflation as determinants of exchange rates.

The pure monetary model assumes that PPP holds, which means expansionary monetary policy leads to inflation and depreciation of the domestic currency.

The Dornbusch overshooting model states that a restrictive monetary policy leads to appreciation of the domestic currency in the short term and a slow depreciation toward the long-term PPP value, and vice versa.

Portfolio Balance Exchange Rate Model

The long term implication of sustained fiscal deficits is that currency will depreciate due to debt levels.

Signs of Impending Currency Crisis

  • Deteriation in terms of trade
  • Official FX reserves dramatically decline
  • Real exchange rates are much higher than the mean reverting level
  • Inflation increases
  • Equity markets experience a boom/bust cycle
  • Money supply increases relative to bank reserves
  • Private credit grows

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