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Lecture 6: Exchange Rate Theory Based on Sloman Chapter 24 Lecture 6: Exchange Rate Theory Based on Sloman Chapter 24.

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Presentation on theme: "Lecture 6: Exchange Rate Theory Based on Sloman Chapter 24 Lecture 6: Exchange Rate Theory Based on Sloman Chapter 24."— Presentation transcript:

1 Lecture 6: Exchange Rate Theory Based on Sloman Chapter 24 Lecture 6: Exchange Rate Theory Based on Sloman Chapter 24

2 Definitions of the Exchange Rate Price of good in UK= price on continent by exchange rate Price of £1 is 1.49 Euros (Euros per pound)

3 Definitions of the Exchange Rate e= Domestic price of foreign currency Price of good in UK = price of foreign currency multiplied by the price of good abroad Price in £ (pennies) of 1Euro –.67 per Euro

4 But what determines ER Trade equalises prices of tradable good Once local prices are determined e is determined. Conversely, if world prices and exchange rate is determined then local prices are determined

5 What determines Prices Some people argue that prices are determined by money supply P.Y= MV GNP=must be paid for GNP= Money by the time it changes hands Some people argue that prices are determined by money supply P.Y= MV GNP=must be paid for GNP= Money by the time it changes hands

6 What determines Prices If so exchange rate is determined by ratio of prices

7 What determines Prices So if increase M d, prices up, E goes down (a depreciation, worth less) If Velocity rises) money goes around faster, prices up, depreciation If Income rises (prices fall!!!), E up So if increase M d, prices up, E goes down (a depreciation, worth less) If Velocity rises) money goes around faster, prices up, depreciation If Income rises (prices fall!!!), E up

8 Big Mac Index Burgernomics is based on the theory of purchasing- power parity, the notion that a dollar should buy the same amount in all countries. Thus in the long run, the exchange rate between two countries should move towards the rate that equalises the prices of an identical basket of goods and services in each country. Our "basket" is a McDonald's Big Mac, which is produced in about 120 countries. The Big Mac PPP is the exchange rate that would mean hamburgers cost the same in America as abroad. Comparing actual exchange rates with PPPs indicates whether a currency is under- or overvalued. http://www.economist.com/markets/bigmac/index.cf mhttp://www.economist.com/markets/bigmac/index.cf m Big Mac Index Burgernomics is based on the theory of purchasing- power parity, the notion that a dollar should buy the same amount in all countries. Thus in the long run, the exchange rate between two countries should move towards the rate that equalises the prices of an identical basket of goods and services in each country. Our "basket" is a McDonald's Big Mac, which is produced in about 120 countries. The Big Mac PPP is the exchange rate that would mean hamburgers cost the same in America as abroad. Comparing actual exchange rates with PPPs indicates whether a currency is under- or overvalued. http://www.economist.com/markets/bigmac/index.cf mhttp://www.economist.com/markets/bigmac/index.cf m

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10 Purchasing Power Parity Tradeable goods prices are equal –Need to exclude transport costs, –Looking only at the purely tradable component -have to discount fact that property prices in London are the same as in Skye ( NON-TRADABLE GOODS) –Labour costs – e.g. Hair cuts in Budapest v Birmingham Tradeable goods prices are equal –Need to exclude transport costs, –Looking only at the purely tradable component -have to discount fact that property prices in London are the same as in Skye ( NON-TRADABLE GOODS) –Labour costs – e.g. Hair cuts in Budapest v Birmingham

11 Alternative Theory – Interest rate parity If I invest money in UK expect same return as invest in France So Interest rates have to be the same But not. SO if invest in UK interest rate +movement on ER = return in France. So if ir f =3% and ir uk =5% then 3% =5%-depreciation of 2% If I invest money in UK expect same return as invest in France So Interest rates have to be the same But not. SO if invest in UK interest rate +movement on ER = return in France. So if ir f =3% and ir uk =5% then 3% =5%-depreciation of 2%

12 Alternative Theory – Interest rate parity So if ir f =3% and ir uk =5% then 3% =5%-depreciation of 2% So can put £1 in UK bank at £1.05 OR buy Euro at.67 per Euro= 1.492537 Get 3% =1.5372313 Sell at 0.683009= 1.5372313*0.683009 =1.05 So if ir f =3% and ir uk =5% then 3% =5%-depreciation of 2% So can put £1 in UK bank at £1.05 OR buy Euro at.67 per Euro= 1.492537 Get 3% =1.5372313 Sell at 0.683009= 1.5372313*0.683009 =1.05

13 So ir reflect EXPECTED depreciation At start - 0.67 At end 0.683009 So price of Euro rises (worth less) at end of period

14 These explanations imply government can control the ER Do I believe? ER as a random variable? OK lets focus in ER as something deterministic driven either by trade or finance flows. Can government manipulate the ER and why? These explanations imply government can control the ER Do I believe? ER as a random variable? OK lets focus in ER as something deterministic driven either by trade or finance flows. Can government manipulate the ER and why?

15 The exchange rate as a price for the demand and supply of domestic currency O Exchange rate E = Price in Euros of 1£ Quantity of £s S1S1 D1D1 er 1 Supply – sell £ to buy Forex for imports or foreign investment – Higher E means buy more abroad Demand – Foreigners buy £ to buy exports or inward investment

16 O Exchange rate Quantity of £s S1S1 D1D1 er 1 er 2 S2S2 D2D2 Adjustment of the exchange rate to a shift in demand and supply Depreciation UK ER fates fall, EU up switch to Euros – S of £ shifts out

17 O Exchange rate Quantity of £s S1S1 D1D1 er 1 er 2 S2S2 D2D2 Depreciation Adjustment of the exchange rate to a shift in demand and supply Fall in demand for UK exports

18 O Exchange rate Quantity of £s S1S1 D1D1 er 1 Adjustment of the exchange rate to a shift in demand and supply

19 O Exchange rate Quantity of £s S1S1 D1D1 er 1 S3S3 D3D3 er 3 Adjustment of the exchange rate to a shift in demand and supply

20 O Exchange rate Quantity of £s S1S1 D1D1 er 1 S3S3 D3D3 er 3 Appreciation Adjustment of the exchange rate to a shift in demand and supply

21 With a floating Exchange Rate the price of £ changes in response to S & D. What will happen to Balance of Payments? Fluctuations in E ensure the value of imports always equals value of exports so Balance of payments always in balance With a floating Exchange Rate the price of £ changes in response to S & D. What will happen to Balance of Payments? Fluctuations in E ensure the value of imports always equals value of exports so Balance of payments always in balance

22 O Exchange rate Quantity of £s S 1 by UK D by overseas residents r1r1 Fixed exchange rate S 2 by UK This creates external imbalance: i.e. currency flow deficit Fixed Exchange Rate and Balance of Payments deficit

23 Fixed Exchange Rate and Balance of payments surplus Fixed Exchange Rate and Balance of payments surplus O Exchange rate Quantity of £s S by UK D from abroad Fixed rate D2D2

24 UK balance of payments as % of GDP: 1980–2000 Source: Datastream

25 UK balance of payments as % of GDP: 1980–2000 Current account Source: Datastream

26 UK balance of payments as % of GDP: 1980–2000 Current account Trade in goods Source: Datastream

27 $ / £ exchange rate: 1976-99 $ / £ Index 1990=100

28 $ / £ exchange rate: 1976-99 $ / £ Index 1990=100

29 $ / £ exchange rate and £ exchange rate index: 1976-99 $ / £ Index 1990=100

30 Exchange rate indices averages for each period (1995 = 100) Source: Sloman based on data in European Economy Statistical Annex (Commission of the European Union)

31 The crawling peg within exchange rate bands O Exchange rate No intervention Central bank buys domestic currency No intervention Central bank sells domestic currency No intervention $1.60 $1.40 Time Source: Sloman

32 Quantity If Government changes ER –depreciation- imports become more expensive (shift in) O Price in £ S of imports Demand for Imports r1r1 S 2 (Ep f ) So imports fall helping deficit - but cost more hurting deficit

33 If Government changes ER –depreciation- and Exports become competitive (shift out) O Price in £ S of Exports Demand for Exports r1r1 D 2 ( p d /E) Exports rise helping deficit

34 If Government changes –depreciates imports become more expensive (shift in) and Exports become competitive (shift out) O Price in £ S of imports Demand for Imports r1r1 S 2 (Ep f ) O Price in £ S of Exports Demand for Exports r1r1 D 2 ( p d /E) Argument is that sales of exports and lower imports outweigh additional expense of remaining imports – SO BOP Better But dedpreciation – import tax (tarrif) and export subsidy

35 UK experience of dirty floatingUK experience of dirty floating –first oil crisis and its aftermath –second oil crisis and the rise in monetarism –effects of growing US budget and trade deficits in the 1980s –the 1985 exchange crisis –joining and leaving the ERM –experience since leaving ERM fluctuations in the pound fluctuations in the pound exchange rate consequences of targeting the inflation rate exchange rate consequences of targeting the inflation rate The volatility of exchange ratesThe volatility of exchange rates UK experience of dirty floatingUK experience of dirty floating –first oil crisis and its aftermath –second oil crisis and the rise in monetarism –effects of growing US budget and trade deficits in the 1980s –the 1985 exchange crisis –joining and leaving the ERM –experience since leaving ERM fluctuations in the pound fluctuations in the pound exchange rate consequences of targeting the inflation rate exchange rate consequences of targeting the inflation rate The volatility of exchange ratesThe volatility of exchange rates EXCHANGE RATE SYSTEMS IN PRACTICE


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