CHAPTER 2 THE DETERMINATION OF EXCHANGE RATES

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CHAPTER 2THE DETERMINATION OF EXCHANGE RATES

• CHAPTER 2THE DETERMINATION OF EXCHANGE RATES

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Part I.What is an Exchange Rate?

• price at which suppliers/demanders of one
  currency are willing to exchange the currency for
  another from demanders/suppliers.
• the price of a unit of a currency in terms of
  another currency

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Part I. Equilibrium Exchange Rates

• Consider a world with two currencies, i.e. the
  dollar and the euro.
• If e0 is the /euro exchange rate, that means
  that demanders of the euro will pay e0 for each
  unit of the euro.

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Goals

• Dd. And Ss. Of foreign exchange
• Equilibrium Exchange rates
• Concepts Spot and forward rates
• - appreciation depreciation
• Expectations and currency values
• The role of central banks

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Part I. Equilibrium Exchange Rates

• I. SETTING THE EQUILIBRIUM
• A. Exchange Rates
• e0 is the market-clearing prices that
  equilibrates 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 Euros to US in order to buy.

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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.

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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 more valuable than the home
  currency.
• b. Conversely, then the foreign
• currencys value has appreciated
• against the home currency.

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Appreciation/Depreciation?

• Define currency appreciation?
• Define currency depreciation?

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Equilibrium Exchange Rates

• Calculating a Depreciation/Appreciation
• (e1 - e0)/ e0
• where e0 old currency value
• e1 new currency value
• suppose the Euro depreciates/ appreciates agains
  the dollar, given direct quotes you would use the
  above formula to find the amount of
  depreciation/appreciation in the Euro.

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Equilibrium Exchange Rates

• To find the currency appreciation /depreciation
  of the USD however we would use
• (e0 - e1)/ e1
• where e0 old currency value
• e1 new currency value

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Equilibrium Exchange Rates

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

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Equilibrium Exchange Rates

• US Depreciation would be
• We use the formula,
• (e0 - e1)/ e1
• substituting
• (.64 - .68)/ .68 - 5.88
• the US depreciation.

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Currency Quotes

• Direct Quote
• Amount of home currency per unit of foreign
  currency
• Indirect Quote
• Amount of foreign currency per unit of home
  currency
• Reciprocals Illustrate!

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Part II.Expectations and The Asset Market Model
of Exchange Rates

• 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
• It reflects the supply of and demand for foreign
  currency denominated assets.
• III. Asset Market Model The demand for money
  today depends on expectations of factors that can
  effect its future value. Currency values are
  forward looking!

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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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Other factors affecting equilibrium exchange
rates

• Differences in interest rates between nations
  Higher interest rates in one country attract
  foreign investments and hence cause domestic
  currencies to appreciate
• Positive Economic (GNP) growth also attracts
  financial capital and lead to similar effects
• Levels of political and economic risks

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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

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What is the role of a central bank?

• Monetary Policy
• Used to stabilize prices (inflation and
  deflation)
• Interest rates
• Currency value interest rate parity

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Some monetary policies

• Change of the reserve requirement
• Trading in the foreign exchange market I.e.
  buying and selling foreign currencies
• Buying and selling treasury bonds
• Printing money

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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. IMPACT OF EXCHANGE RATE CHANGES
• 1. 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 price 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
• - 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