Madura 4 DU

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Exchange Rate Determination 4  Chapter South-Western/Tho mson Learning © 2003

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Madura 4

Transcript of Madura 4 DU

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Exchange Rate Determination4

 Chapter 

South-Western/Thomson Learning © 2003

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Chapter Objectives

• To explain how exchange rate movements

are measured;

• To explain how the equilibrium exchange

rate is determined; and

• To examine the actors that aect theequilibrium exchange rate!

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"easuring

Exchange Rate "ovements• #n exchange rate measures the value o one

currenc$ in units o another currenc$!

• %hen a currenc$ declines in value& it is saidto depreciate! %hen it increases in value& it is

said to appreciate!

• On the da$s when some currencies

appreciate while others depreciate against

the dollar& the dollar is said to be 'mixed in

trading!(

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"easuring

Exchange Rate "ovements• The percentage change )* in the value

o a oreign currenc$ is computed as

+t  , +t -.

+t -.

where St  denotes the spot rate at time t .

• # positive * represents appreciation othe oreign currenc$& while a negative *

represents depreciation!

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Exchange Rate Equilibrium

• #n exchange rate represents the price o a

currenc$& which is determined b$ the

demand or that currenc$ relative to the

suppl$ or that currenc$!

D

+/.0T1

2uantit$ o oreignexchange

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Bangladesh inflation ↑

⇒  ↑ B’desh demand for US goods, and

hence demand for US $ increases.

3actors that nluence

Exchange RatesRelative Inflation Rates

⇒  ↓ US desire for B’desh goods, and hence

the supply of US $ decreases.

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Eect o inlation

• Price of US $1 in taka

D.

D5

+.

+5

67

89

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B’desh interest rates ↑⇒ B’desh demand for US ank deposits ↓,

and hence demand for US $ decreases.

3actors that nluence

Exchange RatesRelative Interest Rates

⇒  ↑ US desire for B’desh deposits, and

hence the supply of US $ increases.

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Eect o :igher nterest Rate

• Price of US $1 in taka

D5

D.

+5

+.

67

89

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Relative Interest Rates

3actors that nluence

Exchange Rates

• t is thus useul to consider real interestrates& which adjust the nominal interest

rates or inlation!

• # relativel$ high interest rate ma$ actuall$

relect expectations o relativel$ highinlation& which discourages oreign

investment!

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Relative Interest Rates

3actors that nluence

Exchange Rates

• This relationship is sometimes called the

Fisher effect !

•   real nominal

interest ≈  interest , inlation rate  rate rate

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B’desh income le!el ↑⇒  ↑ B’desh demand for US goods, and

hence demand for US$ increases.

3actors that nluence

Exchange RatesRelative Income Levels

⇒ "o e#pected change for the supply of US$.

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Eect o increased local national

income• rice o <+ /. in ta1a

D.

D5

+.

8=

89

2uantit$ ooreign exchange

.>

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Government Controls

• ?overnments ma$ inluence the equilibrium

exchange rate b$@ imposing foreign e#change arriers, imposing foreign trade arriers, inter!ening in the foreign e#change market,

and affecting macro !ariales such as inflation,

interest rates, and income le!els.

3actors that nluence

Exchange Rates

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?overnment Control@

.! tari • Eects o Tari 

Price

%emand

Supply

&uantity

Pi

Pi'

  &1  &( &)  &*   &+

  P)

  Pi'

  Pi

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Eects o Tari on 3oreign Exchange

"ar1et• 'ariff reduces the demand for foreign e#change and so

the demand cur!e shifts left to increase the !alue ofdomestic currency. ffecti!eness, howe!er, depends on

the elasticity of the demand cur!e of the commoditymarket. %emand cur!es of our main import commoditiesare inelastic, firstly. Secondly, those e#perienceincreasing trend. -n that case the demand cur!e wouldrather shift right oth in the commodity market as well as

the foreign e#change market. owe!er, since the time oflierali/ation the current trend here is tariff reduction.'his results in rightward shifting of the demand forforeign e#change, and e#change rate increases.

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5! 2uota

• 2uota means quantitative restriction! #

quantitative restriction is imposed on import to

have the almost same eects o tari! Dierence

between tari and quota is that the government

revenue does not ta1e place in case o quota!

Eectiveness o quota depends on the strength

o commercial polic$! <norganiAed econom$

oten lac1s it!

• 3oreign exchange rate becomes avorable due to

the introduction o quota!

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>! nant ndustr$ #rgument@

• -f import duty or 0uota is used to protect local industry

then it is called infant industry argument. -mport may e

completely withheld. %omestic industry in!ol!es in

higher scale of production and gets the ad!antage of

large scale economy and learning effect. Supply cur!e

shifts right and go!ernment withdraws the protection

gradually. 'hus, it is e#pected that such protection is

not needed in the long term. Unlike emerging tigers,most countries e#perience a failure of infant industry

arguments as it encourages inefficiency in production.

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4! +ubsidies

• # subsid$ is a government pa$ment to domestic

producers to increase the competitiveness in the

export mar1et! t ta1es the orm o cash grant& low

interest loans& tax brea1s& and other indirect

incentives to the irm b$ the government! This is

commonl$ called as dumping! ncreased export leads

to a rightward shit o suppl$ curve! Domestic

currenc$ becomes stronger!

• +ubsid$ is also used to substitute import b$ ma1ing

the domestic production cheaper through subsid$!

This is t$picall$ the issue o agricultural subsid$

which was responsible behind the ailure o ?#TT!

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Others methods o government control

• 9! Boluntar$ Export Restrains@ BER is a quota ontrade imposed b$ the exporting countr$& t$picall$ at

the request o the importing countr$s government!

Domestic currenc$ becomes wea1er!

• 8! ocal Content Requirement@ t is a requirementthat some speciic raction o a good be produced

domesticall$! This also reduces import! 3oreign

exchange rate becomes avorable!

• 6! #dministrative olicies@ mport procedure can be

made length$ b$ means o complicated

administrative policies to discourage import!

3oreign exchange rate becomes avorable!

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Expectations

• 3oreign exchange mar1ets react to an$

news that ma$ have a uture eect!

• nstitutional investors oten ta1e currenc$

positions based on anticipated interest rate

movements in various countries!• ecause o speculative transactions&

oreign exchange rates can be ver$ volatile!

3actors that nluence

Exchange Rates

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Interaction of Factors

3actors that nluence

Exchange Rates

• The sensitivit$ o the exchange rate to

these actors is dependent on the volumeo international transactions between the

two countries!

• Over a particular period& dierent actors

ma$ place opposing pressures on thevalue o a oreign currenc$!

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Chapter Review

• 3actors that nluence Exchange Rates elati!e -nflation ates

elati!e -nterest ates elati!e -ncome 2e!els 3o!ernment 4ontrols #pectations

-nteraction of 5actors ow 5actors a!e -nfluenced #change

ates