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Multinational Financial Management Alan Shapiro 7th EditionJ.Wiley & SonsPower Points byJoseph F. Greco, Ph.D.California State University, Fullerton

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CHAPTER 2

THE DETERMINATION OF EXCHANGE RATES

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CHAPTER 2 OVERVIEW:

I. EQUILIBRIUM EXCHANGE RATES

II. ROLE OF CENTRAL BANKSIII. EXPECTATIONS AND THE

ASSET MARKET MODEL

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Part I. Equilibrium Exchange Rates

I. SETTING THE EQUILIBRIUM A. Exchange Rates

market-clearing prices that equilibrate the

quantities supplied and demanded of foreign currency.

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Equilibrium Exchange RatesB. How Americans Purchase

German Goods1. Foreign Currency Demand

-derived from the demand for foreign country’s goods,

services, and financial assets.

e.g. The demand for German goods by Americans

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Equilibrium Exchange Rates2. Foreign Currency Supply:

a. derived from the foreign country’s demand for local goods. b. They must convert their currency to purchase.

e.g. German demand for US goods means Germans convert

DM to US $ in order to buy.

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Equilibrium Exchange Rates

3. Equilibrium Exchange Rate:occurs when the quantity

supplied equals the quantity demanded of a foreign currency at a specific local

price.

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Equilibrium Exchange Rates

C. How Exchange Rates Change1. Increased demand

as more foreign goods are demanded, the price

of the foreign currency in local currency increases and vice versa.

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Equilibrium Exchange Rates

2. Home Currency Depreciation

a. Foreign currency becomes more valuable than the

home currency.b. The foreign currency’s

value has appreciated against the home currency.

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Equilibrium Exchange Rates

3. Calculating a Depreciation:

Currency Depreciation

where e0 = old currency value

e1 = new currency value

Note: Resulting sign is always negative

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e

ee

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Equilibrium Exchange Rates

Currency Appreciation

0

01

e

ee

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Equilibrium Exchange RatesEXAMPLE: dm AppreciationIf the dollar value of the dm goes from $0.64 (e0) to $0.68 (e1), then the dm has appreciated by

0

01

e

ee

= (.68 - .64)/ .64 = 6.25%

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Equilibrium Exchange Rates

EXAMPLE: US$ Depreciation

We use the first formula,(e0 - e1)/ e1

substituting(.64 - .68)/ .68 = - 5.88%

which is the value of the US$ depreciation.

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Equilibrium Exchange Rates

D. FACTORS AFFECTING EXCHANGE RATES:

1. Inflation rates2. Interest rates3. GNP growth rates

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I. FUNDAMENTALS OF CENTRAL BANK INTERVENTIONA. Role of Exchange

Rates:LINKS BETWEEN THE

DOMESTIC AND THE WORLD ECONOMY

PART II. THE ROLE OF CENTRAL BANKS

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B. THE IMPACT OF EXCHANGE RATE CHANGES1. Currency Appreciation:

-domestic prices increase relative to foreign prices.

- Exports: less price competitive

- Imports: more attractive

THE ROLE OF CENTRAL BANKS

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THE ROLE OF CENTRAL BANKS

2. Currency Depreciation

- domestic prices fall relative to foreign prices.

- Exports: more price competitive.

- Imports: less attractive

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THE ROLE OF CENTRAL BANKS

C. Foreign Exchange Market Intervention1. Definition: the official

purchases and sales of currencies through the central bank to influence the home exchange rate.

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THE ROLE OF CENTRAL BANKS

2. Goal of Intervention: -to alter the demand for

onecurrency by changing the

supply of another.

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THE ROLE OF CENTRAL BANKS

D. The Effects of Foreign Exchange Intervention

1. Effects of Intervention: - either ineffective or

irresponsible2. Lasting Effect:

- If permanent, change results

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Part III. EXPECTATIONSI. WHAT AFFECTS A

CURRENCY’S VALUE?

A. Current eventsB. Current supplyC. Demand flowsD. Expectation of

future exchange rate

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EXPECTATIONS

II. Role of Expectations :A. Currency = financial

assetB. Exchange rate =

simple relation of two financial assets

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EXPECTATIONS

III. Demand for Money and Currency Values: Asset

Market ModelA. Exchange rates reflect the

supply of and demand for foreign-currency denominated assets.

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EXPECTATIONS

B. Soundness of a Nation’s Economic Policies

- a nation’s currency tends to strengthen with sound economic policies.

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EXPECTATIONS

IV. EXPECTATIONS AND CENTRAL BANK BEHAVIOR

- exchange rates also influenced by

expectations of central bank behavior.

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EXPECTATIONS

A. Central Bank Reputations

B. Central Bank Independence

C. Currency Boards