EXCHANGE RATE DETERMINATION

Demand for Foreign Exchange Refers to the amount of foreign exchange that will be bought from the market at various exchange rates Corresponds to debit items on the balance of payments Demand for foreign exchange varies inversely with its price

Supply of Foreign Exchange Refers to the amount of foreign exchange that will be offered to the market at various exchange rates. Correspond to the credit items on the balance of payments. Supply for foreign exchange varies directly with its price

Dollar Appreciation due to Decrease in Demand for Pound Dollars per pound S0S0 E D0D0

Dollar Appreciation due to Increase in Supply of Pound Dollars per pound S0S0 E D0D0

Dollar Depreciation due to Increase in demand for Pound Dollars per pound S0S0 E D0D0

Dollar Depreciation due to Decrease in Supply of Pound Dollars per pound S0S0 E D0D0

MARKET FUNDAMENTALS & THE DOLLAR’S EXCHANGE VALUE Factor Dollar’s Exchange Value Increase in foreign demand for U.S. goods, services or assets Appreciation Increase in U.S. demand for foreign goods, services or assets Depreciation Increase in U.S. real incomeDepreciation Increase in U.S. interest ratesAppreciation Increase in U.S. price levelDepreciation Increase in U.S. productivity Appreciation Increase in U.S. import restrictionsAppreciation

Interaction of Exchange Rate Determinants Rise in U.S. interest rate, income & price level. Exchange rate Exchange rate movement depends on the nature of international transactions Currency appreciates (depreciates) if amount of international investment is larger (smaller) than the amount of international trade.

Long-run Exchange Rate Purchasing Power Parity (PPP) Law of one price. Absolute PPP: P = eP *

Overvalued Currency exchange rate If exchange rate rises above the level warranted by economic conditions Nation’s cost will not be competitive A trade deficit will likely occur. Bigmac/Index.cfm Bigmac/Index.cfm

Absolute PPP Doesn’t Always Prevail Because of Trade barriers Transportation costs Non-traded goods Information cost

Relative PPP Changes in relative national price levels determine changes in exchange rates over time. %  e = %  P - %  P * e 1 = e o P 1 US /P 1 UK where e 1 : estimates of exchange rate at time 1 e o : exchange rate at base period

Problems with Relative PPP Capital flow is de-emphasized Choosing appropriate price index Choosing base period During small inflation, other factors become more important. (It appears roughly valid when inflation is extreme.) Doesn’t hold in short-run because of lags in adjustment process.

Factors influencing exchange rates Market expectations As with stock markets, foreign exchange markets react quickly to news or even rumors that point to future changes affecting rates Future expectations can be self- fulfilling; speculative bubbles can start without any real information but can become self sustaining - for a while

Monetary Approach exchange rate Demand & supply of money determines exchange rate Central bank supplies money (M S ) Demand for money is a constant fraction of nominal GDP (kPY). It depends on Real Income (+) Interest rate (-) Price level (+)

Impact on the Exchange Rate According to the Monetary Approach Increase in money supplyDepreciate Increase in money demandAppreciate Monetary Approach

Impact on the Exchange Rate According to the Monetary Approach Increase in money supply Depreciate Increase in money demand Appreciate