exchange_rate_determination.ppt

7/27/2019 Exchange_rate_determination.ppt

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* Exchange

rate determination


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Exchange rates are determined by the interaction

of many forces, some of a long run in nature while

others of a short-run nature.

when the exchange rates are free to fluctuate, the

exchange rate is determined at the intersection of

the market demand and supply curves of foreign

exchange.But saying concretely, exchange rates are

affected by many important forces.

Overview of exchange rate determination


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1. Relative rates of economic growth

If the U.S. grows more rapidly than the rest of the

world, its demand for imports will increase more

rapidly. By itself, this should increase the demand for

foreign currency and lead to depreciation of the

dollar.

2. Relative rates of inflationIf U.S. inflation is greater than the rate of inflation

in the rest of the world, the dollar will decrease in

value.

Cont inued:



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3. Changes in interest rates

If U.S. interest rates fall relative to interest rates

in the rest of the world, the demand for U.S. interest

bearing assets will fall. By itself, this will lead to afall in international demand for the dollar and a

depreciation of the dollar.

4. ExpectationsIf it is expected that the dollar will fall in value,people will move out of dollar holdings.

Cont inued:



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Trade or elasticitys approachThe theory or

approach that stresses the role of trade or the flow

of goods and services in the determination of

exchange rates. This model is more useful inexplaining exchange rates in the long run than in

the short run.

The trade approach to exchange ratedetermination focuses on the role of international

trade in determining exchange rates.

12.3 Trade of elasticity approach


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If the value of the nations imports exceeds the value of

nations exports (i.e., if the nation faces a trade deficit), the

exchange rate will rise (i.e., the domestic currency will

depreciate). This makes the nations exports cheaper to

foreigners and imports more expensive to domestic residents. The

result is that the nations exports rise and its imports fall until

trade is balanced.

Cont inued:12.3 Trade of elasticity approach


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Since the amount and speed of adjustment

depend on how responsive (elastic) imports and

exports are to price (exchange rate) changes, this

approach is referred to as the trade or elasticityapproach. If the nation is at or near full

employment, a larger depreciation of the nations

currency is required to shift domestic resources to

the production of more exports and importsubstitution than if the nation has unemployed

resources.



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Alternatively, domestic policies may be required to

reduce domestic expenditures (absorption) to release

domestic resources to produce more exports and import

substitutes, and thus allow the elasticity approach tooperate.



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1. Purchasing-power parity (PPP) theoryThetheory that postulates that the change in the

exchange rate between two currencies is

proportional to the change in the ratio in the twocountries general price levels.

12.3 Purchasing-power parity theory


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2. Absolute purchasing-power parity theorypostulates that the equilibrium exchange rate

between two currencies is equal to the ratio of the

price levels in the two nations. Specifically:

R=P/P

Where R is the exchange rate or spot (defined as

the domestic-currency price of a unit of the foreign

currency) and Pand P are, respectively, thegenerally price level in the home nation and in the

foreign nation.

Cont inued:12.3 Purchasing-power parity theory


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3. law of one price, a given commodity shouldhave the same price (so that the purchasing

power of the two currencies is at parity) in both

countries when expressed in terms of the samecurrency. If the price of a given commodity is not

equal, the commodity arbitrage would cause the

price of the commodity to be equalized.

Commodity arbitrage thus operates just as does

currency arbitrage in equalizing commodity prices

throughout the market.



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4. Relative purchasing-power parity theoryThe theory that postulates that the percentage

change in the exchange rate is equal to the

difference in the percentage change in the pricelevel in the two countries.



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1. Monetary model of exchange ratesThetheory that postulates that exchange rates are

determined in the process of equilibrating or

balancing the stock or total demand and supply of

money in each nation.

12.5 The monetary model of exchange rates


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According to the monetary model of exchange rates, an

increase in thenations money supply leads to aproportionate increase in prices and depreciation of the

nations currency in the long run, as postulated by the PPPtheory. For example, if U.S. monetary authorities increase

the money supply by 10 percent but the EMU does not, the

general price level in the United States should increase by

10 percent and the dollar exchange rate increase (i.e., thedollar depreciate) by 10 percent, say from R = 1 to R = 1.1,in the long run. The nominal and real exchange rates of the

dollar should then move together by the same percentage

over time.

Cont inued:



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An increase in the U.S. money supply (assuming no change in

other money supplies) will depreciate both nominal (spot) and

real exchange rates.

Cont inued:



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2. Nominal exchangerateThe exchange or the domestic

currency price of the foreign currency.

Cont inued:



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3. Real exchange rate is the nominal exchange rate weightedby the consumer price index of the two nations.

Cont inued:



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1. Asset or portfolio model of exchange rates

The theory that postulates that exchange rates are

determined in the process of equilibrating or

balancing the demand and supply of financial assetsin each country.

12.6 Asset or portfolio model of exchange rates


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Starting from a position of portfolio or

financial and trade balance, the asset or

portfolio model postulates that an increase in a

nations money supply leads to an immediate

decline in the interest rate in the nation and to a

shift from domestic bonds to the domestic

currency and to foreign bonds.

Cont inued:



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The shift from domestic bonds to domestic currency arises

because the cost of holding cash has now diminished, while the

shift to foreign bonds results from their relatively higher interest

rates now that the domestic interest rate has fallen on domestic

bonds.

Cont inued:



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The shift from domestic to foreign bonds causes

an immediate depreciation of the home currency as

individuals and firms exchange domestic for foreigncurrency in order to purchase more foreign bonds.

Over time, this depreciation stimulates the nations

exports and discourages the nations imports. This

leads to a trade surplus and appreciation of the

domestic currency, which neutralizes part of its

original depreciation.

Cont inued:



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Thus, the asset or portfolio model also

explains the overshooting (i.e., the large and

frequent fluctuations) in foreign exchange ratesthat is often observed in the real world. This is

discussed next.

Cont inued:



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Exchange rate overshootingThe tendency ofexchange rates to immediately depreciate or

appreciate by more than required for long-run

equilibrium, and then partially reversing their

movement as they move toward their long-run

equilibrium levels.

12.7 Exchange rate dynamics


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Figure 12.6. Overshooting of Dollar exchange rates

Cont inued:12.7 Exchange rate dynamics


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To summarize, we can say that since financial

markets clear or adjust to disequilibria much

faster than commodity markets, exchange rates

are much more sensitive from day to day and fromweek to week to capital market imbalances than

to commodity market and trade imbalances. The

latter, however, are critical determinants of

medium-run and long-run exchange rate trends, aspostulated by the elasticity approach and the PPP

theory.



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By considering both financial and trade adjustments,

the asset or portfolio model has become the centerpiece

for the analysis of exchange rate determination. In its

present form, however, the model still does not provide acomplete and unified theory of exchange rate

determination that fully and consistently integrates all the

financial and commodity markets forces that affect

exchange rates over the immediate, the short, and the longruns.


exchange_rate_determination.ppt

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