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EXCHANGE RATE EXCHANGE RATE DETERMINATIONDETERMINATION
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Demand for Foreign ExchangeDemand for Foreign Exchange
Refers to the amount of foreign exchange that will be bought from the market at various exchange rates
Corresponds to debit items on the balance of payments
Demand for foreign exchange varies inversely with its price
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Carbaugh, Chap. 12 10
0
0.5
1
1.5
2
2.5
3
3.5
0 1 2 3 4 5 6 7
Billions of pounds
Demand for Foreign Exchange
Dollars
per pound
Foreign exchange markets
E
D0
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Supply of Foreign ExchangeSupply of Foreign Exchange
Refers to the amount of foreign exchange that will be offered to the market at various exchange rates.
Correspond to the credit items on the balance of payments.
Supply for foreign exchange varies directly with its price
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Carbaugh, Chap. 12 10
0
0.5
1
1.5
2
2.5
3
3.5
0 1 2 3 4 5 6 7
Billions of pounds
Supply of Foreign Exchange
Dollars
per pound
S0
Foreign exchange markets
E
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Carbaugh, Chap. 12 10
0
0.5
1
1.5
2
2.5
3
3.5
0 1 2 3 4 5 6 7
Billions of pounds
Exchange rate determination
Dollars
per pound
S0
Foreign exchange markets
Dollar depreciation
Dollar appreciation
E
D0
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0
0.5
1
1.5
2
2.5
3
3.5
0 1 2 3 4 5 6 7
Billions of pounds
Dollar Appreciation due to Decrease in Demand for Pound
Do
llars
per
po
un
d
S0
E
D0
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0
0.5
1
1.5
2
2.5
3
3.5
0 1 2 3 4 5 6 7
Billions of pounds
Dollar Appreciation due to Increase in Supply of Pound
Do
llars
per
po
un
d
S0
E
D0
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Carbaugh, Chap. 12 11
Foreign exchange
Impact of an appreciating US dollar Pros
Lower prices on foreign goods
Keeps inflation down
Foreign travel is cheaper
Less expensive to invest abroad
Cons Exporters’ products
become more expensive abroad
Imports-competing firms face price competition
Travel more expensive for foreign tourists
Slows inflow of foreign investment
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0
0.5
1
1.5
2
2.5
3
3.5
0 1 2 3 4 5 6 7
Billions of pounds
Dollar Depreciation due to Increase in demand for Pound
Do
llars
per
po
un
d
S0
E
D0
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0
0.5
1
1.5
2
2.5
3
3.5
0 1 2 3 4 5 6 7
Billions of pounds
Dollar Depreciation due to Decrease in Supply of Pound
Do
llars
per
po
un
d
S0
E
D0
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Carbaugh, Chap. 12 12
Foreign exchange
Impact of a depreciating US dollar Pros
Exporters can sell abroad more easily
Less competition for US firms from imports
Foreign tourism is encouraged
US capital markets more attractive
Cons Higher prices on
imports
Upward pressure on inflation
Travel abroad more expensive
Harder for US firms to expand into foreign markets
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Carbaugh, Chap. 13 2
Exchange rates
Factors influencing exchange rates
Market fundamentals Bilateral trade balances
Real income
Real interest rates
Inflation rates
Consumer preferences for domestic or foreign products
Productivity changes affecting production costs
Profitability and riskiness of investments
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Carbaugh, Chap. 13 3
Exchange rates
Factors influencing exchange rates
Market fundamentals (cont’d) Product availability
Monetary policy and fiscal policy
Government trade policy
Market expectations News about future market fundamentals
Speculative opinion about future exchange rates
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MARKET FUNDAMENTALS & THE DOLLAR’S EXCHANGE VALUE
Factor Dollar’s Exchange Value
Increase in foreign demand for U.S. goods, services or assets
Appreciation
Increase in U.S. demand for foreign goods, services or assets
Depreciation
Increase in U.S. real income Depreciation
Increase in U.S. interest rates Appreciation
Increase in U.S. price level Depreciation
Increase in U.S. productivity Appreciation
Increase in U.S. import restrictions Appreciation
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Carbaugh, Chap. 13 4
Exchange rates
When are these factors important?
Short run (days) Dominated by financial transfers responding to
Differences in real interest rates
Shifting expectations of future exchange rates
Medium run (months) Primarily influenced by economic cycles
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Carbaugh, Chap. 13 5
Exchange rates
When are these factors important? Long run (years) Dominated by movements of goods, services,
investment, which are influenced by: Inflation rates Investment profitability Consumer tastes Real income Productivity Trade policy
How these factors interact to affect exchange rates depends on the relative importance of trade and financial relations between the countries
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Carbaugh, Chap. 13 6
1993 1994 1995 1996 1997
Exchange rate components
Exchange rates
Yen’s trade-weighted
exchange value
Fundamentally driven long-run equilibrium path Fundamentally
driven medium-run cyclical path
Technically driven short-run
overshooting pathFundamental
equilibrium path
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Carbaugh, Chap. 13 7
Factors influencing exchange rates
Real income differentials
A country with faster economic growth than the rest of the world will have a depreciating currency (other things being equal) Imports rise faster than exports, so demand for
foreign currency rises faster than its supply
Real income changes can also reflect other processes, which might lead to rising exports
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Carbaugh, Chap. 13 8
0 5 10 15 20 25 30 35 40
Millions of Pounds
Impact of real income differentialsDollars
per PoundS0
A
D0
1.60
1.50
B
D1
Factors influencing exchange rates
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Carbaugh, Chap. 13 9
Factors influencing exchange rates
Real interest rates
Short term real interest rate differences influence international capital movements Real interest rate is nominal minus inflation
Low short term rates lead to less demand for the currency and depreciation
High rates lead to greater demand for the currency and appreciation
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Carbaugh, Chap. 13 10
Impact of interest rate differentialsDollars per Yen
S0
A
D0
.0080
.0075
B
D1
Factors influencing exchange rates
S1
30 35 40 45 50 55 60 65 70
Millions of Yens
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Carbaugh, Chap. 13 12
Impact of inflation rate differentialsDollars
per Pound
S0
A
D0
1.70
1.50
B
D1
Factors influencing exchange rates
S1
60 65 70 75 80 85 90 95 100
Millions of Pounds
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Carbaugh, Chap. 13 13
Factors influencing exchange rates
Market expectations
As with stock markets, foreign exchange markets react quickly to news or even rumors that point to future changes affecting rates
Future expectations can be self-fulfilling; speculative bubbles can start without any real information but can become self sustaining for a while
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Interaction of Exchange Rate Interaction of Exchange Rate DeterminantsDeterminants
Rise in U.S. interest rate, income & price level. Exchange rate Exchange rate movement depends on the
nature of international transactions Currency appreciates (depreciates) if
amount of international investment is larger (smaller) than the amount of international trade.
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Carbaugh, Chap. 13 11
Factors influencing exchange rates
Purchasing power parity Law of one price: In theory, a good should cost
the same in all countries (aside from tariffs or transportation costs)
As a result, exchange rates should end up making prices equal across countries
By this theory, if two countries have different inflation rates, exchange rates will move in the opposite direction to keep prices the same
PPP may be more useful for predicting long-term trends than short-run fluctuations
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Long-run Exchange RateLong-run Exchange Rate
Purchasing Power Parity (PPP) Law of one price.
Absolute PPP: P = eP*
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Overvalued CurrencyOvervalued Currency
If exchange rate exchange rate rises above the level warranted by economic conditions
Nation’s cost will not be competitive A trade deficit will likely occur. http://www.economist.com/markets/Bi
gmac/Index.cfm
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Absolute PPP Doesn’t Always Absolute PPP Doesn’t Always Prevail Because ofPrevail Because of
Trade barriers Transportation costs Non-traded goods Information cost
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Relative PPPRelative PPP
Changes in relative national price levels determine changes in exchange rates over time.
%e = %P - %P*
e1 = eo P1US/P1
UK where
e1 : estimates of exchange rate at time 1
eo : exchange rate at base period
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Problems with Relative PPPProblems with Relative PPP Capital flow is de-emphasized Choosing appropriate price index Choosing base period During small inflation, other factors
become more important. (It appears roughly valid when inflation is extreme.)
Doesn’t hold in short-run because of lags in adjustment process.
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Factors influencing exchange rates
Market expectations As with stock markets, foreign
exchange markets react quickly to news or even rumors that point to future changes affecting rates
Future expectations can be self-fulfilling; speculative bubbles can start without any real information but can become self sustaining - for a while
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Monetary ApproachMonetary Approach Demand & supply of money determines
exchange rateexchange rate Central bank supplies money (MS) Demand for money is a constant fraction
of nominal GDP (kPY). It depends on Real Income (+) Interest rate (-) Price level (+)
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Impact on the Exchange Rate According to the Monetary Approach
Increase in money supply Depreciate
Increase in money demand Appreciate
Monetary ApproachMonetary Approach
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Carbaugh, Chap. 13 14
Alternative approaches to exchange rates
Monetary approach
Focus on exchange rates as the result of supply and demand for money at home and abroad
Demand depends on real income, prices, interest rates
Supply is controlled by central banks
Exchange rates seen as returning domestic money supply to equilibrium after a change
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Carbaugh, Chap. 13 15
Alternative approaches to exchange rates
Asset-markets approach
Investors (firms and individuals) balance their portfolios among domestic money, stocks and bonds and foreign stocks and bonds
Short run exchange rate changes are caused by shifts in the kind and location of financial assets investors want to hold
Investors shift between assets based on market expectations for expected returns
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Impact on the Exchange Rate According to the Monetary ApproachIncrease in money supplyDepreciateIncrease in money demandAppreciate
Carbaugh, Chap. 13 16
1.5
1.6
1.7
1.8
1.9
2
2.1
2.2
2.3
2.4
2.5
0 50 100 150 200 250
Billions of Pounds
Short, long run equilibrium: overshootingD
ollars
per
Pound
S0
A
D0
Exchange rate markets
B
C S1
D1
(short run / less elastic)
(long run / more elastic)
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Impact on the Exchange Rate According to the Monetary ApproachIncrease in money supplyDepreciateIncrease in money demandAppreciate
Carbaugh, Chap. 13 17
Exchange rate markets
Forecasting exchange rates
Judgmental forecasts Subjective forecasts based on economic,
political and other data for a country
Technical analysis Uses historical exchange rate trends to project
short-run future movements
Fundamental analysis Includes macroeconomic and policy
information into a predictive model
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Impact on the Exchange Rate According to the Monetary ApproachIncrease in money supplyDepreciateIncrease in money demandAppreciate
Carbaugh, Chap. 13 18
0
0.5
1
1.5
2
2.5
3
3.5
0 100 200
Equilibrium in assets-markets approach
Pounds p
er Dolla
r
S0
Dollar appreciation
Dollar depreciation
A
D0
Alternative approaches to exchange rates
Quantity of Dollar-denominated assets ($ bill.)
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Carbaugh, Chap. 13 19
0
0.5
1
1.5
2
2.5
0 100 200
Assets-markets approach: shift in demand
Pounds p
er Dolla
r
S0
A
D0
Alternative approaches to exchange rates
Quantity of Dollar-denominated assets ($ bill.)
B
C
D1
D2
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Carbaugh, Chap. 13 20
0
0.5
1
1.5
2
2.5
0 50 100 150 200 250
Assets-markets approach: shift in supply
Pounds p
er Dolla
r
S0
A
D0
Alternative approaches to exchange rates
Quantity of Dollar-denominated assets ($ bill.)
B
C
S1 S2