Download Determination of exchange rates

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
-
-
-