1 the determination of exchange rates chapter 2 2 chapter 2 the determination of exchange rates...
TRANSCRIPT
1
The Determination of Exchange Rates
Chapter 2
2
CHAPTER 2THE DETERMINATION OF
EXCHANGE RATES
CHAPTER OVERVIEW:I. EQUILIBRIUM EXCHANGE
RATESII. ROLE OF CENTRAL BANKSIII. EXPECTATIONS AND THE
ASSET MARKET MODEL
3
Part I. Equilibrium Exchange Rates
SETTING THE EQUILIBRIUM EXCHANGE RATESmarket-clearing prices that
equilibrate the quantities supplied and demanded of a foreign currency.
4
Equilibrium Exchange Rates
How Americans Purchase German Goods1. Foreign Currency Demand
-derived from the demand for foreign country’s (German) goods, services, and financial assets by
locals (US).e.g. The demand for German
goods by Americans
5
Equilibrium Exchange Rates
2. Foreign Currency Supply:-derived from the foreign
country’s demand for local (US) goods.
-They must convert their currency to purchase.
e.g. German demand for US goods means Germans convert Euro to US $ in order to buy US
goods.
6
Equilibrium Exchange Rates
3. Equilibrium Exchange Rateoccurs where the quantity supplied of Euro equals the
quantity demanded at a specific local (US) price.
In this example the demand and supply for Euro is not only based on Germany and US
7
Equilibrium Exchange Rates
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.
8
Equilibrium Exchange Rates
2. Increased supplyas foreigners demand
more local goods are, the price of the local currency in foreign currency increases and vice versa.
9
Equilibrium Exchange Rates
3. Equilibrium Exchange Rateadjusts based on the
changes in the quantity supplied and the quantity demanded of a currency.
10
Equilibrium Exchange Rates
Home Currency depreciation - Foreign currency becoming more
valuable than the home currency.- Conversely, the foreign currency’s value has appreciated against the
home currency.
11
Equilibrium Exchange Rates
3. Calculating a Depreciation:
= (e0 - e1)/ e1
where e0 = old currency value
e1 = new currency value
12
Equilibrium Exchange Rates
Currency Appreciation
= (e1 - e0)/ e0
where e0 = old currency value
e1 = new currency value
13
Equilibrium Exchange Rates
EXAMPLE: Euro Appreciation
If the dollar value of the Euro goes from $0.84 (e0) to $0.89 (e1), then the Euro has appreciated by
(.89 - .84)/ .84 = 5.95%
14
Equilibrium Exchange Rates
EXAMPLE: US$ Depreciation
We use the first formula,(e0 - e1)/ e1
substituting(.84 - .89)/ .89 = - 5.62%
the US$ depreciation.
15
Equilibrium Exchange Rates
D. FACTORS AFFECTING EXCHANGE RATES:
1. Inflation rates2. Interest rates3. GNP growth ratesOf the two countries
16
EXPECTATIONS
Role of Expectations :-Currency is a financial
asset-Exchange rate is simple relationship of two
financial assets -Expectations about the future plays an important role in determining the current value
17
EXPECTATIONS
Demand for Money and Currency Values: Asset Market Model
A. Exchange rates reflect the supply of and demand for foreign-currency
denominated assets.
18
EXPECTATIONS
B. Soundness of a Nation’s Economic Policies
A nation’s currency tends to strengthen with sound
economic policies. Strength of the economy is
reflected on the currency.
19
EXPECTATIONS
EXPECTATIONS AND CENTRAL BANK
BEHAVIOR- exchange rates are
also influenced by expectations of
central bank behavior.
20
EXPECTATIONS
A. Central Bank Reputations
B. Central Bank Independence
C. Currency Boards
21
THE ROLE OF CENTRAL BANKS
V. FUNDAMENTALS OF CENTRAL BANK INTERVENTION
A. Role of Exchange Rates:LINKS BETWEENTHE DOMESTIC AND THEWORLD ECONOMY
22
THE ROLE OF CENTRAL BANKS
B. IMPACT OF EXCHANGE RATE CHANGES
1. Appreciation:-domestic prices increase relative to foreign prices.-Exports: less competitive Imports: more attractive
23
THE ROLE OF CENTRAL BANKS
2. Currency Depreciation- domestic prices fall
relative to foreign prices.
- Exports: more price competitive.
- Imports: less attractive
24
THE ROLE OF CENTRAL BANKS
C. Foreign Exchange Market Intervention
1. Definition: the official purchases and
sales of currencies through the central bank to influence the home exchange rate.
25
THE ROLE OF CENTRAL BANKS
Intervention :-Sterilized, by open market
operations-Unsterilized
Effectiveness of intervention