2. 1 The Determination of Exchange Rates Chapter 2

3. 2 CHAPTER 2 THE DETERMINATION OF EXCHANGE RATES CHAPTER OVERVIEW: I. EQUILIBRIUM EXCHANGE RATES II.ROLE OF CENTRAL BANKS III. EXPECTATIONS AND THE ASSET MARKET MODEL

4. 3 Part I. Equilibrium Exchange Rates SETTING THE EQUILIBRIUM EXCHANGE RATES market-clearing prices that equilibrate the quantities supplied and demanded of a foreign currency.

5. 4 Equilibrium Exchange Rates How Americans Purchase German Goods 1. Foreign Currency Demand -derived from the demand for foreign country’s (German) goods, services, and financial assets by locals (US). e.g. The demand for German goods by Americans

6. 5 Equilibrium Exchange Rates 2. Foreign Currency Supply: -derived from the foreign country’s demand for local (US) goods. -They must convert their currency to purchase. e.g. German demand for US goods means Germans convert Euro to US $ in order to buy US goods.

7. 6 Equilibrium Exchange Rates 3. Equilibrium Exchange Rate occurs where the quantity supplied of Euro equals the quantity demanded at a specific local (US) price. In this example the demand and supply for Euro is not only based on Germany and US

8. 7 Equilibrium Exchange Rates How Exchange Rates Change 1. Increased demand as more foreign goods are demanded, the price of the foreign currency in local currency increases and vice versa.

9. 8 Equilibrium Exchange Rates 2. Increased supply as foreigners demand more local goods are, the price of the local currency in foreign currency increases and vice versa.

10. 9 Equilibrium Exchange Rates 3. Equilibrium Exchange Rate adjusts based on the changes in the quantity supplied and the quantity demanded of a currency.

11. 10 Equilibrium Exchange Rates Home Currency depreciation - Foreign currency becoming more valuable than the home currency. - Conversely, the foreign currency’s value has appreciated against the home currency.

12. 11 Equilibrium Exchange Rates 3. Calculating a Depreciation: = (e 0 - e 1 )/ e 1 where e 0 = old currency value e 1 = new currency value

13. 12 Equilibrium Exchange Rates Currency Appreciation = (e 1 - e 0 )/ e 0 where e 0 = old currency value e 1 = new currency value

14. 13 Equilibrium Exchange Rates EXAMPLE: Euro Appreciation If the dollar value of the Euro goes from $0.84 (e 0 ) to $0.89 (e 1 ), then the Euro has appreciated by (.89 -.84)/.84 = 5.95%

15. 14 Equilibrium Exchange Rates EXAMPLE: US$ Depreciation We use the first formula, (e 0 - e 1 )/ e 1 substituting (.84 -.89)/.89 = - 5.62% the US$ depreciation.

16. 15 Equilibrium Exchange Rates D. FACTORS AFFECTING EXCHANGE RATES: 1.Inflation rates 2. Interest rates 3.GNP growth rates Of the two countries

17. 16 EXPECTATIONS Role of Expectations : -Currency is a financial asset -Exchange rate is simple relationship of two financial assets -Expectations about the future plays an important role in determining the current value

18. 17 EXPECTATIONS Demand for Money and Currency Values: Asset Market Model A. Exchange rates reflect the supply of and demand for foreign-currency denominated assets.

19. 18 EXPECTATIONS B.Soundness of a Nation’s Economic Policies A nation’s currency tends to strengthen with sound economic policies. Strength of the economy is reflected on the currency.

20. 19 EXPECTATIONS EXPECTATIONS AND CENTRAL BANK BEHAVIOR - exchange rates are also influenced by expectations of central bank behavior.

21. 20 EXPECTATIONS A.Central Bank Reputations B.Central Bank Independence C.Currency Boards

22. 21 THE ROLE OF CENTRAL BANKS V. FUNDAMENTALS OF CENTRAL BANK INTERVENTION A.Role of Exchange Rates: LINKS BETWEEN THE DOMESTIC AND THE WORLD ECONOMY

23. 22 THE ROLE OF CENTRAL BANKS B.IMPACT OF EXCHANGE RATE CHANGES 1.Appreciation: -domestic prices increase relative to foreign prices. -Exports: less competitive Imports: more attractive

24. 23 THE ROLE OF CENTRAL BANKS 2.Currency Depreciation - domestic prices fall relative to foreign prices. - Exports: more price competitive. - Imports: less attractive

25. 24 THE ROLE OF CENTRAL BANKS C.Foreign Exchange Market Intervention 1.Definition: the official purchases and sales of currencies through the central bank to influence the home exchange rate.

26. 25 THE ROLE OF CENTRAL BANKS Intervention : -Sterilized, by open market operations -Unsterilized Effectiveness of intervention