effect of exchange rate in foreign trade part iv

8/8/2019 Effect of Exchange Rate in Foreign Trade Part IV

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FOREIGNEXCHANGEMARKET AND

EXCHANGE RATES


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FOREIGN-EXCHANGE MARKETEQUILIBRIUM

Todays global economy characterized byhigh degree of international capital mobility.Hence investors can buy financial assetsdenominated in many different currencies inmany markets around the world.Would a situation in which investors couldearn a higher expected return from buying

Japanese rather than U.S. assets persist for along time?What would the opportunity for traders tomake profits result into?


3/23


If the Japanese assets have a higherexpected rate of return than the U.S. assets.

Traders around the world will recognize achance to make a profit by selling U.S. assetsand buying Japanese assets.What effects do these buying and sellingtransactions have on the expected return?


4/23


As traders and investors sell dollar-denominated assets and buy yen-denominated assets.

This increases demand for yen. This leads to appreciation of yen againstdollar.

This appreciation continues till the pointwhen investors are indifferent betweenholding U.S. or Japan assets.

This means the return from both the assetswill be equal.


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Lets assume U.S. interest rate to be 5%. Letscall it R the domestic expected rate of return.Suppose that future yen/dollar exchange rateis 100 and Japanese interest rates are 5%. LeIf current exchange rate is also 100yen/dollar, then R f the expected rate of returnfrom foreign assets equals R.


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But if current exchange rate is 105 yen/dollarand the future expected exchange rate is 100yen/dollar, that means dollar is expected todepreciate.

The dollar is expected to fall by 4.8%. This depreciation of dollar will increase theexpected return from foreign assets R f to9.8% (5% interest rate minus -4.8% expectedappreciation of dollar).


7/23


Alternatively, if current exchange rate is 97yen/dollar and the expected future exchangerate is 100 yen/dollar.

The dollar is expected to appreciate by 3.1%. This would imply that the expected rate of return from foreign assets R f will fall to 1.9%(5% interest rate minus 3.1% expectedappreciation of dollar).If we plot these points and join them we getan upward sloping R f line.


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1.9% 5%9.8%

Currentexchangerate,EX (yen/dollar)

105

100

97R > R f

R = R f

R < R f


9/23

EXCHANGE RATE FLUCTUATIONS:CHANGES IN DOMESTIC REAL INTERESTRATES

Interest rate is sum of real interest rate andexpected rate of inflation.We assume expected inflation is keptconstant.An increase in the domestic interest ratesincreases expected rate of return ondomestic assets.

This shifts the R curve from R 0 to R 1 towardsright.

This indicates a rise in exchange rate, thatmeans the domestic currency will appreciate.


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EXCHANGE RATE FLUCTUATIONS:CHANGES IN DOMESTIC REAL INTERESTRATES

Alternately if the domestic real interest ratesfall, it will lead to shifting of expected realrate of return towards left.

This would result in falling of exchange rates. That means depreciation of the domesticcurrency.


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EXAMPLE


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EXCHANGE RATE FLUCTUATIONS:CHANGES IN DOMESTIC EXPECTEDINFLATION

A change in nominal interest rate can also be causedby a change in expected inflation for any realinterest rate.Initially due to increase in expected inflation the

nominal interest rate rises, this shifts R towards rightleading to higher exchange rate.But later due to inflation, the value of the domesticcurrency is eroded, resulting in rightward shift of theRf curve, this causes exchange rate to fall down.

Most empirical studies have shown that the secondeffect dominates the first.

Thus it results in depreciation of domestic currency.


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EXCHANGE RATE FLUCTUATIONS:CHANGES IN FOREIGN INTERESTRATES

An increase in foreign interest rate shifts theexpected rate of return from foreign assets R f to right.

This means the exchange rate will fallleading to depreciation of the domesticcurrency.An opposite scenario, i.e. decrease in foreigninterest rate, will trigger an oppositemovement, it will lead to appreciation of domestic currency.


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EXCHANGE RATE FLUCTUATIONS:CHANGES IN EXPECTED FUTUREEXCHANGE RATES

An increase or decrease in the expectedfuture exchange rate reflects shifts in one ormore underlying determinants of exchangerate

Differences in price levels.Differences in productivity growth.Shifts in preferences for domestic or foreigngoods.

Differences in trade barriers.Also changes in expected future interest rates.


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EXCHANGE RATE FLUCTUATIONS:CHANGES IN EXPECTED FUTUREEXCHANGE RATES

Factors that cause an increase in expectedfuture exchange rate shift the foreignexpected rate of return to the left and causethe domestic currency to appreciate.Factors that decrease the expected exchangerate have the opposite effect of resulting indepreciation of domestic currency.


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CURRENCY PREMIUMS INFOREIGN-EXCHANGE MARKETS

Sometimes the investors would want somethingextra to treat two financial assets as equal and beindifferent to them while making their investmentdecisions.

Example:One year U.S. Treasury bill gives a rate of 8%.One year Germany government bond gives an interestrate of 5%.Also suppose investors expect dollar to depreciate

against deutsche marc by 4% over the coming year. Thus we get, 8% = 5% ( 4%) h f,dWe get h f,d =1%.


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FOREIGN-EXCHANGE INTERVENTIONAND THE EXCHANGE RATE

Central banks and governments seek to minimizechanges in exchange rates.A depreciating domestic currency raises costs of foreign goods and may lead to inflation.

Central banks attempt to reduce depreciation bybuying their own currency in foreign exchangemarket.An appreciating domestic currency ca makecountrys goods uncompetitive in world markets.Central banks attempt to reduce appreciation byselling their own currencies in the foreign exchangemarkets.


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UNSTERILIZED INTERVENTIONWhen a central bank allows the monetary base torespond to the sale or purchase of domesticcurrency in the foreign exchange market.Now to raise the value of its currency, the centralbank must buy domestic currency from foreignersand sell foreign assets.Foreign exchange intervention reduces themonetary base.If nothing else changes, the intervention increasesthe domestic short-term interest rate.As a result, domestic expected rate of return shiftstowards right .

This leads to increase in exchange rate


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UNSTERILIZED INTERVENTION

The central bank buys foreign assets and selldomestic currency, increasing the monetarybase and reducing the short-term interestrates.

This leads to shifting of domestic expectedrate of return towards left, i.e. it hasdeclined.

This leads to falling of exchange rates.


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STERILIZED INTERVENTION

Central banks could use domestic open marketoperations to offset the change in the monetarybase caused by foreign exchange intervention.Consider if Fed sells $1 billion of foreign assets.

In absence of any offsetting intervention, monetarybase falls by $1 billion.However it could at the same time conduct an openmarket purchase of $1 billion of government bonds.

This will eliminate the decrease in the monetarybase arising from the foreign exchangeintervention.


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SPECULATIVE ATTACK

In 1991, to reduce inflationary pressuresGerman central bank Bundesbank raisedshort term interest rates.As the interest rates rose above England,France, Italy and other European countries,speculators questioned if they would raisetheir interest rates or devalue theircurrencies.

Sweden raised the interest rates.England became the first test case.


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SPECULATIVE ATTACK

Bank of England sold its foreign exchangereserves of marks to buy large quantities of pounds to support its exchange rate againstmarc under ERM.

The purchase shrank the money supply andraised the short-term interest rates.

This restored the exchange rate.Here speculators used pounds to buy marksfrom Bank of England.

They believed pounds devaluation wouldenable them to buy back more pounds later.


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SPECULATIVE ATTACK

There was shift in R f towards right.

This meant deflecting the devaluation of pound would result in high short-terminterest rates.England was suffering from recession.After a week, British government withdrewpound from ERM.

After British, some other countries alsowithdrew from ERM.

effect of exchange rate in foreign trade part iv

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