man 441: internatıonal finance exchange rates and the determination of exchange rates

MAN 441: Internatıonal FinanceMAN 441: Internatıonal Finance

Exchange Rates and The Determination of Exchange Rates and The Determination of Exchange RatesExchange Rates

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THE DETERMINATION OF EXCHANGE RATESTHE DETERMINATION OF EXCHANGE RATES

CHAPTER OVERVIEW:CHAPTER OVERVIEW:

I.I. EXCHANGE RATESEXCHANGE RATES

II. II. EQUILIBRIUM EXCHANGE RATESEQUILIBRIUM EXCHANGE RATES

IIIIII.. ROLE OF CENTRAL BANKSROLE OF CENTRAL BANKS

IIVV. . EXPECTATIONS AND THE EXPECTATIONS AND THE ASSET MARKET ASSET MARKET MODELMODEL

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Definion of Exchange Rates

The price of one currency in terms of another currency is called an The price of one currency in terms of another currency is called an exchange rateexchange rate. .

For example, the $/Euro exchange rate is just the number of dollars that one Euro For example, the $/Euro exchange rate is just the number of dollars that one Euro will buy. If a Euro would buy 1.2154 dollars, exchange rate would be expressed as will buy. If a Euro would buy 1.2154 dollars, exchange rate would be expressed as $1.2154/Euro. In this example, $ is the $1.2154/Euro. In this example, $ is the referencereference currency. currency.

- - Exchange rates has a strong influence on the current account and other Exchange rates has a strong influence on the current account and other macroeconomic prices <-> an important price. macroeconomic prices <-> an important price.

- Is also an asset price, and is governed by the same principles governing the - Is also an asset price, and is governed by the same principles governing the behaviour of other asset prices (form of wealth <-> expectations) behaviour of other asset prices (form of wealth <-> expectations)

Spot RateSpot Rate: the price at which currencies are traded for immediate delivery, or in : the price at which currencies are traded for immediate delivery, or in two days in the interbank market.two days in the interbank market.

Forward RateForward Rate: the price at which foreign exchange is quoted for delivery at a : the price at which foreign exchange is quoted for delivery at a specified future date (e.g. 3 months)specified future date (e.g. 3 months)

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Equilibrium Exchange Rates

Equilibrium EREquilibrium ER is the is the market-clearing price that equilibrate the market-clearing price that equilibrate the quantities supplied and demanded of foreign currency.quantities supplied and demanded of foreign currency.

B. How Americans Purchase German GoodsB. How Americans Purchase German Goods

1. Foreign Currency Demand1. Foreign Currency Demand

-derived from the demand for a foreign -derived from the demand for a foreign country’s goods, services, and financial country’s goods, services, and financial assets.assets.

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

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The Demand for € in the U.S.The Demand for € in the U.S.

Qty

$.50

$/€D

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Equilibrium Exchange RatesEquilibrium Exchange Rates

B.2. Foreign Currency Supply:B.2. Foreign Currency Supply:

a. derived from the foreign country’s a. derived from the foreign country’s demand for local goods. demand for local goods.

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

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

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

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The Supply of € in the U.S.The Supply of € in the U.S.

$/ $/ €€

Qty

$.50

S

88


B.3. Equilibrium Exchange RateB.3. Equilibrium Exchange Rate

occurs where the quantity occurs where the quantity supplied equals the supplied equals the quantity demanded of a foreign currency at a specific quantity demanded of a foreign currency at a specific local price.local price.

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The $/ € Equilibrium RateThe $/ € Equilibrium Rate

Qty

$.50

S

$/ €D

Equilibrium

1010


1. Increased demand1. Increased demand for Euro for Euro

(D curve shifts up)(D curve shifts up)

-More local goods are demanded at the initial equilibrium by foreignersMore local goods are demanded at the initial equilibrium by foreigners

-- Foreign currency loses value in terms of local currency (depreciation)- Foreign currency loses value in terms of local currency (depreciation)

How Exchange Rates ChangeHow Exchange Rates Change

1111

Qty

$.50

S

$/ €

D

D’

$.65

Q1 Q2

The US$ Depreciates The US$ Depreciates

1212


1. Increased 1. Increased Supply of EuroSupply of Euro

(S curve shifts rıght)(S curve shifts rıght)

- More - More foreign goods are demandedforeign goods are demanded at the initial equilibrium at the initial equilibrium

- Foreign currency value increases in terms of local currency - Foreign currency value increases in terms of local currency (appreciation)(appreciation)

1313

The US$ Appreciates WhenThe US$ Appreciates When

Qty

$.50 S

$/ €

D

$.35

Q1 Q2

S’

1414


C.5C.5 Currency Appreciation Currency Appreciation

= (e= (e1 1 - e- e00)/ e)/ e00

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

ee11 = new currency value = new currency value

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EXAMPLE: EXAMPLE: €€ Appreciation Appreciation

If the dollar value of the If the dollar value of the €€ goes from $0.50 (e goes from $0.50 (e00) to $0.65 ) to $0.65

(e(e11), then the ), then the €€ has appreciated by has appreciated by

(.65 - .50)/ .50 = 30%(.65 - .50)/ .50 = 30%

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C.4. Calculating a DepreciationC.4. Calculating a Depreciation for $ for $::

= (e= (e0 0 - e- e11)/)/ ee11 how?how?

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

ee11 = new currency value = new currency value

==>> ( (1/1/ee11)) - - (1/(1/ee00))))/ / (1/(1/ee00))

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EXAMPLE: US$ DepreciationEXAMPLE: US$ Depreciation

Use the formulaUse the formula

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

substitutingsubstituting

(.50 - .65)/ .65 = - 23.1%(.50 - .65)/ .65 = - 23.1%

is the US$ depreciation.is the US$ depreciation.

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

1.1. Inflation ratesInflation rates

2. 2. Interest ratesInterest rates

3.3. GNPGNP/GDP/GDP growth rates growth rates

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1. Inflation Rate – Higher US inflation rate1. Inflation Rate – Higher US inflation rate

Qty

e**S

$/ €

D’

e*

Q1 Q2

S’D

- Excess growth ın Money Supply Excess growth ın Money Supply higher higher inflationinflation

- US goods are more expensiveUS goods are more expensive

- Demand for US products declines => Demand for US products declines => decline in Euro supply (demand for $ also decline in Euro supply (demand for $ also drops). drops).

- Hence, Supply curve for Euro shifts upHence, Supply curve for Euro shifts up

- At the same time, demand for Euroland At the same time, demand for Euroland products increases => Euro demand products increases => Euro demand ıncreases at the same exchange rate. ıncreases at the same exchange rate.

- Hence, Demand curve shifts right Hence, Demand curve shifts right

As a result of these interactions, new As a result of these interactions, new equilibrium results at e**, where US dollar equilibrium results at e**, where US dollar depreciates.depreciates.

““Higher inflation rate in a country leads to a Higher inflation rate in a country leads to a depreciation in its currency”depreciation in its currency”

2020


1. Interest Rate1. Interest Rate

An increase in US real interest rate relative to Euroland will:An increase in US real interest rate relative to Euroland will:

-Shift investments to dollar denominated securities – Increased Euro SupplyShift investments to dollar denominated securities – Increased Euro Supply

- Hence, Euro will depreciate (dollar will appreciate)Hence, Euro will depreciate (dollar will appreciate)

2. Economic Growth2. Economic Growth

Strong economic growth will attract investment capital seeking to acquire domestic assets.Strong economic growth will attract investment capital seeking to acquire domestic assets.

This, in turn, will lead to a higher demand for domestic currency.This, in turn, will lead to a higher demand for domestic currency.

3. Political and Economic Risk3. Political and Economic Risk

Lower political and economic risk will strengthen a nation’s currrency.Lower political and economic risk will strengthen a nation’s currrency.

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Sample ProblemSample Problem

Suppose the U.S. dollar appreciates against the Russian Suppose the U.S. dollar appreciates against the Russian ruble by 500%. How much did the ruble depreciate ruble by 500%. How much did the ruble depreciate against the dollar?against the dollar?

To solve the problem, you can approach it in two steps:To solve the problem, you can approach it in two steps: Solve for eSolve for e11

Substitute and solve for the depreciation (x)Substitute and solve for the depreciation (x)

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U.S. $ APPRECIATIONU.S. $ APPRECIATION

1 0

0

( )5.00

e e

e

2323

RUBLE DEPRECIATIONRUBLE DEPRECIATION

0 1

1

e ex

e

2424

SOLUTION – Step 1 Solve for e1SOLUTION – Step 1 Solve for e1

1 0

0

5e e

e

01

0 0

1

0

1 0

5

1 1 5 1

6

ee

e e

e

e

e e

1 0

0

5e e

e

2525

SOLUTION – Step 2 Substitute and solve for xSOLUTION – Step 2 Substitute and solve for x

0 1

1

( )e ex

e

0 0

0

6

6

5

683%

e ex

e

x

x

2626

SOLUTIONSOLUTION

When the dollar appreciated by 500% When the dollar appreciated by 500% against the ruble, the ruble depreciated against the ruble, the ruble depreciated 83% against the dollar.83% against the dollar.

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EXPECTATIONSEXPECTATIONS

Currency values are affected byCurrency values are affected by

current eventscurrent events

current supply and demand flowscurrent supply and demand flows

expectations about future exchange rate expectations about future exchange rate movementsmovements

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Why expectations?Why expectations?

currencies are financial assetscurrencies are financial assets

exchange rate is simply the relative exchange rate is simply the relative price of two currenciesprice of two currencies

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The desire to hold a currency today depends critically on The desire to hold a currency today depends critically on expectations of the factors that can affect the currency’s expectations of the factors that can affect the currency’s future value.future value.

=> Exchange rates are forward looking. Hence, they are => Exchange rates are forward looking. Hence, they are strongly influenced by expectations about future economic, strongly influenced by expectations about future economic, social and political factors.social and political factors.

Asset Market Model of Exchange Rate Determination:Asset Market Model of Exchange Rate Determination:

The value of a currency today depends on whether or not The value of a currency today depends on whether or not people still want to hold that currency (or assets people still want to hold that currency (or assets denominated in that currency) in the future.denominated in that currency) in the future.

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What is Money?What is Money?

Serves as a Serves as a medium of exchangemedium of exchange. People are . People are willing to accept it in exchange for goods and willing to accept it in exchange for goods and servicesservices

Provides Provides liquidityliquidity. . Store of valueStore of value – transfer purchasing power from – transfer purchasing power from

the present into the futurethe present into the future Unit of accountUnit of account – prices are expressed in terms of – prices are expressed in terms of

a standardized unit of account (e.g. without a standardized unit of account (e.g. without money, how would you buy milk if you only had money, how would you buy milk if you only had eggs?) eggs?)

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Demand for MoneyDemand for Money

Hence, demand for money depends on:Hence, demand for money depends on: İts ability to maintain its valueİts ability to maintain its value Level of economic activity Level of economic activity

Hence,Hence, lower expected inflation lower expected inflation higher demand for money higher demand for money higher economic growth higher economic growth higher demand for money higher demand for money

The demand for money is also affected by:The demand for money is also affected by: Expected real return (positively)Expected real return (positively) Riskiness of country’s assets (negatively)Riskiness of country’s assets (negatively)

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Demand for MoneyDemand for Money

Since exchange rates represent the relative demand Since exchange rates represent the relative demand for two moneys, same factors also impacts the for two moneys, same factors also impacts the exchange rates.exchange rates.

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Central BankCentral Bank

ExchangeExchange rates are also influenced by rates are also influenced by expectations of central bank behavior.expectations of central bank behavior.

A.A. Central Bank ReputationsCentral Bank Reputations – money is like a brand-name product – money is like a brand-name product whose value is backed by the reputation of the central bankwhose value is backed by the reputation of the central bank

– Fiat money: nonconvertible paper money; no anchor to the price level Fiat money: nonconvertible paper money; no anchor to the price level (no standart of value)(no standart of value)

B.B. Central Bank IndependenceCentral Bank Independence and accountability and accountability for a good for a good reputationreputation

Currency BoardsCurrency Boards: issues notes and coins that are convertible on demand and at : issues notes and coins that are convertible on demand and at a fixed rate into a foreign reserve currency. There is no central bank.a fixed rate into a foreign reserve currency. There is no central bank.

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InterventionIntervention

A rise in the real or inflation-adjusted exchange rate raises the prices of A rise in the real or inflation-adjusted exchange rate raises the prices of domestic goods relative to the price of foreign goods.domestic goods relative to the price of foreign goods.

hurts exports; cheaper foreign products for consumershurts exports; cheaper foreign products for consumers

Foreign Exchange market interventionForeign Exchange market intervention refers to official purchases of and sales refers to official purchases of and sales of foreign currency through central banks. of foreign currency through central banks.

– unsterilized: domestic money supply is not insulated from the foreign unsterilized: domestic money supply is not insulated from the foreign exchange transactionsexchange transactions

– Sterilized: The impact of foreign exchange transaction is sterilized Sterilized: The impact of foreign exchange transaction is sterilized through an open market operation (e.g., sale or purchase of treasury through an open market operation (e.g., sale or purchase of treasury bills by Central Bank)bills by Central Bank)

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InterventionIntervention

Suppose both Fed and CB ın Euroland wants to keep old Suppose both Fed and CB ın Euroland wants to keep old equlibrium at eequlibrium at e00. .

excess demand for euros equal to (Q3-Q1)excess demand for euros equal to (Q3-Q1)

excess supply of US dollars equal to (Q3-Q1)* excess supply of US dollars equal to (Q3-Q1)* ee00. .

US Money Supply will fall, Euroland Money US Money Supply will fall, Euroland Money supply will risesupply will rise

Qty

e**S

$/ €

D’

e*

Q1 Q2

S’D

Q3

Sterilized intervention has transitory impact since it impacts expectations and not the fundemantals.

Unsterilized can have lasting impact by impacting money supply and hence creating inflation (or deflation)

man 441: internatıonal finance exchange rates and the determination of exchange rates

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