chapter 12 exchange-rate determination

8/17/2019 Chapter 12 Exchange-Rate Determination

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Exchange-RateDetermination

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'o$er'oint slides !re!ared Andreea Chiritesc#Eastern )llinois *niversity


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+hat Determines ExchangeRates,•

actors that ca#se the s#!!ly anddemand sched#les o% c#rrencies tochange

• Maret %#ndamentals /economic

variales• 'rod#ctivity" ination rates" real interest

rates" cons#mer !re%erences" andgovernment trade !olicy

• Maret ex!ectations• e$s ao#t %#t#re maret %#ndamentals

• 3raders4 o!inions ao#t %#t#re exchange rates© 2011 Cengage Learning. All Rights Reserved. May not e co!ied" scanned" or d#!licated" in $hole or in !art" exce!t%or #se as !ermitted in a license distri#ted $ith a certain !rod#ct or service or other$ise on a !ass$ord&!rotected$esite %or classroom #se 2


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+hat Determines ExchangeRates,•

actors a5ecting exchange rates• 6hort term( trans%ers o% assets

• Di5erences in real interest rates and to theshi%ting ex!ectations o% %#t#re exchange rates

• )nterim( cyclical %actors• l#ct#ations in economic activity

• Long term( o$s o% goods" services" and

investment ca!ital• )nation rates" investment !ro7taility"

cons#mer tastes" !rod#ctivity" andgovernment trade !olicy

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3his 7g#re vie$s the exchange val#e o% a nation4s c#rrency as eing determined y long-term str#ct#ral" interim cyclical" and short-term s!ec#lative %orces.


3he !ath o% the :en4s exchange rate);*RE12.1


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Determining Long-3ermExchange Rates•

Exchange rate changes• Reactions o% traders in the %oreign-

exchange maret to changes in• Relative !rice levels

• Relative !rod#ctivity levels

• Cons#mer !re%erences %or domestic or%oreign goods

• 3rade arriers

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Determinants o% the dollar4s exchangerate in the long term

3A>LE 12.1


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)ncrease in the *.6. !rice levelrelative to !rice levels in otherco#ntries

•

)ncrease in the demand %or %oreignc#rrency

• Decrease in the s#!!ly o% %oreignc#rrency

• De!reciation o% the dollar

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M % d l h 5 h


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)n the long term" the exchange rate et$een the dollar and the !o#nd reects relative !rice levels"relative !rod#ctivity levels" !re%erences %or domestic or %oreign goods" and trade arriers.

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Maret %#ndamentals that a5ect thedollar4s exchange rate in the longterm /a

);*RE12.2

i i


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*.6. !rod#ctivity gro$th is %aster thanthat o% other co#ntries

• )ncrease in the s#!!ly o% %oreign

c#rrency• Decrease in the demand %or %oreign

c#rrency

•

A!!reciation o% the dollar


M t % d t l th t 5 t th


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Maret %#ndamentals that a5ect thedollar4s exchange rate in the longterm /

);*RE12.2

D i i L 3


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An increased demand %or *.6. ex!orts• A!!reciation o% the dollar

• An increased demand %or *.6. im!orts

•De!reciation o% the dollar

• *.6. im!oses trade arriers

• A!!reciation o% the dollar




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Maret %#ndamentals that a5ect thedollar4s exchange rate in the longterm /c

);*RE12.2



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Maret %#ndamentals that a5ect thedollar4s exchange rate in the longterm /d

);*RE12.2


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)nation Rates" '#rchasing 'o$er 'arity"and Long-3erm Exchange Rates

•

La$ o% one !rice• )dentical goods sho#ld e sold

every$here at the same !rice

• +hen converted to a common c#rrency

• Ass#ming that it is costless to shi! thegood et$een nations" there are noarriers to trade" and marets are

com!etitive• 'revailing maret-exchange rate is

the tr#e eB#iliri#m rate



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•

3he >ig Mac )ndex• An attem!t to meas#re the tr#e

eB#iliri#m val#e o% a c#rrency asedon one !rod#ct" a >ig Mac

• Can e #sed to determine the extentto $hich the maret exchange ratedi5ers %rom the tr#e eB#iliri#m

exchange rate

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>ig Mac )ndex 3A>LE 12.2


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•

'#rchasing-!o$er-!arity theory• Exchange rates ad#st to mae goods

and services cost the same every$here

• An a!!lication o% the la$ o% one !rice

• )% the rate o% ination is m#ch higher inone co#ntry• )ts money has lost !#rchasing !o$er over

domestic goods

• C#rrency de!reciation to restore !arity$ith !rices o% goods aroad

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•

'#rchasing-!o$er-!arity theory• 3rade o$s mechanism that maes a

c#rrency de!reciate or a!!reciate

• Changes in relative national !ricelevels• Determine changes in exchange rates over

the long term

• oreign-exchange val#e o% a c#rrencytends to a!!reciate or de!reciate• At a rate eB#al to the di5erence et$een

%oreign and domestic ination© 2011 Cengage Learning. All Rights Reserved. May not e co!ied" scanned" or d#!licated" in $hole or in !art" exce!t%or #se as !ermitted in a license distri#ted $ith a certain !rod#ct or service or other$ise on a !ass$ord&!rotected$esite %or classroom #se 1@


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3he la$ o% one !rice a!!lied to asingle !rod#ct" steel

3A>LE 12.8


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•

'#rchasing-!o$er-!arity theory• *sed to !redict long-term exchange

rates• ' - !rice indexes o% the *.6. and

6$iterland• 0 - the ase !eriod

• 1 - !eriod 1

•60 - eB#iliri#m exchange rate in thease !eriod

• 61 - estimated target at $hich the act#al

rate sho#ld e in the %#t#re© 2011 Cengage Learning. All Rights Reserved. May not e co!ied" scanned" or d#!licated" in $hole or in !art" exce!t%or #se as !ermitted in a license distri#ted $ith a certain !rod#ct or service or other$ise on a !ass$ord&!rotected$esite %or classroom #se 20


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• '#rchasing-!o$er-!arity theory

• Fverloos( exchange-rate movementsmay e in#enced y investment o$s

• 'rolems• Choosing the a!!ro!riate !rice index to e

#sed in !rice calc#lations

• Determining eB#iliri#m !eriod to #se as a

ase• ;overnment !olicy may inter%ere $ith

the o!eration o% the theory• 3rade restrictions



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3his 7g#re s#ggests that the !redictive !o$er o% the !#rchasing-!o$er-!arity theory is most evident in the long term. )n the short term" the theory

has negligile !redictive !o$er.© 2011 Cengage Learning. All Rights Reserved. May not e co!ied" scanned" or d#!licated" in $hole or in !art" exce!t%or #se as !ermitted in a license distri#ted $ith a certain !rod#ct or service or other$ise on a !ass$ord&!rotected$esite %or classroom #se 22

'#rchasing !o$er !arity( *nited6tates - *nited Gingdom" 1?8H2008

);*RE12.8

i i h h


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Determining 6hort-3erm Exchange Rates( 3he Asset-Maret A!!roach

•

oreign-exchange maret activity• Dominated y investors in assets

• 3reas#ry sec#rities" cor!orate onds"an acco#nts" stocs" and real !ro!erty

• Asset-maret a!!roach

• )nvestors deciding et$een domesticand %oreign investments• Relative levels o% interest rates

• Ex!ected changes in the exchange rateitsel% over the term o% the investment


Determinants o% the dollar4s exchange


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Determinants o% the dollar s exchangerate against the !o#nd in the shortterm

3A>LE 12.9


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;LF>AL)IA3)F

)nation di5erentials and the exchangerate

•

'#rchasing-!o$er-!arity theory• Changes in relative national !rice levels

• Determine changes in exchange rates" longterm

• A c#rrency is ex!ected to de!reciate• >y an amo#nt eB#al to the excess o%

domestic ination over %oreign ination

• A c#rrency is ex!ected to a!!reciate• >y an amo#nt eB#al to the excess o%

%oreign ination over domestic ination



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)nation di5erentials and the dollar4sexchange val#e

);*RE12.9

D t i i 6h t 3 E h R t


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• Level o% the nominal /money interestrate

• A 7rst a!!roximation o% the rate o%ret#rn on assets that can e earned ina !artic#lar co#ntry

• Di5erences in the level o% nominalinterest rates et$een economies

• Liely to a5ect internationalinvestment o$s

• )nvestors see the highest rate o% ret#rn© 2011 Cengage Learning. All Rights Reserved. May not e co!ied" scanned" or d#!licated" in $hole or in !art" exce!t%or #se as !ermitted in a license distri#ted $ith a certain !rod#ct or service or other$ise on a !ass$ord&!rotected$esite %or classroom #se 2?

D t i i 6h t 3 E h R t


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• )% interest rates in *.6. J interest ratesaroad

• )ncrease in the demand %or dollars

• Dollar a!!reciation

• )% interest rates in *.6. K interest ratesaroad

• Decrease in the demand %or dollars

• Dollar de!reciation• Real interest rate

• ominal interest rate min#s the ination

rate© 2011 Cengage Learning. All Rights Reserved. May not e co!ied" scanned" or d#!licated" in $hole or in !art" exce!t%or #se as !ermitted in a license distri#ted $ith a certain !rod#ct or service or other$ise on a !ass$ord&!rotected$esite %or classroom #se 2@


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)n the short term" the exchange rate et$een the dollar and the !o#ndreects relative interest rates and ex!ected changes in the exchange rate.


actors a5ecting the dollar4sexchange rate in the short term /a

);*RE12.<

6hort-term nominal and real interest


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6hort-term nominal and real interestrates" 200?

3A>LE 12.<

)nterest rate di5erentials and


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An increase in the *.6. real interest rate increases the ex!ected ret#rn on dollar assets"s#ch as 3reas#ry ills and certi7cates o% de!osit. 3his increase enco#rages o$s o%%oreign investment into the *nited 6tates" th#s ca#sing the dollar4s exchange val#e toa!!reciate. Conversely" a decrease in the *.6. real interest rate red#ces the ex!ected

!ro7taility on dollar assets" $hich !romotes a de!reciation o% the dollar4s exchangeval#e.


)nterest rate di5erentials andexchange rates

);*RE12.=

Determining 6hort 3erm Exchange Rates


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• Ex!ected change in the exchangerate

• #t#re ex!ectations o% an a!!reciationo% the dollar can e sel%-%#l7lling %ortoday4s val#e o% the dollar



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)n the short term" the exchange rate et$een the dollar and the !o#ndreects relative interest rates and ex!ected changes in the exchange rate.


actors a5ecting the dollar4sexchange rate in the short term /

);*RE12.<

Determining 6hort 3erm Exchange Rates(


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• Fther %actors a5ecting investmento$s among economies

• 6ie o% the stoc o% assetsdenominated in a !artic#lar c#rrencyin investor !ort%olios

• 6igni7cant sa%e-haven e5ect ehindsome investment o$s


3he *!s and Do$ns o% the


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3he *!s and Do$ns o% theDollar• 3he 1@0s" a!!reciation and then

de!reciation

• 1?" dollar a!!reciation

• 6har! tightening o% monetary !olicy

• Reagan administration - siale tax c#tsalong $ith increased governments!ending

• 'ea in1@<




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3he *!s and Do$ns o% theDollar• 3he 1@0s" a!!reciation and then

de!reciation

• 6econd hal% o% the 1@0s" dollarde!reciation

• 6!ec#lators H ex!ected dollarde!reciation

• 6iale c#rrency interventions aimed at

$eaening an overval#ed dollar• Ex!ansionary monetary !olicy

• iscal !olicy - to red#ce the sie o%

#dget de7cits© 2011 Cengage Learning. All Rights Reserved. May not e co!ied" scanned" or d#!licated" in $hole or in !art" exce!t%or #se as !ermitted in a license distri#ted $ith a certain !rod#ct or service or other$ise on a !ass$ord&!rotected$esite %or classroom #se 8=



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3he *!s and Do$ns o% theDollar• 3he 10s

• +eaening economy" recession in11• Ex!ansionary monetary !olicy

• iscal !olicy - increased governments!ending and dam!ened tax recei!ts

• Dollar de!reciation




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3he *!s and Do$ns o% theDollar• 3he 10s

• Mid-10s" the *.6. economy $asgro$ing ra!idly• 6har! increase in the !ace o% investment

s!ending y #siness• Maret acceleration in !rod#ctivity gro$th

• 6trong cons#mer demand

•

Dereg#lation 3rade lieraliation Com!#terera

• Declining rate o% ination

• Dollar a!!reciation© 2011 Cengage Learning. All Rights Reserved. May not e co!ied" scanned" or d#!licated" in $hole or in !art" exce!t%or #se as !ermitted in a license distri#ted $ith a certain !rod#ct or service or other$ise on a !ass$ord&!rotected$esite %or classroom #se 8@



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3he *!s and Do$ns o% theDollar• irst decade o% the 2000s

• 2002-2009" de!reciation o% the dollar

• +eaening o% the demand %or dollar-denominated assets

• Recession in the *.6. in 2001

• Declining stoc maret

• *ncertainty ao#t cor!orate acco#nting

!ractices• 6teady decline in interest rates

• *ncertainty d#e to the ongoing $ar on

terrorism and the $ar $ith )raB© 2011 Cengage Learning. All Rights Reserved. May not e co!ied" scanned" or d#!licated" in $hole or in !art" exce!t%or #se as !ermitted in a license distri#ted $ith a certain !rod#ct or service or other$ise on a !ass$ord&!rotected$esite %or classroom #se 8



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3he *!s and Do$ns o% theDollar• irst decade o% the 2000s

• >y 200y 200@" stronger dollar• *.6. - sa%e haven economic crisis o% 200?H

200@

• 200" $eaening dollar© 2011 Cengage Learning. All Rights Reserved. May not e co!ied" scanned" or d#!licated" in $hole or in !art" exce!t%or #se as !ermitted in a license distri#ted $ith a certain !rod#ct or service or other$ise on a !ass$ord&!rotected$esite %or classroom #se 90


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Exchange-Rate Fvershooting

• Exchange-rate overshooting

• +hen exchange-rate short-termres!onse /de!reciation ora!!reciation• 3o a change in maret %#ndamentals

• )s greater than its long-term res!onse

• el!s ex!lain $hy exchange rates

de!reciate or a!!reciate so shar!ly%rom day to day


6h t t Ol t ili i);*RE


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;iven the short-term s#!!ly o% !o#nds /60" i% the demand %or !o#nds increases %rom D0 to

D1" then the dollar de!reciates %rom N2 !er !o#nd to a short-term eB#iliri#m o% N2.20 !er

!o#nd. )n the long term" the s#!!ly o% !o#nds is more elastic /61" and the eB#iliri#m

exchange rate is lo$er" at N2.10 !er !o#nd. >eca#se o% the di5erence in these elasticities"the short-term de!reciation o% the dollar overshoots its long-term de!reciation.© 2011 Cengage Learning. All Rights Reserved. May not e co!ied" scanned" or d#!licated" in $hole or in !art" exce!t%or #se as !ermitted in a license distri#ted $ith a certain !rod#ct or service or other$ise on a !ass$ord&!rotected$esite %or classroom #se 92

6hort-termOlong-term eB#iliri#mexchange rates( overshooting

);*RE12.?


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Exchange-Rate Fvershooting

• Exchange-rate overshooting

• Can e ex!lained y

• 3endency o% elasticities to e smaller inthe short term than in the long term

• Exchange rates tend to e more exilethan many other !rices


orecasting oreign-Exchange


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orecasting oreign-ExchangeRates• orecasting exchange rates

• )s very tricy" es!ecially in the shortterm

• ecessary %or ex!orters" im!orters"investors" aners" and %oreign-exchange dealers

• Cons#lting 7rms


Exchange rate %orecasters3A>LE 12 =


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Exchange-rate %orecasters 3A>LE 12.=



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orecasting oreign ExchangeRates• P#dgmental %orecasts

• 6#ective or common sense models.

• ReB#ire• +ide array o% !olitical and economic data

• )nter!retation o% these data in terms o% thetiming" direction" and magnit#de o%exchange-rate changes

•

'roections ased on a thoro#ghexamination o% individ#al nations• Economic indicators 'olitical %actors

• 3echnical %actors 'sychological %actors© 2011 Cengage Learning. All Rights Reserved. May not e co!ied" scanned" or d#!licated" in $hole or in !art" exce!t%or #se as !ermitted in a license distri#ted $ith a certain !rod#ct or service or other$ise on a !ass$ord&!rotected$esite %or classroom #se 9=



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orecasting oreign ExchangeRates• 3echnical %orecasts

• 3echnical analysis

• *se o% historical exchange-rate datato estimate %#t#re val#es

• )gnoring economic and !oliticaldeterminants o% exchange-ratemovements

• Qistory re!eats itsel%


3echnical analysis o% the :en4s);*RE


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+hen %orecasting exchange rates" technical analysts $atch %or ne$ highsand lo$s" roen trend lines" and !atterns that are tho#ght to !redict !rice

targets and movement.© 2011 Cengage Learning. All Rights Reserved. May not e co!ied" scanned" or d#!licated" in $hole or in !art" exce!t%or #se as !ermitted in a license distri#ted $ith a certain !rod#ct or service or other$ise on a !ass$ord&!rotected$esite %or classroom #se 9@

yexchange val#e

);*RE12.@



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orecasting oreign ExchangeRates• #ndamental analysis

• 3he o!!osite o% technical analysis

• Considerations o% economic varialesthat are liely to a5ect the s#!!ly and

demand o% a c#rrency• Com!#ter-ased econometric models

• or individ#al nations

•

Attem!t to incor!orate the %#ndamentalvariales that #nderlie exchange-ratemovements

• )nterest rates" alance o% trade" !rod#ctivity"

ination rates© 2011 Cengage Learning. All Rights Reserved. May not e co!ied" scanned" or d#!licated" in $hole or in !art" exce!t%or #se as !ermitted in a license distri#ted $ith a certain !rod#ct or service or other$ise on a !ass$ord&!rotected$esite %or classroom #se 9



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orecasting oreign ExchangeRates• Limitations o% econometric models

#sed to %orecast exchange rates

• Rely on !redictions o% ey economicvariales

• actors a5ecting exchange rates thatcannot easily e B#anti7ed

• 'recise timing o% a %actor4s e5ect on ac#rrency4s exchange rate may e#nclear



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;LF>AL)IA3)F

)nternational com!arisons o% ;D'(!#rchasing !o$er !arity

•

;ross domestic !rod#ct /;D'• Add #! the maret val#es o% the

goods and services its economy

!rod#ces• *se maret exchange rate

• Misleading( not all goods and services

are traded in a $orld maret



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;LF>AL)IA3)F


•

Exchange rates• Fverstate the sie o% economies $ith

relatively high !rice levels

•

*nderstate the sie o% economies $ithrelatively lo$ !rice levels

• 6#ect to siale #ct#ations



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;LF>AL)IA3)F


•

'#rchasing !o$er !arity• 3aes into acco#nt the relative cost o%

living and the ination rates o% di5erentco#ntries

• ;D's o% co#ntries converted into acommon c#rrency #sing !#rchasing!o$er !arities

• Are val#ed at a #ni%orm !rice level• Reect only di5erences in the vol#mes o%

goods and services !rod#ced in co#ntries© 2011 Cengage Learning. All Rights Reserved. May not e co!ied" scanned" or d#!licated" in $hole or in !art" exce!t%or #se as !ermitted in a license distri#ted $ith a certain !rod#ct or service or other$ise on a !ass$ord&!rotected$esite %or classroom #se


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3RADECFL)C36

Comercial Mexicana gets #rned ys!ec#lation

•

Fctoer 200@" Comercial Mexicana$as !ros!ering

• Mexico4s third largest retailer and a

com!etitor o% disco#nt giant +al-Mart• e$ days later" it $ent anr#!t"

• oreign c#rrency losses



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CFL)C36Comercial Mexicana gets #rned ys!ec#lation

•

Comercial Mexicana• Made ad ets #sing c#rrency

contracts - lined to the dollarO!eso

exchange rate• Ex!ectations o% a stronger !eso

• +orld credit crisis o% 200@ H

de!reciation o% the !eso

chapter 12 exchange-rate determination

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