exchange rate determination

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  • 1. Abstract of the paperThis paper develops an equilibrium model of the determination of exchange rates and prices of goods. Changes in relative prices of goods, due to supply or demand shifts, induce changes in exchange rates and deviations from purchasing power parity.These changes may create a correlation between the exchange rate and the terms of trade, but this correlation cannot be exploited by the government to affect the terms of trade by foreign exchange market operations.

2. INTRODUCTIONExchange rate and their rate of change are more volatile than the change of the relative price.Frequent changes in the exchange rate have failed to resemble contemporaneous changes in the relative price level in either magnitude or directionProblem in determination of equilibrium . 3. Therefore,This paper proposes an alternative equilibrium explanation of ex- change rate behavior. The explanation is based on a model of the simultaneous determination of exchange rates and relative prices of different goods in international trade in an intertemporal framework with uncertainty and rational expectations 4. Key points of the paperExchange rate may be volatile i.e. changes in the exchange rate will be more than the changes in the relative prices of good in two countriesThe exchange rate and the term of trade cannot exploited by the governmentCreates uncertainty even when all markets are in equilibriumDeviates from PPPCorrelation of the exchange rate and the term of trade for the countries with homogenous monetary policy 5. These relative price changes were emphasized in the traditional literature on exchange rates but have been neglected in the recent exchange rate literature associated with the monetary approach. Government commercial policies such as tariff's or quotas can, however, affect the exchange rate by changing the terms of' trade. Cassel (1922) (discussed the role of commercial policies in causing deviations from purchasing power parity. Muss (1974) examined the effects of commercial policies on the balance of' payments, and his argument could be applied to flexible exchange rate case; the effect he emphasizes is the change in real income and hence the domestic demand for domestic money due to a tariff. 6. Factor affecting determination of exchange rate Inflation rates: Higher domestic inflation means less demand for domestic goods and more demand for foreign goods (increased demand for foreign currency), causing increasing in exchange rate i.e. depreciation of domestic currency. Interest rates: Higher domestic (real) interest rates attract investment funds causing a decrease in demand for foreign currency and an increase in supply of foreign currency. Economic growth: Stronger economic growth attracts investment funds causing a decrease in demand for foreign currency and an increase in supply of foreign currency. Changes in future expectations: Any improvement in future expectations regarding the domestic currency or economy will decrease the demand for foreign currency . Government intervention: Maintain weak currency to improve export competitiveness. 7. INTRODUCTIONA theory of long-term equilibrium exchange rates based on relative price levels of two countries. The theory of purchasing power parity (PPP) explains movements in the exchange rate between two countries' currencies by changes in the countries' price levels. Law of one price Identical goods sold in different countries must sell for the same price when their prices are expressed in terms of the same currency. This law applies only in competitive markets, free of transport costs and official barriers to trade The Relationship Between PPP and the Law of One Price The law of one price applies to individual commodities, while PPP applies to the general price level. If the law of one price holds true for every commodity, PPP must hold automatically for the same reference baskets across countries if each commodity is traded. 8. TWO TYPES OF PURCHASINGPOWERPARITY1. Absolute Purchasing Power Parity 2. Relative Purchasing Power ParityThe Absolute Purchasing Power Parity relation is: e= pd/pf where pd is the domestic price index, pf the foreign price index, and e is the spot exchange rate (domestic currency units per unit of the foreign currency).Relative PPP is said to hold if e=pd - pf Relative PPP states that the percentage change in the exchange rate is equal to the percentage change in the domestic price level minus the percentage change in the foreign price level 9. Absolute PPP indicates that the exchange rate between two currencies is equal to the ratio of the two countries price indexes. The exchange rate is a nominal value, that is, its value is dependent on current price levels.If absolute PPP holds, then relative PPP also holds. If absolute PPP does not hold, relative PPP may still hold.Real events (demand and supply socks) which cause relative price changes are often random or unexpected 10. Problems with Law of One PriceThe more homogeneous goods are, the more the law of one price is expected to hold but it could not be found in reality There are obstacles to equalization of product prices across countries, including differentiated products and costly information. Transportation cost and restricting trade policies (such as tariff and quatas are present) 11. Reasons for Deviations from PPPThe law of one price does not apply to differentiated products or to globally non-traded goods. Prices may differ due to freight costs or tariffs. Relative price changes may result from real economic events such as changing tastes, bad weather, or government policy. Since people in different countries consume different goods, national price indexes may not be comparable. 12. Assets market approach for the determination of exchange rateMonetary approachDeals with the demand and supply of moneyPortfolio approachThe portfolio balance approach points out the imperfect substitution between home assets and foreign assets . 13. Monetary approachChange in exchange rate due to change in demand or supply of moneyDemand for money is the Increasing function of income and the decreasing function of interest rate.If, e= pd- pf then 14. Exchange rater depends upon, Difference in the demand for money Difference in the income Difference in the rate of interesteIf, mfIf, id&eIf, md 15. (Cont.)An increase in domestic money supply causes an excess money supply and results in a price increase in home country and a depreciation of domestic currency. An increase in domestic national income brings about more money demand , the exchange rate falls or in other words, domestic currency appreciates. A rise in home interest rate reduces money demand and causes the price level to increase. The exchange rate then rises causing domestic currency to depreciates. A rise in the expectation of future exchange rates will result in an immediate depreciation of domestic currency. 16. Model emphasizedRole of relative price change due to real disturbance . Traditional elasticity theoryExchange rate 17. Change in money supply Change in stock of moneyIncreases the nominal prices of good and serviceIncreases the nominal prices of foreign exchange 18. Relative price change and exchange rate Nominal price change in each countryExchange rateTerms of tradeCause Shifts in the demand and supplyCorrelation is high for the country with more homogenous monetary policy 19. Relationship of terms of trade and exchange rateAppreciation the currencyFavorable terms of tradeDepreciation of currencyUnfavorable terms of tradeTerms of trade: ratio of the export price/import price px/py for country1 py/px for nation 2 , 20. Relationship with inflation and the exchange rateHigh inflation in the countryLow inflation in the countrydepreciationappreciationCountries with persistently high levels of inflation tend to experience exchange rate depreciation, while low inflation countries have appreciating exchange rates. Thus, inflation and exchange rates tend to move in opposite directions . There is an inverse relationship between the two variables.Inflation only affects purchasing power if the rise happens unevenly across prices of goods and factors of production acros the world. 21. o Ms1 and Ms2 are nominal quantities of money supply . o P1 and P2 is the price of good one and good two. o Country one is the domestic country and country two is the foreign country. o e is the exchange rate where, e=Pd/Pf 22. Assumption The real quantity of money supply remains constant for each country i.e.M1/P1 and M2/P2 is constant over time. The relative prices of one good in terms of other good = T=P1/e*P2(T = relative prices of goods) If relative price shifts i.e. price of good one increases and price of good two decreases then demand for good two increases and good one decreases. 23. T= Pd/e*Pf TPfe=Pd/PfPd=e*PfDemand for the domestic goods decreases, and foreign good increases leading to appreciation of the foreign currency and depreciation of the domestic currency.Exchange rate is high in domestic country-depreciation of the currency Exchange rate is low in foreign country-appreciation of the currency 24. Rational expectation Md=f (i, e) Where, md = demand for money, I = rate of interest e = expected inflation rateswe can know, 1 future rate of monetary growth 2 inflation on the current exchange rate and the price levelIf the expected inflation is going to increase the domestic currency will depreciates. 25. Relationship between exchange rate and relative prices. ASSUMPTION OF THE MODEL.Money is only used for precautionary purpose and transactioanary purposeReal demand for money is not constant .i.e. M1/P1 and M2/P2.] A change in relative price T is partially effected by e and partially effected byP1 and P2. Good1 is produce in country 1and good 2 is produce in country 2 Goods are not stored. Complete specializationShocks to production is independent acr

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