Example 11 in Reading 13 Capital Flows and Exchange Rates

CFA Level II Economics
#1

Hi everyone,

I am having some difficulties with Question 4 in the Blue Box of Example 11 in Reading 13.

The question asks how boom like conditions in an EM country affect the exchange rate between the EM country and a DM country, and in the answer it is argued that the exchange rate (EM is the base currency) increases, because

a) risk premium is decreasing

b) inflation in EM country is increasing (asset bubble)

Now, in the real exchange rate equation we have:

qHL=qHL* +(iH-iL)-(piH-piL)-(riskH-riskL)

As you can see, inflation in the EM, piH, is negative, thus an increase in that variable would decrease the value of the real exchange rate.

So the overall effect is ambiguous, or depends on the magnitude of a) vs. b), right?

Can someone clarify this?

#2

I am still struggling with this question. Am I missing something here?

#3

I think a better way to look at this would be:

qL/H=qL/H* +(rH-rL)-(riskH-riskL)

And, according to the real interest rate parity condition, real interest rates converge of different countries. Hence, rH=rL.

Now due to the boom like conditions, as risk premium declines, we should have an increase in qL/H.

This is what I think should be the possible explanation, though I am not 100% sure.

#4

Thanks Steve. I see your point but then you are starting make assumptions which are not stated in the question. In fact, it reads in the question what the effects in the near term would be, so I am not sure that we are in an equilibrium where interest rate parity holds.

#5

You contradicted yourself here. Inflation increases due to the boom causing qHL to decrease.