1 Foundations of Multinational Financial Management Alan Shapiro 10 th Edition John Wiley & Sons, Inc. PowerPoints by Joseph F. Greco, Ph.D. California State University, Fullerton

2 The Determination of Exchange Rates Chapter 2

3 CHAPTER 2 THE DETERMINATION OF EXCHANGE RATES CHAPTER OVERVIEW: 2.1 SETTING THE EQUILIBRIUM SPOT EXCHANGE RATES 2.2EXPECTATIONS AND THE ASSET MARKET MODEL 2.3 THE FUNDAMENTALS OF CENTRAL BANK INTERVENTION 2.4 THE EQUILILBRIUM APPROACH

Equilibrium Exchange Rates 2.1 SETTING THE EQUILIBRIUM A. The exchange rate is the price of one unit of foreign currency expressed as a certain price in local currency. For example, $1.30/€ means the euro in the U.S. is worth $

5 Equilibrium Exchange Rates B. When Americans Purchase German Goods: 1. Foreign Currency Demanded derived from the demand for foreign country’s goods, services, and financial assets. e.g. The demand for German cars by Americans

The Demand for € in the U.S. Qty $1.10/ € $/€ D At higher exchange rates, Americans demand less euros and vice versa. $1.20/ € $1.00/ € 6

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

The Supply of € in the U.S. Qty $1.10/ € S $1.20/€ $1.00/€ At higher exchange rates, Germans supply more euros and vice versa. $/ € 8

9 Equilibrium Exchange Rates 3. Equilibrium Exchange Rate occurs where the quantity supplied equals the quantity demanded of a foreign currency at a specific local exchange rate

The $/€ Equilibrium Rate Qty $1.10 S $/ € D Equilibrium 10

Equilibrium Exchange Rates C. How Exchange Rates Change 1. Increased demand as more foreign goods are demanded, more of the foreign currency is demanded at each possible exchange rate 2.The exchange rate of the foreign currency in local currency increases. 11

Equilibrium Exchange Rates 3. Home Currency Depreciation a. Foreign currency more valuable than the home currency b. Conversely, the foreign currency’s value has appreciated against the home currency 12

The US$ Depreciates When Qty $1.10/ € S $/ € D D’ $1.20/ € Q1 Q2 13

Equilibrium Exchange Rates Computing a Currency Appreciation = (e 1 - e 0 )/ e 0 where e 0 = old currency value e 1 = new currency value 14

Equilibrium Exchange Rates Computing a Currency Depreciation: = (e 0 - e 1 )/ e 1 where e 0 = old currency value e 1 = new currency value 15

16 Equilibrium Exchange Rates D. FACTORS AFFECTING EXCHANGE RATES: 1.Inflation rates 2. Interest rates 3.GNP growth rates

17 Expectations and the Asset Market Model of Exchange Rates 2.2 The Role of Expectations: A. Currency = financial asset B. Exchange rate = simple relation of two financial assets

18 Expectations C. The Nature of Money and Currency Values: 1. Asset Market Model Exchange rates reflect the supply of and demand for foreign-currency denominated assets.

19 Expectations 2. Soundness of a Nation’s Economic Policies a nation’s currency tends to strengthen with sound economic policies

20 Expectations 3. Expectations and Central Bank Behavior exchange rates are also influenced by expectations of central bank behavior

21 Expectations D. Central Bank Reputations and Currency Values 1. Central bank: the nation’s official monetary authority

Expectations 2. Price Stability and Central Bank Independence: when the Bank limits its focus to price stability, it is more likely to succeed in its goal.

Expectations 3. Currency Boards - exist where there is no central bank - instead the board issues notes - has not discretionary monetary policy

24 Central Bank Interventions 2.3 How Real Exchange Rates Affect Relative Competitiveness A. Appreciation: -domestic prices increase relative to foreign prices. -Exports: less competitive Imports: more attractive

25 Central Bank Interventions B. Currency Depreciation domestic prices fall relative to foreign prices. - Exports: more price competitive - Imports: less attractive

26 Central Bank Interventions C.Foreign Exchange Market Intervention Mechanics of Intervention Sterilized vs Unsterilized Intervention

27 Central Bank Interventions D. The Effects of Foreign Exchange Market Intervention 1. Definition: the official purchases and sales of currencies through the central bank to influence the home exchange rate

The Equilibrium Approach 2.4 The Equilibrium Approach to Exchange Rates A. Disequilibrium Theory and Exchange Rate Overshooting 1. various economic frictions cause prices to adjust slowly over time 2. leads to “overshooting”

The Equilibrium Approach B. The Equilibrium Theory of Exchange Rates and Its Implications 1. markets clear through price adjustments 2. Repeated shocks in supply and demand create a correlation between changes in nominal and real exchange rates.

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