Exchange rates

Exchange Rate Determination

Session 6A-09 Professor Augustine H H Tan MBA Global Economy 1

 Introduction
Š Forces underlying exchange-rate fluctuations
ƒ A system of market-determined (floating) exchange
rates

Session 6A-09 Professor Augustine H H Tan MBA Global Economy 2

 What Determines Exchange Rates?

Š Market fundamentals
Š Market expectations
ƒ Determinants are different for short run, medium
run, and long run cycles
à Framework in which exchange rates are
determined (Fig 12.1)
à Example of ‘‘Forex View’’ column (Table 12.1)Table
12.1

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Session 6A-09 Professor Augustine H H Tan MBA Global Economy 4
 Determining Long-Run Exchange Rates
Š Four key factors - Summary (Table 12.2)
ƒ Relative price levels: (Figure 12.2(a))
ƒ Relative productivity levels: (Figure 12.2(b))
ƒ Preferences for domestic or foreign goods: (Figure
12.2(c))
ƒ Trade barriers: (Figure 12.2(d))

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Inflation Rates, Purchasing Power Parity, Long-Run
Exchange Rates
Š Law of one price
ƒ An identical good should cost the same in all
nations, assuming costless shipping and no
barriers
à Theory: Pursuit of profits and price equalization
à Single price might not apply in practice
ƒ ‘‘Big Mac’’ index
à Primitive and has many flaws but widely
understood
à Serves as an approximation of currency
strength
• Price of a Big Mac (Table 12.3)

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Session 6A-09 Professor Augustine H H Tan MBA Global Economy 9
 Purchasing Power Parity
Š Purchasing power parity theory
ƒ Exchange rates are related to differences in the
level of prices between two countries
à Changes in relative national price levels
determine changes in exchange rates over the
long run
ƒ Given in symbols as:

ƒ Application of the concept (Table 12.4)

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 Purchasing Power Parity Continued

Š Limitations of the theory

ƒ Overlooks the fact that exchange-rate movements
may be influenced by investment flows
ƒ Choosing the appropriate price index
ƒ Determining the equilibrium period base
ƒ Government policy interference
Š Predictive power most evident in the long run
ƒ Purchasing power parity: U.S.-United Kingdom
(Figure 12.3)

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Session 6A-09 Professor Augustine H H Tan MBA Global Economy 13
 Determining Short-Run Exchange Rates: The Asset-Market
Approach
Š Key factors governing investment decisions
ƒ Relative levels of interest rates
ƒ Expected changes in the exchange rate, over the
term of the investment
à Effects of these factors (Table 12.5)

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Session 6A-09 Professor Augustine H H Tan MBA Global Economy 15
 Relative Levels of Interest Rates
Š Differences in the level of nominal interest rates affect
investment flows
ƒ Relative interest rates as a determinant of exchange rates
(Figure 12.4a)
ƒ Distinguishing between the nominal interest rate and the real
interest rate
Real Interest Rate = Nominal Interest Rate – Rate of Inflation
ƒ Short-term real interest rates (Table 12.6)
Real Interest Rate = Nominal Interest Rate - Inflation Rate

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 Expected Change in the
Exchange Rate
Š To determine the actual earnings from an investment
in another currency
ƒ High interest rate may not be attractive enough if
denominating currency is expected to depreciate
ƒ If the denominating currency is expected to
appreciate, the realized gain would be greater
à Effects of investor expectations of changes in
exchange rates (Figure 12.4(b))

Session 6A-09 Professor Augustine H H Tan MBA Global Economy 19

 Diversification, Safe Havens, and Investment Flows
Š Diversification across asset types
ƒ Including the currencies in which they are
denominated
Š Safe-haven effect
ƒ Sacrificing returns for lower risk

Session 6A-09 Professor Augustine H H Tan MBA Global Economy 20

 The Ups and Downs of the Dollar: 1980 to 2005
Š The 1980s
ƒ Path of appreciation and then depreciation
ƒ Peaked in 1985; 50% above 1979 levels
ƒ Depreciation in latter half of 1980s
à Fluctuations significantly caused by policy
changes
Š The 1990s
ƒ Economic weakness; recession in 1991
ƒ Rapid growth in the mid-1990s
à Appreciation: 1995-2001

Session 6A-09 Professor Augustine H H Tan MBA Global Economy 21

 The Ups and Downs of the Dollar: 1980 to Continued
2005
Š The 2000s
ƒ A rising dollar and the large flow of investment into
the U.S. that pushes the currency higher could not
be sustained
ƒ Depreciation in 2002–2004
à Weakening of the demand for dollar-
denominated assets on the part of foreign
investors
ƒ Reversal by 2005
à Strong economic performance

Session 6A-09 Professor Augustine H H Tan MBA Global Economy 22

 Exchange-Rate Overshooting
Š Short-run response to a change in market
fundamentals greater than long-run response
ƒ Helps explain sharp movements
ƒ Tendency of elasticities to be smaller in the short
run than in the long run (Figure 12.5)
ƒ Exchange rates tend to be more flexible than many
other prices

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Session 6A-09 Professor Augustine H H Tan MBA Global Economy 24
 Forecasting Foreign-Exchange Rates
Š Most forecasting methods use:
ƒ Accepted economic relationships to formulate a
model that is then refined through statistical
analysis of past data
ƒ Exchange-rate forecasting organizations and their
methodologies (Table 12.7)

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Session 6A-09 Professor Augustine H H Tan MBA Global Economy 26
 Forecasting Foreign-Exchange Rates Continued
Š Judgmental forecasts
ƒ Subjective or common sense models
ƒ Projections based on a thorough examination of
individual nations
à Use of economic indicators; political factors;
technical factors; and psychological factors
Š Technical forecasts
ƒ Involves the use of historical exchange-rate data to
estimate future values (Figure 12.6)
ƒ Useful in explaining short-term movements

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 Forecasting Foreign-Exchange Rates Continued
Š Fundamental analysis
ƒ Involves consideration of economic variables that
are likely to affect a currency’s value
ƒ Uses computer-based econometric models
ƒ Best suited for forecasting long-run trends

Session 6A-09 Professor Augustine H H Tan MBA Global Economy 29

 Forecast Performance of Advisory Services
Š Better information about future exchange rates than is
available to the market
Š Evaluating the performance of forecasters
ƒ Predict spot rates better than what is implied by the
forward rate

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Factors influencing exchange rates

Real income differentials

Š A country with faster economic growth than the rest
of the world will have a depreciating currency (other
things being equal)
ƒ Imports rise faster than exports, so demand for
foreign currency rises faster than its supply
Š Real income changes can also reflect other
processes, which might lead to rising exports

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Factors influencing exchange rates

Impact of real income differentials

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 Real Income Rise Due to Productivity
Increase, FDI Increase

S
$/£

S*

Millions of £
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Exchange rate markets

Asset-Markets Approach to Exchange-Rate

Determination
Š Residents hold a spectrum of financial assets:
domestic currency, foreign currency,
domestic/foreign securities
Š Continuing Flow component
Š Stock adjustment component emphasized
ƒ Key determinant of short-run movements in
exchange rates
Š Asset allocation between home and foreign depends
on:
ƒ interest rate on domestic securities
ƒ Interest rate on foreign securities
ƒ expected change in exchange rate.

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Alternative approaches to exchange rates

Equilibrium in asset-markets approach

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Alternative approaches to exchange rates

Asset-markets approach: shift in demand

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Alternative approaches to exchange rates

Asset-markets approach: shift in supply

Session 6A-09 Professor Augustine H H Tan MBA Global Economy 37