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THE DETERMINATION OF EXCHANGE RATES

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chapter 2 the determination of exchange rates chapter 2 overview: part i. equilibrium exchange rates ii. role of central banks iii. – PowerPoint PPT presentation

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Title: THE DETERMINATION OF EXCHANGE RATES


1
CHAPTER 2
  • THE DETERMINATION OF EXCHANGE RATES

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

3
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.

4
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

5
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.

6
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.

7
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.

8
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.

9
Equilibrium Exchange Rates
  • 3. Calculating a Depreciation
  • Currency Depreciation
  • where e0 old currency value
  • e1 new currency value
  • Note Resulting sign is always negative

10
Equilibrium Exchange Rates
  • Currency Appreciation

11
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
12
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.

13
Equilibrium Exchange Rates
  • D. FACTORS AFFECTING EXCHANGE RATES
  • 1. Inflation rates
  • 2. Interest rates
  • 3. GNP growth rates

14
THE ROLE OF CENTRAL BANKS
  • I. FUNDAMENTALS OF CENTRAL BANK INTERVENTION
  • A. Role of Exchange Rates
  • LINKS BETWEEN
  • THE DOMESTIC AND THE
  • WORLD ECONOMY

15
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

16
THE ROLE OF CENTRAL BANKS
  • 2. Currency Depreciation
  • - domestic prices fall relative to
    foreign prices.
  • - Exports more competitive.
  • - Imports less attractive

17
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.

18
THE ROLE OF CENTRAL BANKS
  • 2. Goal of Intervention
  • - to alter the demand for one currency
    by changing the supply of another.

19
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

20
Part III. EXPECTATIONS
  • I. WHAT AFFECTS A CURRENCYS
    VALUE? A. Current events
  • B. Current supply
  • C. Demand flows
  • D. Expectation of future exchange rate

21
EXPECTATIONS
  • II. Role of Expectations
  • A. Currency financial asset
  • B. Exchange rate simple relation of two
    financial assets

22
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.

23
EXPECTATIONS
  • B. Soundness of a Nations Economic Policies
  • - a nations currency tends to strengthen
    with sound economic policies.

24
EXPECTATIONS
  • IV. EXPECTATIONS AND CENTRAL BANK BEHAVIOR
  • - exchange rates also influenced by
  • expectations of central bank behavior.

25
EXPECTATIONS
  • A. Central Bank Reputations
  • B. Central Bank Independence
  • C. Currency Boards
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