Download Determination of Exchange Rates

Determination of Exchange Rates
As we have learnt from basic microeconomics
the price of any good is determined by the intersection of the supply and the demand for that
good.
Exchange rates are no exception to that general
rule.
Example: Consider the US Dollar/Euro exchange
rate:
• Demand for Euros:
– US exporters to Euro-zone
– US tourists in Euro-zone
– US investors in Euro-denominated assets
• Supply of Euros:
– European exports to the US
– European tourists in US
– European investors in dollar-denominated
assets
Factors that Determine Exchange
Rates
• Relative Inflation Rates
• Relative Interest Rates
Real Interest Rate = Nominal Interest Rate
- Inflation Rate
• Relative Economic Growth Rates
• Political and Economic Risk
Calculating Exchange Rate Changes
Example: Suppose the euro exchange rate against
the dollar changes from 0.93$/Euro to 0.99$/Euro.
This means that the Euro has appreciated relative to the US dollar. Similarly, it also means
that the US dollar has depreciated against the
Euro.
Euro appreciation =
New dollar value of euro − Old dollar value of euro
Old dollar value of euro
e1 − e0
=
e0
In this case we have that the euro has appreciated by (0.99 − 0.93)/0.93 = 0.0645 or a 6.45%
appreciation.
Dollar depreciation =
New euro value of dollar − Old euro value of dollar
Old euro value of the dollar
1/e1 − 1/e0
e0 − e1
=
=
1/e0
e1
In the case of the change in the dollar we have
(0.93 − 0.99)/0.99 = −0.0606 or a 6.06% devaluation.
Example: Yen Depreciation
During 1995, the Japanese yen went from $0.0125
to $0.0095238. By how much did the yen depreciate against the dollar?
0.0095238 − 0.0125
= −0.2381
0.0125
or a 23.81% devaluation.
By how much did the dollar appreciate against
the yen? At $0.0125/yen we have that $1 =
1/0.0125 = 80 yen and, similarly, at $0.0095238/yen
we can compute that $1 = 1/0.0095238 = 105
yen.
105 − 80
= 0.3125
80
or a 31.25% appreciation of the dollar.
The US Dollar Experience
1960s: Stable political system, low inflation
(1%) and high economic growth (5%). Hence,
the rest of the world was willing to hold dollardenominated assets and the value of the US dollar was high.
1970s: Unstable political system (Vietnam war),
high inflation (OPEC oil price shocks), slow
economic growth (3%). This lowered the attractiveness of dollar-denominated assets and,
therefore, the US dollar lost value.
Early 1980s: Reagan succeeded in lowering
inflation, stimulated economic growth (6.5%)
by lowering taxes. The investment opportunities in the US were again better than in the rest
of the world and, hence, the US dollar increased
in value.
Late 1980s: US growth slowed down relative
to the rest of the world which experienced an
increase in economic growth and, once again,
the US dollar lost value.
Role of Expectations
Recent decline this year of the US dollar relative
to the euro:
• The Federal Reserve Bank to will probably
try to keep interest rates low
• US economic growth will most likely be low
given the recent recession of 2001
• A depressed US labor market given that 3
million US jobs were lost since 2000
• The US government will likely run a budget
deficit
• European economic growth is likely to pick
up relative to the US with the admission of
high-growth Eastern European countries to
the European Union
Money and Currency Values
Major functions of money:
• Store of value
• Means of exchange – liquidity
Demand for money:
• Macroeconomic factors: inflation rate, economic growth
• Financial factors: financial and real asset
returns and riskiness
Supply of money:
• Central bank
• Independence of the central bank is very important for price stability!
• Example: The New Zealand experience in
the 1990s.
Central Bank Interventions
Foreign exchange market intervention:
• Sell foreign currency to buy local currency
– local currency appreciates
• Sell local currency to buy foreign currency
– local currency depreciates
Sterilized vs. Unsterilized intervention:
• Unsterilized intervention: as in both examples above
• Sterilized intervention: adjust the local money
supply to compensate for the effects of the
foreign exchange intervention
Disequilibrium Theory of
Exchange Rates
Suppose the central bank increases the domestic
money supply. Local prices gradually increase
over time.
Initially the increase in the money supply will
drive interest rates down as investors buy more
bonds with the excess cash on hand.
As the interest rates are now lower capital begins to flow out of the country in search of higher
returns.
The capital outflow will result in a sharp decrease in the value of the home currency.
In order for the lower domestic interest rates
to be in equilibrium with the rest of the world,
investors must expect that the local currency
will eventually appreciate to its new equilibrium
level.
Note: There is no empirical evidence in favor of
the disequilibrium theory of exchange rates!
The Equilibrium Theory of
Exchange Rates
Supply and demand for a currency will determine the equilibrium exchange rate.
Governments can do very little to affect the real
exchange rate. If a government policy is anticipated the exchange rate will adjust and reflect
it.
A temporary shock to money supply should be
followed by a temporary change in the exchange
rate.
Empirical Evidence: Mixed
• Changes in anticipated monetary policy does
appear to be fully reflected by exchange rates.
• Exchange rate changes appear to be permanent not temporary.
• Exchange rate changes appear to be more
volatile than the ratio of price levels.