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Factors influencing exchange rates: Supply and Demand for a Currency

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Factors influencing exchange rates: Supply and Demand for a Currency Short run financial transactions Market fundamentals Current account balances – PowerPoint PPT presentation

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Title: Factors influencing exchange rates: Supply and Demand for a Currency


1
Factors influencing exchange ratesSupply and
Demand for a Currency
  • Short run financial transactions
  • Market fundamentals
  • Current account balances
  • Real interest rates
  • Market expectations
  • News about future market fundamentals
  • Speculative opinion about future exchange rates

2
Factors influencing exchange rates
  • Medium run
  • Real income business cycle
  • Monetary policy and fiscal policy
  • Product availability
  • Long run
  • Inflation rates
  • Consumer preferences for domestic or foreign
    products
  • Productivity changes affecting production costs
    and prices
  • Profitability and riskiness of investments
  • Government trade policy

3
Impact of interest rate differentials drop in US
interest rate ? depreciation
S1
Dollars per Yen
S0
B
.0080
.0075
A
D1
D0
4
Impact of real income differentials increase in
US income ? depreciation
S0
Dollars per Pound
B
1.60
1.50
A
D1
D0
5
Purchasing power parity (PPP)The Law of One
Price
  • A good should cost the same in all countries
    (aside from tariffs or transportation costs)
  • Exchange rates should make prices equal across
    countries
  • P ER x P
  • (/bourbon) (/) x ( /scotch) (/scotch)
  • If two countries have different inflation rates,
    exchange rates will move keep prices the same
  • The currency of the high inflation country will
    depreciate
  • (P/P) ? ? ER ? ? (/) ?

6
Impact of inflation rate differentialshigh US
inflation ? depreciation
S1
Dollars per Pound
S0
B
1.70
1.50
A
D1
D0
7
Market expectations
  • As with stock markets, foreign exchange markets
    react quickly to news or even rumors that point
    to future changes affecting rates
  • Future expectations can be self-fulfilling
    speculative bubbles can start without any real
    information but can become self sustaining for a
    while

8
Impact of expectationsexpectation of
depreciation? depreciation
S1
Dollars per Pound
S0
B
1.70
1.50
A
D1
D0
9
Monetary approach
Alternative approaches to exchange rates
  • Focus on exchange rates as the result of supply
    and demand for money at home and abroad
  • Demand depends on real income, prices, interest
    rates
  • Supply is controlled by central banks
  • Ms ? ? depreciates
  • Real income ? ? Md ? ? appreciates
  • Interest rate ? ? Md ? ? depreciates ??!?
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