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Professor Augustine H H Tan MBA Global Economy 1Session 6A-09

Exchange rates

Exchange Rate Determination


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Introduction

Forces underlying exchange-rate fluctuations

A system of market-determined (floating) exchangerates


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What Determines Exchange Rates?

Market fundamentals Market expectations

Determinants are different for short run, mediumrun, and long run cycles

Framework in which exchange rates aredetermined (Fig 12.1)

Example of Forex View column (Table 12.1)Table

12.1


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Determining Long-Run Exchange Rates

Four key factors - Summary (Table 12.2)

Relative price levels: (Figure 12.2(a)) Relative productivity levels: (Figure 12.2(b))

Preferences for domestic or foreign goods: (Figure12.2(c))

Trade barriers: (Figure 12.2(d))


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Inflation Rates, Purchasing Power Parity, Long-RunExchange Rates

Law of one price

An identical good should cost the same in allnations, assuming costless shipping and nobarriers

Theory: Pursuit of profits and price equalization

Single price might not apply in practice Big Mac index

Primitive and has many flaws but widelyunderstood

Serves as an approximation of currencystrength

Price of a Big Mac (Table 12.3)


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Purchasing Power Parity

Purchasing power parity theory

Exchange rates are related to differences in thelevel of prices between two countries

Changes in relative national price levelsdetermine changes in exchange rates over thelong run

Given in symbols as:

Application of the concept (Table 12.4)


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Purchasing Power Parity

Limitations of the theory

Overlooks the fact that exchange-rate movementsmay be influenced by investment flows

Choosing the appropriate price index

Determining the equilibrium period base Government policy interference

Predictive power most evident in the long run

Purchasing power parity: U.S.-United Kingdom(Figure 12.3)

Continued


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Determining Short-Run Exchange Rates: The Asset-MarketApproach

Key factors governing investment decisions

Relative levels of interest rates Expected changes in the exchange rate, over the

term of the investment

Effects of these factors(Table 12.5)


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Relative Levels of Interest Rates

Differences in the level of nominal interest rates affectinvestment flows

Relative interest rates as a determinant of exchange rates(Figure 12.4a)

Distinguishing between the nominal interest rate and the realinterest rate

Real Interest Rate = Nominal Interest Rate Rate of Inflation

Short-term real interest rates (Table 12.6)Real Interest Rate = Nominal Interest Rate - Inflation Rate


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Expected Change in theExchange Rate

To determine the actual earnings from an investment

in another currency High interest rate may not be attractive enough if

denominating currency is expected to depreciate

If the denominating currency is expected to

appreciate, the realized gain would be greater

Effects of investor expectations of changes inexchange rates (Figure 12.4(b))


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Diversification, Safe Havens, and Investment Flows

Diversification across asset types

Including the currencies in which they aredenominated

Safe-haven effect

Sacrificing returns for lower risk


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The Ups and Downs of the Dollar: 1980 to 2005

The 1980s

Path of appreciation and then depreciation

Peaked in 1985; 50% above 1979 levels

Depreciation in latter half of 1980s

Fluctuations significantly caused by policychanges

The 1990s

Economic weakness; recession in 1991

Rapid growth in the mid-1990s

Appreciation: 1995-2001


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The Ups and Downs of the Dollar: 1980 to 2005

The 2000s

A rising dollar and the large flow of investment intothe U.S. that pushes the currency higher could notbe sustained

Depreciation in 20022004

Weakening of the demand for dollar-denominated assets on the part of foreigninvestors

Reversal by 2005 Strong economic performance

Continued


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Exchange-Rate Overshooting

Short-run response to a change in market

fundamentals greater than long-run response Helps explain sharp movements

Tendency of elasticities to be smaller in the shortrun than in the long run (Figure 12.5)

Exchange rates tend to be more flexible than manyother prices


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Forecasting Foreign-Exchange Rates

Judgmental forecasts

Subjective or common sense models

Projections based on a thorough examination ofindividual nations

Use of economic indicators; political factors;technical factors; and psychological factors

Technical forecasts

Involves the use of historical exchange-rate data to

estimate future values (Figure 12.6)

Useful in explaining short-term movements

Continued


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Forecasting Foreign-Exchange Rates

Fundamental analysis

Involves consideration of economic variables thatare likely to affect a currencys value

Uses computer-based econometric models

Best suited for forecasting long-run trends

Continued


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Forecast Performance of Advisory Services

Better information about future exchange rates than is

available to the market Evaluating the performance of forecasters

Predict spot rates better than what is implied by theforward rate


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Factors influencing exchange rates

Real income differentials

A country with faster economic growth than the restof the world will have a depreciating currency (otherthings being equal)

Imports rise faster than exports, so demand forforeign currency rises faster than its supply

Real income changes can also reflect otherprocesses, which might lead to rising exports

F t i fl i h t


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Impact of real income differentials

Factors influencing exchange rates


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Real Income Rise Due to Productivity

Increase, FDI Increase

$/

Millions of

S

S*

D

Exchange rate markets


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Exchange rate markets

Asset-Markets Approach to Exchange-Rate

Determination

Residents hold a spectrum of financial assets:domestic currency, foreign currency,

domestic/foreign securities Continuing Flow component

Stock adjustment component emphasized

Key determinant of short-run movements inexchange rates

Asset allocation between home and foreign dependson:

interest rate on domestic securities Interest rate on foreign securities

expected change in exchange rate.

Alternative approaches to exchange rates


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Equilibrium in asset-markets approach



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Asset-markets approach: shift in demand




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Asset-markets approach: shift in supply


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