International Economics
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Dominick-Salvatore-International-Economics
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The additional variables on which M, D , and F depend that are now introduced are the expected change in the spot rate (in the form of the expected appreciation of the foreign currency or EA), the risk premium (RP) required to compensate domestic residents for the additional risk involved in holding the foreign bond, the level of real income or output (Y), the domestic price level (P), and the wealth (W) of the nation’s residents. We know from the uncovered interest parity condition (Equation (15-8)) discussed in Section 15.3c in connection with the monetary approach that i − i ∗ = EA (15-8) Salvatore c15.tex V2 - 10/18/2012 12:45 A.M. Page 483 15.4 Portfolio Balance Model and Exchange Rates 483 That is, the positive interest differential in favor of the home country (the United States) over the foreign country (the EMU) is equal to the expected appreciation (expressed on an annual percentage basis) of the foreign currency ( ¤) in relation to the home-country currency ($). EA is now also included as an additional explanatory variable in the demand function for M, D , and F in the asset market model. In addition, since the domestic and the foreign bond are now assumed to be imperfect substitutes, there is an extra risk in holding the foreign bond with respect to holding the domestic bond. This extra risk arises from unexpected changes in the exchange rate (currency risks) and/or limitations that foreign nations might impose on transferring earnings back home (country risks). The uncovered interest parity condition of Equation (15-8) must, therefore, be extended to include the risk premium (RP) that is required to compensate home-country residents for the extra risk involved in holding the foreign bond. Thus, the condition for uncovered interest parity becomes i − i ∗ = EA − RP so that i = i ∗ + EA − RP (15-9) Equation (15-9) postulates that the interest rate in the home country (i ) must be equal to the interest rate in the foreign country (i ∗ ) plus the expected appreciation of the foreign currency (EA) minus the risk premium on holding the foreign bond (RP). For example, if i = 4%, i ∗ = 5%, and EA = 1%, then RP on the foreign bond must equal 2 percent in order to be at uncovered interest parity (i.e., 4% = 5% + 1% −2%). If the RP were only 1 percent, it would pay for home-country residents to buy more foreign bonds until the interest parity condition is satisfied, as explained in the next section. Of course, if the domestic bond is more risky than the foreign bond, RP is entered with a positive sign in Equation (15-9). The extended portfolio balance model also includes the real income or output of the nation (GDP), the price level (P), and the wealth (W) of the nation, as in the monetary approach. The extended demand functions for M, D , and F are thus given by Equations (15-10) to (15-12), with the sign on top of each variable referring to the postulated direct ( +) or inverse ( −) relationship between the independent or explanatory variables shown on the right-hand side of each equation and the dependent or left-hand variable in each equation. M = f ( − i , − i ∗ , − EA, + RP , + Download 7.1 Mb. Do'stlaringiz bilan baham: |
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