Exchange Rate Determination International Corporate Finance P.V. Viswanath

Outline The concept of an equilibrium Exchange Rate Basic factors affecting exchange rates Calculating currency appreciation/depreciation with a given exchange rate change Central bank intervention Role of expectations Equilibrium Approach to Exchange Rates P.V. Viswanath

Equilibrium Exchange Rates An exchange rate is the price of one nation’s currency in terms of another currency. Exchange rates are market clearing prices that equilibrate supply and demand in exchange markets. A spot rate is the price of the currency for immediate delivery A forward rate is the price for delivery at a specified future date. The bid rate is the rate at which a dealer is willing to buy The ask rate is the rate at which a dealer is willing to sell. P.V. Viswanath

Supply and Demand P.V. Viswanath

Flow Theory of Exchange Rates Factors affecting supply of foreign currency Foreign country’s demand for home country’s exports (goods and services) supplies foreign currency Demand for exports (in units of goods) is decreasing as a function of foreign currency price. Supply of foreign currency equals total revenue. Total revenue as a function of foreign currency price is decreasing if demand is elastic. Foreign currency price is decreasing in exchange rate. Hence supply of foreign currency is increasing as a function of exchange rate. Home country’s demand for foreign country’s imports demands foreign currency Normally downward sloping as a function of exchange rate P.V. Viswanath

Factors affecting equilibrium rates Terms of trade (price of exports relative to price of imports) The higher the relative price of exports, the less the demand for foreign currency (the greater the supply of foreign currency). Relative inflation in home and foreign countries. If there is inflation in the foreign country, the demand curve for the home country’s goods will move to the left – more will be demanded at a given exchange rate; this will raise the exchange rate, i.e. the number of units of home currency per unit of foreign currency. Foreign Investment in Home Country Relative Real Interest Rates Relative Economic Growth Rates Political and Economic Risk Suppose we think of Y as all the transactions in the economy and PY is the dollar value of all these transactions (sales revenue). Then we need M dollars of money to make all these transactions each period, or M = P Y If the money supply goes up, then so does P. Hence an increase in the money supply will increase inflation and cause the currency to depreciate. P.V. Viswanath

Calculating Exchange Rate Changes If the value of the euro rises from $0.93 to $0.99 per euro, the amount of euro appreciation is computed as (0.99 – 0.93)/0.93 = 6.45% The value of the dollar drops from 1/0.93 euros to 1/0.99. Hence the amount of dollar depreciation is computed as (1/0.93 – 1/0.99)/(1/0.93) = 6.06% P.V. Viswanath

Asset Market Model of Exchange Rates A stock of currency in one country can be thought of as a claim on the assets, whose prices are denominated in that currency, for a given price level. Hence it is, itself an asset – a financial asset. Since an exchange rate is the value of one currency in terms of another, it can be thought of as the ratio of the prices of two financial assets. Hence exchange rates are affected by the same forces that affect asset values. Assets, by their very nature, are forward looking, and their value is determined by market expectations. Hence, exchange rates, too, are affected by market expectations. P.V. Viswanath

Asset Market Model of Exchange Rates The Asset Market Model has predictions that are differ from those of the flow theory. For example, a fiscal deficit might cause people to expect a future expansion of the money supply and hence an immediate depreciation of the currency. In the standard theory, the fiscal deficit would lead to greater borrowing from abroad. This leads to a greater demand for the local currency and a strengthening of the currency. This result obtains because it is assumed that people do not alter their savings and their demands for funds. In practice, it is likely that people will increase their savings in anticipation of higher taxes in the future; this will reduce the domestic demand for the home currency and lead to a drop in the value of the home currency. P.V. Viswanath

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. Money provides liquidity – it can be exchanged for goods and services, or for other assets. Money represents a store of value and a store of liquidity. The demand for money is affected by the demand for assets denominated in that currency – the higher the expected real return and the lower the riskiness of a country’s assets, the greater is the demand for its currency to buy those assets. Factors that increase the demand for the home currency also increase the price of home currency on the foreign exchange market. P.V. Viswanath

The Nature of Money and Currency Values The economic factors that affect a currency’s foreign exchange value include: Its usefulness as a store of value, determined by its expected rate of inflation The demand for liquidity, determined by the volume of transactions in that currency 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. P.V. Viswanath

How money supply affects exchange rates M = money supply; P = price level; y = real GNP; v = money velocity. i = inflation rate; m = growth rate of money supply; gy = growth rate of real GNP; gv = change in velocity of money PPP says: Combining previous identity with PPP, we get: P.V. Viswanath

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. P.V. Viswanath

Price Stability and Central Bank Independence In order to retain public credibility, central banks have to be like company managements or boards of directors: They need to adopt rules for price stability that are verifiable, unambiguous and enforceable. This requires independence and accountability. Central banks that lack independence are often forced by the government to pursue political goals, such as lower interest rates or higher economic growth. Often the bank is forced to monetize the deficit. 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. Monetizing the deficit means supplying purchasing power to the government by buying government debt, which the government will use to finance the deficit. Alternatively, the central bank could simply supply more money to the public, i.e. to the consumers. P.V. Viswanath

Central Bank Independence & Inflation P.V. Viswanath

Central Bank Independence and Growth P.V. Viswanath

Maintaining Trust in the Currency Currency Board 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 The currency board holds high-quality, interest-bearing securities denominated in the reserve currency Its reserves are equal to 100% or more of its notes and coins in circulation. A currency board forces a government to follow a responsible fiscal policy. It cannot force the central bank to monetize the deficit. P.V. Viswanath

Maintaining Trust in the Currency Dollarization This is the complete replacement of the local currency with the U.S. dollar The central bank loses seignorage. 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. Seignorage is the interest that the central bank gets when individuals are willing to hold currency that is non-interest bearing and are willing to give up purchasing power. P.V. Viswanath

Real Exchange Rates and Relative Competitiveness As the real (inflation-adjusted) value of the dollar rises, the dollar prices of imported goods and raw materials drop. Hence, the prices of imports and of products that compete with imports drop. The foreign currency prices of US goods rise – US exports become less competitive in world markets and US import substitutes become less competitive in the US. Unemployment is generated in the traded-goods sector and resources are shifted from the traded- to the nontraded-goods sector. P.V. Viswanath

Foreign Exchange Market Intervention Some governments will prefer an overvalued domestic currency – lower import prices and potentially lower prices. Others will prefer an undervalued currency – better for employment in the traded goods sector. Others might prefer a correctly valued currency, but might not believe that the market rate is correct. For all of these reasons, governments engage in foreign exchange market intervention. P.V. Viswanath

Maintaining a non-equilibrium rate P.V. Viswanath

Maintaining a non-equilibrium rate The equilibrium level of the exchange rate in Fig. 2.2 is e1, at which Q1 euros are demanded and supplied. If the US and German governments decide to maintain the old rate, e0, there will be an excess demand for euros equal to Q3-Q2. Either the American Central Bank or the European Central Bank will have to intervene in the market to supply this additional quantity of euros. The US will face a perpetual balance-of-payments deficit equal to (Q3-Q2)e0 dollars, or equivalently a German balance-of-payments surplus. P.V. Viswanath

Maintaining a non-equilibrium rate If the US government intervenes by selling euros and buying dollars, dollars will become more scarce relative to euros and the dollar will appreciate relative to the euro, as desired. Typically, the government will not sell euros directly; rather it will sell euro-denominated bonds, since that is the form in which foreign currencies are normally kept. In any case, because of the paucity of dollars, the interest rate will be affected – it will rise – and the government may not desire this. P.V. Viswanath

Sterilized vs. Unsterilized Intervention In order to offset this, the government can buy Treasury bills and increase the supply of money correspondingly. This is called sterilization. The net result is that the supply of domestic money is kept constant, and so the interest rate will not be affected. However, the public now holds fewer domestic securities and more foreign securities. If investors consider domestic and foreign securities to be perfect substitutes, then they will be happy to hold the new combination without any change in the exchange rate. This means that the desired lower exchange rate (stronger dollar) will not be achieved. P.V. Viswanath

Sterilized vs. Unsterilized Intervention However, if investors believe that domestic and foreign securities are not perfect substitutes, then they will not want to hold this new portfolio that is skewed towards foreign securities. Investors will try to reduce their holdings of foreign securities by selling them. Consequently, the euro must fall and the dollar must rise in order to move the actual proportion of dollar to foreign denominated security holdings to the desired level. P.V. Viswanath

Sterilized vs. Unsterilized Intervention Empirically, sterilized interventions do not seem to work. This could be because investors don’t accept the premise of an overvalued euro and hence are willing to hold the increased supply of euro-denominated securities at the current exchange rate. Unsterilized interventions can work; however, they do so by causing a change in fundamental variables; in our example, there would be deflation in the US if it bought up dollars (and sold euros) and thus reduced the money supply. Hence if the underlying problem is an excess of dollars, then unsterilized interventions can work. On the other hand, in this case, there is no need for foreign exchange market intervention. Open market purchases of dollars will suffice and the foreign exchange rate will automatically adjust. P.V. Viswanath

Intervention to change the equilibrium exchange rate If the currency is already in equilibrium, but the government for political reasons desires to depreciate the currency, it might engage in intervention, in the hope that a cheaper dollar will increase demand for domestic goods. However, the intervention in this case will ultimately cause inflation because the money supply will go up. This will increase domestic wages and will erode the temporary gain in competitiveness. This may drive the currency lower, if markets expect further interventions, leading to an inflation-devaluation cycle. Sterilization in this case is not likely to work because investors will simply absorb the increased supply of domestic securities without depreciating the dollar. If investors do not want to hold the increased supply of the domestic securities, they will allow the dollar to depreciate so that the relative monetary value of domestic and foreign securities remains constant. P.V. Viswanath

Nominal and Real Exchange Rates The real exchange rate is the exchange rate between real units of purchasing power in two countries. That is, the real exchange rate is simply the nominal exchange rate adjusted for inflation differences. If fundamental factors determine the real exchange rate, the nominal exchange rate should simply reflect the real exchange rate. Changes in the nominal interest rate that are caused by changes in relative money supplies should have no impact on the real interest rate. However, in practice, real and nominal exchange rates seem to be correlated. This suggests that nominal exchange rates affect real exchange rates. That is, monetary disturbances affect real exchange rates. P.V. Viswanath

Dornbusch’s disequilibrium approach to explaining exchange rate changes Suppose the US increases its money supply. In the long run, this will cause US prices to be proportionately higher, and the value of the dollar to be proportionately lower. In the short run, however, a larger nominal money supply will mean a larger real money supply because prices are sticky and don’t rise. Since this forces investors to hold more real money balances than they desire, they will try to buy bonds to get rid of this excess cash. This causes real US interest rates to be lower. Lower real interest rates will cause a more-than-proportionate drop in the value of the dollar; i.e the dollar will drop in real terms. However, this drop in real interest rates and the real exchange rate is temporary. Once the price level adjusts, investors will reverse their purchases of bonds. This will cause the real interest rate to rise, and the real exchange rate along with it. Suppose that the United States increases its money supply. In the long run this must cause the value of the dollar to be lower; in the short run it will lead to a lower interest rate on dollar-denominated securities. But as Dornbusch pointed out, if the interest rate on dollar-denominated bonds falls below that on other assets, investors will be unwilling to hold them unless they expect the dollar to rise against other currencies in the future. How can the prospect of a long-run lower dollar and the need to offer investors a rising dollar be reconciled? The answer, Dornbusch asserted, is that the dollar must fall below its long-run value in the short run, so that it has room to rise. That is, if the U.S. money supply rises by 10 percent, which will eventually mean a 10 percent weaker dollar, the immediate impact will be a dollar depreciation of more than 10 percent—say 20 or 25 percent—"overshooting" the long-run value. The overshooting hypothesis helps explain why exchange rates are so much more unstable than inflation rates or money supplies. P.V. Viswanath

The disequilibrium approach Along with the drop in the real interest rate, the nominal interest rate drops as well, since price levels have not changed. But why would investors be willing to hold US bonds at a lower interest rate, relative to bonds denominated in other assets? This can only happen if they expect the dollar to appreciate. But an appreciation can occur only if the dollar initial falls below its equilibrium real value, i.e. if it overshoots. Hence we have both real and nominal exchange rates moving downwards in the beginning and then recovering, thus causing a positive correlation between the two. The real exchange has to recover ultimately because nothing real or fundamental has changed. P.V. Viswanath

The Disequilibrium Approach P.V. Viswanath

The Equilibrium Approach to Exchange Rates The disequilibrium approach predicts that as domestic prices rise, so should the exchange rate. This has not been observed, in practice. The equilibrium approach concludes, rather, that: Exchange rates do not cause changes in relative prices; rather exchange rates and relative prices are determined simultaneously. The primary source of exchange rate changes, in practice, are not monetary disturbances, as assumed by the disequilibrium approach, but rather real disturbances. Attempts by governments to affect the real exchange rate via foreign exchange market intervention will fail; real exchange rates affect nominal exchange rates and not vice-versa. P.V. Viswanath

The Equilibrium Approach to Exchange Rates Real disturbances to supply or demand in the goods market cause changes in relative prices, including the real exchange rate. These changes in the real exchange rate often are accomplished, in part, through changes in the nominal exchange rate. Repeated shocks in supply or demand thus create a correlation between changes in nominal and real exchange rates. Suppose there is a fall in the demand for domestic goods. This will cause the real value of the domestic currency to depreciate i.e. the real exchange rate will rise. However, the nominal exchange rate will also rise, i.e. the nominal currency will depreciate in nominal terms, as well, since there will be less demand for the nominal currency. This will create a positive correlation between real and nominal exchange rates. P.V. Viswanath

The Equilibrium Approach to Exchange Rates Consider the following example. Suppose there is a fall in the demand for domestic goods. This will cause the domestic currency to depreciate in real terms. However, the currency will also depreciate in nominal terms, as well, since there will be less demand for the nominal currency. This will create a positive correlation between real and nominal exchange rates. P.V. Viswanath

Summary The disequilibrium approach assumes that the central bank can affect real exchange rates, while the equilibrium approach assumes that real exchange rates can only be affected by fundamentals and not by any kind of intervention. If the equilibrium approach is correct, real exchange rates should be less variable in an era of floating exchange rates; in fact, this has not been the case. The real issues is not whether monetary policy has any impact at all on real exchange rates, but whether that impact is of first- or second-order importance. P.V. Viswanath