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Foundations of Multinational Financial Management
Alan Shapiro10th Edition
John Wiley & Sons, Inc.
PowerPoints by
Joseph F. Greco, Ph.D.
California State University, Fullerton
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CHAPTER 2THE DETERMINATION OF EXCHANGE RATES
CHAPTER OVERVIEW:2.1 SETTING THE EQUILIBRIUM SPOT EXCHANGE RATES
2.2 EXPECTATIONS AND THE ASSET MARKET MODEL
2.3 THE FUNDAMENTALS OF CENTRAL BANK INTERVENTION
2.4 THE EQUILILBRIUM APPROACH
Equilibrium Exchange Rates
2.1 SETTING THE EQUILIBRIUM A. The exchange rate
is the price of one unit of foreign currency expressed as a certain price in local
currency.
For example, $1.30/€ means the euro in the U.S. is worth $1.30.
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Equilibrium Exchange Rates
B. When Americans Purchase German Goods:
1. Foreign Currency Demanded derived from the demand for
foreign country’s goods, services, and financial
assets.e.g. The demand for German
cars by Americans
The Demand for € in the U.S.
Qty
$1.10/ €
$/€
D
At higher exchange rates, Americans demand less euros and vice versa.
$1.20/ €
$1.00/ €
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Equilibrium Exchange Rates2. Foreign Currency Supply:a. derived from the foreign
country’s demand for local goods. b. Foreigners must convert their
currency to purchase.e.g. German demand for US
goods means Germans convert € to US $ in order to buy
The Supply of € in the U.S.
Qty
$1.10/€
S$1.20/€
$1.00/€
At higher exchange rates, Germans supply more euros and vice versa.
$/ €
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Equilibrium Exchange Rates3. Equilibrium Exchange Rate
occurs where the quantity supplied equals the quantity demanded of a foreign currency at a specific local exchange rate
Equilibrium Exchange Rates
C. How Exchange Rates Change1. Increased demand
as more foreign goods are demanded, more of the foreign currency is demanded at each possible exchange rate
2. The exchange rate of the foreign currency in local currency increases.
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Equilibrium Exchange Rates
3. Home Currency Depreciation a. Foreign currency more valuable than
the home currency
b. Conversely, the foreign currency’s value has
appreciated against the home currency
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Equilibrium Exchange Rates
Computing a Currency Appreciation
= (e1 - e0)/ e0
where e0 = old currency value
e1 = new currency value
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Equilibrium Exchange Rates
Computing a Currency Depreciation:
= (e0 - e1)/ e1
where e0 = old currency value
e1 = new currency value
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Equilibrium Exchange Rates
D. FACTORS AFFECTING EXCHANGE RATES:
1. Inflation rates
2. Interest rates
3. GNP growth rates
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Expectations and the Asset Market Model of Exchange Rates
2.2 The Role of Expectations:
A. Currency = financial asset
B. Exchange rate = simple relation of two financial assets
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Expectations
C. The Nature of Money and Currency Values:
1. Asset Market Model
Exchange rates reflect the supply of and demand for foreign-currency denominated assets.
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Expectations
2. Soundness of a Nation’s Economic Policies
a nation’s currency tends to strengthen with sound economic policies
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Expectations3. Expectations and Central Bank Behavior
exchange rates are also influenced by expectations of central bank behavior
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ExpectationsD. Central Bank Reputations and Currency
Values
1. Central bank: the nation’s official monetary authority
Expectations2. Price Stability and Central Bank
Independence:
when the Bank limits its focus to
price stability, it is more likely to succeed in its goal.
Expectations3. Currency Boards
- exist where there is no central bank
- instead the board issues notes
- has not discretionary monetary policy
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Central Bank Interventions
2.3 How Real Exchange Rates Affect Relative CompetitivenessA. Appreciation:
-domestic prices increase relative to foreign prices.-Exports: less competitive Imports: more attractive
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Central Bank InterventionsB. Currency Depreciationdomestic prices fall
relative to foreign prices.- Exports: more price competitive- Imports: less attractive
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Central Bank InterventionsC. Foreign Exchange Market Intervention
Mechanics of InterventionSterilized vs Unsterilized Intervention
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Central Bank Interventions
D. The Effects of Foreign Exchange Market Intervention
1. Definition: the official purchases and sales of currencies through the
central bank to influence the home exchange rate
The Equilibrium Approach2.4 The Equilibrium Approach to Exchange Rates
A. Disequilibrium Theory and Exchange Rate Overshooting
1. various economic frictions cause prices to adjust slowly over time
2. leads to “overshooting”
The Equilibrium ApproachB. The Equilibrium Theory of Exchange
Rates and Its Implications
1. markets clear through price adjustments
2. Repeated shocks in supply and demand create a
correlation between changes in nominal and real exchange rates.
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