Dale R. DeBoer University of Colorado, Colorado Springs An Introduction to International Economics Chapter 12: Exchange Rate Determination Dominick Salvatore John Wiley & Sons, Inc.

Dale R. DeBoer University of Colorado, Colorado Springs Forces the determine exchange rates Relative rates of economic growth –If the U.S. grows more rapidly than the rest of the world, its demand for imports will increase more rapidly. –By itself, this should increase the demand for foreign currency and lead to depreciation of the dollar.

Dale R. DeBoer University of Colorado, Colorado Springs Forces the determine exchange rates Relative rates of economic growth Relative rates of inflation –If U.S. inflation is greater than the rate of inflation in the rest of the world, the dollar will decrease in value.

Dale R. DeBoer University of Colorado, Colorado Springs Forces the determine exchange rates Relative rates of economic growth Relative rates of inflation Changes in interest rates –If U.S. interest rates fall relative to interest rates in the rest of the world, the demand for U.S. interest bearing assets will fall. –By itself, this will lead to a fall in international demand for the dollar and a depreciation of the dollar.

Dale R. DeBoer University of Colorado, Colorado Springs Forces the determine exchange rates Relative rates of economic growth Relative rates of inflation Changes in interest rates Expectations –If it is expected that the dollar will fall in value, people will move out of dollar holdings. –As dollar holdings fall, the dollar will depreciate.

Dale R. DeBoer University of Colorado, Colorado Springs Trade approach The trade approach to exchange rate determination focuses on the role of international trade in determining exchange rates. –Also known as the elasticities approach –Works better as a long-run model of exchange rate determination.

Dale R. DeBoer University of Colorado, Colorado Springs Trade approach The trade approach to exchange rate determination focuses on the role of international trade in determining exchange rates. In this approach, the equilibrium exchange rate is the rate that balances imports and exports. –If the nation has a trade deficit, its currency will depreciate. –If the nation has a trade surplus, its currency will appreciate.

Dale R. DeBoer University of Colorado, Colorado Springs Purchasing power parity theory The law of one price –The idea that in the absence of barriers to trade the price of homogenous traded commodities will be identical in all markets. –Example Suppose that glassware sells in the U.S. for $1/unit. If the exchange rate is ¥100/$1, the price in Japan should be ¥100/unit. If this does not occur, then profitable opportunities for arbitrage exist.

Dale R. DeBoer University of Colorado, Colorado Springs Purchasing power parity theory The law of one price –The idea that in the absence of barriers to trade the price of homogenous traded commodities will be identical in all markets. –In other words, $P = ¥PR where R is the dollar price of one unit of foreign currency, $P is the dollar price of the homogenous commodity, and ¥P is the foreign currency price of the homogenous commodity.

Dale R. DeBoer University of Colorado, Colorado Springs Purchasing power parity theory The law of one price If the law of one price holds for all goods, then absolute purchasing power parity (PPP)will hold. –Absolute purchasing power parity holds that equilibrium exchange rates are equal to the ratio of price levels in the two nations. –In other words, P = P * R where R is the dollar price of one unit of foreign currency, P is the price level in the U.S., and P* is the price level in the foreign nation.

Dale R. DeBoer University of Colorado, Colorado Springs Purchasing power parity theory The law of one price If the law of one price holds for all goods, then absolute purchasing power parity (PPP) will hold. Absolute purchasing power parity does not hold in absence to perfect free trade. –Non-traded commodities –Barriers to trade –Transaction costs

Dale R. DeBoer University of Colorado, Colorado Springs Purchasing power parity theory The law of one price If the law of one price holds for all goods, then absolute purchasing power parity (PPP) will hold. Absolute purchasing power parity does not hold in absence to perfect free trade. Relative purchasing power parity postulates that the change in the exchange rate is equal to the difference in the change in the price levels (rates of inflation) of the two countries.

Dale R. DeBoer University of Colorado, Colorado Springs The monetary model of exchange rates The monetary model of exchange rates holds that the exchange rate is determined in the process of equilibrating the domestic demand and supply of currency.

Dale R. DeBoer University of Colorado, Colorado Springs The monetary model of exchange rates The monetary model of exchange rates holds that the exchange rate is determined in the process of equilibrating the domestic demand and supply of currency. An increase in the U.S. money supply (assuming no change in other money supplies) will depreciate both nominal (spot) and real exchange rates. –The real exchange rate is the nominal exchange rate weighted by the consumer price index of the two nations.

Dale R. DeBoer University of Colorado, Colorado Springs The asset model of exchange rates The asset model of exchange rates holds that the exchange rate is determined in the process of equilibrating the domestic demand and supply of financial assets. –It is also known as the portfolio model

Dale R. DeBoer University of Colorado, Colorado Springs The asset model of exchange rates The asset model of exchange rates holds that the exchange rate is determined in the process of equilibrating the domestic demand and supply of financial assets. An increase in the U.S. money supply (assuming no change in other money supplies) will lower interest rates in the U.S. and shift investors from domestic to foreign assets and lead to a depreciation of the dollar.

Dale R. DeBoer University of Colorado, Colorado Springs The asset model of exchange rates An increase in the U.S. money supply (assuming no change in other money supplies) will lower interest rates in the U.S. and shift investors from domestic to foreign assets and lead to a depreciation of the dollar. The depreciation in the dollar spurs U.S. exports and discourages imports. –This encourages the formation of a trade surplus.

Dale R. DeBoer University of Colorado, Colorado Springs The asset model of exchange rates An increase in the U.S. money supply (assuming no change in other money supplies) will lower interest rates in the U.S. and shift investors from domestic to foreign assets and lead to a depreciation of the dollar. The depreciation in the dollar spurs U.S. exports and discourages imports. The movement in trade encourages an appreciation of the dollar that partially offsets the initial depreciation.

Dale R. DeBoer University of Colorado, Colorado Springs Exchange rate dynamics In adjusting to long run equilibrium values, exchange rates tend to “overshoot” the final equilibrium value. Suppose that the exchange rate is initially at $1/€1. Time $/€ 1

Dale R. DeBoer University of Colorado, Colorado Springs Exchange rate dynamics Suppose that the exchange rate is initially at $1/€1. At time A, the money supply in the U.S. increases causing the exchange rate to depreciate. Time $/€ 1 A

Dale R. DeBoer University of Colorado, Colorado Springs Exchange rate dynamics If the long run equilibrium exchange rate (determined by the PPP model) is expected to be $1.10/ €1, in the short run the exchange rate will overshoot this value (perhaps to $1.16/ €1). Time $/€ 1 A 1.16

Dale R. DeBoer University of Colorado, Colorado Springs Exchange rate dynamics The overshooting drives an improvement in the balance of trade that will lead to subsequent appreciation of the dollar. Time $/€ 1 A 1.16

Dale R. DeBoer University of Colorado, Colorado Springs Exchange rate dynamics The overshooting drives an improvement in the balance of trade that will lead to subsequent appreciation of the dollar. Over time, the dollar will fall to its long run equilibrium value. Time $/€ 1 A

Dale R. DeBoer University of Colorado, Colorado Springs Exchange rate forecasting Models of exchange rates have not been very successful at predicting future exchange rates.

Dale R. DeBoer University of Colorado, Colorado Springs Exchange rate forecasting Models of exchange rates have not been very successful at predicting future exchange rates. Reasons –Exchange rates are highly influenced by new information.

Dale R. DeBoer University of Colorado, Colorado Springs Exchange rate forecasting Models of exchange rates have not been very successful at predicting future exchange rates. Reasons –Exchange rates are highly influenced by new information. –Expectations in exchange rate markets tend to be self-fulfilling (at least in the short-run). This may generate movements in the market contrary to what is expected by theory.