Exchange Rate Determination (1): Overview

J.D. HanKing’s University College

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(Key Question)

1.What causes exchange rates to fluctuate?2. How do you predict exchange rates (and their changes) in SR and LR respectively?3. What is the ‘correct or equilibrium exchange rate’?4.What are the benefits of having flexible exchange rates as opposed to not having ones (using the big country’s currency)?

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• International Trade and Price Level->Purchasing Power ParityExchange rates depend on relative price ratio or inflation differentials

• International Investment and Interest Rate-> Interest Parity Theorem

* Overview Revisited: Three TheoriesThere are three theories which link the economic fundamental to FOREX rate

• Real Factor Real AnalysisReal FOREX rate changes due to real factors such as Demand and Supply of Goods

•Monetary Approach -> “Money Supply affects interest rates and inflation rates; Thus this encompasses the above two.

There are Four theories which link the economic fundamental to a specific equilibrium exchange rate

1) International Investment Theory (SR)

- Differences in Rates of Returns

2) Purchasing Parity Theory(LR)

- Relative Prices

3) Monetary Approach- Money affects i and P; thus

Money affects FOREX rates

4) Real Factor Analysis

-S (Technical Innovation)/

D(changes in demand)

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Preview

• The basics of exchange rates

• Exchange rates and the prices of goods

• The foreign exchange markets

• The demand for currency and other assets

• A model of foreign exchange markets role of interest rates on currency deposits role of expectations about the exchange rates

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1. Definitions of Exchange Rates:Direct Quotation

• Exchange rates are quoted as foreign currency per unit of domestic currency or domestic currency per unit of foreign currency(S) .

• For Canadians, S = S units of Canadian dollars to get one unit of U.S. dollar = S Canadian$/U.S.$

• This quotation make the best economics sense:

How much does a Honda cost? $3,000 How much does a unit of U.S. dollar cost = Canadian $1.02

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* Depreciation and Appreciation

• Depreciation is a decrease in the value of a currency relative to another currency. Appreciation is an increase in value.

• Suppose that our quotation of S per FOREX goes up: Canadian $1/U.S.$1 -- Canadian $1.20/U.S.$1 FOREX becomes more expensive; Appreciation of FOREX (U.S. dollar) Depreciation of domestic currency (Canadian

dollar)

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Depreciation and Appreciation (cont.)

• Appreciation is an increase in the value of a currency relative to another currency. An appreciated currency is more valuable (more

expensive) and therefore can be exchanged for (can buy) a larger amount of foreign currency.

$1/€1 -> $0.90/€1 means that the dollar has appreciated relative to the euro. It now takes only $0.90 to buy one euro, so that the dollar is more valuable

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2. Spot Rates and Forward Rates

• Spot FOREX rate or S is exchange rate for currency exchanges “on the spot”, or when trading is executed in the present.

current spot FOREX rate = St

Spot FOREX rate of the future = St+1

expected future FOREX rate for the next period = tSt+1 e

• Forward rates or F is today’s exchange rate for currency exchanges that will occur at a future (“forward”) date: Rates are negotiated between individual institutions in the present, but the exchange occurs in the future.

Contract is done today; the rate is set and known today Delivery will be done in the future; forward dates are typically 30, 90,

180 or 360 days in the future.

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3. The Foreign Exchange Market (cont.)

Characteristics of the market:

• Trading occurs mostly in major financial cities: London, New York, Tokyo, Frankfurt, Singapore.

• The volume of foreign exchange has grown: in 1989 the daily volume of trading was $600 billion,

in 2001 the daily volume of trading was $1.2 trillion.

• About 90% of transactions in 2001 involved US dollars.