Exchange Rate Determination

Remember:

High Interest Rates = High Return Rates

Low Interest Rates = Low Return Rates

There are 4 forces that work to determine Exchange Rates

1) Relative Rates of Economic growth

2) Relative Rates of Inflation

3) Changes in Interest Rates

4) Expectations

What do these mean?

1) Relatives Rates of Economic Growth

  • If the U.S. economy grows faster than others, the U.S.’s demand for imports will increase more than other nations will.

  • Subsequently, this increases the demand for foreign currency, which leads to the depreciation of the dollar.

2) Relatives Rates of Inflation

  • If U.S. inflation is worse than other nations, the dollar will decrease in value compared to foreign currency.

3) Changes in Interest Rates

  • If the U.S. interest rates fall lower than other nations, the demand for U.S. interest assets will fall because investors seek higher returns elsewhere.

  • This leads to a depreciation of the dollar in the foreign exchange market.

4) Expectations

  • If it is expected that the dollar will fall, people will pull out of holdings.

  • As holdings fall, the dollar depreciates

The Trade Approach

The Trade Approach is a method of analyzing exchange rates that focuses on the role of international trade in determining exchange rates.

  • It is most effective in long-run models

  • Also known as the elasticity approach

In the Trade Approach, the equilibrium exchange rate is the rate that balances imports and exports.

  • If the nation has a trade deficit, its currency depreciates.

  • If the nation has a trade surplus, its currency appreciates.

Purchasing Power Parity Theory

Purchasing Power Parity (PPP)

  • The Law of One Price

    • In the absence of barriers to trade, the price of a commodity will be identical across all markets.

Example of the Law of One Price

  • Suppose a glass costs $1 in the U.S.

  • The exchange rate between Japan’s Yuen is Y100/1$

  • Therefore, the glass will cost Y100 in Japan because it is a proportionally equal cost.

The absence of the Law of One Price, or more so the presence of trade barriers, opens the door for arbitrage

  • Arbitrage is when an asset (stock, currency, etc.) is purchased in one country for a cheaper price and then sold in another for a higher price for profit.

If the Law of One Price holds for all goods, then so will Purchasing Power Parity (PPP).

  • Absolute purchasing power parity means that the equilibrium exchange rates are equal to the ratio of price levels between two nations.

Absolute Purchasing Power Parity does not hold in the absence of perfect free trade or:

  • Non-traded commodities

  • Barriers to trade

  • Transaction costs

Relative Purchasing Power Parity suggests that the change in the exchange rate is equal to the difference in the change in the price levels of two countries

  • The change in exchange rates is equal to the difference in rates of inflation between the two countries.

The Monetary Model of Exchange Rates

The Monetary Model of Exchange Rates suggests that the exchange rate of currency is determined in the process of equilibrating the domestic demand and supply of currency.

  • An increase in the U.S. money supply will depreciate both nominal and real exchange rates

    • Nominal as in the U.S. currency unadjusted in relation to another

    • Real as in the nominal exchange rate weighted by the Consumer Price Index of both nations.

      • Consumer Price Index means the average change over time in the prices paid by consumers for a good.

The Asset (Portfolio) Approach to Exchange Rates

The Asset Approach to Exchange Rates holds that the exchange rate is determined in the process of equilibrating the domestic demand and supply of financial assets.

  • Also known as the Portfolio Approach

  • The theory is essentially that an increase in the U.S. money supply will lower interest rates in the U.S.

    • This will shift investors from domestic to foreign assets and lead to a depreciation of the dollar.

  • The depreciation in the dollar spurs U.S. exports and discourages imports.

    • This encourages the formation of a trade surplus, which will lead to dollar appreciation.

  • This process, the movement in trade, encourages an appreciation of the dollar to partially offset an initial depreciation.

Exchange Rate Dynamics

Exchange Rate Dynamics on graphs can be quite complex.

Key details:

  • In adjusting to long-run equilibrium values, exchange rates tend to “overshoot” the final equilibrium value.

  • Overshooting drives an improvement in the balance of trade that leads to a subsequent appreciation of the dollar.

    • Trade surplus

  • Over time, the dollar will fall to its long-run equilibrium value.

Exchange Rate Forecasting

Models of exchange rates have not been very successful at predicting future exchange rates.

This is because:

  • Exchange rates are highly influenced by new information, such as Expectations and spontaneous investor pull-outs.

  • Expectations in exchange rate markets tend to be self-fulfilling (at least in the short run)

    • When investors pull out of domestic assets due to a fear of depreciation, they CAUSE the depreciation even though it might not have otherwise occurred. Similar to Bank Runs.

    • This may generate movements in the market that contradict what is expected by theory.