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The Determination of Exchange Rates

Chapter 2

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CHAPTER 2THE DETERMINATION OF

EXCHANGE RATES

CHAPTER OVERVIEW:I. EQUILIBRIUM EXCHANGE

RATESII. ROLE OF CENTRAL BANKSIII. EXPECTATIONS AND THE

ASSET MARKET MODEL

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Part I. Equilibrium Exchange Rates

SETTING THE EQUILIBRIUM EXCHANGE RATESmarket-clearing prices that

equilibrate the quantities supplied and demanded of a foreign currency.

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Equilibrium Exchange Rates

How Americans Purchase German Goods1. Foreign Currency Demand

-derived from the demand for foreign country’s (German) goods, services, and financial assets by

locals (US).e.g. The demand for German

goods by Americans

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Equilibrium Exchange Rates

2. Foreign Currency Supply:-derived from the foreign

country’s demand for local (US) goods.

-They must convert their currency to purchase.

e.g. German demand for US goods means Germans convert Euro to US $ in order to buy US

goods.

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Equilibrium Exchange Rates

3. Equilibrium Exchange Rateoccurs where the quantity supplied of Euro equals the

quantity demanded at a specific local (US) price.

In this example the demand and supply for Euro is not only based on Germany and US

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Equilibrium Exchange Rates

How Exchange Rates Change1. Increased demand as more foreign goods are

demanded, the price of the foreign currency in local

currency increases and vice versa.

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Equilibrium Exchange Rates

2. Increased supplyas foreigners demand

more local goods are, the price of the local currency in foreign currency increases and vice versa.

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Equilibrium Exchange Rates

3. Equilibrium Exchange Rateadjusts based on the

changes in the quantity supplied and the quantity demanded of a currency.

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Equilibrium Exchange Rates

Home Currency depreciation - Foreign currency becoming more

valuable than the home currency.- Conversely, the foreign currency’s value has appreciated against the

home currency.

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Equilibrium Exchange Rates

3. Calculating a Depreciation:

= (e0 - e1)/ e1

where e0 = old currency value

e1 = new currency value

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Equilibrium Exchange Rates

Currency Appreciation

= (e1 - e0)/ e0

where e0 = old currency value

e1 = new currency value

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Equilibrium Exchange Rates

EXAMPLE: Euro Appreciation

If the dollar value of the Euro goes from $0.84 (e0) to $0.89 (e1), then the Euro has appreciated by

(.89 - .84)/ .84 = 5.95%

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Equilibrium Exchange Rates

EXAMPLE: US$ Depreciation

We use the first formula,(e0 - e1)/ e1

substituting(.84 - .89)/ .89 = - 5.62%

the US$ depreciation.

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Equilibrium Exchange Rates

D. FACTORS AFFECTING EXCHANGE RATES:

1. Inflation rates2. Interest rates3. GNP growth ratesOf the two countries

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EXPECTATIONS

Role of Expectations :-Currency is a financial

asset-Exchange rate is simple relationship of two

financial assets -Expectations about the future plays an important role in determining the current value

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EXPECTATIONS

Demand for Money and Currency Values: Asset Market Model

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

denominated assets.

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EXPECTATIONS

B. Soundness of a Nation’s Economic Policies

A nation’s currency tends to strengthen with sound

economic policies. Strength of the economy is

reflected on the currency.

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EXPECTATIONS

EXPECTATIONS AND CENTRAL BANK

BEHAVIOR- exchange rates are

also influenced by expectations of

central bank behavior.

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EXPECTATIONS

A. Central Bank Reputations

B. Central Bank Independence

C. Currency Boards

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THE ROLE OF CENTRAL BANKS

V. FUNDAMENTALS OF CENTRAL BANK INTERVENTION

A. Role of Exchange Rates:LINKS BETWEENTHE DOMESTIC AND THEWORLD ECONOMY

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THE ROLE OF CENTRAL BANKS

B. IMPACT OF EXCHANGE RATE CHANGES

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

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THE ROLE OF CENTRAL BANKS

2. Currency Depreciation- domestic prices fall

relative to foreign prices.

- Exports: more price competitive.

- Imports: less attractive

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THE ROLE OF CENTRAL BANKS

C. Foreign Exchange Market Intervention

1. Definition: the official purchases and

sales of currencies through the central bank to influence the home exchange rate.

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THE ROLE OF CENTRAL BANKS

Intervention :-Sterilized, by open market

operations-Unsterilized

Effectiveness of intervention