the determination of exchange rates2

The determination ofexchange rates

2011

Group 1Astari IndraputriAhmad Fajarudin

Yogi Ardisa

Management International Class Program

Introduction

Setting the Equilibirum Spot Exchange Rate

Expectations and the Asset Market Model of Exchange Rates

The Fundamentals of Central Bank Intervention

The Equilibirum Approach to Exchange Rates

Table of Content

Introduction

Introduction

The purpose of this chapter is to provide an understanding of what

an exchange rate is and why it might change.

It also examines the different forms and consequences of central bank

intervention in the foreign exchange market.

Settingthe Equilibrium Spot

Exchange Rate

Setting the Equilibrium Spot Exchange Rate

Definition

An exchange rate is the price of one nation’s currency in terms of

another currency, often termed the reference currency.

Example:

the yen/dollar exchange rate is just the number of yen that one dollar

will buy.


Demand for a Currency

The demand for the euro, in the foreign market derives from the American

demand for German goods and services and euro-dominated financial

assets.

Supply for a Currency

The supply of euros is based on German demand for U.S. goods and

services and dollar-dominated financial assets.


Factors that Affect the Equilibrium Exchange Rate

1. Relative Inflation Rates

The supply of currency increases relative to its demand. The

excess growth in the money supply will cause inflation.

2. Relative Interest Rates

Interest rate differentials will also affect the equilibrium

exchange rate. The distinction between nominal and real interest

rates is critical in international finance.


Factors that Affect the Equilibrium Exchange Rate

3. Relative Economic Growth Rates

A nation with strong economic growth will attract investment

capital seeking to acquire domestic assets.

A nation with poor growth prospects will see an exodus of capital

and weaker currencies.

4. Political and Economic Risk

low-risk currencies are more highly valued than high-risk currencies.


Calculating Exchange Rate Change

Depending on the current value of the euro relative to the dollar, the

amount of euro appreciation or depreciation is computed as the

fractional increase or decrease in the dollar value of the euro.


The general formula by which we can calculate the euro’s appreciation

or depreciation against the dollar is as follows:

Amount of euro = New dollar value of euro – Old dollar value of euro

appreciation Old dollar value of euro




The general formula by which we can calculate the euro’s appreciation

or depreciation against the dollar is as follows:

Amount of euro = New euro value of dollar – Old euro value of dollar

depreciation Old euro value of dollar

Expectations andthe Asset Market Model

of Exchange Rates

Asset Market Model

The asset market model argues that exchange rates are

determined by the supply and demand for a wide variety of financial

assets:

1. Shifts in the supply and demand for financial assets alter exchange

rates.

2. Changes in monetary and fiscal policy alter expected returns and

perceived relative risks of financial assets, which in turn alter

exchange rates.


Asset Market Model

The asset market model assumes that whether foreigners are

willing to hold claims in monetary form depends on an extensive set of

investment considerations or drivers (among others):1. Prospects for economic growth2. Capital market liquidity3. A country’s economic and social infrastructure4. Political safety5. Contagion (spread of a crisis within a region)6. Speculation


Monetary Theory of Exchange Rates Currencies are, primarily monies. Hence, a theory of

exchange rates would do well to consider the nature of a money.

1. Money provides liquidity – it can be exchanged for goods and

services, or for other assets.

2. Money represents a store of value and a store of liquidity.

3. The demand for money is affected by the demand for assets

denominated in that currency.

4. Factors that increase the demand for the home currency also

increase the price of home currency on the foreign exchange market.


The Nature of Money and Currency Values

The economic factors that affect a currency’s foreign

exchange value include:

1. Its usefulness as a store of value, determined by its expected rate of

inflation

2. The demand for liquidity, determined by the volume of transactions

in that currency

3. The demand for assets denominated in that currency, determined by

the risk-return pattern on investment in that nation’s economy and

by the wealth of its residents.


Central Bank Reputations and Currency Values

The central bank uses instruments of monetary policy to create price

stability, low interest rates or a target currency value.

Most money today is fiat money – nonconvertible paper money, not tied

to any commodity value.

Hence, trust in the central bank translates into trust in the currency’s

future value.


Price Stability and Central Bank Independence In order to retain public credibility, central banks have to be like

company managements or boards of directors:

1. They need to adopt rules for price stability that are verifiable,

unambiguous and enforceable.

2. This requires independence and accountability.

3. Central banks that lack independence are often forced by the

government to pursue political goals, such as lower interest rates

or higher economic growth.

4. Often the bank is forced to monetize the deficit.


Price Stability and Central Bank Independence

Paradoxically, though, these goals are achievable only to the extent that

the central bank is trusted – and a consistent attempt to put political

objectives over economic ones will cause people to lose trust in the

central bank.


Maintaining Trust in the Currency

Currency Board

1. There is no central bank. The currency board issues notes and

coins that are convertible on demand at a fixed rate into a foreign

reserve currency

2. The currency board holds high-quality, interest-bearing securities

denominated in the reserve currency



Currency Board

3. Its reserves are equal to 100% or more of its notes and coins in

circulation.

4. A currency board forces a government to follow a responsible fiscal

policy. It cannot force the central bank to monetize the deficit.



Dollarization

1. This is the complete replacement of the local currency with the

U.S. dollar

2. The central bank loses seignorage.

3. However, monetary discipline is easier to maintain – with a

currency board, the market might not believe in the government’s

commitment to maintain full reserves.


The Fundamentalsof Central Bank

Intervention

How Real Exchange Rates Affect Relative Competitiveness

The important point for now is that an appreciation of the exchange rate

beyond that necessary to offset the inflation differential between two

countries raises the prices of domestic goods raletive to the price of

foreign goods.

Home currency depreciation results in a more competitive traded-goods

sector, stimulating domestic employment and inducing a shift in

resources from nontraded to the traded-goods sector.


How Real Exchange Rates Affect Relative Competitiveness

The bad part is that currency weakness also results in higher prices for

imported goods and services, eroding living standards and worsening

domestic inflation.


Foreign Exchange Market Intervention

Foreign exchange market intervention refers to official purchases

and sales of foreign exchange that nations undertake through their central

banks to influence their currencies.

• Mechanics of Intervention

The general purpose : to increase the market demand for one currency

by increasing the market supply of another.

• Sterilized versus Unsterilized Intervention


The Effects of Foreign Exchange Market Intervention

The basic problem with central bank intervention ia that it is likely to

be either ineffectual or irresponsible.

Sterilized intervention could affect exchange rates by conveying

information or by altering market expectations.

Unsterilized intervention can have a lasting effect on exchange rates,

but by creating inflation in some nations and deflation in other.


Open-Market Operations

Open-market operation affect the equilibrium exchange rate in a

manner analogous to unsterelized intervention, primarily through their

impact on inflation rates.

To sumarize the empirical evidance, real exchange rates are determined

primarily by real economic variables, such as relative national incomes

and interest rates between countries.


The EquilibirumApproach to

Exchange Rates

The Equilibirum Approach toExchange Rates

Disequilibrium Theory and Exchange Rate Overshooting

The correlation between nominal and real exchange rate

changes is supplied by the disequilibrium theory of exchange rates.

The sequences of events associated with overshooting is as

follows:

1. The central bank expands the domestic money supply.

2. This monetary expansion depresses domestic interest rates.

3. Capital begins flowing out of the country because of the lower domestic

interest rates, causing an instantaneous


The Equilibrium Theory of Exchange Rates and Its

Implications

The equilibrium approach has three important implication

for exchange rate :

1. Exchange rates do not cause changes in relative prices but are part of

the process through which the changes occur in equilibrium.

2. Attempts by government to affect the real exchange rate via foreign

exchange market will fail.


The Equilibrium Theory of Exchange Rates and Its

Implications

The equilibrium approach has three important implication

for exchange rate :

3. There is no simple relation between changes in the exchange rate

and changes in international competitiveness, employment, or the

trade balance.

Thank You

the determination of exchange rates2

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