# Lecture 6: Exchange Rate Theory

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Lecture 6: Exchange Rate Theory
Based on Sloman Chapter 24

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

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

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

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

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

What determines Prices
So if increase Md, 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

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.

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

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 irf =3% and iruk=5% then 3% =5%-depreciation of 2%

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

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

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?

Exchange rate E = Price in Euros of 1£
The exchange rate as a price for the demand and supply of domestic currency S1 Supply – sell £ to buy Forex for imports or foreign investment – Higher E means buy more abroad er1 Exchange rate E = Price in Euros of 1£ Demand – Foreigners buy £ to buy exports or inward investment D1 O Quantity of £s

Adjustment of the exchange rate to a shift in demand and supply
UK ER fates fall, EU up switch to Euros – S of £ shifts out er1 Exchange rate Depreciation er2 D2 D1 O Quantity of £s

Adjustment of the exchange rate to a shift in demand and supply
Fall in demand for UK exports er1 Exchange rate Depreciation er2 D2 D1 O Quantity of £s

Adjustment of the exchange rate to a shift in demand and supply
Quantity of £s

Adjustment of the exchange rate to a shift in demand and supply
Quantity of £s

Adjustment of the exchange rate to a shift in demand and supply
Appreciation er1 Exchange rate D3 D1 O Quantity of £s

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

Fixed Exchange Rate and Balance of Payments deficit
This creates external imbalance: i.e. currency flow deficit S1 by UK S2 by UK Exchange rate r1 Fixed exchange rate D by overseas residents O Quantity of £s

Fixed Exchange Rate and Balance of payments surplus
S by UK Exchange rate Fixed rate D2 D from abroad O Quantity of £s

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

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

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

\$ / £ exchange rate: Index 1990=100 \$ / £

\$ / £ exchange rate: Index 1990=100 \$ / £

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

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

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

If Government changes ER –depreciation- imports become more expensive (shift in)
S2 (Epf) S of imports Price in £ r1 So imports fall helping deficit - but cost more hurting deficit Demand for Imports O Quantity

If Government changes ER –depreciation- and Exports become competitive (shift out)
S of Exports Exports rise helping deficit Price in £ r1 D2 (pd/E) Demand for Exports O

But dedpreciation – import tax (tarrif) and export subsidy
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 r1 S2 (Epf) O Price in £ S of Exports Demand for Exports r1 D2 (pd/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

EXCHANGE RATE SYSTEMS IN PRACTICE
UK 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 exchange rate consequences of targeting the inflation rate The volatility of exchange rates 17