International Economics

By Robert J. Carbaugh
9th Edition

Chapter 13:
Exchange-Rate Determination

Copyright 2004, South-Western College Publishing

Exchange rates

Factors influencing exchange rates

Market fundamentals
Bilateral trade balances
Real income
Real interest rates
Inflation rates
Consumer preferences for domestic or foreign
products
Productivity changes affecting production costs
Profitability and riskiness of investments

Carbaugh, Chap. 13

Exchange rates

Factors influencing exchange rates

Market fundamentals (contd)
Product availability
Monetary policy and fiscal policy
Government trade policy

Market expectations
News about future market fundamentals
Speculative opinion about future exchange
rates
Carbaugh, Chap. 13

Exchange rates

When are these factors important?

Short run (days)
Dominated by financial transfers responding to:
Differences in real interest rates
Shifting expectations of future exchange rates

Medium run (months)

Primarily influenced by economic cycles

Carbaugh, Chap. 13

Exchange rates

When are these factors important?

Long run (years)
Dominated by movements of goods, services,
investment, which are influenced by:

Inflation rates
Investment profitability
Consumer tastes
Real income
Productivity
Trade policy

How these factors interact to affect exchange

rates depends on the relative importance of trade
and financial relations between the countries
Carbaugh, Chap. 13

Exchange rates

Exchange rate components

Carbaugh, Chap. 13

Factors influencing exchange rates

Real income differentials

A country with faster economic growth than
the rest of the world will have a depreciating
currency (other things being equal)
Imports rise faster than exports, so demand for
foreign currency rises faster than its supply

Real income changes can also reflect other

processes, which might lead to rising
exports
Carbaugh, Chap. 13

Factors influencing exchange rates

Impact of real income differentials

Carbaugh, Chap. 13

Factors influencing exchange rates

Real interest rates

Short term real interest rate differences
influence international capital movements
Real interest rate is nominal minus inflation

Low short term rates lead to less demand

for the currency and depreciation
High rates lead to greater demand for the
currency and appreciation
Carbaugh, Chap. 13

Factors influencing exchange rates

Impact of interest rate differentials

Carbaugh, Chap. 13

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Factors influencing exchange rates

Purchasing power parity

Law of one price: In theory, a good should cost the
same in all countries (aside from tariffs or
transportation costs)

As a result, exchange rates should end up making

prices equal across countries
By this theory, if two countries have different
inflation rates, exchange rates will move in the
opposite direction to keep prices the same
The theory may be more useful for predicting
long-term trends than short-run fluctuations
Carbaugh, Chap. 13

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Factors influencing exchange rates

Impact of inflation rate differentials

Carbaugh, Chap. 13

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Factors influencing exchange rates

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
Carbaugh, Chap. 13

13

Alternative approaches to exchange rates

Monetary approach
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
Exchange rates seen as returning domestic
money supply to equilibrium after a change
Carbaugh, Chap. 13

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Alternative approaches to exchange rates

Asset-markets approach
Investors (firms and individuals) balance
their portfolios among domestic money,
stocks and bonds and foreign stocks and
bonds
Short run exchange rate changes are
caused by shifts in the kind and location of
financial assets investors want to hold
Investors shift between assets based on
market expectations for expected returns
Carbaugh, Chap. 13

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Exchange rate markets

Short, long run equilibrium: overshooting

Carbaugh, Chap. 13

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Exchange rate markets

Forecasting exchange rates

Judgmental forecasts
Subjective forecasts based on economic,
political and other data for a country

Technical analysis
Uses historical exchange rate trends to project
short-run future movements

Fundamental analysis
Includes macroeconomic and policy information
in a predictive model
Carbaugh, Chap. 13

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Alternative approaches to exchange rates

Equilibrium in asset-markets approach

Carbaugh, Chap. 13

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Alternative approaches to exchange rates

Asset-markets approach: shift in demand

Carbaugh, Chap. 13

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Alternative approaches to exchange rates

Asset-markets approach: shift in supply

Carbaugh, Chap. 13

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