Download Lecture15-ForeignExchangeMarketB

Lecture 15 – Foreign Exchange
Market
Factors influencing exchange rates
Factors affecting exchange rates
• There are mainly five factors that influence
exchange rates. They are:
– Domestic prices
– Trade barriers
– Import demand
– Export demand
– productivity
Domestic Prices
• In the long run, a rise in a country’s price level
(relative to the foreign price level) causes its
currency to depreciate
• and a fall in the country’s relative price level
causes its currency to appreciate.
Trade Barriers
In international trade some barriers to free trade exist
– such as tariffs (taxes on imported goods)
– And quotas (restrictions on the quantity of foreign goods
that can be imported)
• When trade barriers increase, they increase demand
for local goods local currency tends to appreciate
because local goods will still sell well even with a
higher value of the local currency.
Preferences for Domestic Versus
Foreign Goods.
• Increased demand for a country’s exports
causes its currency to appreciate in the long
run;
• conversely, increased demand for imports
causes the domestic currency to depreciate
• EXAMPE: If the Japanese develop an appetite for
American goods ,the increased demand for American
goods (exports) tends to appreciate the dollar,
because the American goods will continue to sell well
even at a higher value for the dollar.
Productivity
• If a country becomes more productive,
businesses in that country can lower the
prices of goods relative to foreign goods and
still earn a profit.
• As a result, the demand for domestic goods
rises, and the domestic currency tends to
appreciate.
Central bank intervention in exchange
market
• More often, foreign exchange market is not a
free market
• Central bank of the country manages the
exchange rate by buying and selling currencies
• With these interventions, money supply is also
influenced
Unsterilized foreign exchange intervention
• Suppose SBP decides to sell $500 million of its
foreign exchange reserves in exchange for
pakistani currency, this transaction will have
two impacts:
– It will reduce the SBP foreign exchange reserves by
$500 million
– Currency in circulation will fall by the same
amount
• When the central bank activity in the foregin
exchange market results in change in the
monetary supply, it is called unsterilized
foregin exchange intervention
• A foreign exchange intervention with an
offsetting open market operation that leaves
the monetary supply unchanged is called
sterilized foregin exchange intervention
Exchange rate regimes
• Exchange rate regimes in the international financial
system are of two basic types:
• Fixed and floating
• In a fixed exchange rate regime, the value of currency
are kept pegged relative to one currency called the
anchor currency so that exchange rates are fixed
• In a floating exchange rate regime, the value of
currencies are allowed to fluctuate against one
another
• However, countries often attempt to influence
their exchange rates by buying an selling
currencies, so in this case the regime is
refffered to as a managed float regime
Fixed rate regime
• When the domestic currency is overvalued,
the central bank must purchase domestic
currency to keep the exchange rate rate fixed,
but as a result it loses international reserves
• With the domestic currency undervalued, the
central bank must sell currecny to keep the
exchange rate fixed, but as a result it gains
international reserves