Short-Run Exchange Rate Determination

Issues in Global Trade & Finance

Prof. Bryson

Part IFactors Determining Rates

In the Short Run, the price of foreign exchange rises when1. The foreign interest rate rises relative

to ours. Why might this be?(Mobile, investment funds follow the higher rates. As they change countries, they bid up currency values.)

Short-run Exchange Rate Determination

The price of foreign exchange also rises when2. The expected future spot exchange rate rises. How come?(If you expect you will have to pay more for the Euros you will need later

because you expect the Euro/Dollar rate to rise, why not buy now before it does? Thus, the increased demand for Euros will bid the price up now.)

Short-run Exchange Rate Determination

How It Works Normally, returns on domestic and

foreign government bonds tend to equality. Why?

Differences cause investors to reposition their portfolios, affecting exchange and interest rates.

Currency rates will rise when people buy in order to invest in foreign, short-term funds.

Determining Factors in Foreign Exchange Prices The role of expectations is extremely

important in forecasting the future. Lacking other information, what is the universal law of forecasting?

We extrapolate recent change into the future. Lacking other information, the future will look like the present.

The bandwagon effect.

Determining Factors in Foreign Exchange Prices

Once expectations are positive and buying goes on, we can begin a process of destabilizing speculation. Friedman and bad speculation

(buying high and selling low). Bad currency speculation can lead

to overshooting, where speculation may go in the right direction, but move past the equilibrium point.

Determining Factors in Foreign Exchange Prices

Expectations can be based on various kind of news on, e.g., policies, trade data or performance, international political tensions and situations.

Determining Factors in Foreign Exchange Prices

An increase in money supply drives the interest rates down at first, then prices begin to rise (the “chasing

dollars” thing, and currency values are driven down in

the long run.

Determining Factors in Foreign Exchange Prices

When movements in exchange rates are not explainable as a function of the economic situation, they are referred to as speculative bubbles.

Markets, Exchange, and Interest Rates

Investing abroad has two steps. First, get the exchange (DM, F, €, ¥, £)

Second, invest in foreign government bonds at high i rates

P$ P€

Sell Dollars (P$ declines). Buy Euros (P€ increases).

Buy European (high i) bonds. Their price rises, (i falls).

S1 S2

D1 D2

P PSell US (low i) bonds, their p falls (i rises).

Part II.Short-term Rates

and Investment Options

Should we pursue higher interest rates abroad? Check out the options

1. Invest at .05 (= ius) for 90 days (annual yield divided by four) in the U.S. at (1 + ius)

$1 million invested = $1,050,000 in 90 days.

Short-term Investment Options

SHORT-TERM INVESTMENT OPTIONS

2. Invest at .08 for 1 year in the U.K. A. Buy £s in spot market at 1/ rs.

B. Invest at (1 + .08)/ rs

C. At the time of the investment, hedge the investment by selling contracted earnings in the forward market at rf .

SHORT-TERM INVESTMENT OPTIONS

When we hedge the investment by selling contracted earnings in the forward market,

the yield is ( 1 + iuk ) ( rf / rs )$1,080,000 (0.61/0.63) =

1,080,000 (.97) = $1,045,714

Hot Money Investments

Where we have$1,080,000 (0.61/0.63) = 1,080,000 (.97) =

$1,045,714,if the future rate ($1.65) is greater than the

spot rate ($1.63), one expects $ depreciation.

Hot Money Investments

The covered interest differential between the two investments is the yield from the (presumably higher) foreign investment minus the yield from the domestic investment.

It is:CD = ( 1 + iuk ) ( rf / rs ) - (1 + ius)

$1,045,714 - $1,050,000

Hot Money Investments

3. Invest at .08 in UK.A. Buy £s in spot market at 1/ rs.B. Invest at (1 + .08)/ rsC. Do not hedge, but speculate.Wait for the investment to pay out,

take the yield and at that point (in 90 days or a year) purchase dollars with the pounds earned.

Hot Money Investments

If the £ goes up (or the value of the dollar vis-à-vis the pound declines, i.e., r’s > rs , ($3/£ > $2/£ ), we make more money.

But if the dollar appreciates, the £ will

buy back fewer dollars at the end of the investment period.

More Generally, Uses of the Future

Future Change earnings in 90 days at r’s

Future $ Change earnings forward (covered) Future £

Invest in UK Invest in U.S. Borrow in

UK Borrow or sell assets in U.S.

Present

US Current $ currencies Current £ UK

Part III.Exchange Rates in the Long

Run

Purchasing Power Parity:Money and Exchange Rates in the

Long Run

The money supply determines the rate of inflation, which impacts the value of a currency. What is the impact?

Why must an inflating currency depreciate in value (or be devalued)?

Purchasing Power Parity:Money and Exchange Rates in the

Long Run

Demand for a currency will decline if the commodities it will purchase are continually increasing in price.

Currency demand = f(transactions demands).

Purchasing Power Parity:Money and Exchange Rates in the

Long Run

People must hold money balances to make purchases. In general, Md for a particular national currency shows that holding money is like “holding tickets for the GNP.”

Md = f (national GDP/yr).

Money and Exchange Rates in the Long Run

The Quantity Theory of Money

The Cambridge or Marshallian Quantity Theory

M = k (P) (y) y = real national or domestic product

Mf = kf ( Pf ) (yf) k = behavioral ratio (coefficient) related to

velocityf = foreignM = Money SupplyP = Price level

Money and Exchange Rates in the Long Run

The Quantity Theory of Money

In M = k (P) (y) and Mf = kf ( Pf ) (yf)

If k and kf are fixed, these quantity equations determine domestic and foreign price levels, the price ratio between national money and national product.

Price levels and exchange rates

Internationally traded goods will have similar price movements when measured in the same currency through trade’s arbitrage effect.

Price levels and exchange rates

– non-traded goods (e.g., those with large transport costs will not necessarily converge in price terms.

Price levels and exchange rates connected by Purchasing Power Parity

P = rs ( Pf ) where rs = exchange rate, or, rewriting rs = P/ Pf,

We saw above that M = k (P) (y), and solving for P, P = M/ky. So substitute M/ky for P and we have

rs = [M/( k y)] [Mf/(kf yf )]

Exchange rates and Purchasing Power Parity

The nation with slower Ms growth and faster expansion of productive capacity, should have a currency rising in value.

Rapid Ms growth and slow capacity expansion would lead to a depreciating currency.

Exchange rates and Purchasing Power Parity

This theory has proved empirically reliable for the long run only. For the short run, this is not a good predictor. Expectations and speculative movements affect the short run and non-traded goods also have an impact.

Interest Rates and Foreign Exchange

Foreign investors want to take advantage of high interest rates only if the real rates are high.

They will not want to hold foreign assets, and the spot rate of currencies will not be bid up, if real returns are not available because only nominal interest rates are high.

Interest Rates and Foreign Exchange

If interest rates rise merely because prices are increasing as the money supply expands, the currency value must decline.

The real interest rate is the nominal rate minus the rate of inflation.

Real rate = nominal rate - inflation.

Example: 5% = 16% - 11%.

Hopper on “What Determines the Exchange Rate?”

A fundamental belief: “exchange rates are affected by fundamental economic forces, such as money supplies, interest rates, real output levels, or the trade balance.”

Hopper on “What Determines the Exchange Rate?”

But these fundamentals don’t affect the exchange rate in the short run.

The best forecast of the exchange rate, at least in the short run, is whatever it happens to be today.

Hopper on “What Determines the Exchange Rate?”

“The monetary model fails empirically except perhaps in unusual periods such as hyperinflations.” (p. 251)

After it was apparent that the model couldn’t be substantiated, economists tried to develop other ideas.

Hopper on “What Determines the Exchange Rate?”

Hopper discusses attempts to extend the monetary model – Dornbusches overshooting model, the portfolio balance model. Not much empirical support for these ideas has been found.

Econometricians found that a naïve strategy of using today’s exchange rate as a forecast works at least as well as any of the statistical models.

Hopper on “What Determines the Exchange Rate?”

Hopper concludes that “if we look backward or forward over periods of up to a year, the fundamentals don’t seem to explain the exchange rate, contrary to what standard models in international finance textbooks imply…perhaps economists will discover a model that works in the future.” (p. 253)

Hopper on “What Determines the Exchange Rate?”

The alternative view is that exchange rates are determined, at least in the short run (under two years) by market sentiment. Market participants take the fundamentals very seriously when forming exchange-rate expectations. Economists are just starting to build models of market sentiment.

Hopper on “What Determines the Exchange Rate?”

The exchange rates are determined in the long run by fundamentals. The empirical models do better here.

Long-term market forces, the fundamentals, tend gradually to outweigh short-term irrational or unpredictable speculative forces in exchange markets.