Chapter 2

The Determination of Exchange Rates

Chapter 2: Determination of Exchange Rates 2

Chapter 2 Outline

A. Introduction to Exchange Rates

B. Factors Affecting the Equilibrium Exchange Rate

C. Calculating Exchange Rate Changes

D. Asset Market Model of Exchange Rates

E. Central Banks and Currency Values

F. Central Bank Intervention

Chapter 2: Determination of Exchange Rates 3

2.A Introduction to Exchange Rates (1)

Exchange rate – the price of one nation’s currency in terms of another.

– If $1 buys ¥100, the ¥/$ exchange rate, or yen value of the dollar, = ¥100/$1

– The inverse $/¥ exchange rate, or dollar value of the yen, = $1/ ¥100 and tells how many dollars one yen will buy = $0.01.

Exchange rates are market-clearing prices that equilibrate supplies and demands in the foreign exchange market.

Spot rate e0 – the price at which currencies are traded for

immediate delivery.

Forward rate f1 – the price at which currencies are quoted for

delivery at a specified future date.

Chapter 2: Determination of Exchange Rates 4

2.A Introduction to Exchange Rates (2)

Demand for a currency

– Demand for a currency is a function of the demand for foreign goods denominated in that currency. E.g., U.S. demand for Euroland goods increases demand for euros to pay for those goods.

– As demand for euros increases, the value of the dollar falls against the euro.

– As the value of the dollar falls against the euro, Americans demand fewer Euroland goods, services, and assets.

Supply of a currency

– Supply of euros is a function of Euroland demand for U.S. goods.

– Euroland consumers must buy dollars to buy U.S. goods.

– As the value of the euro increases against the dollar, increased Euroland demand for U.S. goods increases demand for dollars, which increases the amount of euros supplied.

Chapter 2: Determination of Exchange Rates 5

2.A Introduction to Exchange Rates (3)

Graphical representation of supply and demand for a currency

If supply of a currency exceeds demand, the value will fall relative to another currency until it reaches a new equilibrium.

If demand for a currency exceeds supply, the value will increase relative to another currency until it reaches a new equilibrium.

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Surplus

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Shortage

Chapter 2: Determination of Exchange Rates 6

2.B Factors Affecting the Equilibrium Exchange Rate (1)

Factors that influence the supply and demand for one currency in terms of another affect the equilibrium exchange rate.

– Inflation rates

– Interest rates

– Economic growth

– Political and economic risks

Chapter 2: Determination of Exchange Rates 7

2.B Factors Affecting the Equilibrium Exchange Rate (2)

Inflation rates – e.g., U.S. inflation > Euroland inflation

1. U.S. imports become more expensive to Euroland consumers

2. Euroland consumers switch to domestic substitutes

3. Demand for $ decreases

4. Supply of euros decreases (fewer euros needed to buy dollars)

5. U.S. consumers substitute Euroland imports for domestic goods

6. Demand for euros increases

7. Supply of dollars increases

$ depreciates: fewer euros required to buy $

€ appreciates over time in an amount such that Euroland and U.S. prices are again in equilibrium

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Chapter 2: Determination of Exchange Rates 8

2.B Factors Affecting the Equilibrium Exchange Rate (3)

Interest rates – e.g., U.S. interest rates > Euroland interest rates

€ depreciates: fewer dollars required to buy €

$ appreciates over time in an amount such that U.S. and Euroland prices are again in equilibrium

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1. Capital shifts from Euroland to U.S. to exploit higher returns

2. Demand for dollars increases

3. Supply of euros increases to buy more dollars

4. Demand for euros decreases as demand to buy U.S. assets decreases

5. Supply of dollars decreases

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Chapter 2: Determination of Exchange Rates 9

2.B Factors Affecting the Equilibrium Exchange Rate (4)

Economic growth – e.g., U.S. GDP growth > Euroland GDP growth

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1. As income increases, U.S. consumers spend more on Euroland imports

2. Demand for euros increases

3. Supply of dollars increases to buy more euros

4. Value of euro increases relative to the dollar

Chapter 2: Determination of Exchange Rates 10

2.B Factors Affecting the Equilibrium Exchange Rate (5)

Political and economic risk

– Investors prefer to hold fewer riskier assets.

– Political and economically stable countries have lower-risk currencies.

– Low-risk currencies are more highly valued and high-risk currencies.

Chapter 2: Determination of Exchange Rates 11

Currency appreciation/depreciation =

(new dollar value of currency – old dollar value of currency)

Old dollar value of currency

2.C Calculating Exchange Rate Changes (1)

Using the $/€ as an example, euro appreciation/depreciation is computed as the fractional increase/decrease in the dollar value of the euro.

General formula for computing currency appreciation/depreciation in dollar terms

E.g.: $/€ increases from $1.25/€1.00 to $1.35/€1.00

($1.35 – $1.25) / $1.25 = 0.08, or 8%

The euro has appreciated 8% against the dollar. That is, the amount of dollars required to buy one euro increased by 8%.

Chapter 2: Determination of Exchange Rates 12

2.C Calculating Exchange Rate Changes (2)

General formula for computing dollar appreciation/depreciation in terms of another currency

Using previous example: $/€ increases from $1.25/€1.00 to $1.35/€1.00

($1.25 – $1.35) / $1.35 = -0.074, or -7.4%

Dollar appreciation/depreciation =

(old dollar value of currency - new dollar value of currency)

New dollar value of currency

The dollar has depreciated 7.4% against the euro. That is, the amount of euros required to buy one dollar decreased by 7.4%.

Chapter 2: Determination of Exchange Rates 13

2.D Asset Market Model of Exchange Rate Determination

The exchange rate between two currencies represents the price that just balances the relative supplies of and demand for assets denominated in those currencies.

Shifts in preferences or expectations of future exchange rate movements affect the exchange rate of two currencies.

The desire to hold currency today depends on expectations of the factors that affect the currency’s future value.

Thus, currency values are forward-looking.

Chapter 2: Determination of Exchange Rates 14

2.E Central Banks and Currency Values (1)

Central banks use monetary policy, including creating money, to achieve price stability, low interest rates, or a target currency value.

Before 1971, currencies were linked to a commodity, usually gold.

Fiat money – nonconvertible paper money

– Is not linked to a commodity and thus has no “anchor.”

– No standard of value for determining a currency’s future value.

– Central bank determines a currency’s value through its control of the money supply.

– Expectations of central bank behavior affect exchange rates.

Chapter 2: Determination of Exchange Rates 15

2.E Central Banks and Currency Values (2)

A central bank’s reputation for maintaining currency stability is critical.

Investors demand a risk premium to hold low-quality currencies.

Central bank independence and focus is necessary to avoid political influence.

The greater risk of political influence over central banks that do not have a clear mandate to pursue price stability will foster the perception of inflation risk.

Central banks lacking independence must often monetize the deficit – that is, finance the deficit by creating money and buying government debt.

– Releasing more money into an economy leads to inflation and currency devaluation.

Chapter 2: Determination of Exchange Rates 16

2.E Central Banks and Currency Values (3)

Currency boards

– Replace central banks

– Issue notes and coins that are convertible on demand and at a fixed rate into a foreign reserve currency

– Have no discretionary monetary policy – the market determines the money supply

– Promote price stability

Without a central bank to monetize a country’s deficit, a currency board compels a government to follow responsible fiscal policy.

HOWEVER, a run on the currency causes a sharp contraction in the money supply and jump in interest rates, slowing economic activity.

Chapter 2: Determination of Exchange Rates 17

2.E Central Banks and Currency Values (4)

Dollarization

– A country replaces its currency with the U.S. dollar

– Promotes price stability and thus low inflation

– Eliminates local currency risk

– Results in loss of seignorage, a central bank’s profit on the currency it prints.

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2.F Central Bank Intervention (1)

How real exchange rates affect relative national competitiveness

– Our previous diagram illustrates how the euro rises over time to fill the inflation differential created by rising U.S. inflation. E.g., if U.S. and Euroland inflation = 1% and U.S inflation increases to 3%, the value of the euro will appreciate by 2% to re-establish price parity.

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Euro appreciation reflects 2% rise in inflation

– Appreciation beyond 2% raises the relative price of Euroland goods, increasing U.S. consumption of domestic goods and stimulating domestic employment. Longer term, U.S. inflation will rise to re-establish price parity.

Chapter 2: Determination of Exchange Rates 19

2.F Central Bank Intervention (2)

Foreign exchange market intervention

– Whether governments prefer an overvalued, undervalued, or correctly valued domestic currency depends on their economic goals.

– Governments may engage in unsterilized intervention, i.e., intervene in the foreign exchange market, to move e0 to a level consistent with their

goals by buying or selling foreign currencies to influence the value of their own currencies.

• To reduce the value of the dollar against the euro, the U.S. Central Bank (“the Fed”) will sell dollars and purchase an equivalent amount of euros, releasing dollars into the foreign market and reducing the supply of euros.

• To increase the value of the dollar against the euro, the Fed will buy dollars with euros, releasing euros into the foreign market and reducing the supply of dollars.

• Using unsterilized intervention, monetary authorities have not insulated their domestic money supplies from the foreign exchange transactions.

• Unsterilized intervention leads to increases in inflation as exchange rates move out of equilibrium. Inflation will in turn affect interest rates.

Chapter 2: Determination of Exchange Rates 20

2.F Central Bank Intervention (3)

Foreign exchange market intervention, continued

– In sterilized intervention, the Fed will intervene in the foreign exchange market AND simultaneously engage in open market operations, or the sale or purchase of domestic Treasury bills.

– Example

• To reduce the value of the dollar relative to the euro, the Fed sells dollars for euros in the foreign exchange market to flood the foreign market with dollars AND sells Treasury bills to reduce the number of dollars in the domestic market.

• Net effect: The value of the dollar relative to the euro decreases without changing the domestic supply of dollars, thereby insulating the U.S. from inflation.

– The effects of sterilized intervention are temporary, because the Fed signals a change in monetary policy to the market, not a change in market fundamentals.

– The effects of unsterilized intervention are permanent, because they create inflation in some countries and deflation in others.