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CHAPTER 2 THE DETERMINATION OF EXCHANGE RATES

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I. EQUILIBRIUM EXCHANGE RATES. II. ROLE OF CENTRAL BANKS ... Equilibrium Exchange Rates. B. How Americans Purchase German Goods ... Equilibrium Exchange Rates ... – PowerPoint PPT presentation

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Title: CHAPTER 2 THE DETERMINATION OF EXCHANGE RATES


1
CHAPTER 2 THE DETERMINATION OF EXCHANGE RATES
  • CHAPTER OVERVIEW
  • I. EQUILIBRIUM EXCHANGE RATES
  • II. ROLE OF CENTRAL BANKS
  • III. EXPECTATIONS AND THE ASSET MARKET MODEL

2
Part I. Equilibrium Exchange Rates
  • I. SETTING THE EQUILIBRIUM
  • A. Exchange Rates
  • market-clearing prices that equilibrate the
    quantities supplied and demanded of foreign
    currency.

3
Equilibrium Exchange Rates
  • B. How Americans Purchase German Goods
  • 1. Foreign Currency Demand
  • -derived from the demand for foreign
    countrys goods, services, and financial
    assets.
  • e.g. The demand for German goods by
    Americans

4
Equilibrium Exchange Rates
  • 2. Foreign Currency Supply
  • a. derived from the foreign countrys
    demand for local goods.
  • b. They must convert their currency
    to purchase.
  • e.g. German demand for US goods means
    Germans convert DM to US in order to buy.

5
Equilibrium Exchange Rates
  • 3. Equilibrium Exchange Rate
  • occurs where the quantity supplied
  • equals the quantity demanded of a
  • foreign currency at a specific local
  • price.

6
Equilibrium Exchange Rates
  • C. How Exchange Rates Change
  • 1. Increased demand
  • as more foreign goods are demanded, the
    price of the foreign currency in local currency
    increases and vice versa.

7
Equilibrium Exchange Rates
  • 2. Home Currency depreciation a. Foreign
    currency more valuable than the home
    currency.
  • b. Conversely, then the foreign
  • currencys value has appreciated
  • against the home currency.

8
Equilibrium Exchange Rates
  • 3. Calculating a Depreciation
  • Currency Depreciation
  • (e0 - e1)/ e1
  • where e0 old currency value
  • e1 new currency value

9
Equilibrium Exchange Rates
  • Currency Appreciation
  • (e1 - e0)/ e0
  • where e0 old currency value
  • e1 new currency value

10
Equilibrium Exchange Rates
  • EXAMPLE dm Appreciation
  • If the dollar value of the dm goes from 0.64
    (e0) to 0.68 (e1), then the dm has appreciated
    by
  • (.68 - .64)/ .64 6.25

11
Equilibrium Exchange Rates
  • EXAMPLE US Depreciation
  • We use the first formula,
  • (e0 - e1)/ e1
  • substituting
  • (.64 - .68)/ .68 - 5.88
  • the US depreciation.

12
Equilibrium Exchange Rates
  • D. FACTORS AFFECTING EXCHANGE RATES
  • 1. Inflation rates
  • 2. Interest rates
  • 3. GNP growth rates

13
THE ROLE OF CENTRAL BANKS
  • I. FUNDAMENTALS OF CENTRAL BANK INTERVENTION
  • A. Role of Exchange Rates
  • LINKS BETWEEN
  • THE DOMESTIC AND THE
  • WORLD ECONOMY

14
THE ROLE OF CENTRAL BANKS
  • B. IMPACT OF EXCHANGE RATE CHANGES
  • 1. Appreciation
  • -domestic prices increase
  • relative to foreign prices.
  • -Exports less competitive
  • Imports more attractive

15
THE ROLE OF CENTRAL BANKS
  • 2. Currency Depreciation
  • - domestic prices fall relative
    to foreign prices.
  • - Exports more price competitive.
  • Imports less attractive

16
THE ROLE OF CENTRAL BANKS
  • C. Foreign Exchange Market Intervention
  • 1. Definition the official purchases and
    sales of currencies through the central
    bank to influence the home exchange rate.

17
THE ROLE OF CENTRAL BANKS
  • 2. Goal of Intervention
  • - alter the demand for one
  • currency by changing the supply of another.

18
THE ROLE OF CENTRAL BANKS
  • D. The Effects of Foreign Exchange
  • Intervention
  • 1. Effects of Intervention
  • - either ineffective or
    irresponsible
  • 2. Lasting Effect
  • - If permanent change results

19
Part III. Expectations and The Asset Market Model
of Exchange Rates
  • I. WHAT AFFECTS A CURRENCYS VALUE?
  • A. Current event
  • B. Current supply
  • C. Demand flows
  • D. Expectation of future exchange rate

20
EXPECTATIONS
  • II. Role of Expectations
  • A. Currency financial asset
  • B. Exchange rate simple relation of two
    financial assets
  • III. Demand for Money and Currency
  • Values Asset Market Model
  • A. Exchange rates reflect the supply of and
    demand for foreign- currency denominated assets.

21
EXPECTATIONS
  • B. Soundness of a Nations Economic
  • Policies
  • - a nations currency tends to strengthen
    with sound economic policies.

22
EXPECTATIONS
  • IV. EXPECTATIONS AND CENTRAL BANK BEHAVIOR
  • - exchange rates also influenced
  • by expectations of central bank
    behavior.

23
EXPECTATIONS
  • A. Central Bank Reputations
  • B. Central Bank Independence
  • C. Currency Boards
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