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## CHAPTER 2 THE DETERMINATION OF EXCHANGE RATES

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### Equilibrium Exchange Rates. Consider a world with two currencies, i.e. the dollar and the euro. ... Equilibrium Exchange Rates. EXAMPLE: Euro Appreciation ... – PowerPoint PPT presentation

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Title: CHAPTER 2 THE DETERMINATION OF EXCHANGE RATES

1
CHAPTER 2 THE DETERMINATION OF EXCHANGE RATES
• CHAPTER 2 THE DETERMINATION OF EXCHANGE RATES

2
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

3
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.

4
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

5
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.

6
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

7
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.

8
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.

9
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.

10
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.

11
Appreciation/Depreciation?
• Define currency appreciation?
• Define currency depreciation?

12
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.

13
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

14
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

15
Equilibrium Exchange Rates
• US Depreciation would be
• We use the formula,
• (e0 - e1)/ e1
• substituting
• (.64 - .68)/ .68 - 5.88
• the US depreciation.

16
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!

17
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

18
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!

19
EXPECTATIONS
• B. Soundness of a Nations Economic
• Policies
• - a nations currency tends to strengthen
with sound economic policies.

20
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

21
EXPECTATIONS
• IV. EXPECTATIONS AND CENTRAL BANK BEHAVIOR
• - exchange rates also influenced
• by expectations of central bank
behavior.

22
EXPECTATIONS
• A. Central Bank Reputations
• B. Central Bank Independence
• C. Currency Boards

23
What is the role of a central bank?
• Monetary Policy
• Used to stabilize prices (inflation and
deflation)
• Interest rates
• Currency value interest rate parity

24
Some monetary policies
• Change of the reserve requirement
• Trading in the foreign exchange market I.e.
• Buying and selling treasury bonds
• Printing money

25
THE ROLE OF CENTRAL BANKS
• I. FUNDAMENTALS OF CENTRAL BANK INTERVENTION
• A. Role of Exchange Rates
• THE DOMESTIC AND THE
• WORLD ECONOMY

26
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

27
THE ROLE OF CENTRAL BANKS
• 2. Currency Depreciation
• - domestic prices fall relative
to foreign prices.
• - Exports more price competitive.
• Imports less attractive

28
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.

29
THE ROLE OF CENTRAL BANKS
• 2. Goal of Intervention
• - alter the demand for one
• currency by changing the supply of another.

30
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