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Foundations of Multinational Financial Management

Alan Shapiro10th Edition

John Wiley & Sons, Inc.

PowerPoints by

Joseph F. Greco, Ph.D.

California State University, Fullerton

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The Determination of Exchange Rates

Chapter 2

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CHAPTER 2THE DETERMINATION OF EXCHANGE RATES

CHAPTER OVERVIEW:2.1 SETTING THE EQUILIBRIUM SPOT EXCHANGE RATES

2.2 EXPECTATIONS AND THE ASSET MARKET MODEL

2.3 THE FUNDAMENTALS OF CENTRAL BANK INTERVENTION

2.4 THE EQUILILBRIUM APPROACH

Equilibrium Exchange Rates

2.1 SETTING THE EQUILIBRIUM A. The exchange rate

is the price of one unit of foreign currency expressed as a certain price in local

currency.

For example, $1.30/€ means the euro in the U.S. is worth $1.30.

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Equilibrium Exchange Rates

B. When Americans Purchase German Goods:

1. Foreign Currency Demanded derived from the demand for

foreign country’s goods, services, and financial

assets.e.g. The demand for German

cars by Americans

The Demand for € in the U.S.

Qty

$1.10/ €

$/€

D

At higher exchange rates, Americans demand less euros and vice versa.

$1.20/ €

$1.00/ €

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Equilibrium Exchange Rates2. Foreign Currency Supply:a. derived from the foreign

country’s demand for local goods. b. Foreigners must convert their

currency to purchase.e.g. German demand for US

goods means Germans convert € to US $ in order to buy

The Supply of € in the U.S.

Qty

$1.10/€

S$1.20/€

$1.00/€

At higher exchange rates, Germans supply more euros and vice versa.

$/ €

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Equilibrium Exchange Rates3. Equilibrium Exchange Rate

occurs where the quantity supplied equals the quantity demanded of a foreign currency at a specific local exchange rate

The $/€ Equilibrium Rate

Qty

$1.10

S$/ €

DEquilibrium

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Equilibrium Exchange Rates

C. How Exchange Rates Change1. Increased demand

as more foreign goods are demanded, more of the foreign currency is demanded at each possible exchange rate

2. The exchange rate of the foreign currency in local currency increases.

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Equilibrium Exchange Rates

3. Home Currency Depreciation a. Foreign currency more valuable than

the home currency

b. Conversely, the foreign currency’s value has

appreciated against the home currency

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The US$ Depreciates When

Qty

$1.10/ €

S

$/ €

D

D’

$1.20/ €

Q1 Q2

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Equilibrium Exchange Rates

Computing a Currency Appreciation

= (e1 - e0)/ e0

where e0 = old currency value

e1 = new currency value

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Equilibrium Exchange Rates

Computing a Currency Depreciation:

= (e0 - e1)/ e1

where e0 = old currency value

e1 = new currency value

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Equilibrium Exchange Rates

D. FACTORS AFFECTING EXCHANGE RATES:

1. Inflation rates

2. Interest rates

3. GNP growth rates

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Expectations and the Asset Market Model of Exchange Rates

2.2 The Role of Expectations:

A. Currency = financial asset

B. Exchange rate = simple relation of two financial assets

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Expectations

C. The Nature of Money and Currency Values:

1. Asset Market Model

Exchange rates reflect the supply of and demand for foreign-currency denominated assets.

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Expectations

2. Soundness of a Nation’s Economic Policies

a nation’s currency tends to strengthen with sound economic policies

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Expectations3. Expectations and Central Bank Behavior

exchange rates are also influenced by expectations of central bank behavior

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ExpectationsD. Central Bank Reputations and Currency

Values

1. Central bank: the nation’s official monetary authority

Expectations2. Price Stability and Central Bank

Independence:

when the Bank limits its focus to

price stability, it is more likely to succeed in its goal.

Expectations3. Currency Boards

- exist where there is no central bank

- instead the board issues notes

- has not discretionary monetary policy

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Central Bank Interventions

2.3 How Real Exchange Rates Affect Relative CompetitivenessA. Appreciation:

-domestic prices increase relative to foreign prices.-Exports: less competitive Imports: more attractive

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Central Bank InterventionsB. Currency Depreciationdomestic prices fall

relative to foreign prices.- Exports: more price competitive- Imports: less attractive

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Central Bank InterventionsC. Foreign Exchange Market Intervention

Mechanics of InterventionSterilized vs Unsterilized Intervention

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Central Bank Interventions

D. The Effects of Foreign Exchange Market Intervention

1. Definition: the official purchases and sales of currencies through the

central bank to influence the home exchange rate

The Equilibrium Approach2.4 The Equilibrium Approach to Exchange Rates

A. Disequilibrium Theory and Exchange Rate Overshooting

1. various economic frictions cause prices to adjust slowly over time

2. leads to “overshooting”

The Equilibrium ApproachB. The Equilibrium Theory of Exchange

Rates and Its Implications

1. markets clear through price adjustments

2. Repeated shocks in supply and demand create a

correlation between changes in nominal and real exchange rates.

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