Determinants of Exchange Rates

Why Study Exchange Rates? To understand the economic environment –Forecasting for planning purposes To understand exposure to currency risk –Financial impact of exchange rate move varies With the nature of the asset/liability With the cause of the move

Outline: Exchange Rate Determination 1.Market Forces 1.Real economic effects 2.Monetary effects 2.Role of Government

Exchange rates are determined by supply and demand for the currencies

Market Forces: Real Effects

To focus on real effects assume: 1.No currency market intervention 2.No inflation in either country

Real exchange rates are determined by real economic events affecting supply and demand for the currencies

Balance of Payment Accounts Components: Current Account - Goods and Services Financial Account - Investment Reserve Account - Government Reserves

Factors Affecting Trade (Current Account) Real price “shocks” –Example: Oil price shock Government policy change –Tariff/ Trade policy

Factors Affecting Investment (Financial Account) Real return “shocks” –example: turn of business cycle Government policy (affecting real returns) –tax policy –labor law Perceived risk –war, political risk

Conclusions about real effects Changes in any of these real factors Shifts supply or demand for currency –Affects exchange rate –Of interest to currency forecasters Is also reflected in balance of payments data –Thus BOP data of interest to forecasters

Market Forces: Monetary Effects

Purchasing Power Parity Logic: “arbitrage” in market for goods

Definitions: PPP Absolute Purchasing Power Parity The purchasing power of the dollar is the same everywhere in the world Relative Purchasing Power Parity Exchange rates move to offset differences in rates of inflation.

How well does PPP predict in practice? Absolute PPP – Not at all Relative PPP Works well –In the long run –When differences in inflation are dramatic Works much less well in the short run

Real Exchange Rate Definition: Exchange rate after removing the effects of inflation If Purchasing Power Parity holds, then real exchange rates never change

Interest Rate Parity Logic: –Arbitrage in financial markets –Return on a dollar invested must be the same everywhere –Called “covered interest arbitrage”

Forward Exchange Rate An exchange rate agreed upon today for a currency exchange to be carried out at a specified date in the future.

Unbiased Forward Rate Definition - forward rates are unbiased predictors of future spot rates Logic: Speculation on forward markets Consequences –Single most useful rule for currency prediction –With CIA connects interest rates to expected exchange rates

Predictions based on parity conditions

Exchange rate forecasting summary 1.Use forward rates (if available) 2.Interest rates can be used to construct an “implied forward rate” 3.Consider anticipated changes in real factors and monetary policies

Exchange Rate Policy The role of government

How governments affect exchange rates Currency market intervention –(intentional) –Central Bank buys/sells home currency in exchange for its foreign currency reserves. Monetary policy –(unintentional through impact of inflation) –Central Bank buys/sells home currency in exchange for bonds

Types of Exchange Rate Policies free float (no intervention) “dirty”or managed float(some intervention) fixed exchange rate or “peg” (unlimited intervention at a fixed rate) –through central bank policy –currency board –dollarization

Lessons about Exchange Rate Policy Policy matters (especially in the short run). In the long run no policy can overcome market forces.