exchange rate determination. demand for foreign exchange refers to the amount of foreign exchange...

EXCHANGE RATE EXCHANGE RATE DETERMINATIONDETERMINATION

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

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

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


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


E


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


Dollar depreciation

Dollar appreciation

E

D0

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

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


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

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

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


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


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


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

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


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


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


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



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


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




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


Impact of interest rate differentialsDollars per Yen

S0

A

D0

.0080

.0075

B

D1


S1

30 35 40 45 50 55 60 65 70

Millions of Yens


Impact of inflation rate differentialsDollars

per Pound

S0

A

D0

1.70

1.50

B

D1


S1

60 65 70 75 80 85 90 95 100

Millions of Pounds



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

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.



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

Long-run Exchange RateLong-run Exchange Rate

Purchasing Power Parity (PPP) Law of one price.

Absolute PPP: P = eP*

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

Absolute PPP Doesn’t Always Absolute PPP Doesn’t Always Prevail Because ofPrevail Because of

Trade barriers Transportation costs Non-traded goods Information cost

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

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.


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

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 (+)

Impact on the Exchange Rate According to the Monetary Approach

Increase in money supply Depreciate

Increase in money demand Appreciate

Monetary ApproachMonetary Approach


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



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

Impact on the Exchange Rate According to the Monetary ApproachIncrease in money supplyDepreciateIncrease in money demandAppreciate


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)



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



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


Quantity of Dollar-denominated assets ($ bill.)


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



B

C

D1

D2


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



B

C

S1 S2

exchange rate determination. demand for foreign exchange refers to the amount of foreign exchange...

Documents

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pounds0ed0 dollar appreciation

pounds0ed0 dollar depreciation

long run yearsdominated

short run daysdominated

relative importance