MAN 441: Internatıonal Finance Exchange Rates and The Determination of Exchange Rates

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

3 Definion of Exchange Rates The price of one currency in terms of another currency is called an exchange rate. For example, the $/Euro exchange rate is just the number of dollars that one Euro will buy. If a Euro would buy dollars, exchange rate would be expressed as $1.2154/Euro. In this example, $ is the reference currency. - Exchange rates has a strong influence on the current account and other macroeconomic prices an important price. - Exchange rates has a strong influence on the current account and other macroeconomic prices an important price. - Is also an asset price, and is governed by the same principles governing the behaviour of other asset prices (form of wealth expectations) - Is also an asset price, and is governed by the same principles governing the behaviour of other asset prices (form of wealth expectations) Spot Rate: the price at which currencies are traded for immediate delivery, or in two days in the interbank market. Forward Rate: the price at which foreign exchange is quoted for delivery at a specified future date (e.g. 3 months)

4 Equilibrium Exchange Rates Equilibrium ER is the market-clearing price that equilibrate the quantities supplied and demanded of foreign currency. B. How Americans Purchase German Goods 1. Foreign Currency Demand -derived from the demand for a foreign country’s goods, services, and financial assets. e.g. The demand for German goods by Americans

5 The Demand for € in the U.S. Qty $.50 $/€ D

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

7 The Supply of € in the U.S. $/ € Qty $.50 S

8 Equilibrium Exchange Rates B.3. Equilibrium Exchange Rate occurs where the quantity supplied equals the quantity demanded of a foreign currency at a specific local price.

9 The $/ € Equilibrium Rate Qty $.50 S $/ € D Equilibrium

10 Equilibrium Exchange Rates 1. Increased demand for Euro (D curve shifts up) - More local goods are demanded at the initial equilibrium by foreigners - - Foreign currency loses value in terms of local currency (depreciation) How Exchange Rates Change

11 Qty $.50 S $/ € D D’ $.65 Q1 Q2 The US$ Depreciates

12 Equilibrium Exchange Rates 1. Increased Supply of Euro (S curve shifts rıght) - More foreign goods are demanded at the initial equilibrium - More foreign goods are demanded at the initial equilibrium - Foreign currency value increases in terms of local currency (appreciation) - Foreign currency value increases in terms of local currency (appreciation)

13 The US$ Appreciates When Qty $.50 S $/ € D $.35 Q1 Q2 S’S’

14 Equilibrium Exchange Rates C.5Currency Appreciation = (e 1 - e 0 )/ e 0 where e 0 = old currency value e 1 = new currency value e 1 = new currency value

15 Equilibrium Exchange Rates EXAMPLE: € Appreciation If the dollar value of the € goes from $0.50 (e 0 ) to $0.65 (e 1 ), then the € has appreciated by ( )/.50 = 30%

16 Equilibrium Exchange Rates C.4. Calculating a Depreciation for $: = (e 0 - e 1 )/ e 1 how? where e 0 = old currency value e 1 = new currency value e 1 = new currency value => (1/e 1 ) - (1/e 0 ))/ (1/e 0 )

17 Equilibrium Exchange Rates EXAMPLE: US$ Depreciation Use the formula (e 0 - e 1 )/ e 1 substituting ( )/.65 = % is the US$ depreciation. is the US$ depreciation.

18 Equilibrium Exchange Rates D. THE FACTORS AFFECTING EXCHANGE RATES: 1.Inflation rates 2. Interest rates 3.GNP/GDP growth rates

19 Equilibrium Exchange Rates 1. Inflation Rate – Higher US inflation rate Qty e** S $/ € D’D’ e* Q1Q2 S’S’ D - Excess growth ın Money Supply  higher inflation - US goods are more expensive - Demand for US products declines => decline in Euro supply (demand for $ also drops). - Hence, Supply curve for Euro shifts up - At the same time, demand for Euroland products increases => Euro demand ıncreases at the same exchange rate. - Hence, Demand curve shifts right As a result of these interactions, new equilibrium results at e**, where US dollar depreciates. “Higher inflation rate in a country leads to a depreciation in its currency”

20 Equilibrium Exchange Rates 1. Interest Rate An increase in US real interest rate relative to Euroland will: - Shift investments to dollar denominated securities – Increased Euro Supply - Hence, Euro will depreciate (dollar will appreciate) 2. Economic Growth Strong economic growth will attract investment capital seeking to acquire domestic assets. This, in turn, will lead to a higher demand for domestic currency. 3. Political and Economic Risk Lower political and economic risk will strengthen a nation’s currrency.

21 Sample Problem Suppose the U.S. dollar appreciates against the Russian ruble by 500%. How much did the ruble depreciate against the dollar? To solve the problem, you can approach it in two steps: l Solve for e 1 l Substitute and solve for the depreciation (x)

22 U.S. $ APPRECIATION

23 RUBLE DEPRECIATION

24 SOLUTION – Step 1 Solve for e 1

25 SOLUTION – Step 2 Substitute and solve for x

26 SOLUTION When the dollar appreciated by 500% against the ruble, the ruble depreciated 83% against the dollar.

27 EXPECTATIONS Currency values are affected by n current events n current supply and demand flows n expectations about future exchange rate movements

28 EXPECTATIONS Why expectations? n currencies are financial assets n exchange rate is simply the relative price of two currencies

29 EXPECTATIONS The desire to hold a currency today depends critically on expectations of the factors that can affect the currency’s future value. => Exchange rates are forward looking. Hence, they are strongly influenced by expectations about future economic, social and political factors. Asset Market Model of Exchange Rate Determination: The value of a currency today depends on whether or not people still want to hold that currency (or assets denominated in that currency) in the future.

30 What is Money? l Serves as a medium of exchange. People are willing to accept it in exchange for goods and services l Provides liquidity. l Store of value – transfer purchasing power from the present into the future l Unit of account – prices are expressed in terms of a standardized unit of account (e.g. without money, how would you buy milk if you only had eggs?)

31 Demand for Money Hence, demand for money depends on: l İts ability to maintain its value l Level of economic activity Hence, l lower expected inflation  higher demand for money l higher economic growth  higher demand for money The demand for money is also affected by: l Expected real return (positively) l Riskiness of country’s assets (negatively)

32 Demand for Money Since exchange rates represent the relative demand for two moneys, same factors also impacts the exchange rates.

33 Central Bank Exchange rates are also influenced by expectations of central bank behavior. A.Central Bank Reputations – money is like a brand-name product whose value is backed by the reputation of the central bank A.Central Bank Reputations – money is like a brand-name product whose value is backed by the reputation of the central bank – Fiat money: nonconvertible paper money; no anchor to the price level (no standart of value) B.Central Bank Independence and accountability  for a good reputation Currency Boards: issues notes and coins that are convertible on demand and at a fixed rate into a foreign reserve currency. There is no central bank.

34 Intervention A rise in the real or inflation-adjusted exchange rate raises the prices of domestic goods relative to the price of foreign goods.  hurts exports; cheaper foreign products for consumers Foreign Exchange market intervention refers to official purchases of and sales of foreign currency through central banks. – unsterilized: domestic money supply is not insulated from the foreign exchange transactions – Sterilized: The impact of foreign exchange transaction is sterilized through an open market operation (e.g., sale or purchase of treasury bills by Central Bank)

35 Intervention Suppose both Fed and CB ın Euroland wants to keep old equlibrium at e 0.  excess demand for euros equal to (Q3-Q1)  excess supply of US dollars equal to (Q3-Q1)* e 0. l US Money Supply will fall, Euroland Money supply will rise Qty e** S $/ € D’D’ e* Q1Q2 S’S’ D Q3Q3 Sterilized intervention has transitory impact since it impacts expectations and not the fundemantals. Unsterilized can have lasting impact by impacting money supply and hence creating inflation (or deflation)