chapter 2 the determination of exchange rates chapter 2 overview: part n i. equilibrium exchange...

CHAPTER 2CHAPTER 2

THE THE DETERMINATIONDETERMINATION OF EXCHANGE OF EXCHANGE

RATESRATES

CHAPTER 2 OVERVIEW:CHAPTER 2 OVERVIEW:

PARTPART I. I. EQUILIBRIUM EXCHANGE EQUILIBRIUM EXCHANGE

RATESRATES II.II. ROLE OF CENTRAL BANKSROLE OF CENTRAL BANKS III.III. EXPECTATIONS AND THE EXPECTATIONS AND THE

ASSET MARKET MODELASSET MARKET MODEL

Part I. Part I. Equilibrium Exchange RatesEquilibrium Exchange Rates

I. SETTING THE EQUILIBRIUM I. SETTING THE EQUILIBRIUM

A. Exchange RatesA. Exchange Rates

market-clearing prices that market-clearing prices that equilibrate the equilibrate the

quantities quantities supplied and supplied and demanded of demanded of foreign foreign currency.currency.

Equilibrium Exchange RatesEquilibrium Exchange Rates

B. How Americans Purchase B. How Americans Purchase German GoodsGerman Goods

1. Foreign Currency Demand1. Foreign Currency Demand

-derived from the demand for -derived from the demand for foreign country’s goods, foreign country’s goods,

services, and financial services, and financial assets.assets.

e.g. The demand for German e.g. The demand for German goods by Americansgoods by Americans


2. Foreign Currency Supply:2. Foreign Currency Supply:a. derived from the foreign a. derived from the foreign

country’s demand for country’s demand for local goods. local goods.

b. They must convert their b. They must convert their currency to purchase. currency to purchase.

e.g. German demand for US e.g. German demand for US goods means Germansgoods means Germans

convert DM to US $convert DM to US $ in in order to buyorder to buy..


3. Equilibrium Exchange Rate:3. Equilibrium Exchange Rate:

occurs when the quantity occurs when the quantity suppliedsupplied equals the quantity equals the quantity demanded of a foreign demanded of a foreign currency at a specific localcurrency at a specific local

price.price.


C. How Exchange Rates ChangeC. How Exchange Rates Change

1. Increased demand1. Increased demand

as more foreign goods are as more foreign goods are demanded, the price demanded, the price

of the of the foreign currency foreign currency in local in local currency currency increases and vice increases and vice versa.versa.


2. Home Currency Depreciation 2. Home Currency Depreciation a. a. Foreign currency becomes Foreign currency becomes more valuable than the home more valuable than the home currency.currency.

b. Conversely, the foreignb. Conversely, the foreign

currency’s value has currency’s value has appreciated against the home appreciated against the home currency.currency.


3. Calculating a Depreciation:3. Calculating a Depreciation:

Currency Depreciation Currency Depreciation

where ewhere e0 0 = old currency value= old currency value

ee1 1 = new currency value = new currency value

Note: Resulting sign is always negativeNote: Resulting sign is always negative

1

10

e

ee


Currency Appreciation Currency Appreciation

0

01

e

ee


EXAMPLE: EXAMPLE: dm Appreciationdm Appreciation

If the dollar value of the dm goes If the dollar value of the dm goes from $0.64 (efrom $0.64 (e00) to $0.68 (e) to $0.68 (e11), then the ), then the

dm has appreciated bydm has appreciated by

0

01

e

ee

= (.68 - .64)/ .64 = 6.25%


EXAMPLE: EXAMPLE: US$ DepreciationUS$ Depreciation

We use the first formula,We use the first formula,

(e(e0 0 - e- e11)/ e)/ e11

substitutingsubstituting

(.64 - .68)/ .68 = - 5.88%(.64 - .68)/ .68 = - 5.88%

which was the US$ which was the US$ depreciation. depreciation.


D. FACTORS AFFECTING D. FACTORS AFFECTING EXCHANGE RATES: EXCHANGE RATES:

1.1. Inflation ratesInflation rates

2. 2. Interest ratesInterest rates

3.3. GNP growth ratesGNP growth rates

THE ROLE OF CENTRAL BANKSTHE ROLE OF CENTRAL BANKS

I. FUNDAMENTALS OF CENTRAL I. FUNDAMENTALS OF CENTRAL BANK INTERVENTIONBANK INTERVENTION

A.A. Role of Exchange Rates:Role of Exchange Rates:

LINKS BETWEENLINKS BETWEEN

THE DOMESTIC AND THETHE DOMESTIC AND THE

WORLD WORLD ECONOMY ECONOMY


B.B. THE IMPACT OF EXCHANGE THE IMPACT OF EXCHANGE RATE RATE CHANGESCHANGES

1.1. Currency Appreciation:Currency Appreciation:

-domestic prices increase -domestic prices increase relative to relative to foreign prices.foreign prices.

- Exports: less competitive - Exports: less competitive

- Imports: more attractive- Imports: more attractive


2.2. Currency DepreciationCurrency Depreciation

- domestic prices fall relative - domestic prices fall relative

to foreign prices. to foreign prices.

- Exports: more competitive.- Exports: more competitive.

- Imports: less attractive- Imports: less attractive


C.C. Foreign Exchange Market Foreign Exchange Market InterventionIntervention

1.1. Definition: the official Definition: the official purchases and sales of purchases and sales of currencies through the currencies through the central bank to influence central bank to influence the home exchange rate.the home exchange rate.


2. Goal of Intervention:2. Goal of Intervention:

-- to alter the demand for to alter the demand for oneone currency by currency by

changing the changing the supply of supply of another.another.


D. The Effects of Foreign D. The Effects of Foreign Exchange InterventionExchange Intervention

1. 1. Effects of Intervention:Effects of Intervention:

- either ineffective or - either ineffective or irresponsibleirresponsible

2.2. Lasting Effect:Lasting Effect:

- If permanent, change - If permanent, change resultsresults

Part III. EXPECTATIONSPart III. EXPECTATIONS

I.I. WHAT AFFECTS A WHAT AFFECTS A CURRENCY’S CURRENCY’S

VALUE?VALUE? A.A. Current Current eventsevents

B.B. Current supplyCurrent supplyC.C. Demand flowsDemand flows

** D.D. Expectation of future Expectation of future exchange rateexchange rate

EXPECTATIONSEXPECTATIONS

II.II. Role of Expectations :Role of Expectations :

A.A. Currency = financial Currency = financial assetasset

B.B. Exchange rate = Exchange rate = simple relation simple relation

of two of two financial financial assetsassets


III.III. Demand for Money and Demand for Money and Currency Values: Asset Currency Values: Asset

Market ModelMarket Model

A.A. Exchange rates reflect the Exchange rates reflect the supply of and demand supply of and demand

for for foreign-currency foreign-currency

denominated assetsdenominated assets..


B.B. Soundness of a Nation’s Soundness of a Nation’s Economic Economic

PoliciesPolicies- a nation’s currency tends - a nation’s currency tends

to strengthen with to strengthen with sound sound economic policies.economic policies.


IV.IV. EXPECTATIONS AND EXPECTATIONS AND CENTRAL BANK BEHAVIORCENTRAL BANK BEHAVIOR

- exchange rates also - exchange rates also influenced by influenced by

expectations of central expectations of central bank behavior.bank behavior.


A.A. Central Bank ReputationsCentral Bank Reputations

B.B. Central Bank IndependenceCentral Bank Independence

C.C. Currency BoardsCurrency Boards

chapter 2 the determination of exchange rates chapter 2 overview: part n i. equilibrium exchange...

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