Copyright ©2004, South-Western College Publishing International Economics By Robert J. Carbaugh 9th Edition Chapter 13: Exchange-Rate Determination

Carbaugh, Chap Exchange rates Factors influencing exchange rates  Market fundamentals  Bilateral trade balances  Real income  Real interest rates  Inflation rates  Consumer preferences for domestic or foreign products  Productivity changes affecting production costs  Profitability and riskiness of investments

Carbaugh, Chap Exchange rates Factors influencing exchange rates  Market fundamentals (cont’d)  Product availability  Monetary policy and fiscal policy  Government trade policy  Market expectations  News about future market fundamentals  Speculative opinion about future exchange rates

Carbaugh, Chap Exchange rates When are these factors important?  Short run (days)  Dominated by financial transfers responding to:  Differences in real interest rates  Shifting expectations of future exchange rates  Medium run (months)  Primarily influenced by economic cycles

Carbaugh, Chap Exchange rates When are these factors important?  Long run (years)  Dominated by movements of goods, services, investment, which are influenced by:  Inflation rates  Investment profitability  Consumer tastes  Real income  Productivity  Trade policy  How these factors interact to affect exchange rates depends on the relative importance of trade and financial relations between the countries

Carbaugh, Chap Exchange rate components Exchange rates

Carbaugh, Chap Factors influencing exchange rates Real income differentials  A country with faster economic growth than the rest of the world will have a depreciating currency (other things being equal)  Imports rise faster than exports, so demand for foreign currency rises faster than its supply  Real income changes can also reflect other processes, which might lead to rising exports

Carbaugh, Chap Impact of real income differentials Factors influencing exchange rates

Carbaugh, Chap Factors influencing exchange rates Real interest rates  Short term real interest rate differences influence international capital movements  Real interest rate is nominal minus inflation  Low short term rates lead to less demand for the currency and depreciation  High rates lead to greater demand for the currency and appreciation

Carbaugh, Chap Impact of interest rate differentials Factors influencing exchange rates

Carbaugh, Chap Factors influencing exchange rates Purchasing power parity  Law of one price: In theory, a good should cost the same in all countries (aside from tariffs or transportation costs)  As a result, exchange rates should end up making prices equal across countries  By this theory, if two countries have different inflation rates, exchange rates will move in the opposite direction to keep prices the same  The theory may be more useful for predicting long-term trends than short-run fluctuations

Carbaugh, Chap Impact of inflation rate differentials Factors influencing exchange rates

Carbaugh, Chap Factors influencing exchange rates Market expectations  As with stock markets, foreign exchange markets react quickly to news or even rumors that point to future changes affecting rates  Future expectations can be self-fulfilling; speculative bubbles can start without any real information but can become self sustaining - for a while

Carbaugh, Chap Alternative approaches to exchange rates Monetary approach  Focus on exchange rates as the result of supply and demand for money at home and abroad  Demand depends on real income, prices, interest rates  Supply is controlled by central banks  Exchange rates seen as returning domestic money supply to equilibrium after a change

Carbaugh, Chap Alternative approaches to exchange rates Asset-markets approach  Investors (firms and individuals) balance their portfolios among domestic money, stocks and bonds and foreign stocks and bonds  Short run exchange rate changes are caused by shifts in the kind and location of financial assets investors want to hold  Investors shift between assets based on market expectations for expected returns

Carbaugh, Chap Short, long run equilibrium: overshooting Exchange rate markets

Carbaugh, Chap Exchange rate markets Forecasting exchange rates  Judgmental forecasts  Subjective forecasts based on economic, political and other data for a country  Technical analysis  Uses historical exchange rate trends to project short-run future movements  Fundamental analysis  Includes macroeconomic and policy information in a predictive model

Carbaugh, Chap Equilibrium in asset-markets approach Alternative approaches to exchange rates

Carbaugh, Chap Asset-markets approach: shift in demand Alternative approaches to exchange rates

Carbaugh, Chap Asset-markets approach: shift in supply Alternative approaches to exchange rates