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Determination of exchange rates Exchange rate = the price of one country’s money in terms of another country’s money - supply of currency and demand for currency - balance-of-payments account = list of reasons a currency being supplied and demanded - how inflation, interest rates, foreign debt, political risk, and expectations about future values of these factors can affect exchange rates - flows, amounts per period of time, of supply and demand for currency – exchange rates change until flow supplies and demands are equal - stock, amounts at each point in time: monetary approach to exchange rates, asset approach to exchange rates, portfoliobalance approach to exchange rates – overshooting - exchange rate systems, standards Summary 1. The balance-of-payments account is a record of the flow of payments between the residents of one country and the rest of the world in a given period. Entries in the account that give rise to a demand for the country’s currency – such as exports and asset sales – are identified by a plus sign. Entries giving rise to a supply of the country’s currency are identified by a minus sign. Therefore, we can think of the balance-of-payments account as a record of the supply of and demand for a country’s currency. 2. The balance-of-payments account is based on double-entry bookkeeping. Therefore, every entry has a counterpart entry elsewhere in the account, and the account must balance. What is important, however, is how it balances. Anything tending to increase the size of positive entries, such as higher exports or increased sales of bonds to foreigners, will cause the account to balance at a higher exchange rate. 3. Credit entries in the balance of payments result from purchases by foreigners of a country’s goods, services, goodwill, financial and real assets, gold, and foreign exchange. Debit entries result from purchases by a country’s residents of goods, services, goodwill, financial and real assets, gold, and foreign exchange from foreigners. 4. The current account includes trade in goods and services, income, and unilateral transfers. The goods or merchandise component alone gives the balance of trade as the excess of exports over imports. If exports exceed imports, the balance of trade is in surplus, and if imports exceed exports, it is in deficit. Income includes the flow of interest and dividend receipts and payments. Unilateral transfers are flows of money not matched by any physical flow, and double-entry bookkeeping requires that we have an offsetting flow that can be marked down as goodwill. 5. A current-account deficit can be financed by selling a country’s bills, bonds, stocks, real estate, or businesses. It can also be financed by selling off previous investments in foreign bills, bonds, stocks, real estate, or businesses. The principal factors influencing investments in foreign financial and real assets are rates of return in the foreign country versus rates of return at home, and the riskiness of the investments. 6. Purchases and sales of financial and real assets result in a supply of or demand for a country’s currency in the same way as do purchases and sales of goods and services. 7. Changes in official reserves occur when governments intervene in the foreign exchange markets to influence exchange rate. When exchange rates are truly flexible, changes in official reserves are zero. 8. Since all entries in the balance of payments should collectively sum to zero, the balance-of-payments accountant can determine the errors that were made, which together are called the statistical discrepancy. 9. With flexible exchange rates, the correctly measured deficit/surplus in the current account equals the correctly measured surplus/deficit in the capital account. With fixed exchange rates, the combined increase/decrease in official reserves of the domestic and foreign governments is equal to the combined surplus/deficit of the correctly measured current and capital accounts. 10. It is equally valid to consider a current-account deficit/surplus to be the cause of, or to be caused by, a capital-account surplus/deficit. 11. The balance-of-payments account is analogous to a firm’s income statement. Deficits are equivalent to corporate losses and can be financed by selling bonds or new equity or by divesting assets. If there is a net outflow from a firm or country due to acquiring new productive capital, this might not be unhealthy. Unfortunately, the balance-of-payments account does not distinguish imports of capital goods from imports of consumption goods. 12. The international investment position is a record of the stock of foreign assets and liabilities. It is relevant for determining the likelihood of a currency devaluation. 13. It is not a good idea to run persistent deficits or persistent surpluses in the balance of trade. Rather, a country should balance its trade on average over the long run. Factors affecting exports and hence demand for U.S. dollars include - the foreign exchange value of the U.S. dollar - U.S. prices versus the prices of comparable goods abroad (inflation in USA vs. inflation abroad) - world prices of products that the U.S. exports (terms of trade) - foreign incomes - foreign import duties (tariffs) and quotas Bc + R + Bk + = 0 Bc = balance on current account R = changes in official reserves Bk = balance on capital account = statistical discrepancy - with flexible exchange rates: Bc + Bk + = 0 and when there are no statistical discrepancies Bc = -Bk i.e. the correctly measured current account deficit/surplus is exactly equal to correctly measured capital account surplus/deficit - with fixed exchange rates: R = -(Bk + Bc) i.e. the increase/decrease in official reserves equals the combined surplus/deficit in the current and capital accounts - with flexible rates and if Bc + Bk = 0, but when Bc is large and negative and Bk is large and positive, the country is likely to run into trouble eventually since the country is paying for its excess of imports over exports by borrowing abroad or divesting itself of investments made in the past this is not sustainable in the long run with fixed rates and if Bc + Bk < 0 and R > 0, this means that the government (or central bank) is buying up its own currency to offset the negative net excess supply due to the current and capital account deficits the government or central bank buys its own currency by selling gold and foreign exchange reserves, which can occur in the short run if the central bank has a large stock of reserves but eventually reserves will run out - - - - temporary deficits are allowed but in the long run as the country will run out of reserves and fall into debt, it will run out of credit - the presumption that trade surpluses are an appropriate policy objective has a long history, from the sixteenth century, mercantilism - national income accounting identity: Y = C + I + G + (X – M) Y = gross domestic output C = consumption I = investments G = government expenditure X = exports I = imports X – I = Y – (C+I+G) having surplus in trade means that what is produced (Y) is more than what is used or absorbed (C+I+G) by the economy the absorption approach to the balance of payments a deficit in trade: the country is living beyond its means - http://www.bof.fi/en/tilastot/maksutase/index.htm http://www.ny.frb.org/research/global_economy/globalindicators.html Yhdysvallat EU Japani Kiina Intia Muut maat Tilastoero Mrd. USD 1500 1000 500 0 -500 -1000 -1500 1997 1999 2001 2003 Vuodet 2007 ja 2008 ennusteita. Lähde: IMF ( World Economic Outlook, Oct. 2007). Current account balance http://www.wtrg.com/prices.htm 2005 2007 Supply-and-demand view of exchange rates Summary 1. Flexible exchange rates are determined by supply and demand. 2. We can construct the supply curve of a currency from a country’s demand curve for imports. We can construct the demand curve for a currency from the country’s supply curve of exports. 3. The effect of any item in the balance-of-payments account on the exchange rate can be determined by identifying how it shifts the currency supply of currency demand curve. 4. Ceteris paribus, an improvement in a country’s terms of trade causes the country’s currency to appreciate. 5. Inflation that is higher than in other countries causes a country’s currency to depreciate. If inflation in different countries is equal, ceteris paribus, exchange rates do not change. 6. Ceteris paribus, the higher are service exports relative to service imports, the higher is the foreign exchange value of a country’s currency. 7. A country’s currency tends to appreciate with increases in interest rates and expected profits relative to those earned in other countries. 8. If import demand is inelastic the currency supply curve slopes downward. This is because depreciation raises the price of imports in domestic currency more than it reduces the quantity of imports. In this way depreciation increases the value of imports, meaning a downward-sloping supply curve of the currency. When the supply curve slopes downward the foreign exchange market may be unstable. Instability occurs when the currency demand curve is steeper than the downward-sloping supply curve. 9. Because import demand elasticities are smaller in the short run than in the long run, instability is more likely in the short run than the long run. 10. The same conditions that cause short-run instability and long-run stability result in a J curve. The J curve shows that a depreciation can temporarily worsen the balance of trade, while an appreciation can temporarily improve the balance of trade. - - - when exchange rates are flexible, they are determined by the forces of supply and demand what are these forces, what makes exchange rates change consideration of the effects of items listed in the balance-ofpayments account on the supply and demand curves flow of payments into and out of a country, or flow demands and supplies of a currency but there is no assurance that the supply curve of a currency will be upward-sloping, if that is the case, then instability in the currency markets may exists, and volatility (high fluctuations in exchange rates) exchange rate instability can explain the so called “J curve” whereby, for example, a depreciation of a currency worsens rather than improves a country’s balance of trade the supply curve of a currency shows the amount of that currency supplied on the horizontal axis and the price of the currency (the - - - - - - - exchange rate) on the vertical axis, however, it is not quantities on the horizontal axis (- like automobiles produced per month - ) but it is values ( - how many British pounds, or how many euros -) values involve the multiplication of prices and quantities, and they respond differently than do quantities the supply curve of a currency derives, at least in part, from a country’s demand for imports, so the amount of the currency supplied is equal to the value of imports e.g. suppose that the world price of wheat is $3 per bushel at an exchange rate of $1,5/£, the pound price of wheat is $3/($1,5/£) = £2 per bushel with that price (£2) domestic production equals domestic demand, and there are no imports at an exchange rate $1,7/£, the pound price is (3/1,7) = £1,76 and wheat imports are 0,75 billion bushels, and the number or pounds supplied at that exchange rate is £1,76x0,75 billion = £1,32 billion per year at an exchange rate $2/£, the pound price is (3/2) = £1,5 per bushel and wheat imports are 1,5 billion, and the number of pounds supplied is 1,5x1,5 billion = £2,25 billion and so on, and we can construct the supply curve of pounds which here slopes upward (1,5 & 0, 1,7 & 1,32 and 2 & 2,25) the demand curve of a currency shows the value of the currency that is demanded at each possible exchange rate the need to buy a country’s currency stems from the need to pay for the country’s exports, the currency’s demand curve is derived from the country’s export supply curve, which shows the quantity of exports at each price of exports e.g. the world price of oil is $25 per barrel if exchange rate is $2/£, the pound price of oil is (25/2) = £12,5 per barrel, oil exports are zero (British production of oil equals British consumption of oil at £12,5) if exchange rate is $1,8/£, the pound price of oil is (25/1,8) = £13,89, and oil exports are 0,1 billion barrels per year, and the - - - value of oil exports and pounds demanded at $1,8/£ is 13,89x0,1 = £1,389 billion if exchange rate is $1,5/£, the pound price of oil is (25/1,5) = £16,67, exports are 0,2 billion barrels, and the value of oil exports and pounds demanded is 16,67x0,2 = £3,33 billion per year the demand curve for pounds slopes downward (2 & 0, 1,8 & 1,389, and 1,5 & 3,33) the exchange rate that equates the value of exports and imports (or the demand for currency and the supply of currency) is the equilibrium rate - - - - - - - an exogenous (an independent) increase in the value of exports at each exchange rate, which shifts the demand curve for pounds to the right, result in an increase in the value of the pound such an increase in the value of exports could occur as a result of a higher world price of oil of from an increase in the quantity of oil exported at each oil price an exogenous increase in the value of imports (supply shifts to the right) will result in a decrease in the value of the pound – higher world price of wheat, which Britain is importing, or an increase in the quantity of wheat imported at each price the price a country’s exports relative to the price of its imports is called the country’s terms of trade the terms of trade improves if the price of exports (oil) increases relative to the price of its imports (wheat), and the pound will appreciate the pound will also appreciate if the quantity of exports (oil) increases relative to the quantity of imports (wheat) exchange rates are also influenced by inflation, which affects the competitiveness of one country’s products versus the same or similar products from another country the exchange rate of the inflating country depreciates by approximately its rate of inflation (if inflation only in one country) if inflation also in other countries: the exchange rate is unaffected imports and exports of services, such as tourism, banking, consulting, engineering, respond to exchange rates in the same way as do imports and exports of merchandise - - - - - - - the supply and demand for a currency from payments and receipts of interest, dividends, rents, and profits do not respond to exchange rates in the same manner as the currency supply and demand from imports and exports of merchandise and services income payments and receipts are largely determined by past investments and the rates of return on these investments net inflows of transfers (income payments) tend to increase the value of a currency and net outflows tend to reduce it net inflows of foreign investments: demand for the country’s currency when that investments occurs – direct investment, portfolio investment, or additions to bank deposits the amount of investment flowing into or out of country depends on rates of return in the country relative to rates of return elsewhere, as well as on relative risks increases in country’s interest rates or expected profits cause a currency to appreciate all conclusions are based on the assumption of that the supply curve of a currency slopes upwards but this assumption may not be valid when the demand for imports is elastic (m > 1 or m < -1, e.g. –1,5 or -2), the supply curve of the currency slopes upward, when the demand for imports is inelastic (m < 1, e.g. –0,8), the supply curve of the currency slopes downward – the downward slope occurs because depreciation raises import prices and reduces the quantity of imports but the value of imports increases when the currency supply curve slopes downward, foreign exchange markets may be unstable - if demand > supply then normally prices go up until markets are cleared and demand = supply – but if demand > supply and prices go up and still d >>s then instability currency markets are unstable if the currency demand curve is steeper than the supply curve - - - - - a sufficient condition for stability: the Marshall-Lerner condition (m + x > 1), for exchange rate instability : m + x < 1 which is possible when demand for imports is inelastic – e.g. m = 0,4 and x = 0,3 a depreciation increases the price of imports in terms of domestic currency, this reduces the quantity of imports but does not necessarily reduce the value of imports, and a depreciation can worsen the balance of trade this worsening of the balance of trade following a depreciation of a currency may be temporary similarly, instability in exchange rates may be only a short-run problem when imports and exports are sufficiently inelastic in the short run, both unstable exchange rates and a temporary worsening of the balance of trade after currency depreciation – but in the long run the imports and exports are more elastic the trade balance turns around and stability returns to foreign exchange market the time path the trade balance looks like a J if the elasticities of demand for imports and supply of exports are smaller in the short run than the long run in the long run people adjust their consumption (and imports and exports change, and elasticities are bigger) http://www.ecomod.net/conferences/iioa2004/iioa2004_papers/389.pd f p. 4 http://www2.sseriga.edu.lv/library/working_papers/AB_2003_13.pdf http://aeq.diw.de/aeq/index.jsp?n=0010&p=1&c=summary/AEQ_03_ 1_4 Modern theories of exchange rates Summary 1. Several theories of exchange rates have been advanced which are based on the stocks of countries’ monies versus the demands to hold these monies. 2. The stock-based theories differ according to the assets they consider and whether they involve expectations of the future. 3. The monetary approach to exchange rates is based on links between money supplies and price levels and between price levels and exchange rates. 4. The monetary approach predicts that an exchange rate will depreciate by the excess of money growth in one country over another. It also predicts that faster growth of real GNP will cause appreciation and that higher interest rates and expected inflation will cause depreciation. 5. The asset approach to exchange rates suggests that the current exchange rate depends on the expected future exchange rate. Since the expected future rate can depend on expected inflation or anything appearing in the balance-of-payments account, the asset approach is consistent with other theories of exchange rates. 6. The portfolio-balance approach assumes different countries’ bonds are not perfect substitutes. As a result, changes in preferences for bonds of one country over another, or changes in bond supplies, can affect exchange rates. 7. If prices are sticky, exchange rates may overshoot their equilibrium. Other explanations of exchange-rate overshooting include varying elasticities of import demand and export supply, and jumps in currency supplies or demands caused by portfolio readjustment. - - stocks of assets: such as money stocks (the monetary theory of exchange rates), or such as bonds (the asset approach to exchange rates) the monetary theory M US M rUS e rUK and UK QUK QUS e PUK PUS - - here MUS and MUK are the U.S. and British money demands, PUS and PUK are price levels, Q’s are real GDPs, r’s are nominal interest rates, and and are parameters that are assumed to be positive and the same for both countries, and e stands for exponential rUK rUS e then for U.S. PUS M US QUS e and for UK PUK M UK QUK according to purchasing power parity (PPP) the spot exchange rate S($/£) = PUS/PUK M US QUK ( rUS rUK ) thus S($/£) = which proposes that money ( ) e M UK QUS demands (and also money supplies), real productions (GDPs) and interest rates (r) have influence on exchange rates - the portfolio approach to exchange rates: demand equations for different monies and bonds in each country, these demands are related to incomes, interest rates, and so on - the Dornbusch Sticky-Price theory: suppose that PPP holds for internationally traded goods but not for goods that are not traded internationally (services, land) and their prices move slowly toward their new equilibrium after a disturbance (prices are sticky) if then the exchange rate falls in proportion to the percentage increase in a country’s money supply, as suggested by the monetary approach, these remains an excess supply of money therefore, the overall price level increases less than the money supply, leaving the demand for money lower than the supply the theory of overshooting exchange rates concentrates on the effect of the increased spending on bonds, arguing that this causes higher bond prices and consequently lower interest rates if a country’s interest rates are lower than other countries’, capital leaves the country until the country’s currency is expected to appreciate by the extent to which its interest rates are below other countries – in order for the currency to be expected to appreciate, the exchange rate must overshoot, going lower than its eventual equilibrium level - - -