THE DETERMINATION OF EXCHANGE RATES

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CHAPTER 2

• THE DETERMINATION OF EXCHANGE RATES

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CHAPTER 2 OVERVIEW

• PART
• I. EQUILIBRIUM EXCHANGE RATES
• II. ROLE OF CENTRAL BANKS
• III. EXPECTATIONS AND THE ASSET MARKET MODEL

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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.

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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

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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.

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Equilibrium Exchange Rates

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

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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.

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Equilibrium Exchange Rates

• 2. Home Currency Depreciation a. Foreign
  currency becomes more valuable than the
  home currency.
• b. Conversely, the foreign
• currencys value has appreciated
  against the home currency.

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Equilibrium Exchange Rates

• 3. Calculating a Depreciation
• Currency Depreciation
• where e0 old currency value
• e1 new currency value
• Note Resulting sign is always negative

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Equilibrium Exchange Rates

• Currency Appreciation

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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
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Equilibrium Exchange Rates

• EXAMPLE US Depreciation
• We use the first formula,
• (e0 - e1)/ e1
• substituting
• (.64 - .68)/ .68 - 5.88
• which was the US depreciation.

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Equilibrium Exchange Rates

• D. FACTORS AFFECTING EXCHANGE RATES
• 1. Inflation rates
• 2. Interest rates
• 3. GNP growth rates

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THE ROLE OF CENTRAL BANKS

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

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THE ROLE OF CENTRAL BANKS

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

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THE ROLE OF CENTRAL BANKS

• 2. Currency Depreciation
• - domestic prices fall relative to
  foreign prices.
• - Exports more competitive.
• - Imports less attractive

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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.

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THE ROLE OF CENTRAL BANKS

• 2. Goal of Intervention
• - to alter the demand for one currency
  by changing the supply of another.

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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

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Part III. EXPECTATIONS

• I. WHAT AFFECTS A CURRENCYS
  VALUE? A. Current events
• B. Current supply
• C. Demand flows
• D. Expectation of future exchange rate

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EXPECTATIONS

• II. Role of Expectations
• A. Currency financial asset
• B. Exchange rate simple relation of two
  financial assets

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EXPECTATIONS

• III. Demand for Money and Currency Values
  Asset Market Model
• A. Exchange rates reflect the supply of and
  demand for foreign-currency
• denominated assets.

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EXPECTATIONS

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

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EXPECTATIONS

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

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EXPECTATIONS

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